10-Year Treasury Yield at Highest Since 2014

10-Year Treasury Yield at Highest Since 2014

Dear Investors,

There have been numerous storylines from global political turmoil, problems with advertising firms such as Facebook, and now concerns about chipmakers and hardware sales.  Rising oil and commodity prices will likely result in increased inflation expectations if they hold.  Continued global growth, points towards the potential for higher interest rates.  Today the 10-year Treasury yield closed at 2.958, which is the highest level since 2014.  A break above 3% could have psychological ramifications for various markets.

“Today the 10-year Treasury yield closed at 2.958, which is the highest level since 2014.”

Higher interest rates are one of the most significant things that can happen to financial markets.  Higher rates increase the cost of a mortgage, which can have a very negative impact on the massive housing market, and its correlated industries.  They also cause fixed income securities to drop in value.  Most bond funds are down quite a bit on the year, which is meaningful because they had such low yields to begin with.  Higher interest rates increase competition for equities in that income-oriented investors may elect to transfer funds from equities into fixed income, once a certain fixed income target yield is reached.

At T&T Capital Management, we have been prepared for if interest rates go higher.  Many of our largest positions would benefit greatly from higher rates.  Companies such as AGO, AIG, VOYA, and Brighthouse Financial would see materially higher investment income from higher rates.  In many ways, it would also help new business volumes, particularly for AGO.  Banks tend to benefit from higher rates through increased net interest margins, but we do not believe that most banks offer the significant margin of safety that we typically require to invest in at current levels.  We have steered away from the expensive areas of the market that have been hit by disruptions such as potential trade protectionism, or just decreased growth expectations.

“At T&T Capital Management, we have been prepared for if interest rates go higher.”

Our strategy over the last 16 months has been fairly conservative.  Many of our positions are cash-secured puts, where we target double-digit income yields and are taking less risk than the overall market.  It hurt us a bit last year when markets did nothing but go up, but it has us nicely positive YTD despite the market being down.  Our advantage should become more pronounced as time goes by and our options get closer to expiration.  In a flat or bear market, I would expect us to do far better than the overall market, assuming our stock selection is just average, and I’d hope that it is far better than average.  Our largest positions are in special situation stocks such as AGO and ALLY, where the future is far more dependent on specific issues, as opposed to relying on a buoyant stock market. These investments are priced for a near-worst case scenario already, so we are confident that they should propel our portfolios’ materially higher as time goes by and we see resolution on key matters.

“Our advantage should become more pronounced as time goes by and our options get closer to expiration.”

In the past, when stocks were far cheaper, our strategy was far more aggressive than it is currently.  Because the market itself is likely overvalued in our estimation, our aggressiveness is limited to our concentrated investments where we feel the odds are stacked in our favor in a major way.  Our job is to protect you and to play the odds.  When valuations are as high as they are now, the odds of the market generating high returns over the next 3-5 years are extremely low.  Anything can happen in an individual year such as 2017, but we have to worry about what can potentially happen, not just what happens in hindsight, which is always 20/20.  Specific stocks can do phenomenally well, and value investing had some of its best years relative to the market while markets were crashing during the bursting of the tech bubble.  This is relevant today, because most market participants are investing in 100% long and value agnostic vehicles such as ETFs and index funds.  Their confidence in the strategy is largely based on recency bias, being that we are now in year-9 of a bull market.  In addition, there is the knowledge that equities have done very well over the long-term.

“Our job is to protect you and to play the odds.”

What is less discussed is that there have been several multi-decade periods where stocks as a whole were negative.  The very roots of value investing were planted as a result of the miserable experience most market participants had during the Great Depression.  Most people investing in index funds and ETFs, have little to no understanding of just how much risk they are taking by buying them at all-time high valuations.  Like tech stocks in the late 1990s and housing in the mid-2000s, the strategy works until it doesn’t, and then the pain is severe.  I firmly believe that we are very well prepared for whatever events take place over the next 3-5-year period.  This is proven by the fact that I invest 100% of my own money and my family’s money the same way that I do for clients.

“I firmly believe that we are very well prepared for whatever events take place over the next 3-5-year period.  This is proven by the fact that I invest 100% of my own money and my family’s money the same way that I do for clients.”

I see a path for double-digit long-term returns using our strategy.  My expectation for the Dow and the S&P 500 is that they will average less than 5% per annum over the next 5 years, and I would not be surprised if returns were negative.  To achieve these potential returns and beat the market, we have to continue to think differently than the masses.  There is no safety in numbers when investing.  Generally, the crowded trade proves to be wrong once a good idea becomes consensus, and I think this will be seen as the case when we look back several years from now.

I have no idea if rates will break higher or go back to their recent trading range, but we are prepared for whatever happens.  Every security we own is thoroughly researched and analyzed based on stressed economic assumptions.  We don’t buy securities that are priced for perfection and where any slip up can result in permanent losses of capital.  We’ll be sure to keep you posted all along the way but I’m optimistic about the way things are shaping up and our potential for considerable growth moving forward.

As always if we can help you with anything at all, please don’t hesitate to call me directly at 805-886-8140!

 

Sincerely,

Tim Travis

 

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