Don’t be BONDed by Rising Interest Rates

handcuffsIn the Whale’s market commentary, “Great Rotation” to Nowhere, we concluded that both bonds and stocks are overvalued and that it may make sense to hedge your portfolio by a) using puts and b) minimizing your position in bonds and in high dividend paying stocks that react in a manner similar to bonds.

Since then, markets have been volatile with the 10-year Treasury ranging between 1.17-1.27% and the S&P 500 whipsawing from 1636 to 1610, and then back to 1636 where it ended today. We expect that volatility like this will continue, and that the market will drag sideways as Quantitative Easing (QE) speculation continues.

We continue to believe that interest rates will rise going forward, hurting bonds and high dividend paying stocks. This is because the direction of the market going forward will likely be determined by three factors:

  1. Federal Reserve comments on the timing of tapering QE,
  2. economic indicators, and
  3. companies’ Q2 top line growth.

Although it is very difficult to determine, we expect that the Federal Reserve could taper asset purchases as early as September, but likely no later than the beginning of 2014. We anticipate one of these scenarios:

Scenario 1: The Perfect Storm

  • Tapering occurs in September, bringing down the value of equities and bonds in the short-term, as interest rates rise
  • Economic indicators are weak and we see a sell off in equities as interest rates remain range bound
  • Companies show weakness in Q2 top line growth, and interest rates fall as investors look for safety, and equities sell off

Overall: interest rates rise, become range bound, and then fall

Scenario 2: Mixed Indicators

  • Tapering occurs between September and the beginning of next year, bringing down the value of equities and bonds in the short-term, as interest rates rise
  • Economic indicators remain mixed, and markets become more volatile
  • Companies show mixed Q2 top line growth, and equities and bonds also become more volatile, but interest rates rise because of the tapering of QE

Overall: interest rates rise, become volatile, and then continue to rise

Scenario 3: Economic Strength

  • Tapering occurs between September and the beginning of next year, bringing down the value of equities and bonds in the short-term, as interest rates rise
  • Economic indicators improve, and equities rise, while interest rates rise
  • Companies have strong Q2 earnings, and equities continue to rise, while interest rates rise even further, as QE becomes more likely to end

Overall: interest rates rise, and continue to rise

Recommendation:

The S&P 500 is already up 14.74% YTD. This 14.74% rise is not consistent with current economic indicators and global growth. Equities at the moment are mostly being supported by QE, while economic indicators are creating volatility.

We believe that Scenario 2 is most likely to occur,  and that interest rates will rise. Scenario 3 is also a possibility, and in this case, interest rates will also rise. In Scenario 1, interest rates will likely rise in the short-term, and fall in the mid-term. Scenario 3, however, is least likely, and if it does occur, you will have larger concerns than minimizing your bond and high dividend stock risk.

Therefore, because we believe Scenario 2 and 3 are most likely to occur, we recommend hedging your portfolio by a) using puts and b) minimizing your position in bonds and in high dividend paying stocks that react in a manner similar to bonds.

Jon Brooks, the “Blacksburg Whale”, does not actively trade in the stock or bond markets, and is not compensated for his recommendations. He and Bobby are not investment professionals, and their recommendations are based solely upon their own opinions.  Please see the disclaimer at the bottom of this page, and invest at your own risk.
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About Jon Brooks

Jon graduated Summa Cum Laude from Virginia Tech with a B.S. in Finance and a minor in International Business. During his undergraduate career, Jon interned with Goldman Sachs and PricewaterhouseCoopers. He was also a Senior Analyst in Bond And Securities Investing by Students (BASIS), the Vice President of the Society of Individual Investors, and a member of Beta Gamma Sigma. Jon is an analyst at a large accounting firm. Jon passed the CFA level 1 exam in January and is a CFA level 2 candidate.

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