Junk Bond Selloff

High Anxiety Liquidity Trap: Selloff in Junk Continues, Follows Largest Drop Since 2011 on Friday

In financial markets, rot starts at the periphery and spreads to the core. For weeks, rot has been visible in the junk bond market and that rot has deepened sharply recently.

JNK – Barclays High Yield ETF

HYG – iShares iBOXX High Yield Corporate Bond Fund

Liquidity Trap

A potentially destabilizing run on junk debt has weighed on the bond markets. Investors in one fund are totally locked out of redemptions. Effective yields have soared.

Please consider The Liquidity Trap That’s Spooking Bond Funds.

The debt world is haunted by a specter—of a destabilizing run on markets.

Last week, this took on more form even if there weren’t concrete signs of panic. Only one mutual fund manager, Third Avenue Management, has said it would halt redemptions to forestall having to dispose of assets in a fire sale. The rest of the industry has been quick to say that while redemptions are elevated, particularly in high-yield bond funds, there doesn’t seem to be a rush to for the exits.

Goldman Sachs, for one, put out a note Friday warning Franklin Resources “is most at risk” given the large high-yield holdings of its funds, poor performance and large outflows. On Friday, its shares fell sharply. Meanwhile, there were unusually large declines Friday in the value of exchange-traded funds that track high-yield debt.

The idea of a “run” on mutual funds might sound strange. Typically, runs are associated with highly leveraged banks engaged in maturity transformation, funding long-term loans with short-term debt. Nearly all the programs designed to avoid destabilizing runs—from deposit insurance to the Fed’s discount window to liquidity requirements—are built for banks.

But unleveraged investors, including mutual funds, can also give rise to runs. That is because there is a liquidity mismatch in mutual funds that hold relatively illiquid assets funded by investors entitled to daily redemptions.

Similar to what can happen in a bank run, investors in open-end funds holding relatively illiquid assets have an incentive to withdraw early to avoid being last out the door.

The problem is potentially more acute when it comes to funds that invest in corporate bonds, which don’t trade frequently, as opposed to stocks. That is an even greater concern today given questions about bond-market liquidity.

Mutual-fund fragility was highlighted in a speech last year by then-Fed Governor Jeremy Stein and a related paper prepared for a Fed policy forum. Mr. Stein noted fund managers were likely to sell more-liquid holdings to meet the earliest redemptions. This leaves remaining investors even more exposed to illiquid bonds.

Panic Early

The message here is clear. If you are going to sell be the first. In short, panic before anyone else does.

That advice is especially important for junk bond ETF holders as managers tend to sell liquid issues first, presumably holding the most illiquid and likely junkiest of junk on the books.

High Anxiety

Why Now?

It is absurd that CCC-rated debt, right on the verge of default would ever yield as little as it did. In regards to that point, I have noted the bubble in junk bonds numerous times over the past couple years.

Why this took so long to sink is anyone’s guess, but undoubtedly the FED’s QE played a part.
Bubbles nearly always go on longer than one might think.

But here we are. And here’s another important point, equity selloffs frequently begin with bond market dislocations or deteriorating equity-market breadth.

Be forewarned. Today we see both, at a time the stock market is more overvalued than ever.

In regards to point one, the Fed after warning about “Macroprudential Tools”, does not even realize QE and interest rate policy are the bluntest of blunt instruments, both prone to bubble-blowing episodes. Once bubbles get big enough or attitudes change enough, tools no longer work. And the opposite tool (in this case ending QE and hiking rates) might have an oversized effect.

In regards to point two, Fed timing could hardly be worse, but the only alternative is even bigger bubbles that would pop on their own accord anyway.

Mike “Mish” Shedlock


Apple is a Buy Here!

Fathers often give their kids advice. But every once in a while they pass on a nugget of truth that can be life changing. For me, that happened just after high school.

As I was getting ready to go off to college, my dad told me not to confuse excellence with perfection. He told me that excellence is within reach if you’re willing to put in a full day’s work. On the other hand, perfection lives outside the reach of mortal man.

Now, I’d like to say that I took his advice to heart. But like most teenagers, I didn’t immediately grasp the significance of what he said.

It wasn’t until a decade later that I fully understood what my dad was telling me. It’s a life lesson I’ve never forgotten. More importantly, it’s a lesson I’ve consciously tried to apply to every area of my life – including investing.

You see, perfection isn’t required to be a successful investor. Most investors can grow their money simply by not making too many mistakes. For at the end of the day, it’s our mistakes that drawdown our capital.

So, it’s important to find a strategy that fits an investors risk tolerance while limiting the mistakes.

Now, there are many investment strategies available to the average investor. But one of the most well-known strategies is the one developed by Warren Buffet’s mentor, Benjamin Graham.

Value investing has proven itself for nearly a century. As well it should. The basic premise is to buy a great company at a good price and hold the stock for as long as the basic investment thesis remains intact.

Of course, this means it’s a long term strategy and wholly unfit for anyone looking to trade their way to riches. Rather, this strategy works very well with a time horizon of a decade or more.

So, if you’re an investor with a medium to long term time horizon, reach for excellence by avoiding the mistake of not buying shares of Apple, Corp (NADSAQ: AAPL).

Apple shares have been trading within a relatively narrow band for the better part a year now. This has spooked some investors into thinking that Apple’s best days are behind it.

Nothing could be further from the truth.

Apple has a strong track record of innovation. And despite recent claims to the contrary, Apple is still an innovator today.

Now, it’s true the company generates more than 60% of its revenues from its iPhone segment. It’s also true that the smartphone industry is becoming mature with future growth rates in the single digits for the first time.

But to assume this means Apple’s growth prospects will follow the overall trend is absurd. According to IDC data, Apple’s market share of the smartphone industry is a mere 16%.

That is already starting to change…

You see, 3Q2015 saw Apple report a 30% increase in Android users switching to iPhones. This was the highest rate of switching ever recorded. And it’s likely to be a precursor to early 2016 when Apple is expected to unveil a long awaited iPhone with a smaller 4-inch screen.

Combined with its other innovative products, Apple is well situated to continue the market dominance that has made it the most valuable company on earth at nearly $650 billion.

Is Apple a Value Play?

Now, possessing an innovative product lineup and the world’s largest market cap doesn’t make the company a value play. So let’s examine the stock much the way Ben Graham would…

At its current price around $116, Apple is trading at just 12.5 times earnings on a trailing basis and just 10.7 on a forward basis. The 12.5 P/E represents a whopping 42% discount to the S&P 500 average of 21.57.

Even so, a low P/E also doesn’t prove a stock is undervalued. So let’s apply some other financial metrics to shed some light.

Calculating a stock’s intrinsic value is a great tool for determining whether a stock is properly valued. And while there are differing methodologies in making the calculations, I prefer two widely accepted methods.

The first is to calculate intrinsic value using normalized earnings. Normalized earnings are a company’s earnings adjusted for cyclical changes over time. This helps even out years in which earnings were significantly higher or lower due to unusual activity.

Normalizing Apple’s earnings gives us an intrinsic stock value of $270.80 a share. Now, by just about any definition, a stock trading at a discount of 57% to its intrinsic value on a normalized basis qualifies as a value stock.

On an unadjusted basis, Apple’s intrinsic value is $223.40. While not as impressive as the normalized value, this still represents a 48% discount to intrinsic value. Clearly, the market is undervaluing Apple shares.

Still not convinced it’s a mistake to overlook Apple?

Let’s examine the company’s expected earnings growth. Analysts expect the company to grow its earnings at more than 15.3% for the next five years.

This translates to a stock price of $251.25 by 2020 – a 116% gain from its current price. And this assumes no change in the company’s price-earnings ratio. If the stock were to be priced at its 10-year average P/E of 18.3, the stock would be priced at nearly $370.

Now, we certainly can’t predict a P/E ratio five years out. But if excellence is defined by limiting mistakes, buying Apple shares now will make you an excellent investor over the long term – and cement my dad’s legacy as a wise man.