Crossing the Rubicon

Crossing the Rubicon   

The European Union’s agreement to continue to backstop Greece in the last quarter was significant: it signals that the Eurozone will continue its stabilization efforts. The two largest economies in the EU, France and Germany, simply have too much to lose by not holding the Euro together.

2012 is an election year in the US, and we sense policy changes in the air whether the current Administration remains, or is replaced.  Either way, we think more certainty is coming, regardless of the current uncertain state of affairs.  Investors and the market are tired of the uncertainties created by excessive cheap money policies and general government intervention.  As Europe eventually stabilizes, and as the election unfolds, we will experience increased certainty and more clarity from a fiscal, tax, and investment perspective. We try not to be political in these recaps, though we need to put election scenarios on the table since they directly affect market and business sentiment. 

If Romney wins the Presidency, we foresee an attempt to slow government spending (AKA the Ryan Plan) in conjunction with more certainty in tax and investment policy, and an earnest attempt to repeal the Affordable Care Act (ACA) if Republicans can garner 51 votes in the Senate.  51 votes is a simple majority requirement to repeal the ACA since it was passed as a “reconciliation” bill.  Then perhaps a bipartisan effort can generate a giant “do-over” that includes some of the obvious advantages that exist now, but with more market-based mechanisms in it.  Additionally, in a Romney campaign/victory, he would need to address the fiscal “tax cliff” that ends 12/31/12, and would attempt to pass legislation retroactive to 1/1/2013; however, much economic carnage will have been experienced by 12/31/12 despite these efforts.  On 1/1/2013 the top federal rate on personal income will increase to 39.6% from 35% (a 13.14% increase), with an additional 0.9% increase in payroll tax for Medicare.  The highest federal rate on dividends will increase to 43.4% from 15% (189% higher!), and the tax rate on capital gains will increase to 23.8% from 15% (“only” 58.6% higher).

If Obama wins the Presidency again, in what is undoubtedly a referendum election, we foresee additional thrust in fulfilling his agenda of “Hope and Change”; in other words, he would take a re-election as a mandate for more of the same. Yet if Obama wins re-election, we view it as less likely that his party will hold either the Senate or the House, thus any effort to repeal the ACA in this scenario will ultimately fail unless both the Senate and House can muster 2/3 supermajority votes to over-ride a certain Presidential veto of a repeal effort.  ACA would almost certainly stand.  We head over the “tax cliff” 12/31/12 and there will be no effort to address this. 

Whoever wins, there will be more certainty.  However, in our opinion the United States is at a giant fork in the road—thus the decision to cross the Rubicon, or not.  Voters must make the decision which direction the country goes— there is no going back.  As Julius Caesar might tell us, “the die has been cast”…but the way it is cast is up to us. 

Julius Caesar, Crossing the Rubicon

Valuations

Against this macro-economic backdrop, common stocks are reasonably valued, while bonds are historically expensive as fear trumps optimism. Valuations between common stocks and fixed-income securities have not changed materially since our last commentary. 10 year yields on US Treasuries touched a low of about 1.45% and have since inched up to approximately 1.60%.

US Stocks are now more attractive than earlier on a valuation basis. S&P 500 earnings estimates suggest that stocks are selling for roughly 13-14X this year’s expected earnings. Stocks are also providing dividend yields of 2.1% which is more than 0.5% greater than the yield on 10-year Treasuries. International stock prices have fallen further and we are seeing interesting opportunities in foreign equities.

We still believe equities are attractive investments, but do not see any near-term catalysts for rising prices. As discussed, economic growth is lackluster and the world is still deleveraging, which suggests limited potential for expansion until more demand emerges.

Risk Adjusted Values:    We continue to favor stocks that look like bonds and bonds that look like stocks.  We are actively screening for equity valuations trading for 7-12x earnings, with dividend yields between 3-6% as an added bonus if we can find it.  By buying the earnings stream of a high quality company at these valuations, we are much more certain in our investment thesis in terms of risk. In other words, we are looking to buy an earnings stream for ½ to ¾ of the valuation placed on the broader market, which only yields 2%. So any stock that pays 3-4% at a minimum is yielding twice as much as the S&P 500 with ½ to ¾ of the price risk.  With the high grade corporate bond index paying between 4-5% yields, it becomes clear that if we can find great companies with even higher payout attributes, we are buying stocks that resemble bonds.  

What is Earnings Yield (E/P) Ratio?

Simply put, Earnings Yield is the inverse of the Price/Earnings ratio.  If the P/E ratio of the S&P 500 is 15.5 (current), the E/P is 6.4%.  This is also a good proxy for what the stock market might give us in terms of return, which is consistent with the CAPM (Capital Asset Pricing Model), which typically maintains an Equity Risk Premium of 4 points over Treasury yields.  We think the “goal posts” of Equity Returns are somewhere in the range of 6-9%, which is consistent with the long term averages of the S&P 500, which is 9.9% over 80 years of data.  So the question is:  what will it take to get the E/P Ratio higher?  Higher earnings in a sideways market works (and we have been sideways for 10 years), or lower prices.  If the “animal spirits” are rekindled through pursuit of the appropriate economic, tax, investment, and fiscal policies, the stock market could experience a surge due to increased optimism and investment.  An expanding P/E multiple (higher prices relative to earnings) would then bring prices up, in other words the confidence in the future increases the price an investor is willing to place on the future earnings stream of a company.

Inflation Is Still A Monetary Phenomenon!

Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. MV=PQ is the equation, and it essentially breaks down into a simple explanation such as “the more money is printed or created by the government, the higher the price level (prices) will be”. The first known instance of inflation occurred in Rome (back to that Julius Caesar theme), when all coins in the realm were brought in, the edges were shaved off, and more coins were made out of the shaved edgings; all new (smaller) coins were re-cast with the same previous denomination.  In other words, inflation (debasement of the currency’s purchasing power). Fed Chairman Ben Bernanke has been expanding the Fed’s balance sheet in a similar fashion.

Last quarter I had the good fortune to be invited to the Hoover Institution in celebration of Milton Friedman’s 100^th birthday.  It was a fantastic gathering of brainpower.  The truly amazing aspect of Milton Friedman is that his body of work did not limit itself to economics.  His books “Free to Choose” and “Capitalism and Freedom” simply reinforce that Capitalism (even with all its warts) is the best system so far discovered in human history.  For a great video discussion between Milton Friedman and Phil Donahue circa 1980, click this link .  It is only about 2 minutes long and is great.

When Will Treasury Rates Re-Set?
Once the Fed stops printing money and stops buying Treasury bonds, what will be the real market for interest rates?  It could be much, much higher. And that could set the economy up for a real big interest-rate shock.  But…not yet, because Ben Bernanke and the Fed just this last week announced that rates will be kept low through 2014… with all of this Quantitative Easing, most people do not realize that the Federal Reserve Bank has been buying about 70% of all newly issued Treasury securities!  The “eventual” concern is that once you start this quantitative easing, you can't stop, because the economic consequences of stopping are too severe.  Another concern is whether there will continue to be enough other buyers of our Treasuries. The only reason we're able to continue to do any quantitative easing at all is because the dollar is the world's reserve currency.  

Frankly, we have wondered why, over the last 3-4 years, the US (the “best house in a bad neighborhood”) failed to issue 7-10 year Treasury securities at extremely favorable rates, which would have allowed the US to effectively retire old debt (higher rates) while issuing new debt (lower rates), simultaneously providing liquidity that was needed.  Effectively the US would have “refinanced” much of the country’s debt load, while also buying the US time to gets is fiscal and policy house in order.   Instead, the US issue short term debt at low rates that is coming due in the next 18-24 months that needs to be repaid or re-issued at the then-prevailing rate.  With an explosion of federal spending and, this adds much risk to Treasuries. 

“Safe Bond” Bubble Danger

Lately we read Peter Schiff’s latest book “The Real Crash: America’s Coming Bankruptcy” and Weidemer/Spitzer’s “Aftershock”.  As you may surmise, these are very happy books discussing the threat of hyperinflation and an end to Pax-Americana that make you want to build a bunker, buy three years’ worth of dehydrated food, a personal water filtration system, firearms, 100 gallons of extra fuel, tobacco, chocolate, and plenty of duct tape.  But they DO point out an interesting point in highlighting US indebtedness, which dovetails into our last 3 years’ opinions on US Treasury Bonds.  The point is not that we know “when” something will happen, but rather that in a rational framework this type of investment carries a great deal of risk in terms of valuation, potential wealth destruction, and loss of purchasing power.

Investors are selling U.S. stocks and buying bonds like they're going out of style. Bond prices have come unhinged from their underlying fundamentals. The bond market is a bubble. Bond holders today are practically guaranteed to lose money... But they're buying more bonds than ever. Remember... the most popular investment is almost always the worst one.  In fact, ICI's historical data indicates investors have been pulling money out of stocks and pouring it into bonds for almost four years... Since June 2008, investors have made net withdrawals of $376.1 billion from equity mutual funds. During the same period, they've poured nearly twice that amount, $723.6 billion, into bond mutual funds. Even though the stock market has more than doubled in value from its March 2009 bottom... investors are still scared of stocks today. They're lusting after the safety of bonds and fleeing the risk they see in stocks. In doing so, they're ignoring the huge risks in bonds... and missing the great benefits of owning stocks over the long term.  Historically, as noted on page 2, the S&P 500 has returned 9.9% on average over 80 years (equity returns + dividends), and currently the implied return of the S&P 500 is below the long term average; so, if we eventually have reversion to the mean, investors should be buying stocks!

At this point, you probably want to know what's so bad about investors buying bonds instead of stocks. They'll still make money. They just won't make as much over the long term... right? And you might also say, they'll never lose money in bonds, especially if they're buying Treasurys or highly rated corporate bonds. But investors aren't aware of just how much money they can lose holding Treasurys and other low-yielding, high-grade bonds... even if all the interest and principal payments are made on time. The ugly truth is, Treasurys and high-grade bonds are virtually guaranteed to lose  money if we're buying them at today's prices.

The Great Disinflation!  Interest rates in 1980 were at 16%, which is not likely to be repeated in our lifetimes.  And lest we forget, this 30 year disinflation period ADDED massively to the returns of bond investors over this time period, since a falling interest rate environment makes the present value of the payments of the total bond payments worth more.  But…the opposite is also true, and unfortunately we live in Opposite World right now; in other words, the odds of an environment of rising interest rates is clearly much higher at these current low levels, which are being engineered by our Fed.
As is evident, 10-year Treasury bonds pay less income today than at any time in the last five decades. If we buy 10-year Treasury bonds today, investors are signing up to make about 2.3% a year, fully taxable, for the next 10 years. That return has no hope of beating inflation. If, as the Obama administration wants, the top income tax rate goes to 39.5% next year, you'll probably make about 1.4% after taxes on a 10-year Treasury at current rates.
The Consumer Price Index says inflation is 2.9% a year, and the Producer Price Index is 3.3%. So let's just say inflation is an even 3% right now. Some sources will say it's just under 2%. If we re-run numbers with that assumption, the returns are still either negative or too tiny to matter. To get the  inflation-adjusted, after-tax return, just subtract our 3% inflation from the after-tax yield...  a -1.6% return. At current prices, an investor will lose about 1.6% a year after taxes and inflation by buying 10-year Treasurys.
Buying even the highest-yielding Treasurys today will lose investors money after taxes and inflation. They're a lousy deal.
All bonds are priced in relation to Treasurys. So when Treasury yields go up (and prices go down), the rest of the bond market moves right along. When talking about Treasury bonds, we're really talking about all bonds.
Still, one might say Treasury bonds are the safest around. And with bonds, the more risk you take, the more yield received. So... what if we take a tiny bit more risk today, perhaps by owning the bonds of the best U.S. corporations? That'd pay more than Treasurys with not much more risk... wouldn't it?  Well, yes, the interest payment is more, but not enough to fight the wealth-destroying effects of inflation. Investment-grade corporate bonds are the second-worst deal in the bond market next to Treasurys.
A good, quick gauge of the market for the safest, highest-rated corporate bonds is the iShares Investment Grade Bond Fund (LQD). Just over 98% of its holdings are investment-grade corporate bonds (rated triple-B or higher by ratings agencies like Moody's or S&P), and roughly 69% are rated A or higher. Sure, the bonds are safe. Investors should get all interest and principal payments. That's not the problem. The problem is the fund pays a yield of just 4.24%. Even if you only assume today's top tax rate (35%), you still wind up with less than 3% after taxes, less than the current rate of inflation. Buying the safest corporate bonds in the world today will lose money after taxes and inflation.
With bond investing, inflation is one of the most important fundamentals, because bonds pay fixed-interest payments, not rising dividends. Their prices have become totally disconnected from the fundamentals. Bonds are a bubble, mostly because they're so vulnerable to the effects of inflation.
It's financially dangerous to own long bonds that pay low, single-digit yields.
Mark Twain once said: History Doesn’t Repeat Itself, but It Rhymes. This whole thing probably sounds ridiculous. But it's happened before and it can happen again.  Folks buying Treasury bonds and high-quality corporate bonds today need to remember what happened to the U.S. bond market starting in 1946... A 35-year bond bear market started that year, lasting until 1981. The long-term effect on those who bought bonds in the mid-1940s was devastating.
If we owned a 30-year U.S. Treasury bond from 1946 to 1981, we'd have wound up with just $170 left out of every $1,000 originally invested – an 83% loss. Put another way, $2.50 worth of Treasury bond income was worth $100 in 1946... and slightly less than $17 in 1981. Maybe we wouldn't hold a bond for 35 years... But it's awfully hard to make money any time in a 35-year bear market. It was a long, devastating bear run for bondholders.  During the great bond bear market of 1946-1981, inflation did its part, too. What cost $1 in 1946 cost $4.67 in 1981. If Treasury yields and prices didn't move from 1946 to 1981, we'd still have lost a lot of money.
Bond Bear   With history as our guide, it sure looks like we're heading into another big bond bear market today. The Fed is doing the same things today as it was in the 1940s. Back then, the Federal Reserve fixed long-term interest rates at a low 2.5% to finance World War II. Today, it's doing the same thing to try to spur a housing and economic recovery. It's targeting 0% interest rates for overnight interbank lending.
The Fed also bought Treasury bonds back then, just like it's doing today. Back in the 1940s, the Fed's Treasury holdings increased 12-fold in just five years, from $2 billion to $24 billion. Since late 2008, the Federal Reserve has increased its Treasury holdings 3.5-fold in about three-and-a-half years, from $479.7 billion in September 2008 to $1.66 trillion as of March 14, 2012. It's all just like it was in 1946, and the result will be the same, with bond investors losing money for many years to come.

Mortgages

Mortgage rates are still near the lowest rates ever recorded. This last week’s announcement from the Fed, that it will hold rates steady for two more years, with a 2% inflation target,  is pushing yields lower.  Some research reports indicate a view that the Fed may stretch this target to 2015 from 2014 in its upcoming August FOMC meeting.  Our view is that Fannie/Freddie’s acting as lender of last resort has put an artificial pricing mechanism into the real estate market.  We acknowledge this artificial price risk, where prices could fall 20-25%, but to also acknowledge that the “price of money” in terms of mortgage rates is incredibly attractive right now. Any investor that qualifies for a mortgage and can lock-and-load on a 30 year fixed mortgage should strongly consider it, regardless of the short term fluctuations of the value (next 5 years) of the property.  In our view it is a risk worth taking. Remember the rule of value investing:  the uncertainty gives us the low price.   

Fixed Income Commentary

Corporate bonds in the high yield category look relatively attractive. We are also finding interesting foreign bond issues (mostly sovereign and Emerging Markets Debt) for new money that look more attractive than US paper in terms of their “ability to pay”.  Generally, higher quality bonds (generally, sovereign debt issues) are not attractive on a forward-looking basis based on our thesis of eventually higher inflation and a higher yield environment.  In such an environment, “quality” bonds offer nothing but low returns and capital destruction. The only plus offered, perversely, is a flight to safety in case of another macro-event. 

Treasury securities with longer maturities should be avoided at all costs in this environment.  Long term Treasury buyers are paying 50x yield right now for “safety”, paying 2%.  Ask the questions: What is risk? What is safety? 

CA Municipal Bonds

CA Municipal Bonds with shorter maturities are still interesting.  While CA has had all sorts of financial issues the last several years, the municipal bankruptcy filing rate has been very infrequent.  The city of Stockton recently filed for bankruptcy, which was like watching a slow-motion train wreck.  However, when a municipality declares bankruptcy, it allows them to renegotiate all pension and union contracts… Other states are essentially in the same boat.  California does have problems, though a recent slate of IPO’s, including Facebook’s May IPO, will help to fill California’s coffers. Scratch that, Gerry Brown just voted in the High-Speed Rail…interesting fact, the “estimated” cost of the High-Speed Rail is $65 Billion.  The current market cap of United Continental Airlines, with all of their planes, infrastructure, and hubs globally, is only $8 Billion.  So CA wants to spend at minimum 8x the entire market cap of the largest airline to build this thing.  Just a thought:  build a line from LA to Vegas, then SF to Vegas, both of which at least stand the chance of profitability, usage, and leisure commerce.  Then build the hypotenuse of the triangle, SF to LA, which would be subsidized by the other two sides.