http://video.foxbusiness.com/v/2652189553001/time-to-dump-bonds/?playlist_id=1071839331001

I’d never heard of Keith McCullough until today when we noticed that Kinder Morgan (KMI), a stock we own, was down 4%. MLPs are weak but KMI and its cousins KMP and KMR are certainly leading the way. The driver appears to be a bearish report on Kinder Morgan to be released to clients of Hedgeye next week. We like KMI for its 4% yield, long history of stable growth and management guidance of 12% dividend growth. KMI owns the IDR’s for Kinder Morgan Partners (KMP) which we also own, and around 50% of distributable cashflow from KMP now goes to KMI. In effect, KMI is a hedge fund manager charging 2 and 50. It seems like a decent investment.

Keith McCullough has in the past made some bold calls. In 2010 he apparently advised clients that France and Italy would both crash as the Euro crisis unfolded, and also at around the same time recommended that they sell all U.S. stocks. I must confess that we didn’t read about those forecasts as the time because we weren’t then (and aren’t now) subscribers. In fact we didn’t hear about them at all until reading about Kevin McCullough today.

Two spectacularly wrong calls don’t tell you anything about whether the KMI call will be right or wrong (and in any case there may have been hundreds of correct calls since 2010). We still like KMI, although we haven’t read Hedgeye’s report. We bought a little more today. He obviously has the ability to cause short term moves in stocks, so we’ll be watching what he has to say (though not as a subscriber).

In writing this month’s letter (just published earlier today) I researched the source of the quote, “If you torture the data long enough, it will always confess.” It was attributed to Ronald Coase, listed on Wikipedia as “Born 1911”. Because his dates did not include an end date for his life, it somewhat improbably suggested he was still alive at the age of 102. However, not wanting to assume Mr. Coase’s demise prematurely, I did not describe him as “the late Ronald Coase”.

I just read in the NY Times that he passed away in Chicago yesterday, at the age of 102. I’m glad I assumed nothing less.

In what will hopefully become the new normal for websites, the Huffington Post last week announced they would no longer be allowing anonymous comments on their website. This is a completely sensible move and one that will add civility (their main objective) as well as raise the quality of comments that are made. How is anyone supposed to properly evaluate a comment or opinion if it’s expressed without disclosing the commenter’s identity? It’s a basic element of public discourse and debate that who is saying something is relevant to what they are saying. The individual’s qualifications to hold an opinion as well as any potential for conflict of interest or inconsistency with past statements are all valid information for the reader. Many argue (always anonymously) that they are prevented from posting their identity because of restrictions imposed by their employer (in which case maybe they should just respect those restrictions). Others claim fear of harassment of some form. But an opinion uttered anonymously is not worth the time it takes to read. Anonymous comments are simply an indulgence to the commenter. I always ignore anonymous comments on anything I write, and only respond to those with a true identity attached. This is the standard that should prevail in the civilized areas of the internet. If you disagree, please don’t bother commenting anonymously.

I was struck by an article today on how much Japan will spend next year servicing its debt. In its next fiscal year the Japanese Ministry of Finance (MOF) expects to spend ¥25.3 Trillion on interest. That’s about $260 Billion, or just over 4% of its GDP. By contrast, the U.S. spends just over 2% of its GDP servicing its Federal debt (although that’s only about half of our total indebtedness; America too has its debt problems).

The big question around Japan’s fiscal outlook is, at what point does this become unsustainable? When does the burden of financing the debt require more debt, in a type of fiscal Rubicon? It’s hard to say definitively. By most historical measures Japan’s situation is already beyond repair. However, a crisis has so far been avoided. This is in large part due to the fact that their debt is domestically owned. Japan is borrowing a lot of money but it is doing so from itself.

It does lend support to the theme of a weakening Yen though. Higher domestic inflation and a negative real return for the savers who own Japanese bonds probably represents the best chance for a drama-free resolution. Shorting the Yen continues to be a trade with lots of optionality – as well as being aligned with stated government policy it may benefit from any number of other macro-economic developments including faster U.S. GDP growth, unfavorable interest rate differentials and perhaps higher energy prices due to growing turmoil in the Middle East.

In recent weeks much has been written and said about who President Obama should select as the next Fed Chairman. Supporters of Larry Summers and Janet Yellen are said to be each pressing the case for their candidate from behind the scenes. For a position that is supposed to float above politics, it is surprisingly political.

So without regurgitating what’s already been said, let me offer a couple of observations. Larry Summers is routinely praised for his intellect. CNBC this morning described him as a “brilliant economist”, a breathless term that many might regard as an oxymoron or at least not wholly complimentary. Although I’ve never met Larry Summers, his high IQ is so often cited by others that one is left with the uneasy feeling that he uses every interaction with people to make sure his brilliance is on display and not missed. Modesty is an adjective rarely in the same zip code as Mr. Summers. That may not disqualify him, since politics and business are both full of people unburdened by much self doubt. Nonetheless, the future is generally uncertain and the next captain of monetary policy might be expected to retain some humility with respect to the brilliance of their own views.

Janet Yellen’s qualifications are that she’s already Vice Chair of the Fed’s Board of Governors. Since 2008 the Fed has been engaged in the most enormous monetary experiment labeled QE and the purchase of more than $3 trillion of bonds. Curiously, CNBC labeled Dr. Yellen’s “ownership” of current policy as a negative. Since the Fed will presumably be navigating an exit from QE during the term of the next Fed chairman, it would seem less disruptive to have the steering performed by someone who helped get us in there in the first place. You can almost hear Fed Chairman Larry Summers, at the first sign of market trouble, proclaiming that had he been in the job since 2008 his intellect would have kept us out of the current situation.

As with many ideas in investing, while we all have opinions on what should be, more interesting is assessing how they will probably be and investing accordingly. My views on the next Fed chairman won’t alter the outcome of that decision. However, exiting QE will represent an enormous communication challenge for either of these candidates. Janet Yellen will be inevitably labeled a dove on monetary policy, and bond investors will likely assume a tightening of short term rates is even farther away than the approximate date of 2015 indicated by the FOMC’s blue dots. The Fed will be either late or very late in restoring rates to neutral. It’s a long time ago now, but I remember in 1987 how the incoming Fed chairman Alan Greenspan was immediately faced with a bond buyers’ strike. Yields rose as investors fretted that nobody could adequately fill the shoes of Paul Volcker, the vanquisher of the inflation dragon. Greenspan was felt to be a poor second act.

As Fed chairman, Larry Summers will be unpredictable. No doubt his prodigious intellect will at some point lead the less intellectually gifted ROTW (Rest of the World) to misinterpret his statements. In either outcome, bond investors will be grappling with less certainty than they were used to. The role of Fed chairman changed in 1975, 1987 and 2006. We’ll soon get only the fourth change in 39 years. It’ll be a big deal. Bond investors probably deserve a little more risk premium in the yields they accept as we head into the next transfer of power.

If you stop to think about it there are several analogies for the Fed’s “tapering”, under which they gradually relax the support which has been underpinning the bond market. Maybe it’s the parent who creeps out of the young child’s bedroom at night believing they’re finally asleep, only to be halted by renewed cries from the little one. Maybe it’s Jenga, a game played with wooden blocks where players alternate turns of removing one without causing the structure to collapse. Or perhaps the magician who dramatically whips the tablecloth smartly off the table while leaving the place settings unmoved.

Whatever imagery does it for you, somewhere within the investment horizon of most people the Fed will make their move. Which is why a Bloomberg article on Bridgewater’s $80BN All Weather fund caught my attention earlier today. It seems that in recent weeks Ray Dalio substantially reduced their exposure to Fixed Income. Apparently not in reaction to the weak bond market of the second quarter, but instead as a result of many months of analysis which concluded bonds were no longer as attractive in a portfolio that’s expected to generate positive, uncorrelated returns most of the time.

The classic justification for holding bonds is the diversification they provide to a heavy weighting in equities. It’s worked more often than not, but we may just be heading into a period of time that will test conventional wisdom. To start with, yields on high grade and government bonds are unattractive on a buy and hold basis. It’ll be hard to finish ahead of taxes and inflation with yields of 2-3%. The idea that bonds will rally during times of equity market stress, thus mitigating the inevitable mark to market swings of a conventionally allocated portfolio only seems to justify bonds if you’d actually sell them when they’re bid up through a flight to quality. Few investors do, and the ownership of bonds for the temporary sugar high that turmoil may bring seems less interesting when the long term prospects are poor. Watch for creative explanations from financial advisors to defend clients’ bond holdings in the future.

But the other side of things is that stocks and bonds may at times be highly correlated on the downside. If the Fed’s attempts to at least slow the growth of its $3.5 trillion balance sheet awake the sleeping child, or perhaps even result in a smashed dinner set all over the floor, weaker stocks may be accompanied if not even caused by weaker bonds. The flight to quality may not work.

We believe the most likely outcome is one of very measured, non-threatening reductions in Quantitative Easing and a further very long interval until short term rates rise. This is what the Fed has told us to expect. But that’s just a forecast, and we could be wrong. However, if we do find ourselves in a substantially weaker equity market caused by the Fed’s lack of manual dexterity, we at least won’t have compounded the error by owning bonds as well.

This morning I noticed an article on Seeking Alpha by Alan Ginsburg making the case for shorting Joseph A Banks (JOSB). The writer makes a good case that the company’s financial statements are untrue and that a conflict-driven management team has at times “looted” the company. We have no position in JOSB and no plans to take one. I was simply reminded of Marc Cohodes, a passionate short seller (they usually are) who in early 2008 made the case at a presentation I attended that JOSB was a sham and was going to collapse. Marc was similarly convincing and had evidently done his homework. Sadly, though, in 2008 his short positions blew up on him during Lehman’s bankruptcy (you may recall a temporary ban on shorting financials at that time which caused a brief but sharp rally). It should have been his year, of all years. But it wasn’t.

Early last year I noted that Marc Cohodes had turned his back on Wall Street to run a chicken farm. It was one of the less likely outcomes of the 2008 Crash. We certainly wouldn’t own JOSB, and we don’t short individual stocks so my only involvement with JOSB will be to occasionally buy a pair of socks there. I haven’t so far been seduced by the “Buy One, Get Two Free” pitch for their suits. But if they do eventually collapse and Alan Ginsburg is right, someone else was on to the story already, if rather too early.

Barron’s published a panel discussion on MLPs this past weekend. The panelists debate whether MLPs are still attractively valued or not and their sensitivity to rising rates. Although MLPs have been very strong this year, with our MLP Strategy +23% year-to-date, we continue to think that distribution yields of 5-6% and conservative growth prospects of 4-6% (implying a total return of 9-11%) make this a good asset class for the long term investor.

It’s important to pick the right names though as in any investment strategy. Because MLP investors are driven in part by the tax deferral treatment of the distributions, this is also not a sector that lends itself to much trading or switching out of names. Indeed, a well-managed MLP portfolio should be the most parsimonious user of brokerage services, because it should have minimal turnover. Selling an MLP typically triggers a taxable gain, and as time goes by the hurdle a new investment must clear in order to justify the tax bill incurred by selling an old one can become almost insurmountable. Earlier this year one friend suggested MLPs were due for a correction and noted a well-regarded MLP investment manager was selling. In our analysis we found that for some long-standing accounts it would have required that the cash thereby raised be reinvested at prices 20% lower simply to break even on the taxes incurred through selling in the first place. Meanwhile, the manager’s track record would not show the after-tax return. His clients could be worse off even while his track record looked as if timing had helped them. As it turned out though, this Spring correction was only around 2% so not worth the trouble.

Some MLPs offer very high but fluctuating yields. Petrologistics, LP (PDH) is an example. They convert propane into propylene, and so their earnings are highly sensitive to the price spread between the two. Their current distribution yields is 9.8%. Their 2011 S-1 registration statement warned of wide fluctuations in their distributions depending on business conditions. Their most recent 10K noted that, “We may not have sufficient available cash each quarter to enable us to pay any distributions to our common unitholders.”

It’s not just that LP investors are typically looking for stable yields and that PDH does not promise that. The additional challenge is that there are probably times to own PDH and times to be out of it. More frequent buying and selling reduces the amount of capital available for an investor to deploy because of taxes.

The Barron’s article mentioned other MLPs with more volatile business models, such as CVR Refining (CVRR). Refining can be a feast or famine business depending on margins which fluctuate widely. CVRR’s current distribution yield is an eye-catching 20%, although there’s clearly some doubt about its sustainability since management recently lowered its guidance.

There was also an interesting piece on Seeking Alpha this morning on StonMor Partners, LP (STON). STON is not in the energy business at all, but is in “deathcare”. They operate cemeteries and funeral homes. For historical reasons they operate as an MLP. The 9.6% distribution yield is attractive, although we’ve never invested because we found the financial structure overly complicated. Managing cemeteries is somewhat similar to running an insurance business, in that you get to invest the float. In STON’s case, people buy cemetery plots with cash and the maintenance costs of the cemetery are spread over many years.

The Seeking Alpha article notes the absence of much insider ownership or even institutional ownership, and asserts that distributions are persistently funded with issuance of debt, rather than out of profits. The writer believes a distribution cut is likely.

If any of these names mentioned above cut their distribution because of insufficient cash, as a friend of mine has said in the past, “Down’s a long way from here.”

http://in.reuters.com/video/2013/07/23/wealth-strategies-avoid-all-fixed-income?videoId=244354762