Wednesday, September 15th, 2010
the indicator revisited

Awhile back, readers of research puzzle pix were presented with a simple chart,research puzzle pix | One writer called this digest of investment information, “short, sweet, and different.” titled “the indicator.”  I promised then to flesh out the story a bit, and today’s the day.

First, an explanation of the indicator:  It is a comparison between the monthly yield of the Moody’s AA Utility Average and its eighteen-month moving average.  As basic as you can get.  It is meant to show the momentum of moves in the bond market, with the “indication” being straightforward — if the latest yield is above the moving average, be defensive as to interest rate risk, and if it is below, be aggressive.

Given the long post-war rise in yields, the indicator signaled caution for years at a time.  Then Paul Volcker slayed the inflation dragon and the other side of the yield mountain was created.  In the summer of 1985, I moved from analyzing equities to helping to manage bonds for large institutional accounts.  All hell was about to break loose.  (In a good way.)

While my boss said to me sometime later that he just wanted someone to talk to, I also came in handy for writing tickets — we embarked on a buying spree, adding duration as fast as we could.  The indicator showed it was time to be aggressive, and given his fundamental views, my boss had an expansive vision of what that meant.

I didn’t have time to do anything other than learn on the job, much in the way described in David Merkel’s excellent series on the education of a corporate bond manager.The Aleph Blog | The series ran to twelve parts. Mostly I bought (as instructed) corporates with unbelievably low coupons.  My boss thought that rates were headed lower, a long ways lower, and he didn’t want to have bonds called away before the fall in yields ran its course.  That was fortuitous, because rates dropped 3.5% in just a few months.

The brokers on the other end of the phone went from incredulous that someone was hunting for bonds with ultra-low coupons to incredulous that it worked in spades.  While I learned quite a bit about the bond market, other lessons were just as important.

Salomon Brothers hosted an annual dinner with Henry Kaufmanthe research puzzle | He was one of the Henrys mentioned in “first name basis.” for a select group of large clients at Windows on the World, on top the World Trade Center.  Kaufman was the most noted prognosticator of interest rates, but in 1985, my boss told the group that he thought that Treasury rates were going to “five and an eighth.”  I wasn’t there, but you can bet folks were wondering who the kook from the Midwest was — the long bond was at 12%.

The next year, after the plunge in rates, they showed more interest in his ideas, and when I was in attendance the year after that, the portfolio managers at the table had shifted their attention from Kaufman to my boss.

Other things had changed too, including the indicator, but we fought its signal rather than listening to it, right through the big rise in yields leading to the stock market crash.  At the end of that fateful day, my boss said, “I feel like buying bonds,” but we were already much longer than our index, and didn’t add to our bet.  When I came in the next morning, the long bond was up nine points and rates have never reached that level again.

And now for some of the lessons:

Our expectations and perceptions are easily influenced by the recent past, and it’s very hard to think beyond the confines of our current world view.  Forcing yourself to do so is good practice.  My boss was not afraid to do that.

We fixate on one guru until another one comes along, until someone else has made a great call.  By definition we are late with our adulation, be it for Kaufman or my boss or the savant of the day.

Tactics and strategy can reinforce or fight against each other.  At first, the indicator fit with my boss’ bold thoughts about rates, but when it didn’t, there was a bit of cognitive dissonance and marketing confusion.

As for marketing, it was a darn hard thing to talk to clients about our approach without mentioning the elephant in the room, a simple (albeit long-term) momentum indicator.  The fundamentals and the indicator worked off of the same thing, a persistent disinflationary trend, but you couldn’t mention the indicator to some clients and prospects, while others thought it was magic.

The really big ideas sometimes last a long time.  The indicator may have flipped on and off over the last quarter of a century, but rates have continued to go lower and lower and lower.  “Five and an eighth” indeed.

And simple can often be better.

It was one of the great experiences of my career.  Thanks, Ed.