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David R. Kotok
Wed May 8, 2024

I will start this commentary with a quote received from Politico Playbook on the Sunday morning after the 150th running of the Kentucky Derby, Politico wrote: 

A new ABC News/Ipsos poll out this morning shows 81% of voters think that Biden is too old for another term, while 55% feel the same way about Trump. Biden’s approval rating is 35%. Trump’s personal favorability is 33%. Two head-to-head numbers: Among all adults, Trump leads Biden, 46% to 44%. But among likely voters, Biden leads Trump, 49% to 45%. 



So, on Derby Day we witnessed a three-horse race with a nose-to-nose finish. Is that a metaphor for November? If more than half the voters reject either Biden or Trump and if only about 1/3 approve of either, does a Kennedy candidacy become the third nose in the race for president?
IMO, financial markets are mostly still ignoring the presidential race, because they face uncertainty and there is no clearly developing trend. Stock markets seem to have overcome fear of the Fed sufficiently to rally after a correction. We note that earnings reports were mostly pleasant surprises, and that certainly helps stock prices remain elevated or trend higher.
The bond market seems sanguine as well. Credit spreads remain very tight. That suggests the corporate credit system is working and that there is no liquidity pinching to cause credit spreads to widen from their present historical narrowness. Was the Fed’s announced slowing of the rate of quantitative tightening (QT) sufficient to keep spreads narrow? It seems the answer is yes.
What about the shape of the yield curve? Well, we know it is essentially flat. The distribution of market-based yields on the entire curve of US Treasury notes and bonds is in the mid 4% range. Only the very-short-term Treasury bills are trading at higher yields, and that is because the Fed’s short-term policy rate target has stayed above 5%. What is the market saying when an investor is paid nearly 4.5% to loan money to the United States for 2 years or 10 years or 30 years?
Market agents have strategies to trade inverted yield curves or steeper yield curves. But when the curve is essentially “dead flat,” there are no forward rates to guide the investor. Without forward rates one can only guess about the future and how the market is pricing it since market-based pricing is not available. For a definition of “forward rate” see: Right now, the forward rate and the spot rate are nearly the same.
So, if the presidential race outcome is murky at best, and if the US Senate and US House outlook as to controlling party is also murky, and if the yield curve offers no guidance, what is an investor to do?
IMO, there are three guidelines for times like these. 

First, keep diversified, which means spreading your risk taking around and not concentrating in one security class or one sector. I know that flies in the face of those who are making huge bets on the tech sector. And that is a personal choice about the degree of risk you want to take. I’m a believer in diversification, not concentration. That is why there are ETFs in Cumberland managed portfolios. 

The second thing is to hold cash reserves for those forecastable events and future payments. If you have money needs a year from now, holding that cash pays you the 5% interest that is very closely tied to the Fed’s policy rate. So, you have a riskless shorter-maturity alternative. Why take any risk if you are not clearly rewarded for doing so?

The last thing is to be seeking anomalous opportunities if you can find them and if they are appealing in light of your investment time horizon. Let me give a specific example.
Let's suppose we are looking at a long-term trust for a client's grandchildren. That trust is a fully taxed generation-skipping trust which is taxed at trust tax rates. They are levels that quickly rise to the highest income tax rates. Let’s use 37%. We have no way to predict what those rates will be in the future. The nose-to-nose politics described above may change them to either higher or lower tax rates in the future. But we can estimate that the trust rates for this client is likely to remain high if policies currently in place are not radically changed.
So, let's assume we buy a high-credit-quality, tax-free bond paying 4.8% (if available). The collateral securing that bond would include federally backed mortgages and the cash reserve held by that specific state’s housing authority. The trust would receive a tax-free interest rate higher than any of the note or bond maturities on the US Treasury curve and would do so until that tax-free bond either matures or is called. The trust would compound that interest receipt until it makes distributions many years from now. We don’t know what the new interest rate will be when the compounding occurs in the future.

Let’s compare that trust investment return with the stock market. If the S&P 500 Index is used, we would guess the taxable dividends’ return to be about 1.5%. That must be added to the expected price appreciation net after taxes for the trust. If the stock market can deliver that after-tax price appreciation return of 6%, then the combined dividend and net price-appreciation return (after taxes) would be about equal to the tax-free bond option. The taxable equivalent yield of the 4.8% tax-free is about 7.6%.
So, to match a time horizon of 12 years, the S&P 500 needs to double in price from its present level of 5000. Can it reach 10,000 in 12 years? Maybe yes or maybe not. But the compounding of the bond option will certainly reach that level if the bonds aren’t called, since their maturity is even longer-term. That early call is possible but currently not likely. The flat yield curve and the absence of forward rates tell you that market agents do not see the early call as likely.
Investors have a choice. The key is to derive the estimates for equivalency and do so while taking into consideration the amount of risk.   That’s what you do when the political outlook is nose-to-nose. 
Or is it nose-to-nose-to-nose? In 6 months, we will find out.


David R. Kotok
Co-Founder & Chief Investment Officer
Email | Bio



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