What is that? The dollar carry-trade is what we get when interest rates are near .25%. This is the path the Fed has chosen to help us re-flate our assets. How? Well, if you are a hedge fund, a government, or some other institutional player, with interest rates near .25%, you can effectively borrow a large quantity of US $ for nearly no cost, and you can probably lever it 10 or 20 to 1 and invest the dollars you borrowed elsewhere. If you borrowed the dollars yesterday, and the dollar goes down a penny or two, your real cost of carry to borrow the dollars was negative. If you invested in gold, commodities, or stocks yesterday, the falling dollar has increased the value of those riskier assets today (in dollar terms).
What this means is that investors are being incented to buy any asset paying (or returning) more than .25%. If inflation is coming, taking out a large mortgage here makes sense, since mortgage rates are so low; buying stocks and commodities makes sense in real dollar terms too.
The Fed is committed for the short term to maintain this extremely easy money policy, which will add stability to markets. But...when the trade reverses, look out. There are a LOT of people on that side of the trade. What could cause a reversal? It appears that the Fed is targeting the unemployment rate in lieu of the value of the dollar. Our US$ is a fiat currency after all, since we can just print more dollars. When unemployment drops below 8%, and we start to show some serious economic recovery (last week's ISM report showed positive manufacturing growth to restock inventories), then the Fed will have the necessary courage to tighten up the money supply.
Thursday, November 5, 2009
Friday, October 30, 2009
Latest Quarterly Commentary from Q3 2009
Market Snapshot
The recent positive developments that have evolved have offset the negatives in the short-term. Earlier in the year, we posited that the Dow Jones Industrial Average would end up in a trading range between 7500-9500. Briefly the Dow traded to about 6350, and has now run up to over 10100. Earnings are coming in above estimates, due to massive cost cutting, and sustainability of earnings is becoming the next concern. Where is the top line growth? Can prices be justified at these levels without it? Some are calling this a “jobless recovery”, though people always talk this way on the way out of a recession. It is important to delineate between the stock market and the economy; they are, and always will be, two different things. While the markets have anticipated recovery, they are not perfect as a barometer of economic health. It is likely that this final quarter of the year will be met with more worry, yet investors continue to pile into equities. Chasing performance here, at these prices, especially by buying index ETF’s, could prove perilous. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products.
The New Normal
The price we pay for a company’s earnings was much lower than it would otherwise be during the recent market price adjustment. Now, we are entering an era of what some term “the new normal”. What does this mean? The “new normal” ostensibly means that the U.S. share of global GDP is declining; we have firmly established ourselves as the largest debtor nation, and our currency is under attack via stronger currency alternatives. On the bright side, emerging market economies are growing rapidly, have surpluses, and the consequent demand for minerals, commodities, and ingenuity (we’re pretty good in that department) remains strong.
Inflation Is A Monetary Phenomenon
We received great feedback of our Milton Friedman inflation piece in the last letter. To sum it up, 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”. In other words, inflation.
We believe that the Fed is engaging rather aggressively in reflation, whereby all asset classes are re-flated due to a commensurate newfound liquidity creation of dollars and Treasuries via debt monetization (i.e. using one credit card to pay off another). The Fed has recently assured us that they will “withdraw policy accommodation in a smooth and timely manner”, meaning the Fed will do everything in its power to control inflation by reducing the money supply as needed to stave off inflation. It must be noted that inflation by itself is not a foregone conclusion, as the Fed actually “could” succeed, which would of course result in dampened economic growth.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by that measure we are likely to avoid it on a grand scale. Apparently the Fed agrees with us. By the way, gold has risen and is between $1,050 to $1,070/ounce.
When we're trying to figure out what's more likely in the future – inflation or deflation, we need to ask a few questions: 1) Would I willingly choose to be a creditor to the federal government, considering its soaring deficits, its $12 trillion in debt, its current economic policies, its endless entitlement programs, and the miniscule interest rates it pays on its debts? 2) Why is the largest creditor to the United States (China) going on an all-out commodity-based spending spree, all over the world? 3) Why, during two decades of soaring productivity and giant technological advances, has the purchasing power of the U.S. dollar continued to fall at an accelerating rate? For the deflationist camp to be right, the U.S. dollar would have to have a sustained increase in purchasing power, which hasn't happened since the creation of the Federal Reserve. To believe in deflation is to believe that government is here to help, that paper money (fiat) currency systems aren’t based on devaluation, that Santa Claus is real, or that Ben Bernanke actually is Santa Claus.
History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and this is the opportunity.
In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises.
Earnings Season
Earnings season is again upon us, and earnings have exceeded expectations 74% of the time thus far. Many companies are reporting strong earnings based on massive cost-cutting maneuvers in the last 12 months, and now some are beginning to question the future sustainability of these earnings streams, since top-line growth looks weak. Earnings of multinationals that repatriate their foreign earnings back into U.S.$ are enjoying higher profits since currency translation is favorable.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a double-dip recession it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
Mortgages
If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Recently the 30 year fixed mortgage dipped to about a 60-year low. It’s still cheap money, and it should be considered a very temporary “gift” from the Fed. This is simply unsustainable and will desist at some unknown point in the future (probably when the data starts to look better). Take advantage of this, especially if you currently hold an adjustable rate mortgage.
Fixed Income Commentary
Corporate bonds, both investment grade and high yield, look relatively attractive. In fact over the last several months investment grade paper had a positive after-tax spread relative to Treasuries, and high yield paper had a positive tax-equivalent yield over municipal debt. We seek to find debt issues with shorter maturities.
Treasury securities with longer maturities should be avoided, though Treasury Inflation Protection Securities (TIPS) could offer some additional protection in case of inflation.
CA Municipal Bonds
CA is not likely to default on its General Obligation bonds, and if it did, it would roil the entire country’s municipal bond market. Expect more IOU’s from the State of CA, followed by either a budget deal or more downgrades. The problems are big, but as a great politician once said: “the answers aren’t easy, but they are simple.”
Website
We’ve made some changes to the website, including a “Typical Client” tab which has helped with your referrals to us. Additionally, under the “Frequently Asked Questions” (FAQ) tab, we have put sub-tabs of regulatory information, as well as an “Account Access” tab which takes Clients to Schwab’s sign-in page. www.accimi.net
401k
After a monster run in the stock market, this is a great time to email or fax your latest statement from your 401k plan. We are happy to assist you in re-balancing your asset allocation for your long term goals. Fax is 650-745-7347.
Succession Planning
This is a big deal with the SEC, and it’s a big deal to us. Over the last two years we’ve been doing due diligence on a few different other Advisory firms, and may at some point elect to engage in a Succession Planning arrangement, Joint Venture, or some other arrangement that provides our Clients with a robust Succession Plan, additional Client service resources, additional Research capabilities, and additional Portfolio Management resources.
Thank you for your continued business and referrals
This has been a crazy year for all of us as investors. Please know that we are 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. Though risks remain, patience will be rewarded.
The “Referrals” tab on the website is designed to provide basic contact info to us for follow-up reasons; as you know, our style of follow-up is not aggressive, but it is consistent. www.accimi.net/referrals.html
The recent positive developments that have evolved have offset the negatives in the short-term. Earlier in the year, we posited that the Dow Jones Industrial Average would end up in a trading range between 7500-9500. Briefly the Dow traded to about 6350, and has now run up to over 10100. Earnings are coming in above estimates, due to massive cost cutting, and sustainability of earnings is becoming the next concern. Where is the top line growth? Can prices be justified at these levels without it? Some are calling this a “jobless recovery”, though people always talk this way on the way out of a recession. It is important to delineate between the stock market and the economy; they are, and always will be, two different things. While the markets have anticipated recovery, they are not perfect as a barometer of economic health. It is likely that this final quarter of the year will be met with more worry, yet investors continue to pile into equities. Chasing performance here, at these prices, especially by buying index ETF’s, could prove perilous. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products.
The New Normal
The price we pay for a company’s earnings was much lower than it would otherwise be during the recent market price adjustment. Now, we are entering an era of what some term “the new normal”. What does this mean? The “new normal” ostensibly means that the U.S. share of global GDP is declining; we have firmly established ourselves as the largest debtor nation, and our currency is under attack via stronger currency alternatives. On the bright side, emerging market economies are growing rapidly, have surpluses, and the consequent demand for minerals, commodities, and ingenuity (we’re pretty good in that department) remains strong.
Inflation Is A Monetary Phenomenon
We received great feedback of our Milton Friedman inflation piece in the last letter. To sum it up, 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”. In other words, inflation.
We believe that the Fed is engaging rather aggressively in reflation, whereby all asset classes are re-flated due to a commensurate newfound liquidity creation of dollars and Treasuries via debt monetization (i.e. using one credit card to pay off another). The Fed has recently assured us that they will “withdraw policy accommodation in a smooth and timely manner”, meaning the Fed will do everything in its power to control inflation by reducing the money supply as needed to stave off inflation. It must be noted that inflation by itself is not a foregone conclusion, as the Fed actually “could” succeed, which would of course result in dampened economic growth.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by that measure we are likely to avoid it on a grand scale. Apparently the Fed agrees with us. By the way, gold has risen and is between $1,050 to $1,070/ounce.
When we're trying to figure out what's more likely in the future – inflation or deflation, we need to ask a few questions: 1) Would I willingly choose to be a creditor to the federal government, considering its soaring deficits, its $12 trillion in debt, its current economic policies, its endless entitlement programs, and the miniscule interest rates it pays on its debts? 2) Why is the largest creditor to the United States (China) going on an all-out commodity-based spending spree, all over the world? 3) Why, during two decades of soaring productivity and giant technological advances, has the purchasing power of the U.S. dollar continued to fall at an accelerating rate? For the deflationist camp to be right, the U.S. dollar would have to have a sustained increase in purchasing power, which hasn't happened since the creation of the Federal Reserve. To believe in deflation is to believe that government is here to help, that paper money (fiat) currency systems aren’t based on devaluation, that Santa Claus is real, or that Ben Bernanke actually is Santa Claus.
History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and this is the opportunity.
In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises.
Earnings Season
Earnings season is again upon us, and earnings have exceeded expectations 74% of the time thus far. Many companies are reporting strong earnings based on massive cost-cutting maneuvers in the last 12 months, and now some are beginning to question the future sustainability of these earnings streams, since top-line growth looks weak. Earnings of multinationals that repatriate their foreign earnings back into U.S.$ are enjoying higher profits since currency translation is favorable.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a double-dip recession it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
Mortgages
If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Recently the 30 year fixed mortgage dipped to about a 60-year low. It’s still cheap money, and it should be considered a very temporary “gift” from the Fed. This is simply unsustainable and will desist at some unknown point in the future (probably when the data starts to look better). Take advantage of this, especially if you currently hold an adjustable rate mortgage.
Fixed Income Commentary
Corporate bonds, both investment grade and high yield, look relatively attractive. In fact over the last several months investment grade paper had a positive after-tax spread relative to Treasuries, and high yield paper had a positive tax-equivalent yield over municipal debt. We seek to find debt issues with shorter maturities.
Treasury securities with longer maturities should be avoided, though Treasury Inflation Protection Securities (TIPS) could offer some additional protection in case of inflation.
CA Municipal Bonds
CA is not likely to default on its General Obligation bonds, and if it did, it would roil the entire country’s municipal bond market. Expect more IOU’s from the State of CA, followed by either a budget deal or more downgrades. The problems are big, but as a great politician once said: “the answers aren’t easy, but they are simple.”
Website
We’ve made some changes to the website, including a “Typical Client” tab which has helped with your referrals to us. Additionally, under the “Frequently Asked Questions” (FAQ) tab, we have put sub-tabs of regulatory information, as well as an “Account Access” tab which takes Clients to Schwab’s sign-in page. www.accimi.net
401k
After a monster run in the stock market, this is a great time to email or fax your latest statement from your 401k plan. We are happy to assist you in re-balancing your asset allocation for your long term goals. Fax is 650-745-7347.
Succession Planning
This is a big deal with the SEC, and it’s a big deal to us. Over the last two years we’ve been doing due diligence on a few different other Advisory firms, and may at some point elect to engage in a Succession Planning arrangement, Joint Venture, or some other arrangement that provides our Clients with a robust Succession Plan, additional Client service resources, additional Research capabilities, and additional Portfolio Management resources.
Thank you for your continued business and referrals
This has been a crazy year for all of us as investors. Please know that we are 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. Though risks remain, patience will be rewarded.
The “Referrals” tab on the website is designed to provide basic contact info to us for follow-up reasons; as you know, our style of follow-up is not aggressive, but it is consistent. www.accimi.net/referrals.html
Wednesday, August 26, 2009
Re-Flation, Commodities, and the U.S. Dollar
Executive Summary
Based on much reading and research, we could end up with a scenario where the markets do well (in general, and not without pullbacks) for the next 18-24 months. Signs of economic growth, however, are being greeted with even more skepticism. Despite measures of positive change at the margin in manufacturing and services indices (ISM), shipping indices (Baltic Dry Index), credit spreads (corporate rates vs. US Treasury rates), retail sales and even employment, many forecasters are still singing the blues about the economy and seem stuck in last years' news with talk about further mortgage defaults continuing to pound the banks, or the sluggish consumer "saving" instead of "consuming." It is our belief that the problem which seems obvious is rarely the one that causes the most trouble, and the one to be most wary about usually lurks underneath the surface. While there certainly are some underlying negative scenarios, which we will outline, the positive developments that are beginning to evolve should offset if not overwhelm the negatives in the mid-term.
The More Things Change the More They Stay the Same
The forces that have damaged the world’s markets and global economy have been indiscriminate, taking down good companies along with the bad. During periods when fundamentals no longer “seem” to apply, they still do. The scale and magnitude of the decline, while painful, also represents long-term investment opportunity. The valuations of many companies appear relatively attractive. The causes of most market declines may all be different, but they also have many similarities. In most cases, the advances that preceded the declines wee the result of delirious optimism and excessive speculation that led to overblown valuations. The damage from this fallout can be widespread, hurting quality companies along with the suspect. Periods such as these are often accompanied by irrational pessimism, risk aversion and unrealistically low valuations. This is the one thing in common that we care about—the price we pay for a company’s earnings is much lower than it would otherwise be.
Inflation Primer: A Monetary Phenomenon
People have been hoarding money, the savings rate is rising, the government is printing money, etc. When a recovery is on the horizon, this is when all the pent-up new supply of hoarded dollars becomes the phenomenon of “too many dollars chasing too few goods”. Voila. Inflation.
Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. His simple equation, MV=PQ explains the relationship between the Money Supply, Velocity of Money, the Price Level, and Quantity of the real value of aggregate transactions in the economy. Over the years dissertation after dissertation has attempted to destroy this formula, and failed. The relationship between M and P has indeed only been bolstered over the years. To solve for Price Level (P), we just re-arrange it to MV/Q=P.
Simply put, the Money Supply, M, has increased more dramatically over the last year (Presidents Bush and Obama) than in the past 50 years, by a factor of 10. It has actually doubled over the last year, but as they say in the Wizard of Oz, “disregard the man behind the curtain [Fed/Treasury]”. The Velocity of money has slowed down due to the “recession” and a higher savings rate, let’s use a 25% slowdown. The eventual Price level is what we are solving for, and the Quantity of aggregate transactions has decreased due to recession, higher savings rates, discounts in the economy, etc (let’s say down 4%).
M (2.0) x V(.75)/Q (.96) = P
In this case, P= 1.56%, which means inflation would be 56%.
Now let’s assume everything the same, except we’ll change the aggregate level of value of transactions in the economy, Q. Let’s assume we end up coming out of the recession with a 4% growth rate, which would be characterized as “incredibly optimistic” under normal circumstances.
M (2.0) x V (.75)/Q(1.04) = P
In this case, P= 1.44%, meaning inflation would be 44%.
This illustration shows the relationship in all of its simplicity. A noteworthy aspect of the formula is that the resulting implied inflation rate jives with common sense; any layman can understand that doubling the number of available dollars could debase the currency by approximately half its purchasing power. The Fed has recently assured us that they will “withdraw policy accommodation in a smooth and timely manner”, meaning the Fed will do everything in its power to control inflation by reducing the money supply as needed to stave off inflation. It must be noted that inflation by itself is not a foregone conclusion, as the Fed actually “could” succeed, which would of course result in dampened economic growth. What the calculation above does not tell us is whether the U.S. could end up with fairly controlled inflation but with a debased currency.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Particularly in Q1 much data pointed to deflation as a hangover effect from the Fall 2008, when business activity fell off a cliff. In Q2 we started to see a bounce in stocks, and for the last two months we have had “mixed” data, which was much better than “terrible” data. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by that measure we are likely to avoid it on a grand scale. In the meantime, and until inflation surfaces, we may be in an asset-inflation “window”, whereby all assets “re-flate” for a while. And yet, economic data and earnings need to come through in order for this to continue. We note that the volatility level in the market has waned, that investors are buying stocks, selling long term bonds, and generally taking more risk.
The Five Year Post-Peak Scenario
On a historical basis, we have come to learn that every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially (so don’t keep it in your mattress). For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could expect a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and this is the opportunity.
Based on the sheer massiveness of the explosion of the money supply, we tend to believe that a scenario like this, if it does transpire, may be more likely in the 2011 time frame. However, until inflation really heats up, we expect a continued rebound in stocks (re-flation of assets), which is consistent with the data, our perception of the market’s psychology, and counter to the pessimism that a rally cannot occur. Since the Panic of 2008 has subsided substantially, investors are fleeing cash, and one of the first things they’re likely to buy is stocks. History suggests we may see new all-time highs in about two years, followed by the a potential visit from the inflation bogeyman. In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a double-dip recession it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
If You have an ARM, Take Advantage of Fixed Rate Mortgages
What else is important during an inflationary run? How about the interest rate on your mortgage? If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Earlier this year the 30 year dipped to about a 60-year low. It’s still cheap money, and it should be considered a “gift” from the Fed. The Fed has been busy monetizing debt. What do we mean by this? Well, the Fed has been taking money into the system by issuing U.S. Treasury securities, and then they’ve been buying up long Treasury securities and specific mortgage backed securities on the market. All the while they’ve been “telegraphing” this to the world. So maybe, just maybe, China, Japan, India, and Russia are selling into this buying? In all likelihood, this is so, therefore this policy works for a while and then treads water at best. By targeting certain bond yields, they’ve artificially created a low-rate environment, all by essentially using one credit card to pay down another. This is simply unsustainable and will desist at some unknown point in the future (probably when the data starts to look better). Take advantage of this, especially if you currently hold an adjustable rate mortgage.
Here’s the math behind why a fixed rate mortgage is better than an adjustable in a period of different rates of rising inflation:
Based on much reading and research, we could end up with a scenario where the markets do well (in general, and not without pullbacks) for the next 18-24 months. Signs of economic growth, however, are being greeted with even more skepticism. Despite measures of positive change at the margin in manufacturing and services indices (ISM), shipping indices (Baltic Dry Index), credit spreads (corporate rates vs. US Treasury rates), retail sales and even employment, many forecasters are still singing the blues about the economy and seem stuck in last years' news with talk about further mortgage defaults continuing to pound the banks, or the sluggish consumer "saving" instead of "consuming." It is our belief that the problem which seems obvious is rarely the one that causes the most trouble, and the one to be most wary about usually lurks underneath the surface. While there certainly are some underlying negative scenarios, which we will outline, the positive developments that are beginning to evolve should offset if not overwhelm the negatives in the mid-term.
The More Things Change the More They Stay the Same
The forces that have damaged the world’s markets and global economy have been indiscriminate, taking down good companies along with the bad. During periods when fundamentals no longer “seem” to apply, they still do. The scale and magnitude of the decline, while painful, also represents long-term investment opportunity. The valuations of many companies appear relatively attractive. The causes of most market declines may all be different, but they also have many similarities. In most cases, the advances that preceded the declines wee the result of delirious optimism and excessive speculation that led to overblown valuations. The damage from this fallout can be widespread, hurting quality companies along with the suspect. Periods such as these are often accompanied by irrational pessimism, risk aversion and unrealistically low valuations. This is the one thing in common that we care about—the price we pay for a company’s earnings is much lower than it would otherwise be.
Inflation Primer: A Monetary Phenomenon
People have been hoarding money, the savings rate is rising, the government is printing money, etc. When a recovery is on the horizon, this is when all the pent-up new supply of hoarded dollars becomes the phenomenon of “too many dollars chasing too few goods”. Voila. Inflation.
Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. His simple equation, MV=PQ explains the relationship between the Money Supply, Velocity of Money, the Price Level, and Quantity of the real value of aggregate transactions in the economy. Over the years dissertation after dissertation has attempted to destroy this formula, and failed. The relationship between M and P has indeed only been bolstered over the years. To solve for Price Level (P), we just re-arrange it to MV/Q=P.
Simply put, the Money Supply, M, has increased more dramatically over the last year (Presidents Bush and Obama) than in the past 50 years, by a factor of 10. It has actually doubled over the last year, but as they say in the Wizard of Oz, “disregard the man behind the curtain [Fed/Treasury]”. The Velocity of money has slowed down due to the “recession” and a higher savings rate, let’s use a 25% slowdown. The eventual Price level is what we are solving for, and the Quantity of aggregate transactions has decreased due to recession, higher savings rates, discounts in the economy, etc (let’s say down 4%).
M (2.0) x V(.75)/Q (.96) = P
In this case, P= 1.56%, which means inflation would be 56%.
Now let’s assume everything the same, except we’ll change the aggregate level of value of transactions in the economy, Q. Let’s assume we end up coming out of the recession with a 4% growth rate, which would be characterized as “incredibly optimistic” under normal circumstances.
M (2.0) x V (.75)/Q(1.04) = P
In this case, P= 1.44%, meaning inflation would be 44%.
This illustration shows the relationship in all of its simplicity. A noteworthy aspect of the formula is that the resulting implied inflation rate jives with common sense; any layman can understand that doubling the number of available dollars could debase the currency by approximately half its purchasing power. The Fed has recently assured us that they will “withdraw policy accommodation in a smooth and timely manner”, meaning the Fed will do everything in its power to control inflation by reducing the money supply as needed to stave off inflation. It must be noted that inflation by itself is not a foregone conclusion, as the Fed actually “could” succeed, which would of course result in dampened economic growth. What the calculation above does not tell us is whether the U.S. could end up with fairly controlled inflation but with a debased currency.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Particularly in Q1 much data pointed to deflation as a hangover effect from the Fall 2008, when business activity fell off a cliff. In Q2 we started to see a bounce in stocks, and for the last two months we have had “mixed” data, which was much better than “terrible” data. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by that measure we are likely to avoid it on a grand scale. In the meantime, and until inflation surfaces, we may be in an asset-inflation “window”, whereby all assets “re-flate” for a while. And yet, economic data and earnings need to come through in order for this to continue. We note that the volatility level in the market has waned, that investors are buying stocks, selling long term bonds, and generally taking more risk.
The Five Year Post-Peak Scenario
On a historical basis, we have come to learn that every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially (so don’t keep it in your mattress). For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could expect a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and this is the opportunity.
Based on the sheer massiveness of the explosion of the money supply, we tend to believe that a scenario like this, if it does transpire, may be more likely in the 2011 time frame. However, until inflation really heats up, we expect a continued rebound in stocks (re-flation of assets), which is consistent with the data, our perception of the market’s psychology, and counter to the pessimism that a rally cannot occur. Since the Panic of 2008 has subsided substantially, investors are fleeing cash, and one of the first things they’re likely to buy is stocks. History suggests we may see new all-time highs in about two years, followed by the a potential visit from the inflation bogeyman. In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a double-dip recession it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
If You have an ARM, Take Advantage of Fixed Rate Mortgages
What else is important during an inflationary run? How about the interest rate on your mortgage? If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Earlier this year the 30 year dipped to about a 60-year low. It’s still cheap money, and it should be considered a “gift” from the Fed. The Fed has been busy monetizing debt. What do we mean by this? Well, the Fed has been taking money into the system by issuing U.S. Treasury securities, and then they’ve been buying up long Treasury securities and specific mortgage backed securities on the market. All the while they’ve been “telegraphing” this to the world. So maybe, just maybe, China, Japan, India, and Russia are selling into this buying? In all likelihood, this is so, therefore this policy works for a while and then treads water at best. By targeting certain bond yields, they’ve artificially created a low-rate environment, all by essentially using one credit card to pay down another. This is simply unsustainable and will desist at some unknown point in the future (probably when the data starts to look better). Take advantage of this, especially if you currently hold an adjustable rate mortgage.
Here’s the math behind why a fixed rate mortgage is better than an adjustable in a period of different rates of rising inflation:
This illustration is not perfect, since investor tax rates will vary in terms of tax savings, though the difference between a fixed and variable mortgage shows the relationship well. In a zero-inflation environment, the ARM will hold up fine, and actually is less expensive in terms of the “real” cost of the funds. As inflation ticks up, and as the ARMs adjust upward (again, imperfect since many are capped at a certain level) we can see that the “real rate” differential starts to become costly (not in terms of the ARM’s real rate, but as compared to the real rate available on a fixed rate mortgage—this is the opportunity cost). In the 10% inflation environment normally an ARM is capped at some point, maybe 5 points over the original ARM rate, so it completely depends what the original rate was. For many people who overextended and who only qualified using large ARMs, the above example may indeed be more real than they’d like. It is for illustration only, and intended only to show the directional spread between the Fixed and Variable rate structures. Be that as it may, the opportunity cost at 10% inflation on an ARM is 4.75% more relative to a fixed rate mortgage! Depending on the ARM’s particulars, this might lull an investor into staying with the ARM, since the ARM holder could conceivably be “getting paid” 1.75% to hold the ARM during a period of high inflation (-1.75% real rate). However, wouldn’t the investor rather be “getting paid” 6.5% (-6.5% real rate) by holding a fixed mortgage? By getting paid, we really mean that the dollars used to pay back the bank are worth only 93.5 cents, but the bank accepts them as full dollars. And of course we haven’t even discussed the increased cash flow requirements of the ARM just to service the mortgage. Adjusted for risk, go the way of the fixed mortgage!
Fixed Income CommentaryCorporate bonds, both investment grade and high yield, look relatively attractive. In fact over the last two months investment grade paper had a positive after-tax spread relative to Treasuries, and high yield paper had a positive tax-equivalent yield over municipal debt.
Treasury securities with longer maturities should be avoided, though Treasury Inflation Protection Securities (TIPS) could offer some additional protection in case of inflation.
CA Municipal Bonds have been all over the place over the last several months as CA has failed to come up with an acceptable budget, and has been issuing IOU’s for the last month. CA has been downgraded a couple of times, and now has one of the lowest credit ratings of any state in the US. Yields are fairly attractive in the 5.1% range, though CA is one or two credit downgrades away from “junk” status; if CA goes to “junk” (i.e. below “investment grade”), many mutual funds, Foundations, etc. cannot hold them due to investment policy guideline restrictions. If such a deterioration continues, we would look to this as perhaps a great opportunity, particularly if yields on CA municipals were to approach or exceed 5.5% double-tax free. Why? The reality is that what makes it into the news is mostly scare tactics that our schools, fire departments, police departments, and services will all be cut substantially. And yet, of the $24 Billion shortfall, $16 Billion of it will literally “go away” if a freeze is instituted on the automatic budgetary increases from 2008 to 2009. The remaining $8 Billion could be worked out by furloughing any type of union employees or state workers. In a terrible economic landscape it sure seems fair to say “you are going to keep your job, but at 90% pay” until things improve; most employees could make that adjustment if they had to do so. However, these moves take political will, and this is in scarce supply. CA is not likely to default on its General Obligation bonds, and if it did, it would roil the entire country’s municipal bond market. Expect more IOU’s from the State of CA, followed by either a budget deal or more downgrades. The problems are big, but as a great politician once said: “the answers aren’t easy, but they are simple.”
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. Though risks remain, patience will be rewarded.
U.S. Debt-- Ticking Time Bomb
For an interesting dynamic look at the U.S.'s debt overhang (or hangover), proceed to the following link: http://www.usdebtclock.org/
The current national debt per capita in the U.S. is about $38k. This is enormous. I don't know about you, but I sure would like to place a "fixed contract" on that number right now (i.e. pay it now), but with the stipulation that anything ABOVE that number should be picked up by members of Congress!
The current national debt per capita in the U.S. is about $38k. This is enormous. I don't know about you, but I sure would like to place a "fixed contract" on that number right now (i.e. pay it now), but with the stipulation that anything ABOVE that number should be picked up by members of Congress!
Tuesday, May 19, 2009
Lifting the Veil, 3/31/09
Green Shoots of Recovery?
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.
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.
Thursday, March 12, 2009
Values Abound email, sent early March 2009
I wanted to check in with you, since market sentiment has turned as ugly as it was at our last discussion. In looking over your holdings, I am reviewing any smaller positions, as well as any European and Global stock positions. As bad as things are here, you no doubt are hearing stories from friends and family that the rest of the world is doing worse. The thesis is this: since the U.S. led everyone into the recession, the U.S. will be the first to snap out of it. While our political class is doing some big spending, they also are at least acting quickly, a stark contrast to the in-fighting among countries in Europe over what to do. Thus the rally in the U.S.$ and short term Treasury securities.
What I’m trying to do is continue to allocate to areas that should be viewed as very strong companies with strong balance sheets and earnings, and to allocate to companies and sectors that should do very well once we get a whiff of relief. I’m currently doing mostly email to cover the most ground; I do want to talk or meet with you to go over any of this if you prefer.
Here are some thoughts on valuation and market sentiment.
We are fast-reaching a bottom and eventually a clearing price will be reached where buyers actually buy. Historically speaking investors tend to make bad decisions using emotion at bottoms, and then miss the upside when mass psychology turns favorable. This environment is awful, which to the contrarian mind is a good place to make investments in high quality companies-- exactly when no one wants to own them. This is the exact reverse of 1999, when everything “felt good” and prices were exorbitantly priced; now everything “feels bad” and prices are selling beneath the intrinsic values of companies. Just look at GE, which was trading at 40x earnings in 1999 and is now selling at 4.5x earnings in 2009. The environment is getting pretty ridiculous out there in terms of sentiment. If I had prognosticated in 1999 that GE would go from 40x earnings to 4.5x earnings, people would have thought I was crazy. So now here we are with GE at 4.5x earnings, and this is one of many situations I would consider purchasing at these levels. It is precisely times like this when long term investments make the most sense, since the price paid for the security is being determined by an inefficient, emotional market. There has been indiscriminate selling; first it was the hedge funds, then mutual funds, exchange traded funds, and now we’re getting back to the basic building blocks of which all of these investment vehicles contain: common stocks.
You continue to own high quality companies, and I will continue to do the best job possible for you in this very difficult environment.
What I’m trying to do is continue to allocate to areas that should be viewed as very strong companies with strong balance sheets and earnings, and to allocate to companies and sectors that should do very well once we get a whiff of relief. I’m currently doing mostly email to cover the most ground; I do want to talk or meet with you to go over any of this if you prefer.
Here are some thoughts on valuation and market sentiment.
We are fast-reaching a bottom and eventually a clearing price will be reached where buyers actually buy. Historically speaking investors tend to make bad decisions using emotion at bottoms, and then miss the upside when mass psychology turns favorable. This environment is awful, which to the contrarian mind is a good place to make investments in high quality companies-- exactly when no one wants to own them. This is the exact reverse of 1999, when everything “felt good” and prices were exorbitantly priced; now everything “feels bad” and prices are selling beneath the intrinsic values of companies. Just look at GE, which was trading at 40x earnings in 1999 and is now selling at 4.5x earnings in 2009. The environment is getting pretty ridiculous out there in terms of sentiment. If I had prognosticated in 1999 that GE would go from 40x earnings to 4.5x earnings, people would have thought I was crazy. So now here we are with GE at 4.5x earnings, and this is one of many situations I would consider purchasing at these levels. It is precisely times like this when long term investments make the most sense, since the price paid for the security is being determined by an inefficient, emotional market. There has been indiscriminate selling; first it was the hedge funds, then mutual funds, exchange traded funds, and now we’re getting back to the basic building blocks of which all of these investment vehicles contain: common stocks.
You continue to own high quality companies, and I will continue to do the best job possible for you in this very difficult environment.
Recent Market Action, sent in mid Feb 2009
Based upon recent market action, I thought I should provide some more perspective on what is happening today. Today the market looks to be re-testing the 7500 level on the Dow which was reached in November. While we could go lower, I do believe that we're likely in a broad trading range between 7500-9500 for at least the next year.
Economic concerns are overwhelming the headlines, and today's signing of the "stimulus" bill, which is comprised of 65% government spending, and 35% tax "rebates" (extremely short term) also concerns the markets, as the U.S. current account deficit is now massive. The concern with our deficit is reaching a tipping point, since we have tremendous future obligations in the form of government pension funds, Medicare, and Social Security benefits. When the deficit is 4% of GDP, it is "ok", but we have now exceeded that number. I recently read a 2002 speech by Ben Bernanke in which he discussed how to fight deflation; he is now running this exact playbook to re-flate our economy. This will eventually mean a devaluation of our currency and/or higher inflation. Did you know that the dollar's value has been devalued by over 90% since the U.S. went off the gold standard? We've seen this movie, and we've been living this movie for some time. Scary as this sounds, it is instructive to think about, and then make conclusions as to what types of assets can compete effectively with inflation, which we had contained for some time. Let's take a look:
Short term Treasury securities paying .48% per year. No.
Cash under your mattress paying nothing. No.
Money market funds paying .4% per year. No. The safest assets short term are the riskiest asset long term, because their value will be eroded by inflation or devaluation.
High quality companies that pay 4-6% dividends, that are currently valued pessimistically. Yes. Long term growth plus dividend yield beats inflation long term, especially at these prices.
Treasury Inflation Protection Securities. Yes. These bonds re-set annually to account for inflation, thus maintaining purchasing power.
Commodity-related companies. Yes. Commodities are priced in dollars; if the dollar goes down, commodity prices rise, earnings rise.
Gold and gold miners. Yes. The oldest hedge on a falling dollar and inflation. I may be early, but would rather be early than late.
You will likely see some changes in your portfolio mix to account for the changing environment. Still, in looking at your accounts, you own strong companies with strong products and services, and many of these companies are quite defensive in nature. Most accounts contain huge doses of high quality health care companies, oil drilling, food, tobacco, alcohol, consumer products/staples. ACC Clients have the comfort that the companies invested in have a bright future, despite the short-term swing in prices.
One of the Warren Buffett maxims I try to adhere to is: own quality companies where we can sleep at night even if the stock exchange was closed for 5 years. Companies with solid balance sheets and big dividend payments look attractive, since there are many solid companies with dividends of 4-6% right now, which exceeds the yields on Treasury securities by a lot (granted not as "safe" as a Treasury, but still extremely attractive). With all the "flight to quality", many investors have flocked to money market and Treasury securities; this trade will eventually reverse as equity yields compete with bond yields. Select municipal bonds also offer good relative values at this time, especially relative to Treasury securities on a price and yield basis.
I know you have placed your trust in me, and I will continue to do the best job possible in this environment. Please give me a call or email if you'd like to discuss this.
Economic concerns are overwhelming the headlines, and today's signing of the "stimulus" bill, which is comprised of 65% government spending, and 35% tax "rebates" (extremely short term) also concerns the markets, as the U.S. current account deficit is now massive. The concern with our deficit is reaching a tipping point, since we have tremendous future obligations in the form of government pension funds, Medicare, and Social Security benefits. When the deficit is 4% of GDP, it is "ok", but we have now exceeded that number. I recently read a 2002 speech by Ben Bernanke in which he discussed how to fight deflation; he is now running this exact playbook to re-flate our economy. This will eventually mean a devaluation of our currency and/or higher inflation. Did you know that the dollar's value has been devalued by over 90% since the U.S. went off the gold standard? We've seen this movie, and we've been living this movie for some time. Scary as this sounds, it is instructive to think about, and then make conclusions as to what types of assets can compete effectively with inflation, which we had contained for some time. Let's take a look:
Short term Treasury securities paying .48% per year. No.
Cash under your mattress paying nothing. No.
Money market funds paying .4% per year. No. The safest assets short term are the riskiest asset long term, because their value will be eroded by inflation or devaluation.
High quality companies that pay 4-6% dividends, that are currently valued pessimistically. Yes. Long term growth plus dividend yield beats inflation long term, especially at these prices.
Treasury Inflation Protection Securities. Yes. These bonds re-set annually to account for inflation, thus maintaining purchasing power.
Commodity-related companies. Yes. Commodities are priced in dollars; if the dollar goes down, commodity prices rise, earnings rise.
Gold and gold miners. Yes. The oldest hedge on a falling dollar and inflation. I may be early, but would rather be early than late.
You will likely see some changes in your portfolio mix to account for the changing environment. Still, in looking at your accounts, you own strong companies with strong products and services, and many of these companies are quite defensive in nature. Most accounts contain huge doses of high quality health care companies, oil drilling, food, tobacco, alcohol, consumer products/staples. ACC Clients have the comfort that the companies invested in have a bright future, despite the short-term swing in prices.
One of the Warren Buffett maxims I try to adhere to is: own quality companies where we can sleep at night even if the stock exchange was closed for 5 years. Companies with solid balance sheets and big dividend payments look attractive, since there are many solid companies with dividends of 4-6% right now, which exceeds the yields on Treasury securities by a lot (granted not as "safe" as a Treasury, but still extremely attractive). With all the "flight to quality", many investors have flocked to money market and Treasury securities; this trade will eventually reverse as equity yields compete with bond yields. Select municipal bonds also offer good relative values at this time, especially relative to Treasury securities on a price and yield basis.
I know you have placed your trust in me, and I will continue to do the best job possible in this environment. Please give me a call or email if you'd like to discuss this.
Tuesday, February 17, 2009
Still a Tale of Two Markets
Still “A Tale of Two Markets”
The market remains in a trading range between 7500-9000, albeit with less of the daily volatility we experienced in Fall 2008. Equity valuations appear much more enticing, with opportunities to purchase high quality equities with low P/E’s, high cash flow, and dividends between 4-6% (or 4-6% better than short-term Treasury securities), and we would argue strongly in favor of solid, dividend-paying companies at this time. 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. The really difficult aspect of this is to stay “in the game”, and to realize that 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 strong 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. Likely candidates are: commodity-related stocks, gold, gold miners, high grade corporate bonds, and inflation protection securities.
Market Climate
As of last week (Jan 13 ‘09), the Market Climate in stocks was characterized by favorable valuations but with deterioration to unfavorable market action recently. However, we do view stocks as relatively undervalued, but we have to be aware of the historical tendency for markets to overshoot on the downside in difficult conditions. As 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.
There is a possibility that the new Obama administration will address some of these issues fairly quickly – particularly in regard to immediate capital infusions to major money center banks. In that event, a recovery of more than a few percent in stock prices would put us in a position to moderately participate in market fluctuations. If we get the Dow Jones back down toward the 8000 level or below, we will likely begin taking on more market exposure on the basis of valuation, as we did in October and November. As always, we'll respond to market conditions as they evolve. Our tone regarding the stock market has taken a quick turn toward a defensive posture, but that quick turn reflects what we've observed in various measures of credit distress and market internals. This is why we generally avoid forecasts. We move as the evidence moves.
Finding Support
We have been in a full-fledged banking crisis, which will not be over until current international stabilization moves are completed. We have been witness to “panic selling”, hedge fund de-leveraging, and indiscriminate selling of every asset class. This is not the time to sell—it’s too late for that. The stock market has been bouncing around, appearing to find support between 7500-9000 on the Dow. This is the time to discriminately buy franchise businesses with strong balance sheets, strong dividends, and strong products at discounts to their intrinsic values. We believe that our stock holdings will retain their long-term value, and that the reasonable investment posture is to hold our diversified stock and bond positions. 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.
Looking Around the Corner
In December the stock market did something notable-- it rallied on extremely bad news. Retail figures were reported, they were horrible, and the stock market rallied. Then on Friday of the same week, the unemployment numbers came out, the worst in 35 years, and the market rallied 250 points. This is important, because it certainly looked like the market was "peeking around the corner" and trying to anticipate the state of the economy in late 2009. We expect the market to re-test the November lows of 7500 on the Dow during the first half of 2009, and would advise dollar-cost averaging into this market.
Perspective is Important
For the last 3 months, the stock market has varied between being priced for Depression (value stocks) and a deep Recession (growth stocks). 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, this trough 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; in other words, when the markets price assets for the extreme case, that is your point of exit or entry to either maximize your selling prices or minimize your buying prices. The truth is that a "normal" market is somewhere between the extremes.
Reasons for Optimism
The usual phrase that is used when we are near a top or bottom in the market is “this time is different”. Frequently this phrase is invoked as a reason to buy more at a top, or to sell out at the bottom. Both are wrong. 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. And now we have seen the Panic of 2008. The market appears to be bottoming somewhere around 7500-9000 on the Dow, and the market has rallied recently on highly negative news. Having said this, the recent market action has been a kick in the gut. We are down 40% from the highs of 2007, and the average Bear Market is down 42% from its peak. History may not repeat itself, but it rhymes.
When Will It Turn Around?
We are in a recession, and together with the Rescue Package needing to take hold, the real estate market needs to show some improvement. It is estimated that about 10 million 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.
Suppose that the borrower would be able to make regular payments on a principal amount of $100,000, and would even be willing to pledge $100,000 in future home price appreciation to the bank in order to make the bank whole. In that case, the present value of the loan need not be massively written off, since a stream of future payments can be allocated many different ways in order to preserve its present value. If the payment schedule of individual homeowners could be restructured, or even better, if some of the losses already taken on these mortgages could be, in effect, “passed along” to distressed homeowners in the form of principal reductions, the rate of foreclosure as well as all of the “add on” effects to the economy could be substantially reduced.
The problem is that there is no mechanism to make this happen in the private lending markets. So many of these mortgages have been securitized by cutting them into a million pieces that it is impossible to restructure the loans without consent of all of those security holders. What is needed is coordination from government. One possibility would be to encourage changes in foreclosure law at the state level, allowing judges in foreclosure proceedings the ability to reduce principal for homeowners in return for a property appreciation right (a claim on future appreciation of the home) to the lender. The other would be something along the lines of the original “troubled asset” plan of the TARP – but in this case, rather than purchasing mortgage securities in expectation of helping bank balance sheets (which is impossible unless the Treasury overpays), the objective would be to collect all of the pieces of various pools of securitized mortgages at a steep discount (say, through “all or none” auctions), and then actually have the government “pass along” those discounts in the form of mortgage principal reductions to the homeowners underlying those securities.
However the intervention occurs, it is clear that government coordination is needed here, in order to reduce the foreclosure rate and the associated economic spillover on consumption, credit markets, employment and other areas. Unfortunately, the fresh deterioration in market action and credit default spreads suggests that the need for intervention is becoming urgent.
Gold and Gold Miners
The funny yellow metal “might” be giving us an opportunity, and we've recently seen this opportunity discussed in Barron’s, Stansberry Research, and by select hedge funds. By tracking the actual price of Gold (we can use iShare symbol GLD) with the Gold Miners Index (GDX), there appears to be an enormous disconnect here. Gold at $750/oz is still quite profitable for the Gold Miners, whose average cost of producing an ounce of gold is around $380/oz. Even if gold prices were to fall in half from here, gold stocks would be fairly valued. The ratio of Gold to Gold Miners index is low. Current deflationary pressures are also keeping gold down, which could hold true during a recession, but lookout for inflation in the next 12-18 months during an economic recovery. The stock market often recovers before a recession has officially ended. And with all of the market uncertainty, questions about the massive debts the U.S. is creating, as well as all that money we are printing, gold and other precious metals could be an interesting insurance policy, particularly if the U.S. ends up de-valuing its way out of this current market weakness, or if inflation runs wild. A devaluation of the U.S.$ by definition means an increase in the price of gold, oil, and other commodities, since all of the above are priced in U.S. $. Whether it is currency devaluation or inflation, or both, all outcomes lead to gold.
Bonds, Yield Curves
Gold, Money Market, and Treasury securities were the assets of choice in the Fall of 2008. Treasury securities have rallied since the Panic began, but now these asset flows are beginning to reverse, which is pushing prices on Treasuries down, and yields up. 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, spreads on High Grade Corporate Bonds have been 6% better than Treasuries, spreads on High Yield Corporate Bonds (aka “junk”) have been 17-20% 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, 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. While CA Muni funds were down substantially in October, long term these securities receive 90% of their returns in the form of payments. Over rolling 10 year periods of time, there has only been one instance in 40 years when Municipal issues did not return 100% of principal; the normal default rate for Municipal issues in the 1991 recession was an extremely low .1%. 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. California is currently in the midst of its own crisis, though General Obligation bonds are backed by the state’s ability to raise taxes—which we anticipate will occur.
The trick going forward with bonds that are sensitive to interest rate changes will be to avoid any major steepening on the yield curve. In an inflationary environment (which we are not in right now, because of the deflationary forces of a recession) the yield curve could steepen on the long end of the curve, as well as steepen on the shorter end of the curve.
TIPS (Treasury Inflation Protection Securities)
The way to think about the relationship between TIPS yields and straight Treasury yields is that the nominal yield on a security is equal to the “real” yield plus expected inflation. At present, we have extraordinarily depressed nominal yields, but relatively high real yields, which means that the inflation rate implied in TIPS is extraordinarily low. Indeed, in order for TIPS to achieve the same total return as straight Treasuries over the next decade, we would need to observe a slight but sustained deflation over that period.
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 (which is why it is important to be careful with TIPS that trade at a substantial premium to par, since the apparently high “real” yields on near-term TIPS can be eroded by deflation). 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.
Retirement and the Required Minimum Distribution
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.
Due to the recent market panic and subsequent decline in asset values across the board, I 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. So far, so good. 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 in this difficult period
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 retirement plans, and to provide a sense of perspective in this market. It is a long term game that just got longer. There are incredible equity valuations now, and though risks remain, patience will be rewarded.
A.Charles Cattano
ACC INVESTMENT MANAGEMENT, INC.
1325 Howard Avenue PMB #433
Burlingame, CA 94010
ccattano@accimi.net
650-344-1600 (w)
415-215-0743 (c)
The market remains in a trading range between 7500-9000, albeit with less of the daily volatility we experienced in Fall 2008. Equity valuations appear much more enticing, with opportunities to purchase high quality equities with low P/E’s, high cash flow, and dividends between 4-6% (or 4-6% better than short-term Treasury securities), and we would argue strongly in favor of solid, dividend-paying companies at this time. 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. The really difficult aspect of this is to stay “in the game”, and to realize that 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 strong 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. Likely candidates are: commodity-related stocks, gold, gold miners, high grade corporate bonds, and inflation protection securities.
Market Climate
As of last week (Jan 13 ‘09), the Market Climate in stocks was characterized by favorable valuations but with deterioration to unfavorable market action recently. However, we do view stocks as relatively undervalued, but we have to be aware of the historical tendency for markets to overshoot on the downside in difficult conditions. As 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.
There is a possibility that the new Obama administration will address some of these issues fairly quickly – particularly in regard to immediate capital infusions to major money center banks. In that event, a recovery of more than a few percent in stock prices would put us in a position to moderately participate in market fluctuations. If we get the Dow Jones back down toward the 8000 level or below, we will likely begin taking on more market exposure on the basis of valuation, as we did in October and November. As always, we'll respond to market conditions as they evolve. Our tone regarding the stock market has taken a quick turn toward a defensive posture, but that quick turn reflects what we've observed in various measures of credit distress and market internals. This is why we generally avoid forecasts. We move as the evidence moves.
Finding Support
We have been in a full-fledged banking crisis, which will not be over until current international stabilization moves are completed. We have been witness to “panic selling”, hedge fund de-leveraging, and indiscriminate selling of every asset class. This is not the time to sell—it’s too late for that. The stock market has been bouncing around, appearing to find support between 7500-9000 on the Dow. This is the time to discriminately buy franchise businesses with strong balance sheets, strong dividends, and strong products at discounts to their intrinsic values. We believe that our stock holdings will retain their long-term value, and that the reasonable investment posture is to hold our diversified stock and bond positions. 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.
Looking Around the Corner
In December the stock market did something notable-- it rallied on extremely bad news. Retail figures were reported, they were horrible, and the stock market rallied. Then on Friday of the same week, the unemployment numbers came out, the worst in 35 years, and the market rallied 250 points. This is important, because it certainly looked like the market was "peeking around the corner" and trying to anticipate the state of the economy in late 2009. We expect the market to re-test the November lows of 7500 on the Dow during the first half of 2009, and would advise dollar-cost averaging into this market.
Perspective is Important
For the last 3 months, the stock market has varied between being priced for Depression (value stocks) and a deep Recession (growth stocks). 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, this trough 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; in other words, when the markets price assets for the extreme case, that is your point of exit or entry to either maximize your selling prices or minimize your buying prices. The truth is that a "normal" market is somewhere between the extremes.
Reasons for Optimism
The usual phrase that is used when we are near a top or bottom in the market is “this time is different”. Frequently this phrase is invoked as a reason to buy more at a top, or to sell out at the bottom. Both are wrong. 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. And now we have seen the Panic of 2008. The market appears to be bottoming somewhere around 7500-9000 on the Dow, and the market has rallied recently on highly negative news. Having said this, the recent market action has been a kick in the gut. We are down 40% from the highs of 2007, and the average Bear Market is down 42% from its peak. History may not repeat itself, but it rhymes.
When Will It Turn Around?
We are in a recession, and together with the Rescue Package needing to take hold, the real estate market needs to show some improvement. It is estimated that about 10 million 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.
Suppose that the borrower would be able to make regular payments on a principal amount of $100,000, and would even be willing to pledge $100,000 in future home price appreciation to the bank in order to make the bank whole. In that case, the present value of the loan need not be massively written off, since a stream of future payments can be allocated many different ways in order to preserve its present value. If the payment schedule of individual homeowners could be restructured, or even better, if some of the losses already taken on these mortgages could be, in effect, “passed along” to distressed homeowners in the form of principal reductions, the rate of foreclosure as well as all of the “add on” effects to the economy could be substantially reduced.
The problem is that there is no mechanism to make this happen in the private lending markets. So many of these mortgages have been securitized by cutting them into a million pieces that it is impossible to restructure the loans without consent of all of those security holders. What is needed is coordination from government. One possibility would be to encourage changes in foreclosure law at the state level, allowing judges in foreclosure proceedings the ability to reduce principal for homeowners in return for a property appreciation right (a claim on future appreciation of the home) to the lender. The other would be something along the lines of the original “troubled asset” plan of the TARP – but in this case, rather than purchasing mortgage securities in expectation of helping bank balance sheets (which is impossible unless the Treasury overpays), the objective would be to collect all of the pieces of various pools of securitized mortgages at a steep discount (say, through “all or none” auctions), and then actually have the government “pass along” those discounts in the form of mortgage principal reductions to the homeowners underlying those securities.
However the intervention occurs, it is clear that government coordination is needed here, in order to reduce the foreclosure rate and the associated economic spillover on consumption, credit markets, employment and other areas. Unfortunately, the fresh deterioration in market action and credit default spreads suggests that the need for intervention is becoming urgent.
Gold and Gold Miners
The funny yellow metal “might” be giving us an opportunity, and we've recently seen this opportunity discussed in Barron’s, Stansberry Research, and by select hedge funds. By tracking the actual price of Gold (we can use iShare symbol GLD) with the Gold Miners Index (GDX), there appears to be an enormous disconnect here. Gold at $750/oz is still quite profitable for the Gold Miners, whose average cost of producing an ounce of gold is around $380/oz. Even if gold prices were to fall in half from here, gold stocks would be fairly valued. The ratio of Gold to Gold Miners index is low. Current deflationary pressures are also keeping gold down, which could hold true during a recession, but lookout for inflation in the next 12-18 months during an economic recovery. The stock market often recovers before a recession has officially ended. And with all of the market uncertainty, questions about the massive debts the U.S. is creating, as well as all that money we are printing, gold and other precious metals could be an interesting insurance policy, particularly if the U.S. ends up de-valuing its way out of this current market weakness, or if inflation runs wild. A devaluation of the U.S.$ by definition means an increase in the price of gold, oil, and other commodities, since all of the above are priced in U.S. $. Whether it is currency devaluation or inflation, or both, all outcomes lead to gold.
Bonds, Yield Curves
Gold, Money Market, and Treasury securities were the assets of choice in the Fall of 2008. Treasury securities have rallied since the Panic began, but now these asset flows are beginning to reverse, which is pushing prices on Treasuries down, and yields up. 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, spreads on High Grade Corporate Bonds have been 6% better than Treasuries, spreads on High Yield Corporate Bonds (aka “junk”) have been 17-20% 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, 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. While CA Muni funds were down substantially in October, long term these securities receive 90% of their returns in the form of payments. Over rolling 10 year periods of time, there has only been one instance in 40 years when Municipal issues did not return 100% of principal; the normal default rate for Municipal issues in the 1991 recession was an extremely low .1%. 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. California is currently in the midst of its own crisis, though General Obligation bonds are backed by the state’s ability to raise taxes—which we anticipate will occur.
The trick going forward with bonds that are sensitive to interest rate changes will be to avoid any major steepening on the yield curve. In an inflationary environment (which we are not in right now, because of the deflationary forces of a recession) the yield curve could steepen on the long end of the curve, as well as steepen on the shorter end of the curve.
TIPS (Treasury Inflation Protection Securities)
The way to think about the relationship between TIPS yields and straight Treasury yields is that the nominal yield on a security is equal to the “real” yield plus expected inflation. At present, we have extraordinarily depressed nominal yields, but relatively high real yields, which means that the inflation rate implied in TIPS is extraordinarily low. Indeed, in order for TIPS to achieve the same total return as straight Treasuries over the next decade, we would need to observe a slight but sustained deflation over that period.
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 (which is why it is important to be careful with TIPS that trade at a substantial premium to par, since the apparently high “real” yields on near-term TIPS can be eroded by deflation). 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.
Retirement and the Required Minimum Distribution
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.
Due to the recent market panic and subsequent decline in asset values across the board, I 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. So far, so good. 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 in this difficult period
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 retirement plans, and to provide a sense of perspective in this market. It is a long term game that just got longer. There are incredible equity valuations now, and though risks remain, patience will be rewarded.
A.Charles Cattano
ACC INVESTMENT MANAGEMENT, INC.
1325 Howard Avenue PMB #433
Burlingame, CA 94010
ccattano@accimi.net
650-344-1600 (w)
415-215-0743 (c)
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