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)