Scorecard & Bonds Part 1

SCORECARD

We have made it through July and the dog days of summer are upon us. Time to see how my advice has done so far this year, so here goes.

#1) Buy Short Term Bonds and Avoid Long Term Bonds: My favorite Short Term Bond Fund = +15.27%, my favorite Long Term Bond Fund = -20.43%. Answer is correct

#2) Buy Mutual Funds that invest in Stocks rather than Gold: My favorite Stock Fund = +34.49%, my favorite Gold Fund = +14.98%. Answer is correct while gold has done better than I had anticipated and I still do not like gold

#3) Better than anticipated corporate earnings will provide support for the US Stock Market: During July, the US Stock Market indexes reached the high for this year and the return during July was the best since July 1998.

Bottom Line: The Business Cycle Investing Strategy is working well.

BONDS PART 1 (FOUNDATION)

If the idea of investing in the Stock Market gives you a headache and you are not happy with the interest rate at the bank what should you do? The answer is to invest in bonds, where you get interest paid for lending your money. The next few newsletters will be devoted to understanding bonds.

Point #1 = The market interest rate of any bond is moved by the US Treasury Yield Curve.

The reason is that the US government continues to auction bonds in time durations from 30 days to 30 years and since this is the most prevalent source of money it sets the interest rate. As you look at this yield curve, the normal shape is to have a higher rate with longer time. Let me explain further. You can purchase US Treasury bonds with time durations including 1 month, 2 months, 3 months, 6 months, 1 year, 2 years, 5 years, 10 years, and 30 years. A normal investor will only buy a longer time duration bond, such as a 30 year bond, if it has a larger return than a shorter term bond, such as a 1 year bond, because of the risk of holding the investment for the longer amount of time. A point of clarification, a short term US Treasury debt is actually called a Treasury Bill while a longer term bond is called a Treasury Bond. This means that normally it means that a better interest rate is obtained by buying longer time duration bonds. The rate for a short term CD rate will typically be close to the inflation rate and be below the interest rate for the same time duration US Treasury bond. To get a higher rate, typically a longer time duration bond needs to be bought.

Point #2 = When the US Treasury Yield Curve changes shape from being normal to flat or inverted it is time to make investment changes

The reason is that when the interest rate on a shorter term bond is the same or higher than a longer term bond it typically means that the economy has reached a top and will be shrinking. Business Cycle Investing says you want to make significant changes.

Point #3 = Bonds are bought and sold in a Secondary Market and you can get a capital gain or loss.

Traders trade everything, including bonds, and many investors buy and sell bonds before reaching the maturity date for a whole host of reasons. Because of this, the face value of a bond can go up or down giving an investor a capital gain or loss. When you sell a bond, the amount of money you make is the difference between your selling price and your purchase price plus any payments, also known as the coupon payment, you received. If you buy a bond and hold it for the entire time duration you get your coupon payments and your money, face value, back. Essentially, you get what you agreed to. When you sell before the entire time duration, you are not guaranteed to get back you face value it could be more or less. An investor will watch interest rates and when an opportunity arises for a capital gain on many occasions will take advantage of it and sell. By the way, Warren Buffet is a master at this and has made lots of money doing this.

Point #4 = Bonds are issued by all types of entities because of the need for money to fund operationsThe reason is that any enterprise has a need for money to operate goes out of business when it runs out of money. This is why the Chief Financial Officer, CFO, or Treasury Secretary makes lots of money because of the risk involved to the business.

Earnings, Warren Buffet, Bonds

Last week's newsletter stated that earnings from companies should be positive, beating estimates, and that this should support the stock market. Last week, 78% of the Dow stocks reported better than the estimated earnings and stock markets around the world rose. The Dow rose to a high for the year breaking the 9000 mark, up about 4% for the week. This earnings trend should continue giving support to the stock market this summer.Numerous experts have been giving their opinion about the direction of the stock market based upon a number of reasons.

These experts cause more confusion than providing real guidance. The best thing to do as an investor is to monitor the data and remember that stock prices increase as earnings grow and earnings grow as economic business conditions improve, which is the current situation. Earnings are growing now due mostly to cost cutting measures and improving business conditions. Since cost cutting only goes so far, revenue growth is key for stock prices next year.

I read in Barron's this week that Warren Buffet was asked this week about where to invest now given that the Dow had reached 9000. It was stated that Warren Buffet recommended continuing to own stocks and avoiding long term treasury bonds and cash for long term investments. Since I have been saying the same thing, I think he is rather smart. It was also reported in Barron's that Warren Buffet stated that the best types of bonds right now are mid term corporate bonds.

A bond is a debt obligation where an investor is paid interest and gets back their original investment. Lots of different types of bonds exist including municipal (state and local government), treasury (federal government) and corporate (companies). Municipal bond interest is tax-free which makes it a good choice for any account other than a tax deferred account like a traditional IRA. Corporate bond interest is taxed which makes it an especially good choice for a tax deferred account like a traditional IRA. Corporate bonds are rated by several agencies and can be lumped into investment grade and junk bond, a conservative investor will want mostly investment grade bonds. A junk bond rating for a company does not mean that the company that issue them is junk, they typically are an excellent company.

Bottom Line: The current investment direction of investing in stocks and stock market mutual funds should be maintained for a long term investor seeking growth who is willing to take some risk. Mid-term corporate bond funds that are mostly comprised of investment grade bonds are also an excellent choice for a conservative investor.

Economic Business Cycle and Earnings

Data from the Federal Reserve of New York, the same info that the Federal Reserve analyzes to set policy, on the current state of the US economic business cycle is analyzed. As an economy recovers from a bottom stage; industrial production should increase, inventory should decline, and commodity prices should increase. This data is critical to an investment strategist that uses a strategy involving the economic business cycle.

The industrial production data shows that production, which had a very severe decline in 2008, has started to recover. This means that people and other businesses have increased spending. A positive sign.

The inventory data shows a buildup during 2008 and early 2009 that is starting to decline. With increased spending business inventories will decline. Inventories go up as business slows down and vice versa as most businesses sell product through a distribution system. Another positive sign.

The commodity data shows that prices are also starting to increase. This is expected as demand increases for commodities based upon the law of supply and demand. Another positive sign.

What is the bottom line of this data? The economy has moved from the bottom stage to an early growth stage. For an investor, you want to maintaim your current position of owning: stocks, mutual funds that invest in stocks, short term bonds, and avoid long term bonds.

Earnings season is upon us once again and this past week some earnings were reported. It was reported that most companies were reporting better than expected earnings which surprised many experts, so much for expert opinion. Improved earnings are favorble for the stock market and stock market indexes around the world went up last week.

For what it is worth, I will give you my opinion that this trend of better than expected earnings should continue for the rest of this quarter. This should continue to support the stock market. The main reason is that companies project earnings, in a conservative manner, based upon the business conditions that exist at the time of the announcement. Since business conditions improved during the quarter it should also lead to improved earnings. This normally happens as the economy is growing.

When a publicly traded company gives earnings guidance it tends to be conservative in nature for a few reasons including: it is impossible to predict the future and if you miss the earnings number the stock price will drop and executives can lose their job. It is done to manage expectations of the major investors such that if you beat the earnings number you look like smart and if you miss it you look incompetent. The #1 objective of the CEO and Board of Directors, besides keeping their job, is to increase stock price.

I look forward to watching the earnings reports during the next 4 - 6 weeks.