From the Editor - February 05

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

Bond Market Behavior

The bond market is in a curious mode of behavior at present. The Federal Reserve continues to raise short-term interest rates. Any reasonably intelligent human being would expect that long-term interest rates would move higher as well. Not so. In fact, just the opposite has happened, with the 10-year treasury note dropping to a yield of around 4.15% while the two-year treasury bill is yielding 3.3%, and climbing. Given that it is likely the Federal Reserve will continue to raise short-term rates at a “measured pace” for the rest of 2005, the possibility of an inverted yield curve (where short-term rates are higher than long-term rates) becomes ever more likely.

What’s so bad about an inverted yield curve? Possibly nothing. Then again, history suggests this is something we would all like to avoid. In virtually every instance over the past 100 years where the yield curve went negative, an economic recession ensued within the next 12 months. This isn’t a guarantee the same thing will happen again, but it does suggest we should all be watching this spread between long-term and short-term rates a little more closely than usual.

Following the Model

At The Prudent Investor we are especially attuned to the changing behavior of the yield curve. A key component of our investment model is tied to the “Fed Model” that we use to help us determine over- or under-valuation of the stock market relative to the bond market. This model currently suggests that we should overweight stocks relative to bonds. The unspoken caveat to this rule, of course, is that if a recession is indeed coming soon, we would prefer to do just the opposite. Going into a recession you typically would see stocks going lower and bond valuations going higher (as the yield continues to drop).

This situation classically illustrates a common problem that any investor who follows an investment strategy ultimately faces. Models are quite useful to encourage investment discipline in an “emotional” marketplace. On the other hand, no investment model (not even ours!) will work 100% of the time. Given that fact, should we (or any investor) second-guess our model and cease following it in the face of an uncertain future?

The short answer is “no.” Second-guessing one’s investment strategy is the cardinal sin of investing. It is the primary reason most individual investors underperform relative to the overall market (assuming they have a defined investment strategy in the first place). This is not to say that one should never change his investment approach. Such changes should be made slowly, over time, and only when there are solid reasons to justify the changes. Our own model has evolved (and will continue to evolve) over the past several years as we gain additional insights into successful investment approaches.

We will continue to follow the “Fed model” signal, which currently has an aggressive bias toward equities over bonds. This may prove to be the wrong bias for 2005, but only time will tell. We fully expect to be wrong some percentage of the time, knowing that no model is perfect. But until we have reason to believe that our model is no longer effective, we will let an “unemotional” model drive our investment decisions instead of second-guessing based on “emotional” intuition or irrational (or sometimes rational) fears. We encourage you to do the same.