Trade War of Words

Trade war of words.  You were warned that picking market direction is a difficult, if not a foolish, endeavor.  The more obvious something seems, the less likely it is to play out in the markets.  Yesterday was one of those “learning” days for home-gamer traders.  Recall the late session trade bluster on Monday sent the markets into a tail spin.  Recall also, that Trump in fact, did actually announce increased tariffs on Monday night.  Yesterday, China made good on its promise to retaliate with tariff’s of its own.  This escalation in trade tensions would be sure to push markets down right?  Wrong!  Markets rallied yesterday in the face of the latest salvo in the trade war reminding us that investors are best off holding diversified portfolios with a long-term perspective and leaving the trading up to well… traders.  As markets were rallying, many were scrambling to come up with a narrative on why markets traded up and this is some of what shook out:  traders who were already long said:  “I knew that the market would go up, something in my gut told me stay long and I was on vacation anyway so why mess with positions”.  Money managers who can only be long said: “It’s all about the strong economy, stupid.  Corporate profits are great.  Things are great and will continue to be great (fingers crossed)”.  The President’s men said: “It’s all about policy stupid, Trump made the market go up, obviously”.  People at home said: “That’s weird, but thank the Lord the market is still going up, my retirement account needs to keep growing.”  The smartest people I know said: “Predicting the direction of the market is a sucker’s bet, but perhaps speculative traders viewed Trump’s actual tariffs as being less than what was expected (remember that many were expecting a 25% tariff and the Administration announced that only 10% would be switched on now and another 15% in December <after elections>).”  OK, OK so many opinions make up a market, but what did happen was that stocks rallied and bonds sank.  Specifically, the S&P 500 is back above 2900, the Dow closed above a key resistance line, the Russell 2000 had a positive consolidation session, and the NASDAQ 100 had a positive session, though it was unable to close above 7500.  All indices remain constructive.  Bonds traded off pushing 10 year yields solidly into 3% territory to around 3.04%.  With no significant resistance above, bonds are eyeing their recent highs of 3.12% and, like clockwork, bond pundits started to call these yields attractive compared to stocks.  Some may be wondering if the bond folks are correct, but what many may really be wondering is: what is yield to maturity?  Because it is geek-out Wednesday, that question will be answered right here.

 

Let’s start with the most basic way of thinking about bonds.  Bonds are fixed income instruments implying that they make fixed payments to an investor until they mature at which time the investor also gets back the invested principal (usually $1000).  The fixed payment is called the coupon.  A bit of history… back in the day (I am sad to say I was there) bonds actually had coupons attached to the physical note and investors would clip off the coupon and send it in to be redeemed.  So if an investor paid par (100) for a bond maturing in 10 years that had a 4% coupon, they would receive $40 every year for ten years until maturity and on that year they would also get back the $1000 they invested.  In this basic example one can say that the bond yields 4%, which is how most people think about them.  In reality, bonds trade in an over-the-counter market and their price in the secondary market changes based on supply / demand, the health of the issuer, and current interest rates (in this discussion I will not address issuer health and ratings etc). Oh, boy here is where it gets slightly complicated but I will try to simplify with another example.  Let’s say that investor 1 buys a 10 year maturity 4% coupon bond for $1000 in year 1.  The investor buys the bond because 4% is a fair return for the risk at the time of the investment.  Let’s say that 2 years later the first investor wants to sell her bond in order to use her money to go on vacation.  In the two years since the investor bough the bond, the Federal Reserve tightened interest rates, meaning that they pushed general interest rates up (I know this is overly simplified, but stay with me), so now a fair return for that same investment might be 6%.  The investor needs to sell the bond in the secondary market to a new investor.  The new investor would not possibly invest in a bond that is paying a coupon of only 4% when bonds of that same maturity are paying 6%.  However, if the new buyer were able to buy the bond at a discount, it would make up for the lower coupon.  In other words, the new investor can buy the bond for $875 at a discount and will at maturity receive the full $1000 face value back adding to the coupon of 4%.  So the total yield would be higher than the 4% coupon and vice versa, if the new investor paid a premium (more than $1000), the yield to maturity would be lower than the coupon.  So the yield to maturity takes into account the coupon, time to maturity, and the price actually paid for the bond.  So far that seems pretty straight forward right?  Yield to maturity is an accurate way to determine the actual return of a bond and it is therefore important for a prospective investor to know a yield to maturity in order to compare it to other bonds of varying risk or even to dividend paying stocks.  OK, I have been nice so far but I feel obliged, because it is Wednesday, to share the actual formula for calculating the yield to maturity.  It goes like this:

 

c(1 + r)^ -1 + c(1 + r)^ -2 + … + c(1 + r)^ -n + PAR(1 + r)^ -n = PP

 

where:

 

c = coupon payment

r = yield to maturity

n = years to maturity

PAR = par value (usually 100)

PP = purchase price

 

Business school grads, MBA’s, and CFA’s will recognize this as a net present value (NPV) equation and the yield to maturity is the internal rate of return (IRR).  If you feel inclined (you like pain), you may simply plug in all of the numbers and solve for r in order to get the yield to maturity.  You can also call me, of course.  But if you are too busy to call, you can use one of the many free ones available on the internet, I suggest this one from Investopedia: https://www.investopedia.com/calculator/aoytm.aspx.  OK now that we know what yield to maturity AKA: bond yield is, you can more accurately respond to this statement: 2 year yields for no risk (to be discussed on another Wednesday) treasuries are at 2.79%, 10 year yields are 3.05%, and the risky S&P 500 will only yield you 1.8%.  Folks looking for fixed returns should consider this carefully!

 

Earlier this morning, we received housing numbers, which were mixed but did represent a greater than expected monthly increase in housing starts (+9.2% vs expected +5.7%).  The strong numbers can be interpreted as contributing to inflation which may weigh on stocks, but they are minor numbers in the midst of many other issues to be chewed on in today’s session.  Today, which can be a lower volume day due to a holiday, will find traders wondering what Judge Kavanaugh has to do with markets, Elon Musk’s trouble with the DOJ, the ongoing trade war of words, and finally that 10 year bond yields look attractive over 3% when they are compared to stocks.

daily chartbook 2018-09-19

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