Attention Pension Plans: Swap Corporate Bonds for Long-Dated Munis

I know what you're thinking: Doesn't Random Glenings realize that municipal interest is tax-exempt, and therefore is not appropriate for tax-deferred accounts?

Well, yes, but once in a while investors get an opportunity to take advantage of year-end supply/demand imbalances in the muni market. If this plays out the way I suspect it will, swapping from corporates to munis now, and reversing the swap in the first part of next year, should give a nice bump in total returns in bond portfolios.

Merrill Lynch put out a report a couple of days ago which provided some timely data on just how much the muni bond market is under pressure.

As I wrote last week, the muni market is currently being swamped with new issue supply. At the same time that municipalities are rushing to market to try to raise funds prior to year-end, investors have become skittish on municipal bonds.

According to Merrill Lynch:

Bond mutual funds have been experiencing very light flows for several weeks now, and are now experiencing strong outflows. Lipper FMI reported outflows of $3.1 bn. from all muni funds, the largest weekly outflow on record.

Meanwhile, while new issue muni supply has not yet hit record levels, it is still pretty heavy: Merrill indicated that about $17 billion in new muni supply hit the markets last week, which is one of the highest amounts in some time.

So this has left muni bond yields at very attractive levels.

Long muni general obligation bonds (GO's) are trading at close to 95% of long A-rated corporates, the cheapest level ever in the history of Merrill's data base. Even if you exclude California GO's (which trade at higher yields than most other states), long muni GO's are still trading close to 90% of A-rated corporates.

Normally long munis trade at 75% or less of the yields of long corporates.

So let's put some numbers on this. Let's just say you have the choice of buying a 20 year corporate bond yielding 4.50% or a muni GO at 4.25% (or about 94% of the yield of the taxable corporate).

Now, let's assume that the corporate/muni ratio returns to historic norms, or around 75%, by the end of March 2011.

If all else has stayed the same (i.e. corporate rates are unchanged), the total return for the corporate will be approximately 1.5% (you've basically earned the coupon).

Meanwhile, the 20 muni GO would now yield 3.4%. This yield decline from 4.25% today to 3.4% by the end of March 2011 implies a capital gain of more than +12% in 4 months.

When you add the 1.4% in interest from the muni GO, your total return becomes +13.4% on the muni vs. +1.5% on the corporate.

Moreover, if the trade takes longer to work than I expect, well, you're still earning a yield well above the 10-year Treasury, and better than many higher rated corporates.

What about credit risk?

There's been lots of talk about municipal credit issues, which is justified. But the fact remains that state GO's almost never default for the very simple reason that states need access to the credit markets, and that access would be lost if a state defaulted. Even in these financially stressed times, Merrill notes, the muni default rate this year has been 1% of new issue volume, and only three Chapter 9 bankruptcy failings (and all by small municipalities).

That sound you hear is Opportunity Knocking.

Evolution of a Tech Stock: Google Works to Retain Nimble Minds

The technology sector has always been a tricky one to invest in, and this year has been no different.

Technology companies historically have had a shorter life span than most companies, and the recent pace of change has, if anything, accelerated. This makes investing in tech stocks more challenging.

For example, if you look at the valuations on some tech stocks, the "old warhorses"( i.e., Microsoft; Intel; EMC; IBM; and Oracle) are all selling at what appears to be very attractive P/E multiples. Moreover, several of these now pay reasonably good dividends.

Problem is, performance and valuation have been inversely correlated this year, with the top performers in the sector have been the smaller, "riskier" names in the group like Akami (+103% YTD) and Salesforce.com (+98% YTD). Among the bigger companies, only Apple (+50% YTD) has been a standout performer, while stocks like IBM (+12%) have basically tracked the market.

In other words, investors in growth stocks like tech tend to focus on growth, and growth potential, than valuation. And (while I'm not sure I totally agree) it could mean that some of the tech giants that are trading at what appears to be attractive prices may be telling investors that their best days are behind them.

This morning's New York Times has an interesting article on Google which illustrates the problems that all tech companies eventually face.

Google is down -5% this year, lagging the overall market and most of the tech group. The market seems to be sensing that the company is struggling to maintain its tech edge, and the article this morning confirms this feeling. Here's an excerpt:

Google, which only 12 years ago was a scrappy start-up in a garage, now finds itself viewed in Silicon Valley as the big, lumbering incumbent. Inside the company some of its best engineers are chafing under the growing bureaucracy and are leaving to start or work at smaller, nimbler companies...

Corporate sclerosis is a problem for all companies as they grow. But a hardening of the bureaucracy and a slower pace of work is even more perceptible in Silicon Valley, where companies grow at Internet speed and pride themselves on constant innovation — and where the most talented people are often those with the most entrepreneurial drive.

Much of Silicon Valley’s innovation comes about as engineers leave companies to start their own. For Google, which in five years has grown to 23,000 employees from 5,000 and to $23.7 billion in revenue from $3.2 billion, the risk is that it will miss the best people and the next great idea.

“It’s a short step from scale to sclerosis,” said Daniel H. Pink, an author and analyst on the workplace. “It becomes a more acute problem in Silicon Valley, where in a couple years, you could have some competitor in a garage ready to put you out entirely.”

Now a Giant, Google Works to Retain Nimble Minds - NYTimes.com

Finally, there is this to consider: some of the "hottest" companies in the tech space are still private: Facebook; Twitter; LinkedIn; and Craigslist, to name a few. These companies present formidable competitors to most of the publicly traded tech stocks, not to mention the fact that when they eventually go public there will no doubt be money flowing out of some other tech stocks.

This is what makes the tech sector interesting.

Now You Tell Me! A Dying Banker’s Last Financial Instructions - Your Money - NYTimes.com

Interesting Ron Lieber column today in the New York Times.

Gordon Murray was a bond salesman for Goldman Sachs, Lehman Brothers and Credit Suisse for 25 years, making a small fortune along the way. Then he received a cruel blow, when he was diagnosed with brain cancer. After battling the disease for a number of months, he got the news that another tumor reappeared, making his eventual recovery problematic.

However, instead of giving up, he decided to write (with the help of co-author Dan Goldie) a book called "The Investment Answer", where he distilled his own personal investment experiences as well as his research on investing into a short book that he hopes will help individual investors.

Lieber's column has been very popular today on nytimes.com ,and it is truly a "feel good" story about a man making the most of his remaining days on the planet. Still, although I give Mr. Murry an enormous amount of credit, I am not sure I totally agree with all of his points, so I thought I might comment here.

First, true confession: I haven't read the entire book yet - I just downloaded it on my Kindle - so some of my points might be addressed in the full book.

Anyway, here's the key thoughts that Murray makes, according to Ron Lieber:

First, the two authors suggest hiring an adviser who earns fees only from you and not from mutual funds or insurance companies, which is how Mr. Goldie now runs his business.

Second, divide your money among stocks and bonds, big and small, and value and growth. The pair notes that a less volatile portfolio may earn more over time than one with higher volatility and identical average returns. “If you don’t have big drops, the portfolio can compound at a greater rate,” Mr. Goldie said.

Then, further subdivide between foreign and domestic. Keep in mind that putting anything less than about half of your stock money in foreign securities is a bet in and of itself, given that American stocks’ share of the overall global equities market keeps falling.

Fourth, decide whether you will be investing in active or passively managed mutual funds. No one can predict the future with any regularity, the pair note, so why would you think that active managers can beat their respective indexes over time?

Finally, rebalance, by selling your winners and buying more of the losers. Most people can’t bring themselves to do this, even though it improves returns over the long run.

This is not new, nor is it rocket science. But Mr. Murray spent 25 years on Wall Street without having any idea how to invest like a grown-up. So it’s no surprise that most of America still doesn’t either.

A Dying Banker’s Last Financial Instructions - Your Money - NYTimes.com

I have a couple of issues with these guidelines. First, the argument that a U.S. based investor to have at least half of their assets based overseas simply because the U.S. represents only half of the world's market capitalization doesn't ring true to me. I think that investors should place their money in sectors which offer the best possibility of long-term returns as measured in their local currencies.

Also, selling your winners and reinvesting the proceeds in your losers is a good idea only if you truly believe you're smarter than the market. Sometimes it's better to just let your winners ride, especially if the fundamentals are still working in your favor. Conversely, hoping onto a losing position, or even adding more to a losing position, works only if you truly believe you're savvier than the market as a whole. Sometimes it's better to just admit you're wrong, take a small loss, and move on.

But still, on the whole, I think that Messrs. Murray and Goldie have done a good service to individuals looking for help in managing their financial assets. If nothing else, giving a clearly stated set of guidelines is surely welcome in a field that too often has been made complex.

Getting the Odds in Your Favor

Michael Mauboussin from Legg Mason Capital has a bullish column this morning in the Financial Times on stocks.

Mauboussin makes three points why he thinks U.S. stocks could be poised for significant gains in the next few months (I have posted the link to the piece below). My favorite part of the article, though, is how he starts his column.

Investing money is sometimes compared to gambling, even though professional investors hate to be considered in the same boat as a Las Vegas card player. However, there have been numerous examples of very successful investors that have also been very good gamblers.

Bill Gross from Pimco, for example, put himself through college by playing blackjack, and is now head of one of the largest and most succesful money management firms in the world. Warren Buffett is an avid bridge player. And Ed Thorp - who wrote the book on blackjack card counting called Beat the Dealer - was also a very successful hedge fund manager.

So when I read these introductory paragraphs from Maubossin today I thought it was a pretty good way to think about investing:

Puggy Pearson, a colourful gambler who won the World Series of Poker in 1973 and dropped out of school before the age of 12, was once asked about the key to his success. “Ain’t only three things,” he crooned. “Knowin’ the 60-40 end of a proposition, money management, and knowin’ yourself.” With a flourish, he added, “Any donkey knows that.”

... Pearson’s point is that an investor should always seek to have an edge, where the expectations implied by the price fail to reflect the fundamental value. Betting on horses provides a simple but accurate metaphor, where the odds on the tote board encapsulate expectations and the likely performance of the horse captures fundamentals. You don’t make money knowing which horse will win or lose; you make money determining which horse has odds that are mispriced.

FT.com / Markets / Insight - Flutter on equities could prove a winner

Put another way, success in money management can be boiled down to three factors: money management; emotional discipline; and looking for situations where the odds are in your favor.

Now to put these ideas to work!

It's That Time of Year: Municipal Bonds Yield More than Treasurys

In the last few years one of the more predictable patterns in the municipal bond market occurs at year-end.

Normally, of course, municipal bonds yield less than comparable maturity Treasury bonds because of their tax-free nature. However, several times over the past few years we have seen situations where as we approach the end of the year that AAA-rated municipals are yield more than comparable Treasury, setting up a nice buying opportunity.

Here's why: this phenomena occurs because, for whatever reason, municipalities wait until year-end to issue a large amount of debt. However, this is also the same time of year when some of the largest buyers of municipal bonds - namely, insurance companies and banks - begin to reduce their investment activity in preparation for year-end. This imbalance - lots of supply, less demand - causes municipal yields to rise.

After year-end, going into the first quarter, supply pressures are lessened, and municipals revert back to their normal relationship relative to Treasurys, i.e., yielding less. Hence the opportunity.

This year the situation has been exacerbated by the possible expiration of the Build America Bond (BAB) program. BAB's were introduced a couple of years ago by the Obama administration as a wait to spur infrastructure spending as well as creating jobs. The interest paid on BAB is subsidized by the federal government (usually the feds pay 35% of the interest tab), making it attractive for municipal governments.

However, at this writing, it is not clear whether this program will be extended into 2011, so there has been a rush by municipalities to issues BAB's. When you throw on the usual year-end spate of new municipal issuance, municipal yields now yield more than Treasurys.

Now I can hear some of my readers say: Not so fast. Municipal credit concerns are growing, and a number of analysts are warning of municipal defaults (which historically have been quite low, by the way).

I don't disagree: I too expect that we will see weaker municipal credits have a difficult time, and possibly try to default. However, unless you are forecasting financial Armageddon, I have a hard time seeing any state defaulting. Moreover, "essential service" bonds like those connected with water and sewer projects are also unlikely to default. Yet even these credits are offering attractive relative yields these days, which to me is a chance to add return to portfolios without adding much risk.

I have attached a link to a Bloomberg story discussing the current market situation.


Munis Yield More Than Treasuries as State Funds Wane (Update4) - Bloomberg.com

The Markets Give QE2 the Bronx Cheer

Ever since the Fed announced its second round of quantitative easing (aka QE2) it has been subjected to pretty severe criticism from a number of sources.

Politicians, of course, will use any excuse to rail against the central bank (all the while hoping that they succeed) but numerous economists and academics have also come out against the plan.

I don't know whether QE2 will work, but I would agree that that the recent sell-offs in the stock and bond markets have been directly related to the negative chorus. Here's a short piece from today's Wall Street Journal:

Criticism of the Federal Reserve's latest bond-buying program, both from insiders and from U.S. politicians, is muting the plan's potential benefits for the economy.

Amid widely publicized skepticism about the efficacy and wisdom of the bond buying, investors and traders are questioning whether the Fed would be able to expand its bond purchases beyond $600 billion—even if inflation continues falling and unemployment remains high. Those doubts have contributed to an increase in yields on U.S. Treasury bonds since the Fed announced the program on Nov. 3, they say.

Criticism Hinders Fed's Easing Plan - WSJ.com

I continue to believe the sell-off has presented an opportunity for bond investors to extend maturities and add yield to portfolios.

Regardless of whether the Fed's initiative is effective or not, I think it is almost a certainty that short term interest rates will remain near 0% for most of 2011, at the very least, which puts an anchor on the overall bond market.

I also think that municipal bond investors should view the recent weakness in the muni market as an opportunity as well.

The muni market has been overwhelmed by a huge wave of new issues (both traditional muni issues as well as Build America Bonds) at a time when muni demand has slackened. Whenever you see AAA-rated muni bond yields higher than Treasurys, in my opinion, this is the time to buy, not sell, regardless of whatever concerns you might have on muni credit worthiness.

Thoughts on Copper and other Commodities

I went to go see Pete Ward, metals and mining analyst at Barclays, yesterday.

Pete, in my opinion, is one of the best analysts in this space. He has been following the group for probably 15 years or so, and has made some terrific calls on his stocks during that time.

Interestingly, before he went to Wall Street, he was a gold buyer for a jewelry company for 10 years, so he has been involved in the industry from a couple of different perspectives.

Pete has been bullish on copper for some time, and remains a "raging bull". The reason, says Pete, is simple demand/supply.

The demand for copper remains robust worldwide. Thirty years ago this demand might have come largely from the telecom companies for use in copper wires, but this has essentially ended (nearly all fiber laid today is fiber optic). Instead, copper is used in areas that require efficient uses of conducting electricity, which means automobile production (especially the new electric cars); housing; and electric grids.

This last part was particularly interesting to me. In the United States, our electricity is largely produced the way it was back when Thomas Edison discovered electricity. Fuel is shipped to a power plant, which then produces the electricity that is then distributed to local customers. The relatively flat topography of the U.S. makes this possible.

However, in the rest of the world, the distribution of electricity is done mostly through copper wires. In China, for example, Pete discussed how the simple vastness of the countryside - coupled with a very rocky terrain - makes transportation of fuel over long distances impractical. Instead, the Chinese will string copper wiring over mountainous terrain to get the electricity to where it is needed.

Thus, this means that Chinese demand for copper will only grow over time. Copper remains the best conductor of electricity - there is no better alternative on the horizon.

Problem is, copper mining is still an incredibly labor and capital intensive business. Opening a new copper mine almost anywhere in the world takes at least 7 to 10 years, assuming there is sufficient copper veins to warrant exploration. And since there are no new mines being opening, this means essentially no new supply.

The newest copper mines are being opened in fairly nasty places, like the Congo and Mongolia. Pete went to the Congo last year, and described an incredibly dangerous environment (he does not plan on returning any time soon, by the way).

The best way to play copper, according to Pete, is Freeport-McMoRan Copper & Gold (ticker FCX). The stock has had a terrific move over the last year, but Pete says there is still a good deal of upside to come. The fact that there are a lot of skeptics on copper is actually good news, said Pete, and I agree: big moves in stocks rarely occur when there is already widespread bullish consensus.

Moving on to the other commodities: Pete still likes the coal stocks, feeling that the market does not appreciate the continuing demand for the fuel despite the environmental concerns.

Interestingly, Pete does not like gold or gold stocks. As a former buyer of gold, Pete finds the current widespread bullish sentiment on gold puzzling. Unlike other commodities, gold is only used in the making of jewelry, and this is not sufficient reason for the recent rise in the price of gold. Moreover, Pete notes that Chinese women often prefer silver jewelry rather than gold, since it matches better against the color of their skin.

Finally, Pete is also not a fan of aluminum. Too much supply (again from China) and not sufficient demand makes Pete a little wary of names like Alcoa.

Viewers pull plug on US cable television

This was an unexpected story that I ran across this morning in the Financial Times.

Cable television - which only a few years ago was being touted as a "growth story" and Comcast CEO Brian Roberts was the talk of the financial world - suffered its largest decline in 30 years in the third quarter. What seems to be happening is either younger viewers are watching TV on their computers, or economic stress is causing subscribers to stop their cable service.

For whatever reason, this could be a major transformation in the entertainment world.

Here's an excerpt from the FT's story:

The number of people subscribing to US cable television has suffered its largest decline in 30 years as younger, tech-savvy viewers lead an exodus to web-based operations, such as Hulu and Netflix.

The total number of subscribers to TV services provided by cable, satellite and telco operators fell by 119,000 in the third quarter, compared with a gain of 346,000 in the third quarter of 2009, according to SNL Kagan, a research company.

Although TV services offered by telecoms and satellite providers added subscribers over the period, cable operators were hit hard, with subscriber numbers falling by 741,000


FT.com / Media - Viewers pull plug on US cable television

This is not to trash Comcast or any other cable company (although, truth be told, I can't tell you the number of times that I have cursed Comcast's internet service, which always seems to crash when I need to get on the web) but rather to point out what former General Electric CEO Jack Welch described as "the law of unintended consequences".

It is obvious to everyone that the internet has transformed most aspects of our everyday life - this was anticipated for many years. However, what most seemed to get wrong is who the ultimate winners and losers in the internet world would be.

Telcos and cable companies are suffering greatly. I would argue, for example, that AT&T and Verizon are heading towards the same fate as GM and Ford were years ago. That is, they suffer from huge infrastructure costs, large legacy pension and health care burdens, and declining revenues from the only profitable parts of their business (landline phone service). To me, both cable and telco are unattractive investments.

What about media?

Good Read from Buffett: Pretty Good for Government Work - NYTimes.com

(I apologize for the late posting of today's note. I have been doing battle with my employer's security software, which suddenly seems to find that Random Glenings - a must-read part of the financial scene for more than a year - has suddenly become a security risk. C'est la guerre).

It is very fashionable in my business to trash the government. Most analyst meetings I attend, and internal investment committee meetings, often diverge into complaints about the government, and government policy. And while I agree that sometimes government policies can be frustrating and irritating, I think sometimes we all benefit from decisions made in Washington, even though we don't like to admit it.

This morning's New York Times carries an op-ed piece from Warren Buffett which I thought was worth reading. He points out that the brave and decisive actions taken by our government a couple of years ago staved off what would have been a financial disaster brought on largely by Wall Street (the Street now, of course, has conveniently forgotten this).

Here's an excerpt:

In the darkest of days, Ben Bernanke, Hank Paulson, Tim Geithner and Sheila Bair grasped the gravity of the situation and acted with courage and dispatch. And though I never voted for George W. Bush, I give him great credit for leading, even as Congress postured and squabbled.

You have been criticized, Uncle Sam, for some of the earlier decisions that got us in this mess — most prominently, for not battling the rot building up in the housing market. But then few of your critics saw matters clearly either. In truth, almost all of the country became possessed by the idea that home prices could never fall significantly.

That was a mass delusion, reinforced by rapidly rising prices that discredited the few skeptics who warned of trouble. Delusions, whether about tulips or Internet stocks, produce bubbles. And when bubbles pop, they can generate waves of trouble that hit shores far from their origin. This bubble was a doozy and its pop was felt around the world.

So, again, Uncle Sam, thanks to you and your aides. Often you are wasteful, and sometimes you are bullying. On occasion, you are downright maddening. But in this extraordinary emergency, you came through — and the world would look far different now if you had not.

Pretty Good for Government Work - NYTimes.com

One irony of today: Buffett was criticized for not mentioning the Obama administration in this editorial, and so had to go on television to point out that such criticism was missing the point of his article (although he said it in more polite language).

Others have pointed out that Buffett - and Berkshire Hathaway - benefited from some of the loans and investments they made in 2008, and so today's editorial is a little hypocritical. To this I say: Buffett was very public that you should be buying stocks, but most were too fearful to do so. Buffett put his money where his mouth was, so to speak, and to me at least he has every right to make the points he did today.

Jeremy Grantham Talks Asset Allocation, the Fed and Where He’s Advising Clients to Invest « Portfolioist.com

I've written about Jeremy Grantham of GMO a number of times on Random Glenings, but when I ran across this article this afternoon on Grantham's latest thoughts I couldn't resist posting it.

The entire article - courtesy of the blog Portfolioist.com - is worth a read. Gratham remains bearish on stocks in the U.S. (with the exception of large cap names like Coca-Cola and Johnson & Johnson) but bullish on the emerging markets. This part is included in the article that can be found on the link below.

The most interesting part (to me, at least) was Grantham's comments on the importance of asset allocation in portfolio returns. Here's an excerpt from the piece:

About 11 minutes into the interview {which in in the link}, Grantham launches into an interesting defense of the importance of weighting your asset allocation correctly. It comes up while he’s discussing emerging markets and how they have returned 3.3 times the S&P 500 since he first recommended overweighting that asset class in 2000.

…That incredible discrepancy…says the main event in investing should be getting the big picture right. It’s nice to pick stocks, but how many good stocks do you have to pick in a whole portfolio to equal that incredible move between the biggest asset class in the world, US equities, and the third or fourth biggest asset class, emerging markets? It’s these movements between the big asset classes that make you money.

As I wrote this morning, the market in 2010 has been all about asset allocation, and not much about stock selection. While this may very change in 2011, most of my client meetings over the last few months have been all about asset allocation, and I suspect this will continue as we move into 2011.


Jeremy Grantham Talks Asset Allocation, the Fed and Where He’s Advising Clients to Invest « Portfolioist.com

Active Managers Struggle Against their Benchmarks

Quantitative strategist Savita Subramanian of Merrill Lynch is out this morning with an interesting report on the performance of equity managers.

According to Savita, only 1 of 5 active equity managers are outperforming their benchmark so far in 2010 (full disclosure: yours truly is lagging the S&P modestly YTD). There have been a couple of problems.

First, as some of my previous posts have mentioned, there has been a very high correlation between stock price movements. This has meant that fundamental analysis has not really been able to add much value, since stocks have all moved in the same direction.

This has meant that the bulk of outperformance for a manager has been based on the "beta trade". That is, if you're quick to jump on lower quality, more volatile stocks when prices are moving higher, you have the chance to outperform - but you also have to be smart enough to reduce beta before the market tumbles. Most managers are not "wired" to do this (including, again, moi).

The second issue with the market indices, according to Savita, has been the fact that low priced stocks have been driving benchmark returns. Her work indicates that:

Roughly a quarter of the value benchmark returns have been contributed by the lowest priced stocks, a disproportionate amount given that these companies represent only about a tenth of the benchmark by weight.
There's some good news for me and my fellow equity mangers, however. Savita continues:

Generally periods like today are followed by markets during which stock selection strategies outperform. The last time correlations were as high and spreads as low was in 1987, and the subsequent years saw fundamentally based stock selection strategies outperform. In particular, stocks with attractive valuation by earnings and cash flow led by a wide margin. This bodes well for active managers in 2011 and we are already starting to see active managers turn around.


10994141.pdf (application/pdf Object)

Longer Lives Mean More Problems for Life Insurers

My last post on Friday mentioned that MetLife - one of the largest life insurance companies in the world, and arguably one of the better managed ones - has decided to exit the long term care insurance market.

As it turns out, Colin Devine of Citigroup was in town last week, and I had the chance to go hear his presentation. Colin follows the life insurance stocks for Citi and, in my opinion, is one of the best analysts on the Street.

Colin spent a good portion of his luncheon presentation talking about the issues in long term care, as well as the annuity markets, that all of the insurers are facing.

Here are the basic problems: we're all living too long; interest rates are too low; and too many policyholders have figured out that some of the deal that insurers were offering a few years ago were very attractive, and so "lapse ratios" are trending well below expectations.

The first problem of longevity is of course good news for most of us. A couple who reaches the age of 65 has a good chance that at least one spouse will live another 30 years. This is at least 10 years longer than even just a few years ago. Problem is, most recently written insurance policies - including annuities - assumed that most people would not survive much longer than 80 years old, so insurance companies are having to pay out more than they expected.

Low interest rates present a challenge to all investors, and insurance companies are no different. Colin noted that virtually all insurance companies (with the exception of Met, interestingly) assumed a year ago that interest rates were going to move higher in 2010, and so priced policies accordingly. Now that interest rates are 100 basis points lower than they were a year ago, these assumptions are coming back to bite.

Finally, many annuity contracts written over the past decade made promises that are now proving to be very hard to fulfill. For example, Prudential was offering annuity holders a 7% lifetime guaranteed return just a few years ago. Even a cursory glance of investment returns over the last few years will tell you just how far underwater Pru must be on these policies. Even if stock markets move sharply higher in the next few years, it is hard to see how a balanced portfolio of stocks and bonds can achieve a 7% return after fees with interest rates so low.

This Saturday's New York Times carried an article about long term care insurance which is well worth reading. Here's an excerpt, with the full link below:

The good news here is that the {premium} increase seems to be necessary in part because long-term care itself is so good. People are staying alive longer than companies predicted, and they’re continuing to pay their premiums for longer periods of time, too, in order to remain eligible for that care.

But the bad news is that a price increase of this magnitude suggests that some companies had no idea how to set prices on many of their policies. If they have it wrong today too, you could sign up for a $2,500 premium at age 60 and end up paying two or three times as much for it when you’re 85 and on a fixed income.

Long-Term Care Insurance No Longer an Easy Sell - NYTimes.com

Problems in the Long Term Care Insurance Market

One of the more frequent conversations I have in client meetings these days is about long-term care insurance (LTC).

All of us will eventually face the need for more help as we get older (as my mother points out, the alternative to getting older is not attractive to most people). Although medical technology has developed more ways to live longer, we still have not figured out how to help people live their later years in a safe environment without bankrupting their life savings.

The appeal of LTC insurance is to meet these needs. Problem is, even the insurance companies don't know how to correctly price these policies. No one knows, for example, how long someone might need assistance with the daily chores of everyday life. Moreover,with medical costs rising faster than inflation, and low interest rates hurting investment returns on insurance company portfolios, many insurance companies are finding that writing LTC policies is simply not attractive.

This morning's Lex column in the Financial Times notes that MetLife announced yesterday that it will stop writing LTC policies. Met, along with many other insurers, had once thought the market for LTC would be an attractive one from them, but it has turned out otherwise.

Here's an excerpt from the piece, with the full link below:

Insurer MetLife announced on Thursday that it will stop writing long-term care (LTC) policies, a segment thought less than a decade ago to be one of the brightest growth areas for the industry as baby boomers prepared for retirement. Medical cost inflation, rising life expectancies and poor investment returns have instead made it a disaster. Several small insurers have stopped issuing new policies in the past decade and, of those in the business, the average LTC financial strength rating by AM Best has dropped four notches to C++.

What policies are still on offer are becoming less attractive due to high premiums. Consider that Medicare will only pay for a full 20 and partial 80 days of nursing home care while the median cost has been rising nearly 5 per cent a year to $75,190 annually according to Genworth Financial. Policies could keep paying far longer than expected as more otherwise healthy seniors suffer from maladies like dementia.

FT.com / Lex - Fixed rate blues

Kiss Your Assets Goodbye When Certainty Reigns: Barry Ritholtz - Bloomberg.com

My friend Bob Quinn brought this article to my attention. I think it makes a number of good points.

As the author indicates, everything is always uncertain in the markets, otherwise there wouldn't be a market. While this sounds obvious, I have been constantly surprised when I go to an analyst's meeting, and someone says, "Well, I am going to start getting aggressive once the uncertainty goes away." And, of course, once the "uncertainty" leaves, prices usually move to the level that reflects the new information.

Charlie Munger has been Warren Buffett's investment partner for nearly 50 years, so knows a little bit about investing money. One of Munger's heroes is Ben Franklin. Franklin used to say that he did not feel qualified to comment on a subject unless he could state his opponent's point of view better than his opponent could. It seems to be true in investing as well: if we can figure out why someone is selling a particular stock, for example, we can also try to determine why their point of view might be wrong.

Here's an excerpt from Bloomberg:

“The markets hate uncertainty.”

If you wandered anywhere near a television in advance of the midterm elections, the Federal Open Market Committee meeting or October’s employment report, that cliche was unavoidable. It was the pundits’ preferred proverb.

Wall Street has a sweet tooth for such investing maxims. They infect the trading community like influenza in December. Repeat mindless dictums ad nauseum, and they soon become the accepted wisdom.

The problem with these supposed truisms is they are no more accurate than the flip of a coin. A closer look at this uncertainty meme reveals it to be a false-ism -- one of those emotionally appealing phrases that ping around trading desks. The lack of evidence supporting their premise seems to matter very little.

To recognize how meaningless these statements are, consider the opposite: Could markets function without uncertainty? It takes only a little thought to realize that markets actually thrive on doubt, imperfect information and a lack of consensus.

Uncertainty drives the market’s price-discovery mechanism. Investing requires there to be differences of opinion. When there is broad agreement as to an asset’s fair value, trading volume falls. Without any uncertainty, who would take the opposite side of your trade?

History teaches that whenever the opposite occurs -- when certainty overwhelms uncertainty -- the herd tends to be wrong. In rare instances, when there is a near-total lack of uncertainty in the market, the outcome is usually a spectacular disaster.

Kiss Your Assets Goodbye When Certainty Reigns: Barry Ritholtz - Bloomberg.com

Is GLD Overdue To Buy Two Hundred Tons Of Actual Gold?

Lots of articles in the press about gold today.

First, gold prices continue to surge, closing above $1,400 yesterday and trending higher this morning. There may be several reasons, but the headlines that World Bank President Zoellick is suggesting a partial return to the gold standard doubtlessly helped.

Then there was the comment from an official from the Chinese central bank named Li suggesting that it is "absurd" that the dollar is still the world's reserve currency. The Chinese are not thrilled with the U.S., to say the least.

The blog Zero Hedge had an interesting post yesterday about the gold exchange-traded fund (ticker: GLD), which has been widely used by smaller investors to invest in gold.

The tricky thing about GLD is that is supposed to actually own the physical metal. However, apparently it does its buying in spurts, rather than continuously, which is what most exchange-traded funds do.

Here's an excerpt from Zero Hedge:

One of the completely unmentioned side effects of the recent surge in gold prices, has been the fact that one of the biggest holders of gold, the GLD ETF (presumably physical, even though it is kept in the cellars of HSBC in London, one of the two banks recently charged with a RICO suit for precious metal price manipulation) which as of close today held 1,294 tonnes, has not really bought any gold in over 5 months...

The bottom line is that GLD is now long overdue to replenish its actual gold holdings, net of redemptions. Assuming that GLD will increase its holdings in line with prior accumulations, when gold price surged, the ETF may soon be due to buy about 200 tonnes of gold. Should that happen, GLD will further increase its distance to 6th sovereign holder of gold, China, which as of September 2010 held "just" 1,040 tonnes.


Is GLD Overdue To Buy Two Hundred Tons Of Actual Gold?

More Thoughts on QE2

Lots of articles over the weekend on the Fed's latest gambit.

First, from an investor's standpoint, I think you have to go with the flow, and stay invested in stocks and bonds so long as the Fed wants to help you.

As this note from Barron's over the weekend discusses, you might be worried about the longer term implications of flooding a financial system that is already drowning in liquidity, but that is a question for debates, not investing.

Here's an excerpt:

"DON'T WORRY ABOUT the horse being blind; just load the wagon."

This sage observation of footballer John Madden, who apparently also has a deep understanding of financial-market dynamics, is good advice for anyone afraid the world soon might end because the Federal Reserve just wagered $600 billion in one of the most high-risk trades in the history of civilized man.

Yet the greatest risk is being too cautious on stocks during the next three to six months. Traders, investors, inveterate gamblers, dumb money and smart money are buying stocks and calls and even selling puts to profit from a potential tsunami-like shift into stocks, as the Fed effectively declares war on the interest rates critical to bonds.

The buzzword among traders is that "tail risk is to the upside," meaning stocks are much more likely to rally than not. The crowd is backing off from defensive index puts in listed and over-the-counter markets.

So, rather than getting self-righteous about the financial and moral turpitude of modern America, try to relax. Trade what is, not what is not.

Strategies to Trade on the Fed's QE2 - Barrons.com

That said, one certain aspect of QE2 is that we have managed to make the rest of the world angry at us. The overwhelming consensus from foreign leaders is that Fed's move is not only wrong, but will lead to a currency war that will hurt everyone.

One of the most strident criticisms has come from Germany. The comments from German leaders reminds me of the 1970's, when Helmut Schmidt used to regularly lecture Jimmy Carter and the rest of the U.S. political establishment about their fiscal policies.

Today, the German finance minister is named Wolfgang Schauble, and he thinks the U.S. is crazy. Here's an excerpt from an interview in Der Spiegel (I have added some highlights):

Schäuble: The German export successes are not the result of some sort of currency manipulation, but of the increased competitiveness of companies. The American growth model, on the other hand, is in a deep crisis. The United States lived on borrowed money for too long, inflating its financial sector unnecessarily and neglecting its small and mid-sized industrial companies. There are many reasons for America's problems, but they don't include German export surpluses...

SPIEGEL: Last week, the US Federal Reserve Bank decided to flood the economy with $600 billion in new money. Will this stimulate the economy as hoped?

Schäuble: I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don't recognize the economic argument behind this measure.

SPIEGEL: The US wants to depress the value of the dollar in this way, so that it can sell its products abroad more easily. In light of the ailing US economy, isn't that a completely reasonable strategy?

Schäuble: No. The Fed's decisions bring more uncertainty to the global economy. They make it more difficult to achieve a reasonable balance between industrialized and emerging economies, and they undermine the US's credibility when it comes to fiscal policy. It's inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money.

http://www.spiegel.de/international/world/0,1518,727801,00.html

A lot of the current debate reminds me of the book Lords of Finance, where author Liaquat Ahamed discussed how the central bankers in the late 1920's and 1930's attempted to deal with a world struggling with weak economic growth, high unemployment and, yes, deflation.

Hopefully we will be able to avoid the same travails of the 1930's. So far, at least, recent economic releases have been promising.

Washington Post Editorial: The problem with the economy? Confidence.

After I posted my comment on QE2 this morning, this editorial from the Post authored by David Smick arrived in my email.

This may be what Bernanke is thinking, and why he hopes the QE2 is the answer:

Recovery will be a long, hard slog, and our national mood could make the difference between success and failure. Fortunately, America's problem is not a lack of money. Nor is it a lack of adequate stimulus. It is a lack of confidence. Between $2.5 trillion and $4 trillion of private capital is waiting on the sidelines to "reliquify" a new era of American confidence and innovation.

Drawing in that money requires bipartisan leadership. Obama has two years to persuade Americans, as journalist David Brooks put it, "to salivate for the future again." It seems unlikely that will happen without a bipartisan effort to reduce our deficits and debt, to provide certainty about future rates of taxation and to reform a badly slipping public educational system without increasing our debt.

David M. Smick - The problem with the economy? Confidence.

The Fed Tries to Unleash the Economy's "Animal Spirits"

I spent a lot of time reading articles and talking to clients yesterday about the Fed's QE2 announcement. My bottom line remains that the Fed wants stock prices to move higher, and interest rates to move lower, and for the time being investors shouldn't "Fight the Fed".

Meanwhile, I am still struggling to understand what Bernanke & Co. are trying to do.

One explanation might be found in a book published about a year ago by Robert Shiller and George Akerlof titled Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Here's a summary from Amazon.com:

Akerlof and Shiller reassert the necessity of an active government role in economic policymaking by recovering the idea of animal spirits, a term John Maynard Keynes used to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery.

Like Keynes, Akerlof and Shiller know that managing these animal spirits requires the steady hand of government--simply allowing markets to work won't do it. In rebuilding the case for a more robust, behaviorally informed Keynesianism, they detail the most pervasive effects of animal spirits in contemporary economic life--such as confidence, fear, bad faith, corruption, a concern for fairness, and the stories we tell ourselves about our economic fortunes--and show how Reaganomics, Thatcherism, and the rational expectations revolution failed to account for them. Animal Spirits offers a road map for reversing the financial misfortunes besetting us today. Read it and learn how leaders can channel animal spirits--the powerful forces of human psychology that are afoot in the world economy today. In a new preface, they describe why our economic troubles may linger for some time--unless we are prepared to take further, decisive action.

In other words, by targeting asset prices, the Fed is hoping that rising stock prices and improving house prices (by driving mortgage rates lower) will lift some of the gloom pervading the populace, induce more spending and improve economic conditions.

Whether this works or not remains to be seen but it certainly is having an effect. Most of my clients are reluctantly concluding that dividend-paying stocks should play at least some role in their portfolios, even thought all are still rightfully concerned about the economy.

Meanwhile, the rest of the world is furious at the U.S. The FT notes this morning that China, Brazil and Germany, among others, are warning that the Fed's action could lead to a currency war that will hurt the entire global economy. And leaders of several emerging market countries worry that the U.S. moves will lead to massive inflows in their own countries, and hike inflation.

FT.com / Global Economy - Backlash against Fed’s $600bn easing

The Fed Wants You to Buy Stocks and Bonds

I don't know if there is a precedent for this, but Fed Chairman Bernanke has an editorial in this morning's Washington Post explaining (defending?) the Fed's thinking to embark on another round of quantitative easing.

I'm still a little skeptical about QE2, but I think you have to give Bernanke the benefit of the doubt. His entire professional career (prior to coming to the Fed) was spent studying The Great Depression of the 1930's. Moreover, he was quite vocal during Japan's "lost decade" of the 1990's about what policy moves Japan's central bank should be doing.

In other words, he's thought about all of this at some length.

Here's a excerpt from the editorial. Note I have highlighted the part that might have some relevance for investors:

This approach {QE} eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html?wpisrc=nl_opinions

In other words, the Fed wants bond and stock prices to move higher, and is willing to throw a cool $900 billion ($600 billion + reinvestment of interest from existing holdings) into the capital markets between now and the end of June 2011 to help this happen.

Do you really want to bet against the Fed?

Then there was this comment in the FT yesterday after the QE2 announcement, written by Gavyn Davies. Here's an excerpt (again, I have added my highlights):

Clearly, the fuss is mostly about asset prices. The announcement of QE2 has broken new ground not so much in its initial quantum, but in the fact that the Fed is willing to embark on this unconventional programme in the absence of any obvious financial or economic emergency. In fact, it has been willing to do so in the face of recent economic data which are definitely not indicative of a double dip in the economy. The ISM figures released in the past few days suggest that the economy may re-accelerate in the current quarter, despite the Fed’s insistence that the recovery remains disappointingly slow.

And, importantly, the Fed said that it would be willing to adjust the pace and overall size of its asset purchases in the light of future economic circumstances, which may encourage the markets to believe that there is a “Bernanke put” underlying the equity market. Almost certainly, the Fed is happy to see rises in equity prices and declines in the dollar, despite warnings that this stance may induce bubbles to develop in the US and overseas.

QE2 is about asset prices, not the economy | Gavyn Davies blogs on macroeconomics | FT.com

I'm not sure about the longer run impact of QE2, but for now I think you need to be fully invested in the markets.

Sell the Long Maturities, Buy Intermediates

The yield spread from 5 year Treasury maturities to 30 years is now near 300 basis points - a record.

Forget the Elections; The Rest of the World Hates QE2

While we Americans were focused on the midterm elections, the rest of the world is focused on the Fed.

Bill Gross of Pimco yesterday warned that the U.S. dollar might depreciate by 20% over the next couple of years if the Fed aggressively pursues its second round of quantitative easing (QE2).

Gross joins other prominent investors like Buffett and Soros in questioning the effectiveness of another round of monetary easing, especially when the possible risks to a QE2 strategy are taken into account.

Personally I'm not sure what adding another $500 billion or so in monetary stimulus to a system already awash with liquidity will accomplish. That said, I'm afraid that the Fed is the only player in Washington that has the stomach for some sort of economic stimulus. Yesterday's election results make any sort of fiscal stimulus essentially impossible for the next couple of years.

Meanwhile, the rest of the world - which, by the way, are our creditors - are furious with the U.S. policy. Consider this excerpt from Ambrose Evans-Pritchard's column in yesterday's London Telegraph:

China's commerce ministry fired an irate broadside against Washington on Monday. "The continued and drastic US dollar depreciation recently has led countries including Japan, South Korea, and Thailand to intervene in the currency market, intensifying a 'currency war'. In the mid-term, the US dollar will continue to weaken and gaming between major currencies will escalate," it said.

China, of course, has about $2.5 trillion of dollar-based assets, which would obviously be seriously eroded in value if the dollar nose-dives.

But it's not just China. Our benign neglect of the value of the dollar is driving prices higher around the world, causing central banks in countries like Australia to tighten their own monetary policy. More seriously, food prices for many developing countries have soared, whacking poor countries:

The innocent bystanders caught in the crossfire of Fed policy are poor countries such as India, where primary goods make up 60pc of the price index and food inflation is now running at 14pc. It is hard to gauge the impact of a falling dollar on commodities, but the pattern in mid-2008 was that it led to oil, metal, and grain price rises with multiple leverage. The core victims were the poorest food-importing countries in Africa and South Asia. Tell them that QE2 brings good news.

I don't know what the Fed has planned - I guess we'll learn more this afternoon, and in weeks to come. I continue to believe that any significant monetary stimulus sets us up for a decent stock market rally over the next few months, as well as lower interest. It may also push up the value of gold, as investors across the globe flee paper currencies.

Longer term, however, I am not convinced that simply depreciating our dollar will solve all of our economic woes. Moreover, at some point, the Fed will have to consider withdrawing some of the massive monetary medicine it has been administering, or risk huge inflation risks at some point in the future.


QE2 risks currency wars and the end of dollar hegemony - Telegraph

What Should Investors Expect Post-Election?

Regardless of the election results, investors will wake up tomorrow still faced with the task of finding investment value in a low growth, low interest rate world.

Conventional wisdom is that a gridlocked government - which this morning seems likely, with Republicans poised for some big wins in Congress - is good for the stock market. However, based on past history, this might not be the case.

Slate magazine carried an interesting article on what historic returns have been for stocks in different political environments (tip of the hat to Ezra Klein of the Washington Post for bringing the article to my attention). Here's a couple of excerpts from the piece, with the full link below.

First, the near term outlook:

One thing is certain: Markets love midterm elections. Brian Gendreau, a market strategist for Financial Network, found that the Dow has risen after 19 of the 22 most recent midterms. From 1922 to 2006, the Dow jumped 8.5 percent in the 90 trading days following the midterms, versus just 3.6 percent in non-midterm-election years.

But longer term, according to Sam Stovall of Standard & Poor's:

Over all years, the S&P rose at a 6.8 percent annual pace. During times of total unity, 67 of the 111 years analyzed, it gained 7.6 percent annual pace. During times of partial gridlock, accounting for 32 years, they gained 6.8 percent. And during the 12 years of a gridlocked Congress, the S&P gained just 2 percent per year. Looking at more recent years, since 1945, the pattern holds. Under total unity, stocks climbed at a 10.7 percent annual pace. Under partial gridlock, they gained 7.6 percent per year. And under total gridlock, which accounts for eight of the 65 years, they gained just 3.5 percent per year.
And in terms of sectors:

But Stovall only looked at the S&P 500. What about the market as a whole? Scott Beyer of the University of Wisconsin-Oshkosh, Gerald Jensen of Northern Illinois University, and Robert Johnson of the CFA Institute examined broader market returns in a 2004 article for the Journal of Portfolio Management.

Like Stovall, they found that big-company stocks suffer during times of gridlock—returning 0.8 percentage points less during times of unified government. But gridlock really hurts small stocks—the equity of little companies with less ability to adapt. During times of unity, they returned an annualized 23.5 percent. During times of gridlock, they returned 11.4 percent per year.

To me, the best conclusion to draw from all of this is that you have several reasons to be bullish on the near term outlook for stocks, at least based on historic cycles.

First, as noted above, midterm elections tend to be good for stocks. In addition, the third year of any presidential cycle tends to have strong investment results. Politically, then, you have some tailwinds.

Next, the Fed will almost certainly begin the next round of quantitative easing either later this week or next. No one knows how large the program will be, but this too should provide some stock market boost.

Finally, the period from November to January has historically provided the best stock market returns.

Should be an interesting period ahead.

Why is the stock market looking forward to political gridlock? - By Annie Lowrey - Slate Magazine

Worried About the Economy? Buy Stocks (part II)

The markets are up nicely this morning, as manufacturing data continues to show that industrial activity is expanding at a moderate rate. Still, most Americans would say that economic conditions are relatively poor.

For example, did you catch 60 Minutes last night? David Stockman - former Budget Director under President Reagan - was on talking about the need for a combination of tax hikes and spending cuts to address our $10 trillion fiscal deficit. At one point in his interview, however, he makes that statement that the economy is improving. Correspondent Leslye Stahl looks incredulous, but even Stockman acknowledges that unemployment will remain high for some time to come:




That's what makes today's market environment so tricky. Corporate profits are booming, but cost-cutting and overseas investing are the reasons. The Fed is poised to begin another round of quantitative easing, which will flood the markets with liquidity that will probably boost asset prices and keep interest rates low - but will have an uncertain impact on the lives of Americans.

For example, Goldman Sachs suggested last week that bond investors buy 30-year Treasury notes in front of any announcements from the Fed:

Goldman Sachs (GS) was out with a note on Friday recommending that clients buy long-dated Treasuries ahead of the Federal Reserve quantitative easing announcement, which will take place on Wednesday.

Previously, the consensus was that the Fed would focus on shorter maturity bond purchases. Goldman, however, believes that the purchases will extend out to the 30-year bond.

As long as Fed policy is driving the market, investors will have to spend as much time focusing on Fed pronouncements instead of economic fundamentals to figure out how to position portfolios.

Frontrunning The Fed: Buy Long-Dated Treasuries - BloggingStocks