Several MLPs released earnings last week. Results were mixed. November is seasonally a weak month (see Why MLPs Make a Great Christmas Present), and many investors are weary of the sector after its second ever worst year. So reports below expectations resulted in steep drops, while good earnings caused modest ones.

Plains All America (PAA), which is in the crosshairs of the drop in U.S. crude oil production as the largest crude oil pipeline operator, met 3Q15 expectations but lowered 4Q15 guidance and didn’t provide any for 2016 which drew a sharply negative reaction. Their current distribution of $2.80 yields just under 10%. There’s no plausible risk of it being cut and flat 2016 growth should be followed by a resumption of growth in 2017. Plains GP Holdings, PAA’s GP, yields 7.2% having just increased its distribution 21% year on year. At $12.82 PAGP is down almost 60% from its August 2014 high of $31.55. What’s probably not well understood is that PAGP has only $559MM of debt. The $10.2BN of long term debt they show on their consolidated balance sheet is mostly $9.7BN at the PAA level. With $617MM of distributions coming to PAGP from PAA, and a public float of only $2.8BN (65% is already owned by management and entities with board representation), PAGP could easily take itself private through an LBO. They’d simply switch public equity holders for debt, increasing their upside exposure by 50% by using what the company would have paid in dividends to service the debt. This would not be a good outcome for public unitholders since the price is so low, but would represent an opportunistic roundtrip for the insiders who only took PAGP public two years ago at almost twice today’s price.

NuStar (NS) lowered 2016 guidance due to reduced volumes out of the Eagle Ford in Texas, and its price fell sharply as a result. Crude oil pipelines represent a quarter of NS’s EBITDA and gasoline & distillate pipelines comprise 30% while Storage of refined products and crude oil represents just under half (they have a small marketing business). The Storage business did well; the silver lining of excess crude production is increased demand for places to put it. They are at capacity and are raising prices on renewals. Neither NS nor its GP, Nustar GP Holdings (NSH) are growing their distributions at present, although we believe that will eventually happen. Meanwhile, NS and NSH yield 9.6% and 8.9% respectively. Energy Transfer Equity’s (ETE) three MLPs (Sunoco, Sunoco Logistics and Energy Transfer Partners) all had good quarters but nonetheless sold off.

Enlink Midstream Partners (ENLK) modestly exceeded expectations but its price fell nonetheless. Its GP, Enlink Midstream, LLC, yields 5% and reaffirmed its guidance for 15% distribution growth in 2016. ENLC purchased ENLK units recently alleviating all equity capital requirements in the near term.

The biggest shock of the week though was the announcement by Targa Resources that its GP (TRGP) will buy in its MLP (NGLS). While operationally Targa is well run, its strategic mis-steps are breathtaking. In the Summer of 2014, negotiations to sell itself to Energy Transfer Equity (ETE) broke down when TRGP was trading at $150. At that time, management argued the stock was undervalued. Now, having lost fully two thirds of its value, they see fit to issue TRGP shares in order to buy in NGLS. The case in favor for NGLS investors is a lower cost of capital and modestly better distribution coverage (although they’ll be receiving a lower distribution from TRGP than they were from NGLS). As with the Kinder Morgan transaction, the NGLS assets move to TRGP with a stepped up cost basis, eliminating TRGP’s tax obligation for many years but at the expense of being a taxable transaction now for NGLS unitholders. The 18% premium that TRGP is paying for NGLS is intended to compensate but in our view is needlessly generous. Most significantly for us, TRGP is foregoing the GP/MLP structure, which sacrifices valuable flexibility and is one of their most attractive features. The GP is also a prized acquisition target. The market reaction was swift, and by day’s end investors in both securities were worse off than if the transaction hadn’t been announced. We think management may be acting defensively to pre-empt a bid for TRGP in the same way that Williams Companies (WMB) sought to buy its MLP, Williams Partners (WPZ) before eventually agreeing to sell itself to ETE.

Leon Cooperman, whose fund Omega is a significant investor in TRGP, noted the 8% drop in the stock price and dryly asked on the conference call, “did the advisors that worked through this transaction with you expect this type of market reaction?” Since investors in both TRGP and NGLS saw a substantial loss in value on the announcement, and since TRGP management has shown themselves to be strategically inept, one would think that shareholder approval of the deal is by no means certain and perhaps even a hostile bid will appear to relieve TRGP of its burdensome stewards. We would be supportive of such. TRGP needs new leadership.

The deal hurt valuations of other GPs as investors considered where else investment bankers might show up. The MLP GP is the most attractive place to be in the MLP structure, and TRGP’s apparent rejection of it has led to selling of other GPs and left investors puzzled. In recent weeks they’ve persuaded Kinder Morgan (KMI) to issue dilutive, poorly structured securities (see MLP Earnings Offer Scant Support for Bears and Rich Kinder Gets Outplayed) and now destroyed value for TRGP/NGLS. We’d all be better off if Wall Street bankers refrained from offering any more help, and let the industry just get on with its business.

We are invested in ENLC, ETE, KMI, NSH, PAGP, and TRGP.

We’re in earnings season and several Master Limited Partnerships provided updates this week that were generally unsurprising and reflected the stability of their business models. On Monday, Energy Transfer Partners (ETP) announced an 8% year-on-year increase in their distribution. Their GP Energy Transfer Equity (ETE) increased its distribution 37% on a year ago. These securities yield 9.5% and 5.5% respectively. ETE expects to close on its acquisition of Williams Companies (WMB) during 1Q16 which will add Williams Partners (WPZ) to the family of its MLPs it already controls (along with ETP they also control Sunoco LP and Sunoco Logistics Partners, LP).

Enterprise Products Partners (EPD) announced earnings showing 5% growth in distributions with 1.3X coverage. Its price rallied but still yields 5.8% based on its forecast next twelve months’ distribution. WPZ reported a 21% year-on-year increase in 2015 EBITDA driven by good performance from several fee-based projects. WPZ rallied on the news although curiously its future controlling entity ETE did not, even though ETE will ultimately benefit from this performance through its ownership of WMB. On the earnings call Williams noted that low prices for natural gas had led to about 900 million cubic feet (MMCF) per day of “shut-ins” whereby the E&P company temporarily stops producing natural gas because of the low market price or lack of infrastructure to get it to market. To put it in perspective, the U.S. consumes around 77 BCF per day, so this is a little over 1% of consumption. It didn’t seem to hurt results and they expect some of that production to come back online in the near term.

Overall, results were steady and unspectacular, which is usually the case. Distributions were as expected, growth guidance was generally reaffirmed. As I often say, the business performance is far less exciting on a quarterly basis than one might conclude by observing movements in MLP unit prices.

Kinder Morgan (KMI) also issued a $1.6BN mandatory convertible security, and regrettably it looks as if they were ripped off by their bankers. When they began contemplating alternatives to issuing equity, their stock was trading in the low $30s and their reluctance to sell equity at this level was understandable. Instead, they’ve sold equity at possibly as low as $27.56 (the lowest possible price at which conversion can occur). This is where their shares wound up when the deal was priced, no doubt depressed by the underwriters shorting the stock to hedge the new convertible issue. The 9.75% coupon they’re paying on this security is higher than either KMI’s debt or equity even though it sits between those obligations in seniority on their balance sheet, and the only risk being taken by the investor is the possibility of being converted into common at $27.56 at a time when the market price is below that. While the rating agencies treat the issue as equity, those bearish on the security will argue it’s high-cost leverage and that management is signaling they’re worried that the stock is headed much lower than $27.56.  The bulls will see it as super expensive, dilutive equity.  It’s inconceivable that KMI expected this outcome; they would have been far better off continuing with their original plan of regular equity issuance. A rare lose-lose from Rich Kinder.

My new book, Wall Street Potholes, was just released and it’s aimed at retail investors. I may have to start working on another version written for capital markets clients outfoxed by their bankers.

Overall, there wasn’t much over the past week in fundamental news to provide much support to bears. The most negative issue might be the continued volatility and relatively high dividend yields.

We are invested in EPD, ETE, KMI and WMB

Recently, an important threshold was breached in terms of relative valuation between stocks and bonds. The yield on ten year U.S. treasuries drifted below the dividend yield on the S&P 500. It’s happened a couple of times in recent years but only because of a flight to quality and never for very long. This time looks different.

It’s worth examining  this relationship over a very long period of time. The chart below goes back to 1871 and reminds us that for decades stock dividends were regarded as risky and uncertain. Little attention was paid to the possibility of dividend growth, and investors clearly placed greater value on the security of coupon payments from bonds.

This spread began to reverse in the late 1950s and since then, during the careers of a substantial percentage of today’s investors, bond yields have remained the higher of the two. Dividend growth (defined as the trailing five year annualized growth rate) was more variable prior to the 1950s with several periods when it was negative, so it’s understandable that investors of the day regarded dividends as quite uncertain. However, since the S&P500 dividend yield dipped below treasury yields, dividend growth has never been negative. The five year annualized growth rate since 1960 is 5.8%. Assessing a long term return target for equities is inevitably a combination of art and science, but adding a 5% growth rate to today’s 2% dividend yield suggests 7% is a defensible assumed return.

The trend of bond yields to decline towards dividend yields began a long time ago – back in 1981 when interest rates and inflation were peaking. It’s taken over 30 years, but the relationship is now back where it was during the Korean War. The investment outlook is, as always, uncertain with multiple areas of concern. However, the Federal Open Market Committee has made it abundantly clear that rates will rise slowly; recent earnings reports from Coke (KO), Dow Chemical (DOW), Microsoft (MSFT) and Amazon (AMZN) have all been good. These and many other stocks are near 52-week highs and in some cases all-time highs. FactSet projects earnings and dividends to grow mid to high single digits over the next year. These considerations are once again highlighting the inadequacy of fixed return securities as a source of after-tax real returns, and with one major asset class devoid of any value investors are again turning to stocks. The tumultuous markets of late August and September are receding; rather than portending a coming economic collapse, they simply represent additional evidence that far too much capital employs leverage.

The long term trend suggests that treasury yields will remain below dividend yields for the foreseeable future. We’re not forecasting such, simply noting that a 2% yield that is likely to grow on a diversified portfolio of stocks looks a whole lot more attractive than a 2% yield that’s fixed. It didn’t look so smart in recent weeks, but if you don’t use leverage and restrict yourself to companies with strong balance sheets you can watch such shenanigans from the sidelines.

Master Limited Partnerships (MLPs) have begun reporting earnings. Kinder Morgan (KMI) disappointed investors by trimming their 2016 dividend growth from 10% to 6-10%. KMI isn’t technically an MLP any more since they reorganized into a C-corp last year. However, they are squarely in the energy infrastructure business like midstream MLPs. Rather than issue equity to fund their growth projects, they plan to access an alternate, not yet disclosed source of capital through the middle of next year. Their free cashflow covers their distribution, and they access the capital markets to finance growth.

MLPs have had a torrid year, with the sector down far more (in our view) than lower crude oil would justify. As Rich Kinder said, “…we are insulated from the direct and indirect impacts of very low commodity environment, but we are not immune.” KMI owns pipelines and terminals; 54% of their cashflows come from natural gas pipelines; 11% come from a CO2 business that supports oil production; they transport about a third of the natural gas consumed in the U.S. 96% of their cashflows are fee-based or hedged: “insulated…but not immune”.

Selling energy infrastructure stocks is fashionable, and owning them is not. While bond yields are dipping below the S&P’s 2% dividend yield, KMI yields more than three times as much (7.25% on its 2016 dividend assuming the low end of the 6-10% growth range) and its dividend will grow at least as fast. Owning such securities will once more be fashionable.

We are invested in KO, DOW and KMI.

Many years ago, in a different investing climate and a different decade, a cut in interest rates was usually regarded as a stimulative move by the Federal Reserve. Lower financing costs were regarded as helping the economy more than hurting it. They certainly help the U.S. Federal Government, as the world’s biggest borrower. The amount of treasury bills issued at a 0% interest rate recently reached a cumulative $1 trillion. Although declining interest rates adjust the return on lending in favor of the borrower and at the expense of the lender, a lower cost of capital stimulates more borrowing for more investment and consequently boosts demand. However, the intoxicating nectar of ultra-low rates is gradually losing its potency, and while it’s overstating the case to say that markets would cheer higher rates, certain sectors would and the confirmation of an economy robust enough to prosper without “extraordinary accommodation” as the Fed puts it would be novel to say the least.

Several major banks released their quarterly earnings over the past week. Balance sheets continue to strengthen, but another less welcome trend was the continued pressure low interest rates are imposing on income statements. Deutsche Bank expects most major banks to report declining Net Interest Margins (NIMs) as older, higher yielding investments mature and are replaced with securities at lower, current rates. JPMorgan expects to make further operating expense reductions since quarterly earnings were lower than expected.

It’s a problem facing millions of investors. The timing of a normalization of interest rates, which is to say an increase, is both closely watched and yet seemingly never closer. If you look hard enough you can always find a reason to delay a hike, and the Yellen Federal Open Market Committee (FOMC) looks everywhere. Recent speeches by two FOMC members suggest a December decision to hike may not receive unanimous support. The FOMC’s long run rate forecasts continue to drop, as shown in this chart (source: FOMC).

Income seeking investors are unlikely to find much solace in the bond market. As I wrote in Bonds Are Not Forever, when rates are punitively low, discerning investors take their money elsewhere.

Suppose you could buy equity in a hedge fund manager, a fanciful suggestion because they’re virtually all privately held. But suppose just for a moment that such a security existed. The question is, how should you value this investment? What multiple of fees to the manager would you be willing to pay or in other words what yield would entice you into this investment?

Hedge fund managers don’t need much in assets beyond working capital and office equipment; the assets they care about sit in the hedge fund they control. So let’s consider a hedge fund manager’s balance sheet which consists mostly of a small investment in its hedge fund, representing a portion of the hedge fund’s total assets, and a bit of cash. It has virtually no debt. Our hedge fund manager earns income from its hedge fund investment, as well as a payment for managing all of the other assets that sit in the hedge fund. These two revenue streams are roughly equal today and constitute 100% of the hedge fund manager’s revenue. The fees charged by the hedge fund manager for overseeing the hedge fund aren’t the familiar “2 & 20”, but are instead are currently 13% of the free cash flow generated by those assets and 25% of all incremental cash flows going forward. Moreover, the equity capital in the hedge fund is permanent capital, which is to say that investors can exit by selling their interests to someone else but cannot expect to redeem from the hedge fund. Meanwhile, our hedge fund manager can decide to grow his hedge fund and thereby his fee stream for managing its assets by directing the hedge fund to raise new capital from investors. This represents substantial optionality to grow when it suits the manager by using Other People’s Money (OPM). This hedge fund’s assets are not other securities but physical assets such as crude oil terminals, storage facilities and pipelines. The hedge fund is returning 9% and is expected to grow its returns by 4+% annually over the next few years.

The hedge fund manager in this example is publicly traded NuStar GP Holdings, LLC (symblol: NSH), the General Partner (GP) for NuStar Energy, LP (symbol: NS). NSH, by virtue of being the GP of NS and receiving Incentive Distribution Rights (IDRs) equal to roughly 25% of NS’s incremental free cash flow, is compensated like a hedge fund manager. NS, a midstream MLP,  is like a hedge fund, albeit the good kind with far more reliable prospects and greater visibility than the more prosaic kind, whose returns have generally remained poor since I predicted as much in The Hedge Fund Mirage four years ago. To return to our question: at what yield would you buy this hedge fund manager’s “fees”, given its option to increase the size of its hedge fund, the hedge fund’s respectable and growing return, the permanence of its capital and the perpetual nature of its substantial claim to the hedge fund’s free cash flow? NSH currently yields 7.6% which should increase ~10% annually over the next several years based on the company’s capex guidance at NS.

We are invested in NSH.

In time we may all owe a debt of thanks to Martin Shkreli, CEO of Turing Pharmaceuticals and a former hedge fund manager. Their 5,456% increase in Daraprim brought attention to the the importance of regular price hikes in driving revenue growth at major drug companies. The Wall Street Journal later noted that almost 80% of the increase in the top line for the manufacturers of 30 top-selling drugs came from raising prices versus increasing volumes. It strikes me that this may just become a political issue in the U.S., especially heading into an election year. High drug prices affect millions of Americans and it’s easy for the media to find some poor individual whose needed medication has suddenly tripled in price. Hilary Clinton’s infamous “price gouging” tweet shows that the issue easily lends itself to sound bites, a necessary condition to retain media interest. Big pharma represents a fairly easy target. Congressional hearings no doubt loom for companies such as Valeant (VRX), whose business model relies on testing the limits of the market’s acceptance for price hikes. They operate as a ruthless capitalist in a market where the laws of economics routinely fail, since customers (patients) are rarely informed buyers and typically incur the expense not directly through paying the asking price, but indirectly through consequently higher health insurance premiums or ultimately higher taxes. One friend told me he holds an investment in health care stocks as a hedge against rising medical expenses for him and his wife, an unusual yet insightful approach.

A common refrain from drug companies  is that high drug prices (and the relatively unregulated U.S. market has the highest) allow money to be reinvested back into R&D. This is a weak argument. If research has a high enough IRR, it can be funded through capital from the public and private markets; it doesn’t have to be through retained earnings. It’s just as likely that the ability to charge whatever they can dramatically increases the IRR on R&D. High drug prices themselves makes the R&D more worthwhile than it would be otherwise.

We don’t invest in healthcare stocks, as might be apparent. Therefore, to the extent we run investment strategies that are benchmarked against the S&P500, we are effectively short the health care sector, which has outperformed the S&P500 for the last three years and remains on pace to do so again in 2015.  The issue of drug pricing isn’t likely to recede soon though, and maybe health care stocks will start receiving some of the opprobrium so routinely heaped on banks and oil companies. The energy sector is due for a break as most out of favor.

Martin Shkreli used to work at a hedge fund, and he would probably like the economics of the General Partner (GP) in the MLP sector too. Targa Resources Partners (NGLS) is an MLP whose business is divided between the midstream activities of Gathering and Processing (G&P) of crude oil and natural gas across the central U.S., and downstream activities of Marketing and Distribution. NGLS recently provided guidance for 2016 that included flat distribution growth, reflecting the more challenging environment for some energy infrastructure businesses. However, as the hedge fund is to the hedge fund manager, so is NGLS to Targa Resource Corp (TRGP), the GP of NGLS. The same guidance projected 15% dividend growth at TRGP. Flat returns for hedge fund clients rarely hurt the hedge fund manager, and so it is at TRGP whose Incentive Distribution Rights (IDRs) are at the 50% level, entitling it to half the Distributable Cash Flow from NGLS, the MLP it controls through its ownership of the GP and IDRs. TRGP currently yields  6.3% on its forecast $4.12 2016 dividend, and with a market cap of $3.7BN is of sufficiently modest size to be of interest to many potential acquirers.

We are invested in TRGP.

In September Master Limited Partnerships had a tumultuous month. On September 29th, one day before month’s end, we were looking at the worst monthly performance in the history of the Alerian Index. A strong recovery on the 30th reduced the damage somewhat, but MLPs have had a terrible year and September was nonetheless awful.

Why the market did what it did is far and away the most common question we receive. We’re not market timers and so don’t devote much effort to figuring out near term direction. But people want to know, and we’ve developed a narrative that we think explains recent sharp moves.

Regular readers of this blog are used to me attempting different ways to say the same thing, which is that MLPs are cheap. In September they became cheaper still. If you need reminding of the case, you might peruse recent posts such as Why MLPs Make a Great Christmas Present, Listen to What the Oil Price is Saying, or MLPs Now Look Attractive Relative to Equities. The Alerian Index yields 8%. The case remains, even while prices have dropped. On Thursday, Enterprise Products Partners (EPD), a $72BN enterprise value midstream MLP with significant crude oil and Natural Gas Liquids business, declared a $0.385 quarterly dividend. This represented a 5.5% year-on-year increase and their 54th distribution increase since going public in 1998. It yields 5.56%.

Our Separately Managed Account (SMA) clients remain steadfast, and we have seen inflows from existing and new clients in recent months. Mutual fund clients vary a little more. Many are long term investors focused on understanding the fundamentals and therefore unwilling to let market fluctuations shake them unless supported by altered business conditions. But some do rely on recent price movements to support their conviction, or put another way lose confidence when prices are falling.

It’s clear in the many quarterly account reviews with clients for which Financial Advisors (FAs) are preparing. The third quarter hasn’t been pretty for investors generally; MLPs simply represent the more extreme type of adversity being faced. Some $60BN in mutual funds, ETFs, ETNs and closed end funds exist to provide MLP exposure to retail investors without those dreaded K-1s. Not all these funds are poorly structured, but many are. Owning MLPs via a C-corp structure offers the desired exposure with the simpler 1099 tax form, albeit with the highly unattractive feature of a 35% corporate tax liability (see The Sky High Expenses of MLP Funds).

Expense ratios of as high as 9% are somehow an acceptable price for the K-1 averse would-be MLP investor. The 35% tax roughly means you get 65% of the return. It’s therefore reasonable to assume that the holders of such securities, or the FAs who select them on their client’s behalf, are not the most discerning investors. It’s unlikely they spend much time examining the underlying holdings and their distribution yields, growth rates and capex plans. These are the investors for whom investment analysis begins and probably ends with a price chart. Year-to-date performance for 2015 that was by September 29th -35%, close to equaling 2008’s -36.9%, was challenging for a great many of these.

Fund flows have clearly been negative, supporting the notion that fund sellers have been an important factor in recent weakness. Barrons noted that closed end funds were forced to sell because they were hitting their leverage limits, an example of the stupidity of investing with borrowed money whether you’ve done so directly or through your choice of fund. Moreover, indiscriminate selling of MLPs across the sector bore out the wholesale exit by a certain class of holder. Some writers inferred the market’s rejection of Energy Transfer Equity’s (ETE) acquisition of Williams Companies (WMB) when it was finally announced on the morning of Monday, September 28th. But there was very little new in the ultimate transaction that wasn’t already widely known the Friday before. So why was Energy Transfer Partners (ETP) down 6.5% on Monday? All that changed was that ETP would now be able to connect its pipeline network in useful places to the WMB network. ETP isn’t otherwise involved in the transaction, controlled as it is by its GP, ETE. We are invested in EPD, ETE and WMB.

We think there are a couple of other explanations. One is that the Deferred Tax Liability (DTL) on many of the poorly structured MLP funds came close to flipping signs, as unrealized gains evaporated with a market that had wiped out three years’ prior returns. The consequence of a taxable MLP fund moving from an unrealized taxable gain to an unrealized taxable loss is that they no longer have a DTL. Its mirror, a Deferred Tax Asset (DTA), which might be expected to act like a net operating loss in that it creates a potential future tax benefit, can’t exist for open-ended funds. Hence the Alerian ETF (AMLP) began offsetting its DTA with an equal but opposite “Valuation Allowance”. It’s likely that most if not all taxable MLP funds could be shown to have reached this state, if they published such figures on a daily basis like AMLP. Taxable MLP funds that cross from a DTL to a DTA expose their holders to 100% of the downside (since there’s no longer a DTL cushion) but only 65% of the upside (since gains remain  taxable). Some of these funds started showing daily returns equal to the index on down days, a truly unpleasant asymmetry for many investors, and no doubt an additional inducement to sell for those paying attention.

Many FAs we’ve talked to have been concerned about upcoming quarterly account reviews with clients, since although MLPs had a terrible quarter many other sectors were weak as well. September 29th was the last day when you could sell an underperforming fund so as to keep it off the quarter-end client statement. Discussing a tough quarter can be easier if the offending investments are no longer in the client’s portfolio. The market certainly behaved as if indiscriminate selling climaxed on that day. If MLPs were private and investors had to form opinions by studying their financial statements instead of looking at a stock chart, there wouldn’t be much of a story.

The chart below compares the Alerian Index from its peak preceding the 2008 Crash with its current path from the August 2014 peak. We’ve come down a long way.

Using such a cheery headline following the week MLPs have had will tempt wisecracks that Christmas tree baubles might be better investments than MLPs. Nonetheless, your blogger is looking beyond the latest round of forced selling and taking the longer-term view on returns. It is likely that buyers better understand the values they are getting than sellers do the values they are rejecting. Midstream MLPs with little or no crude oil exposure have seen their equity prices fall. Even StonMore (STON) an MLP in the “deathcare” business, has revealed unexpected linkage between WTI crude and dying. It is in any case hard to explain recent moves beyond noting that sellers evidently seized their task with greater urgency than buyers.

Seasonal patterns in financial markets can draw great interest. The January effect in stocks is well known if less commonly experienced; other folklore includes the adage to avoid selling on Mondays (presumably because a weekend of stressing over a poor investment induces action as soon as possible). As is often the case with statistics, identifying correlation without causality will part many a superficial investor from his capital. There needs to be an economic explanation for an effect for it to mean anything.

Many investors plan their allocations around year-end, but this is especially so for retail investors for whom Christmas offers some time to contemplate finances while recovering from an excess of merriment and (perhaps) family togetherness. Master Limited Partnerships (MLPs) remain widely held by individuals; hence the seasonal pattern they exhibit is both valid and pronounced.

A dilemma for investors is approaching. As we close in on only the second worst year in the history of the Alerian Index (since January 1996), do they forget the pain so far and add, or lick their wounds and wait. The average monthly return on the Alerian Index is 1.17%, although 2015 provided numerous results inferior to that. November is seasonally the worst month, with an average return of -1.0%. December tends to be average, but January averages +4.3%. On average, being invested only for the two months of December and January provides over a third of the annual return.

Of course, there’s always more detail to consider; November’s average return is the worst because it includes November 2008’s -17.1% drubbing. That month alone knocks the November average down by 0.27%. Then again, January’s average is helped by the January 2009 result of +15.25%, which adds 0.55% to January’s average. You can of course include and exclude months variously and get different results, the validity of which is to a person’s taste.

Nonetheless, the clear pattern is that MLP investors tend to buy (or sell less) in the first month of every quarter. This is probably because it coincides with quarterly distributions. The quarterly affect is magnified by the turning of the calendar.

Around this time of year, we advise MLP clients that if they’re contemplating making a commitment the seasonals suggest doing so in November, when prices are weak. If you’re a seller it makes sense to wait for January, since so few sellers seem to be available then.

The seasonals have not worked so well the last couple of years. Whether this is because they’re now so well known that they no longer work won’t be clear for a while longer. However, I’d bet that the universe of MLP sellers waiting until December or January to act is fairly small. If the recent price dislocations didn’t yet force you out, you’re probably in for the very long run. By contrast, the paucity of available sources of yield should draw reallocations towards a very cheap sector from investors digesting their Christmas dinner and pondering where their 2016 returns will come from.

Please remember that past performance is not indicative of future returns.

If you aspire to achieve acceptable returns from bond investments, the Fed is in no hurry to help you. They have other objectives than ensuring a preservation of purchasing power for buyers of taxable fixed income securities. Their failure to raise rates on Thursday is not that important — what’s more significant is the steadily ratcheting down of their own forecasts for the long term equilibrium Fed Funds rate.

For nearly four years the Fed has published rate forecasts from individual FOMC members (never explicitly identified) via their chart of “blue dots”. They now produce a table of values so there’s little ambiguity about its interpretation. Traders care mightily about whether they’ll hike now or in three months. It’s all CNBC can talk about. For investors, the Fed’s expectation for rates over the long run is far more interesting.

Since you might expect long run expectations about many things to shift quite slowly, by this standard the Fed’s long run forecast has plunged. The steady downward drift accelerated in recent meetings and it’s now fallen more than 0.5% since last year, to 3.35% (see chart). What this means is that their definition of the “neutral” fed Funds rate (i.e. that which is neither stimulative nor constraining to economic output) is lower. They don’t have to raise rates quite as far to get back to neutral.

Their inflation target remains at 2%, although inflation, at least as measured, is clearly not today’s problem. So the real rate (i.e. the difference between the nominal rate and inflation) has now come down to less than 1.5%. Since bond yields are in theory a reflection of the average short term rate that will prevail over the life of a bond, the Fed believes investors in investment grade debt with negligible default risk should expect this kind of real return. For a taxable investor, this will result in more or less a zero real return after taxes.

The Fed’s communication strategy has  not been that helpful over the short run. Although we are provided with far more information about their thinking, it simply reveals that they don’t know much more than private sector economists and like them are always waiting for more information. The FOMC doesn’t want to provide firm guidance, since that requires a commitment which results in lost flexibility (see Advice for the Fed). The evenly split expectations for last Thursday show that forward guidance hasn’t helped traders much. But that doesn’t matter for investors; the insight into their long term thinking, presented as it is in a quantitative form, really is useful.

Hawkish is not an adjective that will be applied to this Fed anytime soon. In fact, one FOMC member included a forecast for a negative Fed Funds rate by year-end, a no doubt aspirational forecast but probably the first time an FOMC member has advocated such a thing. The Fed chair is clearly among ideological friends. Janet Yellen’s deeply held feelings for the unemployed inform her past writings and those of her husband George Akerlof. These are admirable personal qualities and not bad public policy concerns. Given that inflation remains below the Fed’s target, monetary policy can remain focused on doing all it can to promote growth, thus raising both employment AND inflation. Wgat some perceive as the Fed’s short run trade-off between maximizing employment and controlling inflation is unlikely to be tested anytime soon. Rates will rise slowly, because the future is always uncertain and because the neutral policy rate is in any case steadily falling towards the current one.

The low real rate contemplated by the Fed reflects their lower estimate of the economy’s growth potential. This is not a contentious view, it’s just that we’re seeing it play out through their rate forecasts.

The clear implication for bond investors though is that it’ll be a very long time before they make any money. The Barclays AGG is +0.64% YTD. This is the type of return bond investors can expect. Taxable investors are losing money in real terms and the Fed hasn’t even begun raising rates yet. Moreover, it’ll be years before this Fed gets bond yields to levels where a decent return is possible. It’s as I said two years ago in Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. Bond holders are in for years of mediocre results or worse. It’s not going to be worth the effort. Take your money elsewhere.

On May 22, 2013 then-Fed chairman Ben Bernanke inadvertently added “taper tantrum” to the lexicon of terms used to describe the impact of the Fed’s activities. That date marks the formal beginning of the Fed’s efforts to prepare financial markets for an eventual tightening of policy — or the start of the removal of accommodative policy, to use their description. In the belief that transparent policy deliberations reduce the possibility of a monetary surprise with its consequent financial market upheaval, the Fed’s public statements, release of projections and even the ubiquitous “blue dots” showing the rate forecast of each FOMC member have all been provided to help us. In fact, for almost four years I’ve been constructing an “FOMC Futures Curve”, which is what short term interest rate futures would look like if FOMC members were the only participants. It’s been absorbing for brief moments around four times a year when they provide updated information. Many might find it a nerdy preoccupation, but having spent a good part of my career in Fed-engineered darkness over their intentions, the shift to greater openness begun under Greenspan has been fascinating.

Forward guidance presumably is intended to let us know what the Fed will do before they do it. As we head into a two-day FOMC meeting on September 16-17, opinions are evenly split about whether they’ll raise rates. Perhaps we ought not to be surprised in either outcome, but it seems to me that if there’s no consensus after years of openness, the communication strategy has failed. The problem with providing meaningful forward guidance is that it involves a commitment, and a commitment reduces your ability to change your mind. The window into the Fed’s deliberations has simply revealed that they want to retain maximum flexibility until the day they meet. Announcing a hike with a delayed effective date would soften the blow (see Advice for the Fed) but it’s too late for that.

Following the FOMC’s announcement and the elimination of near term uncertainty, investors will be faced with the same dilemma as before: how are they to invest so as to preserve the purchasing power of their assets after taxes and inflation? Whether ten year treasury yields move up 0.25% or not this week, the paucity of assets offering acceptable returns will remain Dilemma #1.

Suppose a taxable investor visits her financial advisor with the objective of constructing a portfolio with a 6% return and moderate risk. Assuming our investor is facing a 30% average tax rate (combination of Federal and state taxes on capital gains, dividends and ordinary income), a pre-tax 6% is 4.2% afterwards. 2% inflation (the Fed’s target) knocks that return down to 2.2%. Then there are the advisor’s fees, and the possibility that returns won’t be as hoped. 6% doesn’t seem that demanding given all of this, and yet the building blocks with which to achieve it are limited.

Public equities yield around 2%, and assuming the fifty-year average dividend growth rate of 5% prevails (for a total return of 7%), stocks clearly are part of the portfolio. Bonds (as defined by the iShares Aggregate Bond ETF which tracks the Barclays Aggregate Index) yield 2.4%. Since the yield at which you buy a bond heavily impacts your total return, it’s going to be hard to do much better than 2.4% with investment grade debt. Moreover, the ability of bonds to offset a falling equity market is limited given their already low yields. Backward-looking models may justify them, but to us they look like returnless risk. Moving up the risk spectrum to High Yield gets you 5.5% (as defined by the iShares High Yield Corporate Bond ETF). There is some chance for capital appreciation — but this year capital losses have more than wiped out coupon income reflecting the preponderance of energy names in the index.

REITs yield 4.4% (as defined by the Vanguard REIT ETF), and this, combined with some modest growth may deliver a return that at least equals the investor’s 6% target.

Regular readers can by now guess where this is going. The Alerian MLP Index, yields 7.25%, and MLP distributions even grew in 2009 following the financial crisis. However, MLPs are down 23% so far in 2015. In fact, they’ve fallen that much since the end of April, creating an unpleasant backdrop to an otherwise glorious Summer for anyone more than tangentially involved.

There is a bear story to MLPs, as those prescient enough to sell at the highs of August 2014 well know. A 33% drop can’t happen without a fundamental story, and the collapse in oil is challenging the expected production growth of U.S. shale plays with its attendant reduction in needed infrastructure. The growth story that has driven MLP prices is in doubt.

It’s therefore instructive to examine metrics on a number of businesses as they were in August 2014 and how they appear today. The table below shows forecasts for 2016 distributions from selected MLPs (chosen unscientifically because we are invested in them or the General Partners that control them), and shows how those 2016 forecast distributions have changed from the market peak in MLPs 13 months ago to now. The data is from JPMorgan but such figures are typically heavily influenced by company guidance.

Looking at the numbers, you certainly wouldn’t think we’d seen a collapse in oil. The 2016 forecast distribution for this group is modestly lower at $2.90 (cap-weighted) versus $2.99 a year ago. The market cap of these companies (excluding Kinder Morgan since during the intervening period it combined with its two outstanding MLPs to create a substantially larger entity) has fallen by 16%, hence the 2016 yield has risen from 5.2% to 6.8%. Just looking at the General Partners in this group (KMI, OKE, PAGP and WMB) provides a similar result. The operations of these firms and their cashflow generating abilities have on average not shifted that much. Plains All America (PAA) and its GP (PAGP) have seen forecast reductions because of their crude oil exposure. The same is true of Oneok (OKE).

But overall, the fall in their security prices has simply driven up their yields. These names are representative — they’re all midstream, which is to say they operate toll-like business midels with limited direct commodity exposure. There are MLPs concentrated in Exploration & Production (upstream) and others that run refineries (variable distribution MLPs), but we don’t care about those.

So for the investor seeking a 6% portfolio return, the most compelling reason to exclude MLPs is the 23% drop since April which has made few people happy. However, looking beyond the undoubted voting by many investors who have abandoned the sector, 7% yields combined with 8-9% growth rates (the cap-weighted forecast on the group of names listed) seems pretty compelling for long-term investors willing to look beyond recent price action and focus on the fundamentals by including MLPs, perhaps even with an overweight, in their portfolios.

Everybody wants to know why the market just did what it did, and what is its next likely move. Chinese equities don’t seem that important to us, but the U.S. sell-off in August coincided with the Chinese one so maybe there’s a stronger connection than we thought. It’s important because investors would love to alter their risk profile profitably — taking more risk when markets are rising and less risk when they’re falling. There is of course an easy way to do this, which is through buying call options. Through their command of Greek, an option’s Delta (your exposure) moves in synchronicity with the market in a thoroughly satisfying way (if you’re long), and the more Gamma you have the more co-operatively your Delta recalibrates your risk appropriately. The snag with this most Utopian of investment postures is that buying options costs money. The happy state in which options deposit their holders cannot be had for free.

Nonetheless, the search for free, optimized risk is never-ending. Investors want more risk when it’s low and less when it’s high.  Put another way, they want less risk but not yet, as St. Augustine (“Give me chastity…but not yet”) might say if he was alive today and glued to CNBC. Older readers will recall Portfolio Insurance, which was blamed for the 1987 crash. Its adherents were required to sell when prices were falling and buy when they’re rising, mimicking the exposure shifts created by being long options but without having to fork over the option premium. It must have worked for a while, but most good ideas in investing eventually die of popularity, and too many portfolio insurers ultimately ran out of less-informed market participants against whom to trade. For the iron rule of hedging is that it requires the availability of a counterparty who isn’t hedging.

Today’s Risk Parity (RP) strategies are more sophisticated, as you might expect given the quantum increase in desktop computing power over the last 28 years. Practitioners target a specified amount of risk (typically defined as volatility) for each chosen asset class, and vary the amount of assets invested as needed. Higher expected volatility tomorrow, which is usually the result of higher actual market volatility today, requires reduced holdings in that asset class so as to maintain constant risk exposure. At its most basic, RP reduces down to changing your risk profile as your forecast of market volatility changes. Equity markets rise slowly and fall sharply, so looking back at a rising market makes you want more of it, and less of one that’s falling. These are pro-cyclical strategies, and they’ve evidently been very successful because their followers are growing in number. RP and other momentum strategies are now blamed by some for the performance of stocks in August. Leon Cooperman of Omega Advisors, a big hedge fund, blamed risk parity strategies for both his fund’s and the S&P500’s poor results. How ironic that one overcapitalized sector (hedge funds) is complaining about another over-capitalized one (RP). For more on hedge funds, see Direct or Indirect, the hedge fund industry can’t deliver.

Before you discount Leon Cooperman as offering a self-serving defense, you should know that JPMorgan’s Marko Kolanovic published a recent research note in which he sought to quantify the volume of selling that such strategies might execute in different market scenarios. By calculating the amount of RP and momentum-based capital and adding informed judgments on how it reacts, he came up with numbers, and he concluded that selling in the hundreds of billion of dollars is possible. Moreover, because such portfolio adjustments take place over many different time periods, the type of dislocation that we saw on, say, Monday August 24th will, in his opinion, be repeated.

Much of this risk on/risk off activity measures risk as volatility, which is not the best measure for most investors unless you use leverage. Investing with borrowed money means you not only care about whether an investment travels from 10 to 20, but also the path it takes on its way there. Stopping at 5 first represents merely an inconvenient detour for the cash investor but a potentially capital-destroying one for the leveraged one as a margin call forces untimely liquidation. Cash investors who worry excessively about the market are emotionally leveraged if not economically so; their best move is to reduce their positions to the point at which they are more concerned with their golf swing. For a cash investor, the risk of a permanent loss is the risk they care about. If you own companies with strong balance sheets and earnings power, the path prices follow needn’t concern you. Just focus on the health of your companies’ businesses.

The nice thing about Leon Cooperman’s complaints is that our inability to link Chinese equity volatility with the U.S. looks slightly more forgivable. In fact, it renders most short term market judgments invalid unless they accommodate the emotionless algorithmic activity of RP. Explaining market moves in the context of fundamental developments may be less important than interpreting them through the eyes of systemic traders. This is our Brave New World. Investors should conduct their affairs accordingly.