The Toughest Market to Analyze

Driven by Politics

A Sucker’s Bet

Two Conservative Investments

I have been involved in the market for almost 25 years now as a student, writer and trader. Having been at it this long, I am usually able–by carefully consulting numerous indicators and statistics–to achieve an understanding of the market and an idea of what it is likely to do next.

But that has not been the case in the current market.

The current market is not being driven by fundamental, technical or sentiment factors–it’s being driven by domestic and foreign political situations … and I don’t have any analysis tools for politics.

Economists were appointed to replace leaders in Greece and Italy, with the hope that they will help repair their economic status. Initially, the news was well received by investors–at least initially.

In the U.S., investors have been concerned about the U.S.’s debt situation since the showdown last summer over raising the debt ceiling. Now the so-called debt supercommittee has failed to reach a budget compromise and neither party is willing to negotiate.

How does this impact the market?

The market’s fundamentals are actually pretty decent. Earnings season was stronger than expected, and the bulk of companies appear to be on the right track. During the height of earnings releases in October, the S&P experienced one of its best monthly performances in history. This was at a time when political rhetoric was in a lull, allowing the market to move on the back of some positive news.

Now that the political rhetoric has picked back up and earnings season is coming to a close, investors are fleeing equities. (Although the low volume shows that it hasn’t been a mass exodus.) Investors aren’t comfortable enough to add to their stock holdings, but they also aren’t ready to jump ship en masse.

Meanwhile, U.S. Treasuries continue to attract investors, and I don’t understand why.

Treasury yields are at or near record lows and the U.S. has debt problems of its own. How safe is it to buy debt instruments of a country with a budget deficit problem and a government that is unable to cooperate enough to fix it?

To me, a long-term investment in Treasuries seems like a sucker’s bet. Eventually, the economic and political turmoil will settle down and interest rates will start to climb, causing the price of Treasuries to fall. Investors who buy Treasuries now get low yielding investments with little upside potential for the long haul.

One analyst on Bloomberg described dollar-backed investments as the best of the worst, saying “the dollar is the fastest horse at the glue factory.” I had never heard this expression before, but it made me laugh as I realized he was right.

So how do you invest in this market?

I can tell you that I have cut back on equity holdings and increased cash and fixed income holdings. The two funds I have been adding are the iShares iBoxx Investment Grade Corporate Bond Fund (LQD) and the SPDR Barclay’s High Yield Bond Fund (JNK).

The LQD is a fund of the highest-rated corporate bonds. Right now, corporations are sitting on cash levels not seen since 1963 and thus their ability to pay their debts is much higher than that of the U.S. government. The LQD also has a considerably better yield than the 30-year Treasury Bond–it yields 4.5 % compared to 2.94%.

The JNK is quite the opposite of the LQD as it invests in junk bonds. I have noticed that JNK moves more like a stock fund than a bond fund. When the market dipped in the bear market of 2007-2009, the JNK dropped as well, but not nearly as much. When stocks rallied from March 2009 to March 2010, the JNK moved in lockstep with the S&P 500.

However, there is a big difference between the JNK and the S&P 500 SPDR (SPY): The JNK yields 7.88% compared to just under 2% for the SPY.

By adding these two funds, I have lowered risk and increased yield, while still retaining the potential for capital gains. During uncertain times, accomplishing these three things seems prudent.
Good luck and good investing,

Rick Pendergraft
Editor of Cabot Options Trader

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