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Are You Afraid Of Rising Interest Rates? Here’s A Possible Solution

Summary The yield curve is an important graph that offers key information about the economy. Given that investors in a bull market are afraid of rising interest rates, other opportunities are being looked at. The Steepener and Flattener ETNs offer opportunities to take advantage of an increase in interest rates. The Fed recently decided to keep interest rates flat. But I believe interest rates will not remain flat forever. Therefore, it is worth taking a look at how someone could protect themselves against the rise of interest rates in the future. This article will focus on the characteristics of the yield curve with an emphasis on the Steepener ETN (NASDAQ: STPP ) and the Flattener ETN (NASDAQ: FLAT ). ETNs are structured products that are issued as senior debt notes, while ETFs represent a stake in an underlying commodity. These two ETNs are perfect opportunities to protect any investor against rising interest rates, as this surge will have an adverse effect on the stock market (NASDAQ: QQQ ). The Yield Curve The yield curve is a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity. Here’s the current U.S. yield curve: (click to enlarge) Source: Treasury.gov . The short-term interest rates are administrated by the FOMC , while the long-term interest rates are created by the forces in the stock market. The Yield Curve Spread The yield curve spread is the yield differential between two different maturities of a fixed instrument. For example, the difference in yield between a two-year Treasury note and a 10-year Treasury note would create another line, a so-called spread. The later-maturity leg is considered a back leg and the leg that matures first is called the front leg . The spread between the two- and 10-year Treasury instruments has shown significant patterns over the last few decades, as seen here: Source: Forbes . The spread increases during bubbles, such as the tech bubble (1999-2001) and the mortgage crash (2007-09). This indicates that this strategy (taking advantage of the difference between the two- and 10-year yields) can be played out from time to time when equity markets might be under threat and heading toward a bear or bull market. This pattern is perfectly described below: (click to enlarge) Current times make things interesting, as interest rates are expected to increase in the future. This is a situation that has happened over and over again the last few decades: (click to enlarge) Source: Fed . As the graph above depicts, interest rates cycled upward and downward during the bull and bear periods of the economy. Yield Curve Strategies – Steepener and Flattener Source: Created by author. Flattener Strategy A flattening curve is a situation where the yields on the short-term and long-term dated treasuries are converging. In other words, they are coming closer together. From a bank perspective, this is not always considered favorable as banks borrow money at short-term rates while lending it out at long-term rates. When the yield curve converges, the short- and long-term yields come closer to each other and thus diminishing the profit for the bank. Yet, the steeper the yield curve gets, the higher the differential between long-term yields and short-term yields. That means more profit for a bank. When the yield curve becomes more flat, the iPath U.S Treasury Flattener ETN comes into play as it tracks the spread between the two-year and 10-year yields. One should not forget that these ETNs are leveraged, as a 0.1% move in the spread will indicate a 2% price change for FLAT . The flatter the yield curve gets, the better for the Flattener ETN. Steepener Strategy When the differences in yield in the short and long term are diverging (i.e., getting more steep), the iPath U.S. Treasury Steepener ETN is another option. The objective of this product is to hold a weighted long position in the two-year Treasury future and a weighted short position in the 10-year future, in contrast to the flattener. With a steepener you buy the spread, while with the flattener you sell the spread. They are opposites: Negative Rates As this article assumes rates will eventually go up, a potential scenario with negative rates — even though it has been deemed unlikely by Janet Yellen — should not be ignored. That’s because some economists believe the economy is still not growing as expected, and negative rates would basically indicate that anyone who wanted to borrow money would get paid. This would act as a potential strong stimulus to the economy. Even though it might appear to be an unlikely scenario at first, there are places in Europe that currently have negative rates in place, such as Switzerland. In the Fed’s projections, a negative Fed Funds rate was deemed plausible: Source : Fed . Summary Investors do not have to worry about a potential increase in interest rates as there are good investment vehicles to protect themselves against these potential rate hikes. As the yield curve has shown many predictable signs of explaining the economy , it’s important to keep an eye on how the yield curve develops over time. I currently do not hold positions in either ETN. However, both are on my watch list as I consider them splendid investment opportunities for when the equity markets dwindle lower or when the Fed finally decides to start increasing the Fed rate. Liquidity is a minor issue with both ETNs, but when interest rates eventually increase I expect liquidity to increase as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Investing In A Turbulent Market

Summary In turbulent times, investors need a plan and stick with a few basic rules. Assess macro conditions to guide investment decisions. Recognize the fact that danger and opportunities usually go hand in hand. Actively tweak winning odds to our favor as frequently as we can. It’s been two months since I left my role as a systematic global macro manager to focus on a few equity strategies I have been developing over the past few years. The timing was not great as world equities have been in a tailspin. Many blame China, the US Federal Reserve, and anemic world economic growth as the causes of the selloff. To me, they are just excuses. The real culprit of the market downturn is the investor jitters. Disciplined investors should follow some basic principles for investing in a turbulent environment. Here are some rules I follow: 1. Assess macro conditions to guide investment decisions 2. Recognize the fact that danger and opportunities usually go hand in hand 3. Actively tweak winning odds to our favor as frequently as we can. Assessing Macro Conditions to Guide Investment Decisions An old saying “rising tide lifts all boats” has found new meaning in stocks since 2009. Central banks around the world injected trillions of dollars into the world financial system. Ample money supply is undeniably one of the most important reasons for the current equity bull market. An equity investor should have done well if he recognized this simple macro factor. Therefore, accurately assessing the global macro environment is instrumental in performance. Differing opinions of economic conditions are the root cause of investor anxiety. So where are we now? China, as the world economic growth engine for the last decade, is facing some headwinds. It needs to absorb the excess from multi-decade economic expansion, rein in speculation, transition its economy from low-cost manufacturing to service and consumption, and steady investments and long-term growth to a sustainable level. Such a transition is not going to be easy and painless at all times. As someone who grew up in China before the reform began in earnest, I often found investors not giving enough credit to the success of China’s economic policies that has elevated a poor country with food rationing to a world economic powerhouse. Over the past 20 years, there were many calls of hard landing in China by market “gurus,” but none materialized. There is a certain arrogance to those calls. Is China facing hard landing again this time? I doubt that! Just as we like to say in the West “quiet water runs deep,” people in the East like to say, “narrow water runs far.” Publicizing policies has never been a strong suit of running things in China. Nevertheless, I believe China has economic means and a deep bench of highly skilled policy makers to navigate choppy waters. Everyone can make mistakes, but so far, there is no indication that China won’t be successful again in turning the ship around this time. In my view, they are proactively using policy tools to minimize the negative impact in a changing world. Investors are fickle. Before the two-day US Federal Reserve policy meeting last week, futures market implied a 30% chance of an interest rate hike in September. The market was right, the Federal Reserve did not hike interest rates. At the same time, investors reacted poorly to the decision as the US dollar sold off and interest rates dropped immediately after the announcement. Was the decision a surprise or was it expected? Investors cannot make up their mind. In my view, the timing of the Fed rate hike is not that important. There is no urgency to a rate hike in the absence of inflationary pressures. Nevertheless, barring significant economic deterioration, we will get a rate hike in December. Otherwise, Chairman Yellen’s credibility will be at risk as she previously indicated a hike this year. Given that outlook, I suspect both US dollar and interest rates will trade higher in the next two months. Moreover, according to some studies, a 25 basis points hike will only roughly translate into a 0.1% decline in GDP growth. There is simply no reason to be fixated on that. Accurate macro assessments can not only help us achieve long-term profitability, but also guide our short-term trading. A number of recent selloffs in global equity markets were in sympathy to selloffs in the Chinese equity market. Given the Chinese National Day is coming on October 1, an imminent meltdown in China is almost impossible. Therefore, any significant selloff could create short-term buying opportunities. Recognize the Fact that Danger and Opportunities Usually Go Hand in Hand Novice investors tend to chase markets and hang on to losers too long. It is much better to pick up quality names in a down market when everyone else is selling. In addition, losers tend to go down less than quality names precisely because some investors cannot psychologically part with losers, and instead sell stocks with gains to raise funds during a market downturn. Do not be afraid of selling losers! Better yet, pick up some winners in a down drift by selling losers for harvesting capital losses to reduce realized capital gains. Furthermore, global economic conditions are getting better, not worse – Europe is finally getting ahead of its sovereign debt crisis, the US economic growth is intact, China is working out short-term pains for long-term gains, the weak energy price should largely be stimulative to growth, and global monetary policies will remain accommodative for the foreseeable future. Therefore, there are opportunities to be had in the current passing danger. Actively Tweak Winning Odds to Our Favor as Frequently as We Can I consider myself as a long-term investor as I look to profit from fundamental research and typically hold stocks for an extended period of time. Fundamentals never play out overnight. However, I question the effectiveness of the “buy, hold and do nothing” strategy in the current market environment where information is so readily available through the internet, media, and social networks, affecting investor psyche constantly, and generating market volatility. Because of daily marks to market, professional hedge fund managers cannot sit idle and do nothing during market turbulence. I would argue that individual investors who look after their own portfolios should also be actively looking for ways to increase winning odds by using available tools such as listed equity options. Here are a few suggestions: a. If one wants to buy 100 shares of stock XYZ, he can sell one contract of put option at a strike price lower than or close to the current stock price. At maturity, if the stock price is higher than the strike price, one gets to keep the put option premium; otherwise, one acquires the stock at a price lower than the current price. b. When a stock in a portfolio has appreciated significantly, one should consider selling some covered calls to lighten up the load. At maturity, if the stock price is higher than the strike price, one effectively sells the stock at the strike price plus option premium; otherwise, he gets to keep the option premium. c. In fact, instead of following the red-hot “dividend investing” strategy, a) and b) can be viewed as a “create-your-own-dividend” strategy on any stock. With weekly options, one can aim to generate 10% annual yield by selling options. That’s 10% income and/or cushion one doesn’t have if he does nothing. d. During a market downturn, instead of buying quality stocks outright, one can buy calendar spreads, i.e. buying long-term calls against selling short-term calls at appropriate strikes to further reduce risk. e. Shorting high beta, richly valued stocks can be a more effective hedge than shorting index futures in the portfolio. There are many strategies that can be deployed day in and day out to generate consistent returns or opportunistically in turbulence when everything is out of whack. But one should always have a plan to deal with different market conditions and follow a set of rules so that he is not caught off guard. Let me know what you think. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The Dividend Discount Model And You: Proper Use And Limitations

Summary The dividend discount model is a simple valuation model for dividend investors to use in valuation. Like all models, it is only as good as the inputs used. Regardless of its drawbacks, the use of models forces investors to forecast company results and evaluate their own risk tolerance, which can only be positive for investor returns and contentment. Valuation can be a tricky subject for investors managing their own portfolios. As investors, we might like a particular company, its business, and its future prospects. But what exactly is a fair price to pay? Sure, we can look at valuation measures like P/E and EV/EBITDA and compare those numbers against historical values, but then we are just speculating that the company will return to its long-run average. Is there a better way? Financial models can be one answer to that problem. Novice investors usually start with the dividend discount model. The dividend discount model is an extremely simple, conservative valuation technique for evaluating dividend-paying stocks. While every model has its weaknesses, I believe that at the bare minimum, applying the dividend discount model to your holdings encourages you to think about, understand, and then model your portfolio holdings. Understanding the application and foundations of the dividend discount model is fairly simple. It fits into the broad bucket of discounted cash flow analysis. What we are trying to accomplish when using the model is to put a value on what a company’s future dividend cash flow is worth to us in today’s money. When we talk about “discounting” those future cash flows, we’re adjusting those numbers to reflect its value today. For example, because of the time value of money, a payout of $1,000 one year from now is worth less than $1,000 to you today. Money today has the ability to earn returns and avoid inflation, something that money in the future cannot claim. The median point where we are ambivalent between two amounts of money at different times can help us calculate our required rate of return, along with evaluating the riskiness of holding a particular stock we are analyzing. So, if our required rate of return is 8%, the discounted value of $1,000 one year from now is $925.93 ($925.93 * 1.08 = $1,000). The Basic Formula (click to enlarge) What you’ll notice from the formula is that it assumes a constant dividend growth rate. We all know dividend growth rates vary from year to year, but in the best case for modeling, we attempt to use what the long-run average will be. The weakness here as well is that the greater the dividend growth, the more minor differences between your hypothesized growth and real-world results can skew our model. So this simplistic model works best for securities with lower dividend growth rates and stable earnings. For income investors, using this model for utilities stocks should spring to mind quickly. Real-World Application Example Below, we have an example of ALLETE (NYSE: ALE ), a utility that generates energy for customers in Wisconsin, Michigan, and other surrounding states. It currently trade at $48.55/share. I’ve written a fairly pessimistic article on ALLETE , but we can see if the results from the dividend discount model back or disprove my thesis, based on various inputs. ALLETE currently yields $2.02/share annually, and has grown its dividend at an average 2.2% annual rate for the past five years, so we’ll use those numbers to run our valuation, along with an 8% required rate of return. We will assume the dividend will be $2.12 next year. P = 2.12 / (.08 – .022) P = 2.12 / 0.058 P = $36.55/share Based on this valuation, we come to a fair value of $36.55/share, or roughly 25% below current prices. To show how the model can be sensitive, let us instead change our assumptions. Perhaps based on our research, we find that going forward, management will be able to raise the dividend 3.25% annually instead of 2.2%, because maybe we have found information that has led us to believe the utility will be allowed a higher rate of return by its regulators. Additionally, we find that our own required rate of return is only 7% for ALLETE, because the stock has less financial risk than we previously thought. P = 2.12 / (.07 – .0325) P = 2.12 / 0.0375 P = $56.53/share Our calculated fair value per share is now $56.53, or more than 15% above current prices. Which is correct? That depends, based on your analysis of management’s ability to continue to raise dividends into the future and your own assumptions on the riskiness of the holding, which factor into your required rate of return. Multi-Step Models What if we think the dividend will grow at 3.5% for the next five years for ALLETE, and then 2.25%, after using an 8% required rate of return? The dividend discount model can be adapted to be used for multiple stages of growth to suit the reviewer’s needs. Year One Dividend = $2.12 * 1.035 = $2.23 Year Two Dividend = $2.23 * 1.035 = $2.31 Year Three Dividend = $2.31 * 1.035 = $2.39 Year Four Dividend = $2.39 * 1.035 = $2.47 Year Five Dividend = $2.47 * 1.035 = $2.56 Year Six Dividend = $2.56 * 1.025 = $2.62 Once we have the values, we can then discount those to their net present value: $2.23 / (1.08) = $2.06 $2.31 / (1.08) 2 = $1.98 $2.39 / (1.08) 3 = $1.90 $2.47 / (1.08) 4 = $1.82 $2.56 / (1.08) 5 = $1.74 We can then apply the constant growth model we used previously to determine their value, based on the fifth-year dividend value: P = 2.62 / (.08 – .0225) P = 2.62 / 0.0575 P = $45.57/share This value has to be discounted to net present value as well. P = 45.57 / (1.08) 6 P = 45.57 / 1.5868 P = $28.72 Add up the values of the five higher-growth dividends with your constant growth value: P = 2.06 + 1.98 + 1.90 + 1.82 + 1.74 +1.65 + 28.72 P = $39.87/share Conclusion Like any and all financial models, the dividend discount model is sensitive to the inputs used to value the security. Thus, financial modeling isn’t the grand answer to record-beating returns, and I wouldn’t advocate for retail investors to bury themselves in Excel spreadsheet models. However, financial modeling can force investors to think about issues that are extremely important to the stock valuation process, which can drive critical re-evaluations of your positions based on your own inputs and expectations. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.