Risk Adjusted Values: We continue to favor stocks that look like bonds and bonds that look like stocks. We are actively screening for equity valuations trading for 7-12x earnings, with dividend yields between 3-6% as an added bonus if we can find it. By buying the earnings stream of a high quality company at these valuations, we are much more certain in our investment thesis in terms of risk. In other words, we are looking to buy an earnings stream for ½ to ¾ of the valuation placed on the broader market, which only yields 2%. So any stock that pays 3-4% at a minimum is yielding twice as much as the S&P 500 with ½ to ¾ of the price risk. With the high grade corporate bond index paying between 4-5% yields, it becomes clear that if we can find great companies with even higher payout attributes, we are buying stocks that resemble bonds. To flip the equation, in the bond market we are looking for high grade corporate bonds (4-5%) and “vanilla flavored” high yield bonds (7-8%). Why? Our profligate money-printing should lead all investors to ask the question: who do I trust more to pay me back, corporate America or the USA? Increasingly the answer is corporate America, since we can easily examine a corporate balance sheet and determine the percentage of the company that is financed by debt. In a word, debt at the corporate level is a finite number; whereas government debt is dangerously in the other direction.
Inflation Is Still A Monetary Phenomenon! Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. MV=PQ is the equation, and it essentially breaks down into a simple explanation such as “the more money is printed or created by the government, the higher the price level (prices) will be”. The first known instance of inflation occurred in Rome, when all coins in the realm were brought in, the edges were shaved off, and more coins were made out of the shaved edgings; all new (smaller) coins were re-cast with the same previous denomination. In other words, inflation (debasement of the currency’s purchasing power). Fed Chairman Ben Bernanke has been expanding the Fed’s balance sheet in a similar fashion. This past week I had the good fortune to be invited to the Hoover Institution in celebration of Milton Friedman’s 100th birthday. It was a fantastic gathering of brainpower. The truly amazing aspect of Milton Friedman is that his body of work did not limit itself to economics. His books “Free to Choose” and “Capitalism and Freedom” simply reinforce that Capitalism (even with all its warts) is the best system so far discovered in human history. For a great video discussion between Milton Friedman and Phil Donahue circa 1980, click this link . It is only about 2 minutes long and is great.
When Will Treasury Rates Re-Set? Once the Fed stops printing money and stops buying Treasury bonds, what will be the real market for interest rates? It could be much, much higher. And that could set the economy up for a real big interest-rate shock. But…not yet, because Ben Bernanke and the Fed just this last week announced that rates will be kept low through 2014… with all of this Quantitative Easing, most people do not realize that the Federal Reserve Bank has been buying about 70% of all newly issued Treasury securities! The “eventual” concern is that once you start this quantitative easing, you can't stop, because the economic consequences of stopping are too severe. Another concern is whether there will continue to be enough other buyers of our Treasuries. The only reason we're able to continue to do any quantitative easing at all is because the dollar is the world's reserve currency. Frankly, we have wondered why, over the last 3-4 years, the US (the “best house in a bad neighborhood”) failed to issue 7-10 year Treasury securities at extremely favorable rates, which would have allowed the US to effectively retire old debt (higher rates) while issuing new debt (lower rates), simultaneously providing liquidity that was needed. Effectively the US would have “refinanced” much of the country’s debt load, while also buying the US time to gets is fiscal and policy house in order. Instead, the US issue short term debt at low rates that is coming due in the next 18-24 months that needs to be repaid or re-issued at the then-prevailing rate. With an explosion of federal spending and, this adds much risk to Treasuries.
“Safe” Bond Bubble Danger: Investors are selling U.S. stocks and buying bonds like they're going out of style. Bond prices have come unhinged from their underlying fundamentals. The bond market is a bubble. Bond holders today are practically guaranteed to lose money... But they're buying more bonds than ever. Remember... the most popular investment is almost always the worst one. In fact, ICI's historical data indicates investors have been pulling money out of stocks and pouring it into bonds for almost four years... Since June 2008, investors have made net withdrawals of $376.1 billion from equity mutual funds. During the same period, they've poured nearly twice that amount, $723.6 billion, into bond mutual funds. Between this historical data and last week's report, it seems investor psychology didn't survive the financial crisis. Even though the stock market has more than doubled in value from its March 2009 bottom... investors are still scared of stocks today. They're lusting after the safety of bonds and fleeing the risk they see in stocks. In doing so, they're ignoring the huge risks in bonds... and missing the great benefits of owning stocks. At this point, you probably want to know what's so bad about investors buying bonds instead of stocks. They'll still make money. They just won't make as much over the long term... right? And you might also say, they'll never lose money in bonds, especially if they're buying Treasurys or highly rated corporate bonds. We understand this view. And it's almost true. For example, the Treasury won't stop making bond interest payments. Neither will America's biggest, safest corporations. In that way, high-grade bonds are safe. But investors aren't aware of just how much money they can lose holding Treasurys and other low-yielding, high-grade bonds... even if all the interest and principal payments are made on time. The ugly truth is, Treasurys and high-grade bonds are virtually guaranteed to lose money if we're buying them at today's prices. Let's look at the safest bonds first, U.S. Treasury bonds. The 10-year U.S. Treasury bond is widely used as a benchmark for the overall bond market. Here's the 10-year Treasury yield going back to the 1960s...
As is evident, 10-year Treasury bonds pay less income today than at any time in the last five decades. If we buy 10-year Treasury bonds today, investors are signing up to make about 2.3% a year, fully taxable, for the next 10 years. That return has no hope of beating inflation. If, as the Obama administration wants, the top income tax rate goes to 39.5% next year, you'll probably make about 1.4% after taxes on a 10-year Treasury at current rates. The Consumer Price Index says inflation is 2.9% a year, and the Producer Price Index is 3.3%. So let's just say inflation is an even 3% right now. (Some sources will say it's just under 2%. If we re-run numbers with that assumption, the returns are still either negative or too tiny to matter.) To get the inflation-adjusted, after-tax return, just subtract our 3% inflation from the after-tax yield... a -1.6% return. At current prices, an investor will lose about 1.6% a year after taxes and inflation by buying 10-year Treasurys. The highest yielding US Treasury is the 30-year bond, yielding around 3.4%. With income taxes of 35% (this year's top rate) or more and inflation of 3%, investors will lose money in inflation-adjusted terms every year as long as they hold those bonds. Treasury bonds today look safe... unless viewed in the context of inflation. Then, they don't look very good at all.
Buying even the highest-yielding Treasurys today will lose investors money after taxes and inflation. They're a lousy deal. All bonds are priced in relation to Treasurys. So when Treasury yields go up (and prices go down), the rest of the bond market moves right along. When talking about Treasury bonds, we're really talking about all bonds. Still, one might say Treasury bonds are the safest around. And with bonds, the more risk you take, the more yield received. So... what if we take a tiny bit more risk today, perhaps by owning the bonds of the best U.S. corporations? That'd pay more than Treasurys with not much more risk... wouldn't it? Well, yes, the interest payment is more, but not enough to fight the wealth-destroying effects of inflation. Investment-grade corporate bonds are the second-worst deal in the bond market next to Treasurys.
A good, quick gauge of the market for the safest, highest-rated corporate bonds is the iShares Investment Grade Bond Fund (LQD). Just over 98% of its holdings are investment-grade corporate bonds (rated triple-B or higher by ratings agencies like Moody's or S&P), and roughly 69% are rated A or higher. Sure, the bonds are safe. Investors should get all interest and principal payments. That's not the problem. The problem is the fund pays a yield of just 4.24%. Even if you only assume today's top tax rate (35%), you still wind up with less than 3% after taxes, less than the current rate of inflation. Buying the safest corporate bonds in the world today will lose money after taxes and inflation.
With bond investing, inflation is one of the most important fundamentals, because bonds pay fixed-interest payments, not rising dividends. Their prices have become totally disconnected from the fundamentals. Bonds are a bubble, mostly because they're so vulnerable to the effects of inflation. If we put $1,000 into a 3% bond, we're going to get $30 a year and not a penny more for as long as we hold the bond. If inflation is zero, you're fine. But what if inflation is just 2%, which is generally considered a tolerably low level? Our inflation-adjusted, after-tax yield on a 3% bond would be negative.
It's financially dangerous to own bonds that pay low, single-digit yields: Ask any bond broker in the U.S. He'll say business is booming. On February 28, a JPMorgan Chase bond report noted that "almost all [bond] investors we speak with report that they continue to see inflows into their [bond] funds even with yields at these levels. This includes investors from overseas as well." The great mass of know-nothing investors – professional and individual alike – are all blindly following one another, like a column of Boy Scouts marching around, lost in the woods, following each other in circles. This whole thing probably sounds ridiculous. But it's happened before and it can happen again. Folks buying Treasury bonds and high-quality corporate bonds today need to remember what happened to the U.S. bond market starting in 1946... A 35-year bond bear market started that year, lasting until 1981. The long-term effect on those who bought bonds in the mid-1940s was devastating. If we owned a 30-year U.S. Treasury bond from 1946 to 1981, we'd have wound up with just $170 left out of every $1,000 originally invested – an 83% loss. Put another way, $2.50 worth of Treasury bond income was worth $100 in 1946... and slightly less than $17 in 1981. Maybe we wouldn't hold a bond for 35 years... But it's awfully hard to make money any time in a 35-year bear market. It was a long, devastating bear run for bondholders. During the great bond bear market of 1946-1981, inflation did its part, too. What cost $1 in 1946 cost $4.67 in 1981. If Treasury yields and prices didn't move from 1946 to 1981, we'd still have lost a lot of money. With history as our guide, it sure looks like we're heading into another big bond bear market today. The Fed is doing the same things today as it was in the 1940s. Back then, the Federal Reserve fixed long-term interest rates at a low 2.5% to finance World War II. Today, it's doing the same thing to try to spur a housing and economic recovery. It's targeting 0% interest rates for overnight interbank lending, a key interest rate benchmark for the U.S. economy. The Fed also bought Treasury bonds back then, just like it's doing today. Back in the 1940s, the Fed's Treasury holdings increased 12-fold in just five years, from $2 billion to $24 billion. Since late 2008, the Federal Reserve has increased its Treasury holdings 3.5-fold in about three-and-a-half years, from $479.7 billion in September 2008 to $1.66 trillion as of March 14, 2012. It's all just like it was in 1946, and the result will be the same, with bond investors losing money for many years to come.
Mortgages: Mortgage rates are the lowest rates ever recorded. This last week’s announcement from the Fed, that it will hold rates steady for two more years, with a 2% inflation target, is pushing yields lower. Our view is that Fannie/Freddie’s acting as lender of last resort has put an artificial pricing mechanism into the real estate market. Our focus when talking to our Clients has been to acknowledge this artificial price risk, where prices could fall 20-25%, but to also acknowledge that the “price of money” in terms of mortgage rates is incredibly attractive right now. Any investor that qualifies for a mortgage and can lock and load on a 30 year fixed mortgage should strongly consider it, regardless of the short term fluctuations of the value of the property. In our view it is a risk worth taking. Remember the rule of value investing: the uncertainty gives us the low price.
Fixed Income Commentary: Corporate bonds in the high yield category look relatively attractive. We are also finding interesting foreign bond issues (mostly sovereign) for new money that look more attractive than US paper in terms of their “ability to pay”. Generally, higher quality bonds (generally, sovereign debt issues) are not attractive on a forward-looking basis based on our thesis of eventually higher inflation and a higher yield environment. In such an environment, “quality” bonds offer nothing but low returns and capital destruction. The only plus offered, perversely, is a flight to safety in case of another macro-event. Treasury securities with longer maturities should be avoided at all costs in this environment. Long term Treasury buyers are paying 50x yield right now for “safety”, paying 2%. See prior commentary
CA Municipal Bonds: CA Municipal Bonds with shorter maturities are interesting. While CA has had all sorts of financial issues the last several years, the municipal bankruptcy filing rate has been “invoked” very infrequently. When a municipality declares bankruptcy, it allows them to renegotiate all pension and union contracts… Other states are essentially in the same boat. California does have problems, though a recent slate of IPO’s, including the impending Facebook IPO, will help to fill California’s coffers.
Thank you for your continued business and referrals: 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. We hope you enjoy reading our independent Quarterly Commentary as much as we enjoy writing it! Though risks remain, patience will be rewarded.
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