Monday, February 28, 2011

College Tour 2011

As I mentioned in a previous note, Mrs. Random Glenings and I spent last week visiting colleges with our daughter Caroline.

Caroline is a high school junior, and a pretty good student, if I do say so myself. She's not exactly sure what she would like to study in college (who does at age 17?) but she's got pretty high ambitions.

We had a great week. We visited Duke; University of North Carolina; University of Virginia; Johns Hopkins; Georgetown; and University of Pennsylvania.

I thought I would share a few impressions, since the whole process is so different than when I went through this process a generation ago.

First, to say that there is strong demand for these elite schools is an understatement. Most schools reported that the total applications that they will receive will number anywhere from 25,000 to 30,000. Of course, I suspect that a large percentage of these applicants are simply sending out dozens of applications to schools, but it means that the overall acceptance rate is around 10% or so.

Second, the facilities at the schools we visited were unbelievably good. In particular, the buildings at places like Hopkins and Duke seemed almost new, despite the fact that the colleges themselves have of course been around for a long time. It's amazing what a multi-billion endowment can do.

Which leads me to my third point: the cost.

Tuitions for these elite schools take your breath away. Duke and Hopkins, for example, estimate the yearly cost to attend their college for a year will be around $56,000 a year. Even a state school like Univerity of Virginia will charge out-of-state students $42,000 a year. Now, to be sure, most schools offer financial aid to most of their students, but still these number still hit home with Caroline's father.

I did a quick calculation of how much tuition costs have risen since I attended the University of Michigan in the 1970's.

I was an out-of-state student at Michigan, so my parents had to pay the "exorbitant" rate of around $5,000 per year.

Tuition today would be 10x this amount, or a compound rate of nearly 7% per annum. This is higher than CPI during the same time period, and is in line with the growth of stock market.

There have been numerous articles written about why college costs so much, so I won't attempt the subject here (although I have attached a link to a recent New York Times piece below). Still, the fact that the universities are able to charge these tuitions and still receive a blizzard of applications would suggest that they are simply charging what the market will bear.

One final point: the overwhelming gender of both the students in the audience and the representatives of the universities was female. I read somewhere that the typical college campus student body is 60% women, but judging from our little tour last week this seems to be on the low side.

On one hand you can argue this is terrific news: women in my mother's generation were discouraged from attending college, and my mother can still relate stories of discrimination.

But it makes me wonder what all the male high school students are thinking. I don't know what the future holds, but I suspect that education in an era where intellectual skills will be more important than physical strength in most areas of our society.

Friday, February 25, 2011

Housing Malaise Points to Deflationary, Not Inflationary, Pressures

The papers continue to be full of talk of inflationary pressures. Oil prices have rocketed to nearly $120 a barrel, propelled by the unrest throughout the Middle East. Other commodity prices have stayed high as well.

Most strategists think interest rates will move higher as well, despite the fact that most bond yields have moved lower over the past few weeks.

However, housing prices continue to drift lower, despite massive efforts on the part of the federal government to stimulate housing demand. Nearly 1 out of 11 houses in the United States now stand vacant, and 1 out of 4 mortgages are underwater.

In other words, those looking for inflationary pressures have obviously not been looking at housing, despite the fact that housing accounts for nearly 40% of the typical American household budget.

I ran across this article a couple of days ago in the New York Times, and came away suitably concerned. Here's an excerpt:

Robert J. Shiller, the Yale economist who is the author of “Irrational Exuberance” and who helped develop the Standard & Poor’s/Case-Shiller Home Price Index, put himself in this last group. Mr. Shiller said in a conference call on Tuesday that he saw “a substantial risk” of the market falling another 15, 20 or even 25 percent.

The 20-city Case-Shiller composite is already off 31.2 percent from its peak, according to data released Tuesday. Average home prices in Atlanta, Cleveland, Las Vegas and Detroit are below the levels of 11 years ago. A drop the size that Mr. Shiller says he thinks could happen would put Chicago, Dallas, Charlotte and Minneapolis there, too. It would create a lost decade for housing in much of the country even before the effects of inflation.

Mr. Shiller said several political trends indicated a dreary future, including the uncertainty over the mortgage holding companies Fannie Mae and Freddie Mac and proposals to reduce the mortgage tax deduction.

Home Prices Slip in Most U.S. Cities, Case-Shiller Index Shows -

I hope Professor Shiller is wrong - the article goes on to cite several other industry experts who do not believe the outlook is as dire as he portrays - but I do think he raises some valid concerns.

Saturday, February 19, 2011

Random Glenings Goes on Vacation

Mrs. Random Glenings and I are taking our daughter to visit colleges - should be a fun road trip!

Next post will be February 25.

Friday, February 18, 2011

Don't Look Now, But the Muni Market is Rallying

I doubt you will see this mention amongst all of the angst surrounding the municipal bond market recently, but this landed in my email in box last night from Merrill Lynch:

The muni market has experienced rallies for the last 6 trading days.
For the last 6 trading sessions, the 10 Yr Treasury yield has decreased by 8bps to 3.57%, however the 10 Yr AAA Muni rate has decreased by a significant 21bps to 3.18%. We think the rally of the muni market today can be partly attributable to the rally of Treasurys today, and another factor is the limited municipal primary calendar next week. The current 10 Yr AAA Muni/Treasury ratio of 89.0% has been the lowest level since 9/27/2010 and is below its 1 Year average of 89.3%.

In other words, munis are following their historic pattern: weakness into year-end, followed by a strong first quarter.

Thursday, February 17, 2011

Is Anyone Not Bullish On Stocks?

If so I am having trouble finding one.

I just returned from an investment committee meeting of a small endowment. Like so many other meetings these days, most of the discussion revolved around about adding to equities, and selling bonds.

This may be the right move (as an equity manager, I sure hope so!) but it worth a look back at history. Investing with the consensus is rarely a profitable move, so the rampant bullish sentiment is definitely a cause for concern.

I went back to some of the blog posts I made about a year ago in Random Glenings.

Here's an excerpt from dated March 19, 2o10 that I found interesting (the full link is posted below). I had just come back from attending an investment conference sponsored by the brokerage firm UBS, and here's what I found:

What I was struck by, however, was the overwhelming consensus of the "correct" investing strategy at this point in the market. Everyone, it seems, is fleeing stocks (especially US stocks) in favor of bonds and alternative investments. And everyone "knows" that interest rates are heading significantly higher, and so are keeping their portfolios structured accordingly...

So when I think that stocks in the US can move higher, and interest rates lower, I recognize that this is a minority view, which gives me another reason to believe that events should unfold as I anticipate.

With that background, here's a report on pension investing from Merrill Lynch. Their survey work is in line with what I heard earlier this week (I have added the highlighting):

Volatility reduction on the mind…

Currently, we see a significant overall desire to reduce surplus volatility within
corporate pension plans. This will typically be achieved by the continuing sale of
equities and buying of bonds....

…but rate triggers will ultimately determine moves

However, the belief among many larger plan sponsors that rates should rise is
having the most profound effect on delaying implementation. Many large plan
sponsors are on the sidelines waiting for rates to rise and are prepping
implementation when interest rate triggers are met. We believe when a plan
sponsor is comfortable and their rate trigger has been met they will begin a
meaningful shift away from equities into long-duration fixed income securities.

Forecasts imply increasing long-end rates…

Nearly every rate forecaster in Bloomberg’s current rate forecast survey believes
we should see increasing long-end (10- and 30-yr) Treasury rates in the future.
So overall, while the need to hedge surplus risk among plan sponsors seems
widespread, the timing of a sizable duration extension is tactical. Many plan
fiduciaries are holding off on an extension in the belief that interest rates will rise.

Consensus Views (cont.)

So where are we now? Well, interest rates are lower than they were a year ago, and stocks are much higher.

I would particularly highlight the fact that so much financial planning assumed a year ago that interest rates would be much higher today. This was obviously a costly assumption.

And I would also note that a lot of institutional investors and their advisers were fleeing stocks a year ago, and have missed a good portion of the recent stock market rally. Today they are going back to the equity market - but are they too late?

Wednesday, February 16, 2011

Is the Oracle of Omaha Turning Cautious on Stocks?

Yesterday's Investment News carried an article discussing recent stock activity in the Berkshire Hathaway portfolio.

Usually it is unwise to make too much of reported changes in Berkshire's equity holdings for at least a couple of reasons.

One, some of Berkshire's other subsidiaries have equity positions that are not directly managed by Warren Buffett.

And, two, Buffett may be planning another major acquisition which would require cash.

Still, I think that his most recent changes were so significant that they warrant a mention.

First, he has thrown in the towel on his BankAmerica holding, which was a losing trade (even the Great One makes mistakes!):

Warren Buffett's Berkshire Hathaway Inc. sold its stake in Bank of America Corp., ending an investment that spanned three and a half years in which the lender's stock lost more than two-thirds of its value.

But note that he remains the largest shareholder in Wells Fargo, so its not that he dislikes banks - this is clearly a negative vote for Bank America.

But here was the part I found more interesting:

Berkshire also eliminated its stakes in Nike Inc., Comcast Corp., Nalco Holding Co., Fiserv Inc., Lowe's Cos. and Becton, Dickinson & Co. in the fourth quarter. In November, Berkshire disclosed that it had sold holdings of Home Depot Inc., trash hauler Republic Services Inc. and Iron Mountain Inc., a provider of records management. Buffett's U.S. portfolio had 25 stocks and a value of about $52.6 billion at the end of December.

I went back to Value Line and did a little research. As it turns out, 60% of Berkshire's publicly-traded equity holdings are now concentrated in just three stocks: Wells Fargo; American Express; and Coca Cola. I suspect that Buffett views all three of these positions as more-or-less permanent. The other stocks that remain (e.g. Washington Post) are also long-term holdings.

However, here's the more relevant question. Why is raising cash? As of the end of the year, Berkshire already had more than $35 billion on its balance sheet, even after the Burlington Northern purchase for $26 billion last year.

Buffett in the past has talked about how frustrating it is to him to have so much cash, especially with money market rates so low. Moreover, the portfolio of businesses that Berkshire now has are cash machines, so liquidity is not a problem. Some of the stocks he sold pay decent dividends - if he was OK with the stocks, why not just hold on and collect the payouts?

The Investment News piece suggested that he might be simply repositioning the portfolio for a transition to a new manager (Buffett is, after all, 80 years old) but this doesn't ring true to me.

I know I am projecting, but I am guessing that Buffett is just getting a little cautious on stocks in general. Remember that he told everyone to buy stocks in October 2008, and the S&P is up +41% since that time.

It may be that he just feels he will be able to deploy his cash in private equity deals rather than in the public markets, or maybe he thinks he will be able to get a better buying opportunity in the markets down the road.

Tuesday, February 15, 2011

The "I" Word

In nearly every investment presentation I go to these days, the theme of most speakers invariably go toward one of the i-words (inflation; internet; internet; interest rates).

However, the most favorite topic these days is inflation.

A recent Merrill Lynch survey of mutual fund managers found that roughly 75% of those surveyed expect a significant increase in inflation. Even the most recent publication from bond guru Bill Gross discusses inflation.

Commodity prices are usually listed as the primary culprit for inflationary pressures, followed by government spending and Federal Reserve policy.

So I read with interest a story on the front page of the New York Times which detailed the apparent trend of companies that are raising prices to try to maintain their margins in the face of rising raw material prices.

But then I ran across these paragraphs:

The sharp rise in commodity prices since last year has not translated into all new records. Food commodity prices are about 8 percent below the high in the summer of 2008, while energy prices are less than half their zenith. Prices of a basket of other commodities are about 4 percent below the heights of mid-2008.

The cost of raw materials accounts for a small portion of the cost of most consumer goods, as labor, processing and packaging tend to make up a larger share of the price at the cash register. Foods like coffee, meat and milk, which are closer to raw materials, will probably show some of the biggest price jumps.

Companies that try to pass on all their costs could meet resistance. Although consumer spending has risen, unemployment remains at 9 percent, and average hourly earnings are up less than 2 percent over the last year.

In other words, commodity prices are higher, but most are lower than 2 years ago.

Moreover, as a percentage of the typical household budget, the rising prices that get the attention of most of us - food, gas, etc. - are not nearly as important to our overall financial picture as, say, the amount of money we spend on housing.

Finally, I would add one more point: Corporate margins are currently at all-time highs. Through a combination of other i-words - international outsourcing and judicious use of the internet - corporate America is reaping large profit rewards even when it is struggling to keep its top-line growing.

My suspicion is that for companies that face significant competition - for example, packaged food companies - margins this year are going to be squeezed, as consumers will be reluctant to swallow (pardon the pun) large price increases.

Monday, February 14, 2011

Questions for The Economy

It's been interesting: most of the equity strategists that I have listened to recently seem to focus most of their attention on the bond market.

The vast majority believe that interest rates are moving higher at some point this year. I do not necessarily agree with this, as numerous posts have discussed.

On the other hand, if interest rates do go higher, it will probably be a sign of an improving economy, which would be great news.

Still, I saw several news items over the last couple of days that call into question the durability of the current economic recovery.

First, there was an article in this morning's New York Times describing how home prices have been falling in areas that had been considered "safe". Here's an excerpt:

CoreLogic, a data firm, said last week that American home prices fell 5.5 percent in 2010, back to the recession low of March 2009. New home sales are scraping along the bottom. Mortgage applications are near a 15-year low, boding ill for the rest of the winter.

It has been a long, painful slide. At the peak, a downturn in real estate in Seattle was nearly unthinkable. In September 2006, after prices started falling in many parts of the country but were still increasing here, The Seattle Times noted that the last time prices in the city dropped on a quarterly basis was during the severe recession of 1982.

Two local economists were quoted all but guaranteeing that Seattle was immune “if history is any indication.” A risk index from PMI Mortgage Insurance gave the odds of Seattle prices dropping at a negligible 11 percent.

These days, the mood here is chastened when not downright fatalistic. If a recovery depends on a belief in better times, that seems a long way off.

Those who must sell close their eyes and hope for the best. Those who hope to buy see lower prices but often have lighter wallets, removing any sense of urgency.

Then there's the President's budget proposal for fiscal 2012.

How much of the apparent improvement in the U.S. economy is due to continued government deficit spending is not clear, but this paragraph is not particularly happy reading (I have added emphasis):

For the current fiscal year 2011, which ends Sept. 30, the Obama budget projects a deficit of more than $1.6 trillion, a level equal to nearly 11 percent of the gross domestic product, making it the largest shortfall since the end of World War II. That projection has swelled recently mostly due to the big tax cut deal that Mr. Obama and Congressional Republican leaders agreed to in December to spur the still-fragile economic recovery. It included a payroll tax cut this year for all Americans.

The deficit for fiscal year 2012 is projected to be more than $500 billion less, $1.1 trillion, due largely to the end of some of those tax cuts and of the two-year stimulus package that Mr. Obama signed into law soon after taking office. Economic growth and deficit-reduction measures account for a lesser share of the expected improvement.

In other words, at a time when most economists are revising their growth forecasts higher, and equity strategists are nearly uniformly saying that stocks are poised to take their cue from the economy and move higher, why is their the need for such huge government deficit spending?

And finally there is this: if interest costs are truly set to move higher for our government, how will lawmakers find the funds to meet their obligations? While this may seem like a relatively minor problem today, if the Obama budget future projections are close to reality, interest cost might become more of a topic for discussion:

Feb. 14 (Bloomberg) -- Barack Obama may lose the advantage of low borrowing costs as the U.S. Treasury Department says what it pays to service the national debt is poised to triple amid record budget deficits.

Interest expense will rise to 3.1 percent of gross domestic product by 2016, from 1.3 percent in 2010 with the government forecast to run cumulative deficits of more than $4 trillion through the end of 2015, according to page 23 of a 24-page presentation made to a 13-member committee of bond dealers and investors that meet quarterly with Treasury officials.

While some of the lowest borrowing costs on record have helped the economy recover from its worst financial crisis since the Great Depression, bond yields are now rising as growth resumes. Net interest expense will triple to an all-time high of $554 billion in 2015 from $185 billion in 2010, according to the Obama administration’s adjusted 2011 budget...

The amount of marketable U.S. government debt outstanding has risen to $8.96 trillion from $5.8 trillion at the end of 2008, according to the Treasury Department. Debt-service costs will climb to 82 percent of the $757 billion shortfall projected for 2016 from about 12 percent in last year’s deficit, according to the budget projections....

“If government debt and deficits were actually to grow at the pace envisioned, the economic and financial effects would be severe,” Federal Reserve Chairman Ben S. Bernanke told the House Budget Committee Feb. 9. “Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on U.S. output, incomes, and standards of living.

Falling housing prices and unsustainably high federal deficit spending - are these the cracks in the ice beneath the better economic figures?

Friday, February 11, 2011

Reason #85 Why Investors Should Worry About The Inflation/Deflation Debate

OK, the title of this post is a little facetious, but there are obviously lots of reasons that all investors should focus on which direction prices are heading.

But here's one that you might not have thought about.

In a deflationary world (e.g. Japan for the last two decades) the direction of bond yields and stock prices move in the same direction. That is, if interest rates move higher, stock prices tend to go up as well.

On the other hand, in an inflationary environment (e.g. the U.S. during the 1970's), bond yields and stocks move in opposite directions. Rising interest rates lead to falling stock prices in periods of inflation.

There are several reasons for this, but the overwhelming explanation has to do with the direction of the economy during times of inflation or deflation.

Inflation usually happens when economic growth is robust, and there is more demand than supply, while deflation occurs in the opposite environment.

Recent data from Ned Davis Research confirms that we have been living in a deflationary world in the United States over the past few years.

Joseph Kalish, who is a senior macro strategist at Ned Davis, wrote yesterday that the 12-month correlation between Treasury bond returns and equity returns has:

..reached an extreme level, falling to its most negative reading since November 2002. Since 1927, the only other time the correlation was more negative was in 1956. From a historical perspective, this condition won't last much longer.

Mr. Kalish goes on to note:

Over the past 35 years, when the 3-month rate of change of the bond/stock ratio has fallen 6.6% or more, long-term Treasury bond prices have fallen at a 14.0% annual rate.

If you believe - as I do - that we will remain in a deflationary environment, further selling pressures in the bond market will lead to continued gains on stocks.

On the other hand, if you believe that we are edging closer to the time when inflation will be a more important factor in our economy (as Ned Davis Research does), we may see a divergence between stock and bond market movements, as well as more volatility.

Thursday, February 10, 2011

Deflating Inflation Expectations

Talk of inflation seems to be everywhere these days.

Clients and analysts point to soaring commodity prices, including oil, that inflation is finally reappearing after years of being dormant. The bond market is also cited as sniffing inflationary pressures, since interest rates have risen in the last few weeks (but are unchanged from a year ago).

Still, I don't agree, and I thought Fed Chairman Bernanke did a good job yesterday discussing price pressures.

Bernanke (who is a pretty fair economist, after all) noted that most measures of inflation in the United States do not show any evidence of rising, but are certainly evident in the emerging markets:

"The inflation is taking place in emerging markets because that's where the growth is. That's where the demand is. And that's where, in some cases, the economies are overheating."

In the U.S., on the other hand, there is too much excess capacity, and too many unemployed workers, for any serious inflationary pressures to take place.

That was the point also raised by The Economist on its blog. Not only does the magazine dismiss the idea that the U.S. (or the U.K., for that matter) should be concerned by rising commodity prices, it also argues that any premature tightening of monetary policy could have disastrous consequences:

Just as the plunge in the price of oil in 1998 did not signal deflationary pressure in America, its rise today does not signal inflationary pressure here, unless it works its way into expectations and wages, of which there’s no sign yet...

...In fact, it could do the opposite: by draining more American purchasing power to overseas suppliers, higher oil prices leave less money to spend on stuff made in America. (America is a net food exporter so higher food prices are positive for American growth.) If the Fed were to tighten monetary policy today in response to Asia’s inflation problem, it could be the opposite of the mistake it made in 1998, compounding a deflationary shock at a time when the economy is significantly below potential.

Commodity prices: Inflation lessons from the Asian crisis | The Economist

Inflation can be a scary thing for the economy, and it is right that policy makers remain vigilant to make sure that we do not return to the high inflation days of the 1970's.

On the other hand, deflation can be even worse - just look at Japan, which remains stuck in an economic malaise that has now lasted more than 20 years. Premature tightening of monetary policy in Japan has occurred several times over the last couple of decades, and each time the policy changes had to be reversed.

Wednesday, February 9, 2011

How Risky are Municipal Bonds?

Easily one of the most "popular" topics in my client meetings these days is municipal bonds.

I have written several posts over the last few weeks about municipals. I strongly believe that while there are doubtlessly some municipal credits that should be avoided, in general munis are one of the most attractive segments in the capital markets these days.

This seems to be a minority opinion, however.

Indeed, while munis are a source of worry for my clients, no one has any serious problem with either stocks or corporate bonds (a complacency which may be a cause for concern, but that's another story). Hence the reason I often spend more time discussing municipal bonds.

Meredith Whitney is one of the reasons that munis are under such pressure.

Ms. Whitney appeared on the television show 60 Minutes in December to announce that the municipal market was facing "hundreds of billions of dollars of defaults" in the coming months. Since she had been quite prescient in seeing the major problems facing the U.S. banks in 2007, her comments received a lot of attention.

Most of the major municipal bond dealers, as well as numerous trade groups, have come out with voluminous reports essentially debunking Ms. Whitney's work. Some of the attacks seem almost personal, which has lead other commentators to try to defend her analysis.

Problem is, Ms. Whitney has refused to publish her research that supports her dire predictions, although copies are apparently leaking out. In addition, she declined an opportunity to appear before a Congressional subcommittee to go over her thoughts in more detail.

Many are now suggesting that she is motivated less by her concerns about municipal bond investors than her desire to build her own business.

Here's an excerpt from an article in Monday's New York Times discussing the controversy:

“We believe the financial challenges facing states could be the next systemic risk within the U.S. financial markets,” {Ms. Whitney} wrote in the report, a copy of which was provided to The New York Times. Ms. Whitney also draws comparisons between the risk-taking on Wall Street and the budget practices at many state governments.

In fact, there are important differences between the problems facing states and municipal governments, bad as they may be, and those the banks encountered during the financial crisis.

For starters, states have the power to raise taxes — something private companies with a shortfall cannot do, Mr. Rosner of Graham Fisher said. They can also try to force concessions from their workers in terms of reduced pay and benefits, in some cases.

Even if municipal issuers run into distress, a financial control board can shield bondholders from a default, as happened recently in Nassau County. These boards usually create a so-called intercept, or a structure that can grab new tax dollars as they come in, before they can go into the locality’s general fund. The money goes into a special fund to pay the bondholders their interest and principal, a system that prevents elected officials from spending it on other things.

Meredith Whitney’s Muni Bond Prediction Draws Scrutiny -

Tuesday, February 8, 2011

Is the Fed Really Responsible for Rising Commodity Prices?

I've been reading "The Financial Crisis Inquiry Report". This 650 page missive is the end result of the Financial Crisis Inquiry Commission's 18 month investigation into the financial meltdown of 2008.

This may sound kind of nerdy (can't you find a compelling novel to read, Dave?) but the report really is pretty interesting.

I'll be writing more about this in the next few days, but one of the aspects of the report that is particularly striking is the fact that there is no "smoking gun" which points out the persons or institutions that were responsible.

No, as the old expression goes, "We have met the enemy, and it is us".

All of us - investors, homeowners, government officials, rating agencies - were involved in the fallacy that home prices were destined to go up forever.

Warning signs abounded for much of the last decade, but they were ignored. Debt levels soared to unimaginable heights, but no one seemed to care.

And when the Day of Reckoning came, no one was spared, and we are now left with one of the biggest financial hangovers in modern history.

Today, however, everyone seems to know who to blame for soaring commodity prices and the weak dollar: Ben Bernanke and the Fed.

While it is easy to bash the Fed (although I personally think that Bernanke is doing a pretty good job), many of the economic events that surround us are not the responsibility of the central bank of the United States, as this recent article from Fortune magazine points out.

Here's an excerpt:

The true stars of the story of rising copper, corn and livestock prices are rising incomes and growing appetites in Asia and other emerging economies. That combination stokes robust demand for goods and raw materials that doesn't fade with rising prices. Also making an appearance are foreign politicians crossing their fingers and hoping, as policymakers often do, that the party will wind down without anyone having to actually yank away the punch bowl....

..."You can't blame Bernanke for the Russian drought or the cotton crop failures in Asia," said Howard Simons, a strategist for Bianco Research in Chicago. "More money does create an inflationary environment, but rising commodity prices can't be totally blamed on the creation of money."

The Bernanke-bashing bubble - Street Sweep: Fortune's Wall Street Blog

Monday, February 7, 2011

Should Investors Be Concerned About Egypt?

Last week I sold most of my emerging markets exposure in my client accounts.

Don't get me wrong: I'm a big believer in investing in the fastest growing parts of the globe. Not only are countries like Brazil, South Korea, and, yes, China, posting very strong economic numbers, but their demographics (i.e. lots of younger people) bode well for growth in the years to come.

That said, I think that most would agree that the ride to prosperity in the emerging markets will not be a smooth one.

I think of investing in the emerging markets as investing in California in the early part of the 20th century: the future looks bright, but there will be many periods that it makes sense to step aside.

I think that the current time is one of those periods. I don't know what how the outcome of the unrest in Tunisia, Egypt, etc. will turn out, but I think we're seeing backlash between the huge wealth being created in relatively poor countries that are only benefiting a tiny fraction of the population.

This weekend's Financial Times had a good piece about the emerging markets written by columnist John Authers.

After noting that although there has been a modest outflow from emerging markets mutual funds, most of the market indicators indicate an overall calmness.

Indeed, there seems to sense of complacency, if not ennui, with scenes of thousands of Egyptians throwing rocks at representatives of an American-backed government.

However, Mr. Authers notes that at other times of crisis in the Middle East - the Yom Kippur war of 1973; the Iranian hostage crisis of 1979; and the invasion of Iraq in1990 by Saddam Hussein - the markets reacted in a very similar fashion to today. Initially there was a sense of denial, but eventually reality hit investors, and the markets took a tumble.

As Mr. Authers concludes his column:

Investors should still look at the underlying driver of discontent in the Middle East. Rising food prices are destabilizing many emerging markets on which the world relies for growth and have prompted equity investors to move to the exits. Low western interest rates add fuel to this fire. And oil is reaching prices that could damage even the less oil-addicted modern economy.

Therefore, it is still a concern that the markets in need of an excuse to sell off have instead opted to ignore a pressing reason for one.

I hope I am wrong, but I would rather err on the side of caution on this one.

Friday, February 4, 2011

What are the Charts Saying About the Markets?

I went to hear Mary Ann Bartels, chief technical analyst at Merrill Lynch yesterday.

Mary Ann been looking at charts for Merrill for a number of years now, following in the footsteps of such market analyst legends like Bob Farrell and Dick McCabe. While she's not always right on the markets (a point she is always quick to note in her presentations), I think she's had a pretty good track record, so she's certainly worth a listen.

Any good technical analyst - and I would include Mary Ann as part of this group - does not try to force their particular views on economic or company fundamentals to determine their opinions. Instead, by looking for trends in price patterns, they try to let the markets tell them what the future holds.

(By the way, I realize that many academicians scoff at technical analysis, claiming that it is no better than "voodoo". That said, most of the best portfolio managers I have met over the course of my career spend a good portion of their time looking at charts.)

Mary Ann's overall message was pretty bullish for 2011. She has a year-end target for the S&P 500 of around 1400 (which would be +7% from here). Her favorite sectors are energy (by far); consumer discretionary; and technology. She would avoid healthcare; financials; and the utilities sectors.

Interestingly, although she is bullish on stocks, she also believes that interest rates remain in a downward trend, so bonds remain a buy. Her work would suggest that U.S. Treasury 10-year notes have not yet reversed the secular downtrend began in the 1980's. While she would not be surprised to see the 10-year move to around 4% at some point (it is around 3.60% at this writing), she still thinks that we will once again test the lows in yields that we saw last year, which would imply 2.30% or so.

Mary Ann remains very bullish on commodities, especially copper. She thinks that gold remains in an uptrend, with a target of at least $2,000, although this is a longer term target.

One cautionary note: the transportation stocks have been weak recently, although the broader market averages have continued to move higher. This is a classic Dow Theory warning signal, and could project into some near-term market weakness. However, to Mary Ann, any pullback should be used to add to stock positions.

Warm thoughts on a cold winter's day.

Thursday, February 3, 2011

Did Congress Fuel the Mortgage Debt Crisis?

One of the main reasons that I worry that the U.S. is going to be in for a long period of sluggish economic growth is the huge hangover of debt that remains after the last couple of decades.

The numbers are staggering, from the $14 trillion federal government debt to the trillions owed by mortgage borrowers.

Many of my clients (as well as the Chinese government) believe that the Fed is trying to reignite inflation to get us out of our collective debt hole. Even if this is truly what the Fed is trying to accomplish (which I doubt), I remain skeptical that they will be successful.

If you go back over the last, say, 150 years, you will be hard-pressed to find a industrial country that was able to inflate its way out of its debts. Instead, the example of modern Japan seems more relevant, where low interest rates, disinflation, and sluggish economic growth are the norm.

In any event, Bethany McLean had a good piece in the on-line magazine Slate about all of this, and the overwhelming debt burden that needs to eventually be repaid.

She makes an interesting point. Much of the debt explosion started in 1986, when Congress eliminated the tax detectability of interest for any debt other than mortgages. Didn't take long for Americans to figure out that borrowing against the equity in their homes was the best way to go, especially in the last decade (I have added areas of emphasis):

The numbers in the commission's report chart the surge in housing-related debt: "By refinancing their homes, Americans extracted $2 trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than seven times the amount they took out in 1996." Of course, all of this came at a cost: "Overall mortgage indebtedness in the United States climbed from $5.3 trillion in 2001 to $10.5 trillion in 2007. The mortgage debt of American households rose almost as much in the six years from 2001 to 2007—more than 63%, or from $91,500 to $149,500—as it had over the course of the country's more than 200 year history." This was during a period when overall wages were stagnant. To cut the figures a different way, as the commission helpfully does: Household debt rose from 80 percent of disposable personal income in 1993 to almost 130 percent by mid-2006. More than three-quarters of this increase was mortgage debt. Did all this debt hurt economic growth? On the contrary, it supplied it: "[B]etween 1998 and 2005, increased consumer spending accounted for between 67% and 168% of GDP growth in any given year.
FCIC report: Wall Street's debt problem is different from yours. - By Bethany McLean - Slate Magazine

Ms. McLean goes on. Once Main Street figured out that mortgage debt was a great way to borrow and spend, it didn't take long for Wall Street to leverage up their balance sheets, buy and then package all of these mortgages and make boatloads of money for themselves.

Problem is, of course, is that too much of a good thing eventually comes back to bite you, and that's what seems to be happening now.

Wednesday, February 2, 2011

Muni Selling Pressures Create Opportunities

When investing in bonds for my clients, there are two themes that I keep in mind.

First, I continue to believe that the bigger risk for most investors is that interest rates could move lower, not higher. Yes, I understand that commodity prices are moving higher, but I still think that the overall economic picture is one of disinflation, if not deflationary, trends.

The second theme I am following is that I believe that municipal bonds are extremely attractive relative to most other alternatives in the capital markets. I understand the huge financial problems facing state and local governments, but I also think that solutions will be found.

To be honest, however, most clients do not agree with me on either theme.

The overwhelming consensus opinion is that interest rates will be moving sharply higher sooner rather than later. Most cite the huge federal budget deficits, combined with very generous Fed policy, as reasons that the "bond market vigilantes" will eventually demand higher rates.

However, municipal bonds have been very much in the news, and investors in municipal bond funds have been fleeing the sector.

A recent column written by Randall Forsyth in Barron's cites some work done by Barclays Capital which points out that investor fears on municipal debt has driven municipal bonds guaranteed by corporate borrowers to higher interest rates than taxable bonds issued by the same corporate borrower.

Here's an excerpt:

For instance, the Barclays analysts found a Dow Chemical (DOW) IDR due 2033 yielding 6.25% tax-free while a Dow corporate due 2029 yielded 5.67%. The chemical company's debt is rated triple-B-minus by Standard & Poor's, a single grade above junk. Other Dow IDRs yield from 58 basis points 172 basis points above comparable Dow corporates. (A basis point 1/100 of a percentage point.)

An International Paper (IP) tax-exempt IDR due in March 2014 yielded 3.50%, above the 2.94% on the taxable bond due June 2014. Their ratings Baa3 by Moody's, its lowest investment grade, and triple-B by S&P

Some Muni Yields Exceed Similar Corporates -

So not only are municipal bonds yielding more than Treasurys across most of the maturity spectrum but munis are often yielding more than corporate bonds of the same credit.

In my opinion, such indiscriminate selling usually spells opportunity, and I think the muni market today represents a good buy.

Tuesday, February 1, 2011

The Markets at the Beginning of February

Good column this morning about the current market environment by Richard Milne in the Financial Times.

The consensus view is that stocks should have a good year in 2011. Corporate earnings are improving (despite lackluster sales growth); Fed policy remains extremely friendly; and alternative investments like bonds offer only modest returns. Moreover, historically the third year of a presidential cycle nearly always has offered investors attractive stock market returns.

At the same time, there are enormous problems still remaining in the economy.

Unemployment rates are very high, and there is little prospect that employment will increase dramatically any time soon (a fact even acknowledged by Treasury Secretary Geithner last week). Housing remains a mess, and probably will be for several years.

Municipal and federal deficits are unsustainably high, and will need to be addressed at some point in the very near future through some combination of higher taxes and lower spending, which will act as a drag on economic growth.

So what's an investor to do?

My own opinion is that you have to stay invested, particularly for the first part of this year. Valuations on quality large cap companies in particular stand out as appealing, not to mention the fact that dividend yields on many of these stocks are far higher than bonds issued by the same companies.

But around mid-year I think investors would be wise to heed the advice of Jeremy Grantham of the investment firm GMO.

Mr. Grantham is one of the more astute investment strategists out there, and he is always worth a listen. Here's today's column in the FT reports that his most recent strategy piece contains the following advice:

So what are investors to do? In Mr. Grantham's latest note called "Pavlov's Bulls" - about how the market salivates on cue ahead of any promised government stimulus - he warns that "you are living on borrowed time as a bull" with the S&P 500 worth only 910 rather than its current level of 1,280. His advice? "The speed with which you should pull back from the market as it advances into dangerously overpriced territory this year is more of an art than a science, but by October 1 you should probably be thinking much more conservatively." / Markets / Insight - Why investors have adopted teenage temperaments

I would add one final point. In a world where unexpected events can change the investment landscape dramatically in a heartbeat (e.g. as I mentioned yesterday, we are watching events in Egypt very closely), a diversified portfolio makes more sense than ever.