QUOTE OF THE WEEK
“We can never obtain peace in the outer world until we make peace with ourselves.”
- Dalai Lama
TECH CORNER
Since my last letter investing circumstances have changed. It is important to understand that we make decisions based on the data. If the data changes we will adjust your investment portfolio accordingly.
Over the last few weeks, we have had a change of an increase in the rate of inflation plus the Fed has become more aggressive in their intent to raise interest rates and/or to keep them higher for longer. Both of these trends will be bad for the stock market. The data is showing that the stock market is now in a downward trend and fortunately we haven’t had any exposure to the stock market. Even though the business press says the stock market is doing well, the return for the S&P 500 was down during the last quarter (3rd quarter) and has been recently down substantially. We are very negative on the stock market at this time.
Concerning our positions, we have sold our investments in long duration Treasuries and have moved the proceeds to a US Government money market paying around 5.25% We still own 1 – 3 year Treasuries also paying the same as the money market. The markets are in such a state of uncertainty that we want to be on the sidelines and wait for some direction in the markets.
We are still convinced that a recession is still around the corner so we definitely don’t want to touch the stock market. The correct trade going forward will be long duration Treasury Bonds but not quite yet. If you look at history of the last three recessions long duration Treasuries have done really well. Remember when interest rates fall bond prices go up. Long duration interest rates fall during recessions.
We are waiting for two things to give us the green light to take a position in long duration Treasuries. The first is the start of a decline in real interest rates which is self-explanatory. The second signal is an increase in credit spreads. Credit spreads always increase before the start and during a recession. By the way, credit spreads have just started to increase.
The definition of Credit Spread is “The difference between the yield (return) of two different debt instruments with the same maturity but different credit ratings”. In other words, the spread is the difference in returns due different credit qualities.
For example, if a 5-year Treasury note is trading at a yield of 3% and a 5-year corporate bond is trading at a yield of 5%, the credit spread is 2% (5%-3%)
The spread is used to reflect the additional yield required by an investor for taking on additional credit risk. Credit spreads commonly use the difference in yield between a same maturity Treasury bond and a corporate bond. As Treasury bonds are considered risk-free due to their being backed by the U.S. Government, the spread can be used to determining the riskiness of a corporate bond. The higher the spread, the riskier the corporate bond.
So how does the increase in credit spreads help us predict harder economic times to come? If the economy is headed down, the potential of a corporation to pay the interest and the return of principal, is lower. Especially if the company has a poor financial situation and could be in trouble if we have a recession. So, the investor or a bank loaning money to a corporation will require a higher interest rate to offset the increased risk.
This situation is a self-fulfilling issue. As the economy slows, the risk of a company not being able to service the debt goes up so the rise in the interest rate they have to pay is a negative hit to its income. If the net income goes down after having to pay higher interest rates, the company may have to declare bankruptcy or cut back on expenses including employees. The cut in expenses or the laid off employees further drags the economy down. So, what we have is a cycle where companies don’t buy as much, the laid off employees don’t spend as much so other companies don’t earn as much and the downtrend feeds on itself.
So, in summary, an increase in credit spreads is a precursor to a slower economy and a possible recession. During every recession, credit spreads spike up as the risk of companies servicing their debt increases.
