The market is trying to recover, though it faces headwinds and needs the housing sector to stabilize before a sustained recovery can occur. While the market broke through 7500 for a few days in February (intraday it reached 6300 on the Dow), this oversold condition snapped backed quickly, and it appears (for now) that the market remains in a trading range between 7500-9000, and it had recently reached the 8250 range. Equity valuations are favorable. The current environment has been deflationary, and the Federal Reserve is pulling out the stops to prevent deflation, because inflation is always preferable to deflation. However, our Treasury and Fed are working in concert, and the Obama Administration is spending even more wildly than the Bush Administration. The Chinese government is right to worry about their investments in our Treasury securities as we monetize debt, print money, and threaten to devalue our currency. All Treasury has to say is “we’ve never defaulted on our debts”, but that is not the issue; the Chinese government does not want to be paid back in 60-cent dollars! The current policy prescriptions appear to be “growth at any cost”. Even in this environment, the long term prospects for Equities at these prices and valuations are very attractive. The short term looks deflationary, and the mid-term looks like we will eventually end up fighting inflationary head-winds once the effects of our massive money printing press takes hold. Therefore, you will begin to see some new defensive hedges in the portfolios as we attempt to be prepared for future market developments. For new investment we are looking to commodity-related companies, oil, oil services, agriculture, mining, materials as inflation hedges.
Market Climate/Banks
The current Market Climate in stocks is characterized by favorable valuations but with additional volatility amongst earnings concerns. However, we do view stocks as relatively undervalued, and thus far the economic data and earnings data have been “mixed”, which is a better state of affairs than we have seen in the last 7-8 months when all data was negative. Investor sentiment has followed this mixed data, though it is quite possible, and probable, that we could end up with another leg to the downside based on some additional bad news. However, as long term investors we need train ourselves to welcome market weakness because it allows us to establish greater investment exposure at a point where stocks might be priced to deliver higher long-term returns.
The Obama administration, in the eyes of the market, threw many mixed signals during the first 90 days of the year, which reached its peak of opacity during early February. At the time, Treasury Secretary Geithner appeared to be in favor of nationalizing the banks; Fed Chairman Bernanke was against it; President Obama could not dispel the notion. When the government nationalizes an entity, it crowds out the common equity holder, and in this case it appeared that Citigroup and Bank of America were the first targets to suffer common equity shareholder dilution. The potential dilution was abot 45-50%. The following week, Citigroup received funds representing 45% of its capital, taking the shares to 80 cents/share. So to wrap up what occurred, the attempt to “save the banks” led to opaque and confused policy discussions at the highest levels, which obtusely led to uncertainties so severe as to threaten the viability of the banking system. Investors and depositors voted with their feet, depleting the banks of their capital, which made it more and more likely for a need to nationalize the banks. This is the crux of the situation; markets need certainty and the system needs trust. When these two elements become threatened, the entire system becomes threatened.
Valuation Hunting
Where we can find them, the deeper value investment opportunities we gravitate towards involve companies whose Total Assets/Total Stockholders Equity ratio is higher than 50%, with a Price/Earnings ratio under 10—this is classic Benjamin Graham value investing. This is usually a good place to start digging deeper, as the high asset ratio gives us a strong margin of safety. When we look at the prices of companies, it is important to separate “why” they are trading at a certain price (indicating its valuation), and to realize that the confluence of events in virtually any market can deliver either high or low valuations. We don’t necessarily care “why”, we just care that we can buy it cheaply. A good analogy right now exists in the retail clothing area; many high-end stores are selling their wares at 80% off. High quality clothing, especially the conservative style-neutral, can last a *long* time, so one would not care “why” prices were low, but rather focus on increasing the size of one’s wardrobe significantly. The stock market will likely remain erratic, it may trend further down before finally stabilizing, but we remain alert and know there will be, and are, good opportunities for the long term investor.
Perspective is Important
A little perspective is in order here. Just as the peak of the 1999/2000 tech bubble looked like it was "different this time" in an optimistic sense, the Panic of 2008 looked like it was "different this time" in a pessimistic sense. The only thing we can point to is that in both instances, the extreme view over time is not likely to be warranted. It’s always easier to identify fear than greed. The truth is that a "normal" market is somewhere between the extremes.
Mark Twain had it right when he famously said “history doesn’t repeat itself, but it rhymes”. The message here is that we will get through this. We’ve been through worse, with higher unemployment, higher interest rates, and more misery. Just in recent history, recall that in October of 1987 the market dropped over 20% in one day, with no bottom in sight, leaving the S&P 500 Index at 224.84. This year, on October 1, the S&P 500 Index was as 1161.06, up 416% since the 1987 crash. This is a stunning advance through a whole series of crises: the savings and loan crisis, the Gulf War, the collapse of Long Term Capital Management, the Russian default, the dot-com bubble’s burst, the attacks of 9/11/01, and a brutal 2002 Bear Market. We have now seen the Panic of 2008 and the market appears to be in a bottoming process between 7500-9000 on the Dow.
Real Estate Needs to Recover
The real estate market needs to show some improvement. It is estimated that about 10million homeowners are living in homes with no equity. The market needs the banking and real estate sectors to stabilize before we can make any real progress. The housing issue is complicated, and needs some new thinking. As mentioned in the prior issue, mortgage debt obligations need to be restructured, and a coordinated effort from government entities would help in this regard. Credit default spreads suggest the need for coordination is needed yesterday.
Gold and Gold Miners
By tracking the actual price of Gold with the Gold Miners Index (GDX), there still appears to be an enormous disconnect here. Even if gold prices were to fall in half from here, gold stocks would be fairly valued. The ratio of Gold to Gold Miners index is low. Current deflationary pressures are also keeping gold down, which could hold true during a recession, but lookout for inflation in the next 12-18 months during an economic recovery. The stock market often recovers before a recession has officially ended. And with all of the market uncertainty, questions about the massive debts the U.S. is creating, as well as all that money we are printing, gold and other precious metals could be an interesting insurance policy, particularly if the U.S. ends up de-valuing its way out of this current market weakness. We recently read a research report which suggested that if all of the debts and future obligations of the United States were backed by gold then the requisite price of gold needed to be $15,000/ounce (currently around $950). A devaluation of the U.S.$ by definition means an increase in the price of gold, oil, and other commodities, since all of the above are priced in U.S. $. There is a threat, though remote, that foreign countries and organizations (such as OPEC) could demand payment in Euro instead of U.S.$, which would of course wreak havoc, would immediately create a major disruption between the U.S.$/Euro leading to a much weaker U.S.$.
Bonds, Yield Curves
Gold, Money Market, and Treasury securities were the assets of choice in the Fall of 2008. The bottom line is that the Fed has lowered rates to between 0- 0.25% and Treasury securities do not pay relative to other securities. As credit conditions have continued to thaw out (or as the Fed has forced investors to chase higher yields!), spreads on High Grade Corporate Bonds are 5- 6% better than Treasuries, spreads on High Yield Corporate Bonds (aka “junk”) are 15-20% higher than Treasuries, and some high quality franchise stocks are yielding 5-6%. Should inflation rear its ugly head, or should other countries find Treasuries less than appealing due to our profligate spending, a sell-off in Treasuries could ensue. The implied returns of a 30 year Treasury Bond is ridiculously low, while the implied returns for the stock market at this time look much more attractive with a long term perspective. CA Municipal bonds have been volatile in price, but have stabilized significantly in recent weeks. With yields in the 5.1% range, double-tax-free CA Municipal looks extremely attractive. The recent 5.1% yield on CA Municipals is a 10.2% Tax Equivalent Yield if you factor in the highest Federal bracket and CA state taxes.
The way to think about the relationship between TIPS (Treasury Inflation Protection Securities) yields and straight Treasury yields is that the nominal yield on a security is equal to the “real” yield plus expected inflation. It does not appear that we are near the point where there is any real risk of inflation, and we may very well observe negative near-term inflation rates. TIPS can't mature at less than par, but if there is a deflation, the accrued inflation adjustment on these securities can be whittled down. Suffice it to say that we are holding TIPS not because we anticipate a near-term resurgence of inflation, but because the real, inflation-adjusted yields available over the next decade are quite high on a historical basis, and will adequately provide for the maintenance and growth of purchasing power over time, regardless of the near-term course of consumer prices.
Lifting the Veil
The below graph illustrates one of the more interesting insights I’ve seen in 15 years in terms of research. If we equal-dollar-weight the S&P 500, Nasdaq 100, and current Dow Jones Industrial average (three major indices) as compared to the Dow Jones of the 1930’s, we are capturing a very good look at the “broad market”; recall that back in the 1930’s, the Dow Jones was the broad market. If this chart doesn’t support the financial theories of behavioral economics, nothing will.
The burning question in retrospect becomes: have we really been in a depression since March of 2000? What was different? What happened to disguise it? September 11, 2001, plain and simple. 9/1l occurred, and our response to it was to take the Fed funds rate down dramatically and for too long, which put our economy on steroids. Unfortunately the Fed let all of us take steroids too, which led to the credit bubble, housing bubble and, one could argue, a “false Bull market” that topped out in November 2007. September 11 put a veil on our economy, and the credit crisis lifted the veil in 2008. Fortunately there have not been many “lost decades” on record such as what we have just suffered in the stock market, and valuations are quite compelling.
Retirement and the Required Minimum Distributions
When people retire, they have different philosophies on enjoying their retirements, leaving assets to children, leaving assets to charitable organizations, or taking the attitude that “you can’t take it with you”. Generally speaking, a withdrawal rate of between 4-6% is advisable on the corpus of your assets in order to create an annual income that is achievable over a long period of time within the context of your asset allocation. Over 20-30 years, a 4% withdrawal rate on your assets, using the correct allocation, should create a virtual perpetual annuity (i.e. at the end of 20-30 years your asset values would approximately equal the beginning value). This is achieved because the average annual return your portfolio would be “aiming for” would either match or exceed your withdrawal rate over time during retirement. As the withdrawal rate is raised to 5%, 6%, etc., the probability of your returns beating the withdrawal rate falls. This does not mean, however, that your retirement plan is flawed or will fail; it just means that your withdrawal rate would be eating into the corpus of the assets.
We have been busy meeting with recent retirees, or soon-to-be-retirees, in addressing the above consequences of withdrawal rates within the context of a proper asset allocation. If you would like to go over this same exercise, please give me a call and we can sit down and do so.
Thank you for your continued business and amazing referrals
I know this has been a very unsettling experience for all of us as investors. Please know that I am here to answer your questions, to go over your portfolio positioning in the context of your retirement plans, and to provide a sense of perspective in this market. Investing is a long term endeavor. There are incredible equity valuations now, and though risks remain, patience will be rewarded.
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