Feeling the Elbow

Somewhere out there on that horizon
Out beyond the neon lights
I know there must be something better
But there's nowhere else in sight

- Eagles

There is a time for temperance and a time for tolerance. Unfortunately, investors are practicing neither.

Long-term investors typically play in more return oriented areas such as long-term corporate bonds, high yield bonds, equities and alternative investments. These investors temper their allocations to "cash" or low-risk investments such as money market funds or Treasuries. By definition this must be the case, as their return bogeys are higher than those offered by cash and Treasuries, so every dollar invested in these asset classes is a loser.

However, times of market strain drive them toward the sidelines. One measure of sideline assets is total investments in $1 NAV money market funds. As I've mentioned before, balances in these funds are near an all-time high of $4 trillion versus a more typical balance of $2 trillion. That's a lot of losing investments waiting to come home to the risk markets.

In the meantime, this intemperance of allocations has helped drive yields further into the ground in these asset classes.

Of course, our typical clients are not described above. In fact, they are more likely the antithesis in every aspect, including investment objectives which place capital preservation first and return attainment third - right after liquidity.

Nonetheless, these two types of investors are sharing the same space and fighting over the same scraps. Recent Treasury auctions attest to the consistent demand for our government's securities, even though credit quality (if that's what you can call it) is certainly on the downswing. In fact, during the week after July 4th, the U.S. Treasury sold $73 billion of new issues over a four-day period. In the good old days, Wall Street wouldn't have been around to answer the phones so close to a major holiday.

In reaction to ever-decreasing yields in this space, our clients have begun to bring yield back into portfolio strategy conversations. Though not as aggressively as pre-crisis levels, clients want to be sure they are getting the most for their investments. This is the right way to behave.

But it remains puzzling that at a time when risk-seeking investors, such as pension and endowment funds, are moving to the sidelines that typical sideline-based investors are considering moving out the curve.

Instead, I believe cash investors should realize these unwelcome, risk-seeking investors are only temporary visitors and should remain tolerant of the very low yield levels available in the marketplace today.

Eventually, these unwelcome houseguests will seek greener grass elsewhere and abandon our domain, which will lessen the demand in the cash space and create yield-enhancing opportunities in our own backyard. Until then, managing expectations is key.

Key Developments:

According to Morningstar Inc., bond mutual funds took in $81.2 billion in the second quarter, while stock funds brought in just $16.4 billion. Fear continues to grip the typical investor, even as the stock market has rallied nearly 40 percent. Risk aversion is driving return prospects lower for safer investments, continuing to crush yields in the short end of the curve.

Both producer and consumer prices blipped upward in June, due primarily to large jumps in energy prices. Over the last year, however, both measures have dropped with producer prices down 4.6 percent and the consumer version down 1.4 percent. Inflation fears have faded recently as little indication has arisen that the economy is gaining traction.

Housing starts rose 3.6 percent in June to a pace of 582,000 per year. Unfortunately, this remains less than one-third the run rate experienced as recently as early 2006 and below estimates of housing attrition due to fire, flood or other disaster.