U.S. Treasury bonds are generally considered low risk investments. They are usually lumped into this category because the chance that the U.S. government will default on its obligation is slight. What many investors fail to consider is that there are many ways in which one can invest in Treasury bonds and they all have varying risk levels.

The risk level is low if an investor is actually purchasing the Treasury bonds themselves and holding them until maturity. For example, consider an investor who purchases a $100,000 10-year Treasury bond paying a 2% yield. If he holds the bond until maturity (10 years) he will receive his original $100,000 back at the end of the period. Along the way he will have received $2,000 per year in yield payments.

But many investors do not want to tie up their investment capital for the periods required by long-term Treasury investments. So instead of buying the actual bonds, they opt for investment vehicles such as mutual funds or exchange-traded funds (ETFs) that invest in long-term Treasury bonds. Sometimes they falsely believe that these other investment vehicles offer the same low risk level as the actual bonds.

In reality, bond mutual funds or ETFs can be quite volatile and offer no real protection against downside risk.

To understand this, take a look at the chart below. The black line reflects the daily price movements of TLT, an ETF that invests in long-term U.S. Treasury bonds. The gold line is the S&P 500, included for comparative purposes.

Over the two years covered by the chart, it is easy to see that the price of TLT has fluctuated dramatically. An investor who purchased at the peak in December 2008 would have seen the value of his investment decline by more than 30% just six months later. That hardly qualifies as a low risk investment.

The blue arrows on the chart point to price gaps. That means the fund opened higher or lower than the prior day’s close. Gaps are usually indicative of an investment that is volatile.

Investors also mistakenly believe that bonds always move inversely to stocks and as a result can be used to hedge against market declines. The red arrows on the chart reflect periods where both TLT and the S&P 500 were falling at the same time.

The volatility of bonds results when investors elect to sell them before maturity. At that point, the price of the bond is determined by what someone is willing to pay. Consider another example. Let’s imagine that an investor pays $100,000 for a 20-year Treasury bond yielding 3%. After five years, the investor chooses to sell his bond. The person buying the bond might not be willing to pay the full $100,000. So he might try to buy it at a discount.

If the bondholder sells his bond for $90,000, it appears as though he lost $10,000. But remember that he received a yield of 3% ($3,000) for each of the five years he held the bond. So he actually gained $5,000 on his five-year investment.

On the other hand, the person who purchased the bond for $90,000 is now going to be receiving the $3,000 per year yield payment. But since he only paid $90,000 he is receiving a 3.3% annual return. In addition, if he holds the bond until maturity, he will receive $100,000. So his original $90,000 investment will return $3,000 a year for 15 years ($45,000) plus an additional $10,000 (the difference between the $90,000 he paid and the $100,000 he received at maturity). That means his overall return will be nearly 4.1% on an annualized basis instead of the original 3% yield.

Obviously this is a simplified example that does not take into consideration tax implications or capital gains or losses.

When hundreds or thousands of such transactions are bundled together inside a mutual fund or some other investment, it becomes easier to see why investing in bonds is not as simple as it seems. Include the fact that many bond traders are speculating on the price based on what they guess interest rates might be 10 or 15 years in the future. Then one can begin to understand why secondary bond instruments can become quite volatile.

Keep in mind that this discussion focused only on long-term U.S. Treasury bonds. There are many other types of bonds such as high quality corporate bonds, zero coupon bonds, high yield bonds, international bonds, and many more. And virtually all of these bonds have derivatives and secondary markets.

So don’t make the mistake of thinking that just because you have invested some of your assets in a bond position the risk of loss is low or a positive return is assured.

F.S.

Wednesday President Obama gave his first State of the Union address. This weekly market outlook focuses on finance, not politics. Certainly there are links between the two. But as an investment advisor and as investors, we need to focus on the things we can control and politics is not one of them.

But the concept of looking back to see where we have come from and to try to assess where we might be going can be helpful in giving us perspective on the present.

A year ago stocks were near the end of a precipitous fall. Of course at the time no one knew that the end of the decline was near. From early March until the middle of June, stocks staged a sharp ascent. The uptrend that was established is still intact, but the past few sessions have provided the most serious pullback since summer 2009.

Below is a chart that shows the NYSE composite—in other words, all of the stocks that trade on the New York Stock Exchange. The gold line is a simple 50-day moving average (MA) of the daily price of this index. The 50-day MA is a fairly good indicator of whether an investment is breaking down or starting to rally.

In this instance, we see that the NYSE broke below its MA a few trading sessions ago. But so far this downturn looks very similar to the downturns in July and October 2009 when it also broke below its 50-day MA. In both those prior instances, stocks quickly regrouped and the NYSE needed only a handful of trading days before climbing back above its MA.

Of course we do not know what will happen this time, but a couple of other indicators can give us a clue. The very bottom portion of the chart is a stochastic oscillator. This indicator helps identify extremes in momentum. Right now, it is showing that the NYSE is oversold and due for a rebound. In fact, it turned back upward after Wednesday’s trading.

The portion of the chart directly above the stochastic oscillator is a moving average convergence divergence indicator (MACD). It is a good tool for showing changes in investment momentum. Once again, the last two times this indicator was at its present level were July and October 2009. Unlike the stochastic oscillator, this indicator has not yet turned positive. But it appears to be converging and could reverse with one or two more positive trading sessions.

The remaining chart section is a relative strength index (RSI). This indicator dropped below the 50 level, reflecting a weakening stock market. It has leveled off the past couple of days, but still has not turned upward.

Unfortunately, the combination of these indicators and others is providing a mixed signal. The investment markets could be on the verge of the most serious correction in almost a year. Or the markets could be consolidating before beginning the next upward move in a rally that has endured since March 2009.

At this juncture, wisdom would seem to suggest that for all but the most aggressive investors, risk outweighs the potential for reward. Another week or two should provide a clearer picture of which direction the markets will choose. In the meantime, the best strategy is to be cautious and patient.
F.S.

On January 12, Haiti was devastated by a powerful earthquake.  Eight days later on January 20, the country was dealt another blow by an aftershock that registered 5.9. Additional destruction occurred and more people were injured. According to news accounts, the temblor was the largest of more than 50 significant aftershocks so far. One expert was quoted as saying that aftershocks can die out quickly or they can continue for weeks and months.

A year ago, the U.S. financial markets were suffering from a massive economic disaster—described frequently as the worst since the Great Depression of the 1930s. The recovery from that market meltdown began in March 2009. For several months afterward many investors and advisors—us included—were worried about another serious aftershock. Luckily so far there has not been a renewed downturn and major indices have staged an impressive rally. That does not mean all the danger is past. The market downturn January 20-22 could be compared to an aftershock from an earthquake.

In fact, during much of 2009 our technical indicators were showing that high levels of market risk remained, even though a rally was underway.

The chart below is a good example. I have previously written about the VIX, an investment instrument called the Volatility Index and also nicknamed the Fear Index. VIX is a measure of market volatility. The value of VIX rises when market volatility increases. Some investors and advisors use VIX as a hedge to protect other investments against downturns.

The chart covers the previous five years. I added a blue line to the chart to identify a level that historically coincides with high levels of market risk. You can see that the VIX began to trend above that level in the latter stages of 2007—about the same time that major market indices began the most recent bear market.

It has only been in the past month or so that VIX has again fallen below the high-risk level. But that might not last, because this week has seen an increase in market volatility.

For months we have warned that although the market was rising, many of our indicators showed that risk remained above acceptable levels. Today that is still largely true. Although we have dabbled in a few small positions, most of our assets remain in cash. The past few trading sessions lend justification to such a position.

Thursday saw the Dow drop by more than 200 points. Many investors and traders remain worried about unemployment, the prospect of rising inflation and interest rates, ongoing weakness in the realty market, etc.

In recent weeks I’ve heard from a number of acquaintances who are bragging about how much money they made in the stock market in recent weeks. Usually I hear those kinds of comments near market tops. While that is certainly not a supportable indicator for what the stock market is likely to do next, there are many other technical indicators like the VIX warning that investors still need to exercise caution. Additional aftershocks in the financial markets remain a strong possibility.
F.S.

Ever since stocks began advancing again in March 2009, one of the strongest sectors has been technology. With the rally moving into its 10th month, that situation remains the same. So as we begin to ease back into the markets, it only makes sense that we should consider the technology arena.

This week in Strategis Financial Group’s Foundation Strategy, we took a small position in Fidelity Select Software & Computers (FSCSX). The chart below shows performance of this fund over the past year. (This is not a recommendation to buy. Whether or not you should consider this fund for your portfolio depends on you specific investment objectives and risk tolerance.)

We chose this position because of its solid track record and because it is less volatile than many other technology fund alternatives.

The gold line on the chart is a 50-day simple moving average (MA) of the fund price. Notice that the fund moved above its MA in March and has trended above that line ever since. The 50-day MA is a simple and good indicator to identify funds that are in a strong upward trend. A fund that is trending above its 50-day MA can be considered for purchase.

The middle portion of the chart is a relative strength index (RSI). This is another simple indicator of a fund’s momentum and strength. A fund that is trending above 50 RSI has strength and momentum to continue advancing.

Finally, the bottom portion of the chart is a stochastic oscillator. This tool is used to help identify overbought or oversold fund conditions. In other words, a stochastic oscillator can help determine an investment’s turning points. When the oscillator gets above 80, there is a high likelihood that the fund will soon turn down. Conversely, when the oscillator drops below 20, a fund is likely to turn upward.

As you can see on the chart above, these indicators are all showing that the next likely move for this fund is up and it in fact gained almost 1% on Wednesday.

Major indices like the Dow, the S&P 500 and the Nasdaq have advanced in recent sessions, but those moves appear labored and at risk of a break down. By careful selection of positions in the stronger market sectors, we attempt to mitigate some of the overall market risk while still participating in the advance.

Another industry sector that has shown good strength is health care. We also recently took a small position in health care in the Foundation Strategy.

We remain cautious about the overall market at this time; however, as the advance continues, it makes sense to carefully select positions that allow us to participate.

Obviously this week’s financial news has been overshadowed by the devastating earthquake in Haiti. My son is currently in the Dominican Republic—away from the danger zone but still close enough to spark some parental concerns.

These kinds of events help all of us realize that while we worry about things like our pensions and investment accounts, all that we plan for and care about can be wiped out in an instant. We are truly blessed and fortunate to live in this great country. Please keep those less fortunate in your thoughts and prayers at this time.
F.S.

Since the beginning of November, major market indices have been trading in a narrow, sideways channel. Over the past week or so, there have been indications that stocks are breaking out of the pattern and advancing.

Below is a chart that shows price movement of the Dow (DJIA), the Nasdaq, the S&P 500 and the New York Stock Exchange composite (NYSE) over the past three months. You can see that with the exception of the Nasdaq, these indices didn’t really break out to new yearly highs until the end of December. However, the past few trading sessions they have been unable to add to the advances and appear to be trading in a sideways pattern again.

Until stocks can sustain an upward break out, the situation for conservative investors is quite risky. This has already been a fairly prolonged sideways trading range and we should not have to wait too much longer to see which way the market will go when a new trend develops.

One expert says government is manipulating stock prices

In the early 1990s, a former money manager for Strategis Financial Group frequently alleged that the stock market was manipulated by the government. The group responsible was nicknamed the Plunge Protection Team (PPT). The PPT was supposedly put in place by Ronald Reagan after the 1987 stock crash to prevent future meltdowns.

Although there has never been any acknowledgement that the PPT exists, the rumor persists. The possibility of a PPT was raised again this week by a credible source. In a special report, Charles Biderman, chief executive of TrimTabs Investment Research, reported that secret government moves might be partially responsible for driving up stock prices in 2009.

TrimTabs is a research firm that has tracked liquidity flows into the markets since 1995. According to the company’s web site, “TrimTabs Investment Research is the leading independent institutional research firm focused on equity market liquidity. Our key premise is that stock prices are a function of liquidity rather than value. Like the prices of any tradable good, the prices of stocks are driven by supply and demand.”

In a statement Tuesday, Biderman said TrimTabs has been unable to identify the source of the new money that caused stock prices to rally so quickly in 2009. His report said a significant portion of the $6 trillion increase in U.S. stock-market capitalization since March cannot be explained by traditional sources of money flowing into the market such as mutual funds, direct retail investment, pension funds, hedge funds or foreign purchases.

He contends that the logical explanation for the unexplained inflows is secret buying by the government. He also acknowledged that he has no hard evidence of any government purchases.

Many might be skeptical that a secret government plan to buoy stock prices could exist for 30 years without any solid proof. On the other hand, there are plenty of examples of conspiratorial secrets that remain undiscovered for lengthy periods. The Madoff scandal is a familiar recent example.

Obviously there are many well known instances of government intervention in the financial sector. The government has long been the dominant force in fixed income securities—buying and selling Treasury bonds, notes, and mortgage-backed instruments. In the past year it has provided hundreds of billions to assist the banking, insurance and auto industries. So there is certainly precedent for the government protecting its own financial interests.

If the government were bolstering the stock market by buying stocks to prevent a crash there is good reason to keep it quiet. Knowing that the government was ready to step in to prevent a collapse would remove some of the potential risk involved with equity investing. Any time stocks dropped, people would clamor for the government to infuse money. People who should probably not invest in stocks because of the risk might go ahead because of a false sense of security knowing that the government was there to provide a foundation.

Without any hard evidence, discussion about the PPT is purely speculation. But when the head of a company dedicated to tracking market inflows says he cannot account for $600 billion worth of investment infusion, it is worthy of note.
F.S.