Tuesday, May 31, 2011

Getting Better With Age? Woody Allen and the Graying of America

My wife and I went to see Woody Allen's new movie Midnight in Paris yesterday.

We thought it was terrific, and, judging from the packed theater that burst into applause at the end of the movie, most of the viewers enjoyed the movie as well.

Woody Allen is now 75 years old, and Midnight in Paris is his 41st movie.

While I am not a movie critic, I think it is fair to say that while the content of Mr. Allen's films have changed considerably from his earlier years, the quality remains of the highest caliber.

Mr. Allen's work ethic has not been slowed by his age, a trait he shares with a number of individuals in areas such as finance and law.

Americans, it seems, have become less eager to retire, and with advances in health care we are able to work longer than previous generations were either able or desired.

However, this trend is not without its controversial aspects, particularly in situations where older workers are not producing the same level of work as their younger counterparts.

The New York Times on Saturday carried an interesting article on this subject. Here's an excerpt:

As roughly 44 million baby boomers hit retirement age over the next decade, the problem of how and when to step aside is becoming a hot-button issue, said Robert J. Gordon, a professor of economics at Northwestern University. Many older workers have had to put off retirement because of stock market losses during the recent deep recession. And while unemployment among older workers is lower than the national average at 6.2 percent, it is up sharply from three years ago, when it stood at 2.9 percent.


Writing in the Financial Times over the weekend, Gillian Tett observed that this desire to avoid retirement seems to be largely an American phenomena.

According to Ms. Tett, in Europe, retirement is something that is eagerly anticipated rather than dreaded - recall the large protests in France when President Sarkozy tried to raise the French retirement age from 60 to 62 years old.

Still, with nearly every industrial country facing huge fiscal shortfalls, and with birthrates still low in Europe and the United States, delaying retirement may become more the norm than the exception globally.

Friday, May 27, 2011

Japan's Fiscal Woes

Interesting piece in today's New York Times about Japan.

I wanted to post it because it presents a good counter-argument to my semi-bullish comments earlier this week about the Japanese stock market.

(Let it be noted that Random Glenings tries to look at all sides of an issue!)

While most of the talk in the United States naturally focuses on our fiscal debt woes, Japan's are in some way even worse.

Ever since the Japanese bubble burst in the late 1980's, successive Japanese governments have attempted to reinvigorate their economy through massive fiscal stimulus packages.

Unfortunately, these attempts have been largely unsuccessful, but the debt burden continues to grow.

You wouldn't know it from Japanese interest rates. The 10-year Japanese government bond yields around 1.1%. With Japan trapped in a deflationary spiral, any sort of positive return is attractive to investors.

In addition, Japan is a country of savers. Unlike the U.S. - where spending and credit are viewed as a birthright - the typical Japanese citizen reacts to a slower economy by saving more. 95% of the Japanese fiscal debt burden is held by Japanese citizens, which makes it less vulnerable to outside creditor pressures.

Today's article suggests that this might begin to change:

...the numbers are frightening, especially given Japan’s lack of political leadership around fiscal issues. Government debt stands at about 1,000 trillion yen ($12 trillion), with gross borrowings of around 200 percent of gross domestic product. The productive means to pay off those liabilities are shrinking as Japan’s average age creeps toward 50. Thanks to scant immigration, the country also loses one million people a year.

Could Japan’s Debt Lead to a Crisis? - NYTimes.com

The article goes on to describe a scenario where the Japanese might need to start relying on foreign capital to finance its debt. This in turn could force interest rates higher, and push the Japanese fiscal deficit even higher.

As the Times notes:

If non-Japanese creditors demanded higher yields to compensate for low growth, the country’s dependence on short-term borrowing would quickly lead to spiraling debt service costs. Even a 5 percent haircut on government debt would equate to $600 billion.

Few have pockets that deep. Europe’s resources are tapped out on its problems. America is struggling, and would be even more so if Japan dumped the almost $1 trillion in United States Treasuries that it holds. The only sizable pool of capital available would probably be Chinese.

Sobering thoughts.

Thursday, May 26, 2011

Is the Market Due for A Correction?

Most of the research I'm reading these days has turned cautious on the stock market.

Many strategists cite the length of the current bull market - it has been more than 2 years since stocks bottomed early March 2009, which is longer than more cyclical bull markets have historically run.

There are also the concerns relating to weakness in areas like manufacturing and housing, where recent data would suggest the economy has been slowing.

Here, for example, is a paragraph from this morning's research piece from Mary Ann Bartels, Merrill Lynch's chief technical market strategist.

Note that Ms. Bartels views the consensus bearish view as mildly positive from a contrarian viewpoint:

AAII Bulls/Bears at lowest level since the Jul/Aug 2010 lows
Based on data from the American Association of Individual Investors (AAII), US investor bullish sentiment relative to US investor bearish sentiment is at the lowest level since the late August and early July 2010 lows. As an indicator of sentiment, the AAII Bulls/Bears ratio is at or near oversold or bullish contrarian levels and suggests that individual investors are the most bearish since last summer's bottom for the S&P 500 at 1040-1010. In our view, AAII Bulls/Bears is a potential positive for the US equity market. In yesterday's Chart Talk, we highlighted that Investors Intelligence % Correction suggests that too many investors expect a correction, which is also contrarian bullish for the US equity market. Our key support on the S&P 500 remains 1305-1294.

I went to hear Ed Clissold, Global Equity Strategist at Ned Davis Research (NDR) this morning.

I've written about NDR a number of times on Random Glenings. The firm does top-shelf research on the global equity and bond markets, based on their huge database of historic market data. The firm is not always right, but I find their research very thoughtful and useful in my investment work.

NDR is among those strategists looking for at least a pause in the market's bull phase. Ed noted that NDR would not be surprised to see a 5% or 10% decline in the markets over the next few months. However, given the positive backdrop of low interest rates and an accomodative Fed policy, NDR would also not be surprised to see stocks recover nicely by year-end.

In their opinion, NDR would suggest moving to more defensive stocks as a tactical asset decision. Specifically, they like the "SHUT" sectors: Staples; Healthcare; Utilities; and Telecom for investors who want to stay in the equity market.

However, NDR's overall asset allocation remains overweight equities, and underweight bonds. It is hard to get bulled up on bonds with rates so low, and while stocks are obviously more volatile they still offer better return potential than fixed income alternatives.

Wednesday, May 25, 2011

Goldman Sachs: "Japan equities set to rally back to pre-crisis highs"

Kathy Matsui of Goldman Sachs wrote a bullish piece on the Japanese stock market in yesterday's Financial Times.

Japan, of course, is currently mired in attempting to recover from the disastrous aftereffects of the earthquake and tsuanmi. First quarter GDP was -3%. Electricity remains in short supply, and many businesses have cut back production. The response of the government has been widely criticized, and Prime Minister Kan has been scrambling to contain the political damage.

And yet, as Ms. Matui writes:

Compared to the 1995 Kobe earthquake, when price to earnings multiples traded at 77 times, the full year p/e {for the Topix} stands at a more globally comparable 13 times.

For reconstruction, the government has approved a $50bn supplementary budget, and a second budget totalling $125bn is expected this summer. Since the earthquake, the Bank of Japan has conducted sizeable fund supply operations and expanded its asset purchase scheme by 14 per cent to $500bn. The BoJ has stated that, if necessary, it will take further steps to ease policy.

FT.com / Markets / Insight - Japan equities set to rally back to pre-crisis highs

The Nikkei is currently trading at a lower multiple, and offers a higher dividend yield, than the S&P 500, and yet the Japanese stock market has lagged most of the global stock markets.

I'm not totally convinced that this is the time to jump into the Japanese stock market - even the bullish Ms. Matsui doesn't think that the Nikkei will start to move until the fall - but I like the concept.

Japan is full of world-class companies, and its famous work ethic remains intact despite 20 years of economic malaise. With the government poised to throw massive resorts into rebuilding, I am confident that Japan will begin to show signs of recovery by this fall.

The question is: When do you start buying Japan?

Tuesday, May 24, 2011

Good News for Vertex

Last month I wrote a short note discussing my first encounter with Joshua Boger of Vertex Pharmaceuticals:


After graduating from Wesleyan University in the 1970's, Dr. Boger earned a PhD in biochemistry from Harvard. His obvious talents lead to a job offer from drug giant Merck, and so he started in their research laboratory.

But Boger soon became dissatisfied with the way that Big Pharma attacked drug research, and wanted to go out on his own. So, despite having three small children, he left Merck to go off on his own.

Dr. Boger started Vertex in late 1980's. His goal for the company had been to develop new and innovative research techniques in the process of attacking some of the more difficult diseases. Given that he had been on track to be head of Merck's research laboratory, it was a pretty risky career step, but one that paid off handsomely.

If you want to read about the early years of Vertex, I highly recommend reading The Billion Dollar Molecule, written by Barry Werth. Although the book was published in 1994, it is a fascinating look into the high risk/high reward world of biochemistry research.

Dr. Boger still is on the board at Vertex, but has recently turned his attention to other endeavors in the last couple of years.

Vertex today has a market cap of over $11 billion, despite the fact that it has never made any money in its entire history.

This is about to change.

Yesterday Vertex received final approval for its drug called Incivek, which offers a cure for hepatitis C. Sales for Incivek are projected to be very strong, although it is also expected to receive strong competition from Merck's Victrelis, which also treats patients with hepatitis C.

Incivek treatments will not be cheap. Here's the lowdown from this morning's New York Times:

Vertex set the wholesale price of Incivek, also known as telaprevir, at $49,200 for the entire course of treatment. Merck’s Victrelis, also known as boceprevir, costs $26,400 to $48,400 depending on the duration of treatment. Both drugs would be used in addition to the standard therapy, which costs about $15,000 to $30,000 depending on duration.

Vertex executives defended the price, saying that cures can prevent the problems that can be caused by hepatitis C, like liver cirrhosis, liver cancer and the need for a liver transplant.

“Cure is rare in medicine and that makes the economics very compelling,” said Joshua Boger, who founded Vertex. He stepped down as chief executive two years ago, but is still a director.


When I mentioned the Vertex news last night to a group of clients, they asked:

"Why does it cost so much?"

Instead of giving a flip answer - Vertex is charging what they think the market will bear - I pointed out how long it took for the company to actually get to this point.

Testing on this drug actually started in 1993. Eventually the costs added up to nearly $4 billion, with no certainty of success. Thus, while it is true the gross margins for Incivek will be impressive for Vertex, you could also argue that in some ways they are trying to recoup some of their research costs.

But the issue still remains: who will pay for Incivek?

Monday, May 23, 2011

Emerging Market Investing

Paul Lim had a good column in yesterday's New York Times about investing in emerging markets stocks.

Mr. Lim pointed out that it seems almost universally accepted that investing in the emerging markets makes sense. However, the performance of this sector has been mixed so far this year, largely lagging the gains in the S&P 500.

Unlike the Federal Reserve and Bank of Japan, most central banks in the emerging economies have been struggling to rein in growth and inflation. The Bank of China, for example, has raised rates several times this year trying to slow growth, as has the Brazilian central bank.

The actions of the central banks, combined with attempts by governments to slow down the rate of inflows from overseas investors, have curtailed gains in emerging markets stocks relative to the U.S.

The article also notes that stocks in the emerging markets economies are more tied to commodity prices than might be generally perceived:

International stocks generally have higher correlations with commodities markets than do domestic equities. While energy and materials companies make up less than 16 percent of the S.& P. 500 index of domestic stocks, those two categories account for 27 percent of emerging-market stocks.

The Allure of Foreign Stocks Starts to Fade - NYTimes.com

Emerging markets bond funds have also seen large inflows, which has pushed yields in countries like Brazil and Mexico to levels lower than many European countries. As this morning's Financial Times reports:

The credit default swap index for 15 major emerging market countries has fallen by a third to 206, while the iTraxx SovX index for western European CDS has climbed to almost 190.

I agree that, longer term, the emerging markets offer an appealing combination of strong economic growth and powerful demographic tailwinds.

However, the ride forward will not be smooth, and the emerging markets probably carry more risk than investors are currently perceiving.

Meanwhile, high quality, dividend-paying US stocks continue to trade at attractive valuations, especially if current economic slowdown persists.

Friday, May 20, 2011

General Stanley McChrystal

It's not often that I get the chance to have a casual conversation with a four-star general, but it happened to me last night.

I have been attending the Global Transportation Conference here in Boston put together by Merrill Lynch's excellent transportation analyst Ken Hoexter for the last couple of days.

The conference featured presentations by a number of leading transportation (railroad, air freight, etc.) companies. It's a great way for me to get the chance to hear a number of leading companies in a fairly efficient fashion.

As part of the conference, Merrill hosted a dinner last night that featured General Stanley McChrystal as the after-dinner speaker.

You might remember General McChrystal: he was head of the U.S. Armed Forces in Afghanistan until about a year ago.

Then, last April, he made some ill-considered remarks about several senior people in the Obama administration in a magazine article. In the ensuing uproar, the General was recalled to Washington and then tendered his resignation.

It was a fairly inglorious end to a spectacular career in the military. General McChrystal played a lead role in numerous military conflicts over the past three decades, and also was an important part of the fight against terrorism. By all accounts, he is a very smart man.

Since he left the military he has been teaching a course at Yale. He also has started a consulting company featuring other retired military commanders which works with businesses large and small in addressing management issues.

He also is on the board of several corporations, including the airline jetBlue, which is why he was at the conference last night.

Now to my brush with fame.

Before the dinner started Merrill had a small cocktail hour for the participants at the conference. I really didn't know too many other people, so I was introducing myself to another attendee when I turned around and found myself face-to-face with General McChrystal.

Contrary to his reputation, the General could not have been nicer and more gracious. Since he had just arrived, I had the chance to talk to him for a few minutes.

(To say that others were envious would be an understatement.)

One of the most interesting comments he made concerned the types of meetings he had when he was head of US operations in Afghanistan.

Unlike what I imagined, the General said the meetings were very open, and no one felt constrained to offer their opinion even to the point of being argumentative.

Oh, really, I said? Even to a four-star General?

With a smile, General McChrystal said "Especially to a general!"

He went on to explain.

Today's US military is made of professional soldiers. Not only have they been involved in numerous deployments in the Middle East and Afghanistan, but they also have spent a good part of their adult lives learning and training about how to battle the enemy throughout the world.

Moreover, unlike in previous generations, most of our military are older, and many have families in the United States. It's one thing, the General explained, to order an 18 year-old recruit to execute an order to attack. It's another to tell a 38 year-old soldier who might have a family stateside to put themselves in harm's way just because an officer thinks it's good idea.

General McChrystal cited the recent incredible raid by Navy SEALS to finally execute Bin Laden.

"I'll bet you anything," the General said, "that every one of those SEALS helped plan that raid. It was too risky, and they're too highly trained, not to get those men involved. And given that the success of the mission depended on their execution, you have to know that they were involved almost from the beginning."

I came away from our discussion not only impressed with General McChrystal but also with a much greater awareness of how much changes in society have influenced virtually every part of American society, including the military.

As he noted, General Eisenhower could simply tell his subordinates to execute his orders, and get on with his day. Today's military commanders have to constantly work at communication, and in making sure that everyone in his command is "on board" with the decisions that are being made.

I should add that his after-dinner remarks were excellent, and well worth a listen.

Thursday, May 19, 2011

LinkedIn IPO

LinkedIn is a great way to reconnect with friends, colleagues and, on occasion, business opportunities on the internet.

Think of it as Facebook for business.

LinkedIn just went public, valuing the company at $4.5 billion. This seems pretty steep for an offering for a company with less than $250 million in revenue last year but, hey, maybe I'm just jealous that I didn't think of the idea.

So what made LinkedIn go public now?

Well, I don't know any of the principals of the company, and most Street analysts just shake their head, but I suspect it boils down to just one idea:

They're going public because they can reap billions at a time when no one seems to care that their revenue growth is slowing, and they probably will not be profitable this year.

I'm going to continue to use LinkedIn, and I suggest you do as well. But I would be very careful of this particular offering.

Here's the take of the Wall Street Journal; I have added areas of emphasis:

In 2010, revenue at LinkedIn doubled to $243 million and net income was $15.4 million, compared with a loss of $4 million a year earlier. In the first quarter of 2011, revenue also doubled to $94 million and net income rose 14% to $2.1 million from a year earlier.

The company expects its revenue growth rate to slow and warns that it won't be profitable in 2011 as it invests in what it calls future growth, such as technology and product development. It also warns that it expects that its results in the future could become more cyclical and seasonal.

Caveat emptor.

Wednesday, May 18, 2011

Surveying Small Investor Sentiment

Faithful Random Glenings reader and fellow investment manager Bob Quinn sent along some comments concerning recent investor surveys.

Bob was struck by the fact that surveys of individual investors continue indicate a large degree of squeamishness about investing in the stock market.

Although the markets have rebounded sharply since the financial debacles of 2008, a large portion of investors believe that the markets are headed for another large leg downward.

Bob - who has a passionate interest in behavioral finance - notes that that investors are always "fighting the last war".

A recent University of Chicago survey, for example, found that nearly half (!) of those survey believed that there is a significant likelihood of a 30% decline in the stock market.

And, yet, based on 60 years of data from Ned Davis research, there is roughly a 2% chance that we will see a repeat of the 2008 stock market bloodbath.

Bob was nice enough to include a recent article from Yahoo! Finance. While the article warns investors that any investment in equities will have its ups and downs, the piece also makes that following point:

Corrections will come. We may get one here soon. However, a long-term bear market isn't in the cards. The opportunities to buy into equities will be short lived. The spikes down quickly picked up by those who realize the vastness of the opportunity at hand.

In the meantime, a majority of the investment population will remain in distrust. Leaning to the right when they should be leaning left. Relying on their intuition to profit from a counterintuitive business. Not realizing that the market is now offering them a wax with their brainwash...

...The greatest bull markets of our time have risen from points where mistrust of everything Wall Street was at its greatest. This bull market is no different. It's only the magnitude of its greatness that is to be decided.

Financial Markets Hate You: Opinion - Yahoo! Finance

I would add one final point. While not minimizing the possibility of a summer stock market correction, I am still puzzled by the mass hoarding of investors into short maturity bonds in their retirement accounts, which presumably should have a long time horizon.

It's hard to get rich on 1% yields.

Tuesday, May 17, 2011

The Problem With Low Interest Rates (Continued)

Interest rates continue to grind lower, defying the predictions of inflation bears and deficit doomsayers.

The yield decline has been broad-based, with rates on most bond types declining.

As I wrote last week, yields are so low now on bonds that it presents a real challenge for investors.

For example, I have a number of clients who invest in municipal bonds. Munis, of course, offer tax-free yields and, if held to maturity, good principal protection.

According to Merrill Lynch, as of yesterday the 10 year Treasury has decreased by 43 basis points over the last 25 trading days.

Meanwhile, the 10 year AAA Muni rate has decreased by 65 basis points over the same time period, to 2.62%. High quality muni yields are now where they were in early November 2010.

The strategy of many investors has been to keep the maturities of their bond holdings relatively short, hoping for rates to move higher. Now, in order to earn more than 1% on munis you have to go out at least 4 years, which hardly seems to be worth it, in my opinion.

Buying short maturities has been a losing strategy for several years now, as Citigroup's veteran muni strategist George Friedlander wrote in his regular Municipal Market Comment last Friday:

It is also important to note that, in our experience, far too many investors are "huddled" in very short maturities, waiting for higher Treasury yields to pull muni yields higher all along the yield curve. We frequently speak to investors who have taken this approach since roughly 2004! The amount of income left on the table by investors utilizing this approach remains extremely high, given the steep slope of the muni yield curve.

I have some thoughts on investment alternatives over the next few posts, but for now my one strong recommendation is to avoid investing in short (under 5 years) munis. If you want fixed income, and don't want to stay in a money market fund, consider just adding Treasurys for the short term.

Monday, May 16, 2011

What Role Should Gold Play in A Diversified Portfolio?

There was a good article in yesterday's New York Times titled "For Gold Investors, a Sudden Reminder of Its Volatility" which I thought was pretty interesting.

Written by Jeff Sommer, the column questioned the use of gold, or any other commodity, as an effective tool to reduce risk in a diversified portfolio.

Most presentations discussing the positive aspects of investing in gold use the early 1970's as a starting point. Gold in 1971 was trading at $35 an ounce before President Nixon took the United States off the gold standard. Gold then proceeded to soar in value, helped by the high inflation rates experienced in this country during the late 1970's. By 1980, gold was trading at $850 an ounce.

Today gold is trading around $1,500 an ounce, which of course is considerably higher than a year ago but represents a meager 0.8% compound return over the last 31 years. Moreover, if gold had simply kept pace with inflation, gold would be trading a $2,400. Viewed from this perspective, then, the case for holding gold in a diversified portfolio becomes much less compelling.

So how should an investor properly structure a diversified portfolio?

Mr. Sommer cites some pioneering research work done by Gary Brinson in the 1980's and early 1990's. Brinson's papers from the Financial Analysts Journal are required reading for CFA candidates, since they represent some of the basic foundations on which many portfolios are constructed today.

As Mr. Sommer discusses:

In two papers in the Financial Analysts Journal, {Gary Brinson} and several colleagues found that broad decisions about asset classes... accounted for more than 90 percent of a portfolio’s performance.

He concluded that eight asset classes — none of them gold or any other commodity — were all that an investor needed. For a model “moderate risk” portfolio under normal market conditions, he said in the interview, those eight and their allocations are: stocks from developed markets, 49 percent; emerging-market stocks, 6 percent; investment-grade bonds from developed markets, 25 percent; emerging-market bonds, 2 percent; high-yield bonds, 3 percent; commercial real estate, 10 percent; and private equity and venture capital combined, 5 percent.

Interesting stuff.

For Gold Investors, a Sudden Reminder of Its Volatility - NYTimes.com

Friday, May 13, 2011

The Problem with Low Interest Rates

If you're a conservative investor - and lots of my clients are - you probably have a significant portion of your investment portfolios in bonds.

Bonds, of course, offer the twin benefits of principal stability and moderate amounts of income.

In addition, if you invest in individual bonds (as opposed to a bond mutual fund), you have the additional comfort of knowing that the par (face) amount of the bond will be returned to you at maturity, regardless of the level of interest rates.

But here's the problem today: rates are low on bonds, especially on shorter maturity bonds.

For example, 5 year Treasury note yields at 1.8% don't look all that appealing - except if you compare them to a 5-year AAA-rated municipal bond, which yields 1.3%.

Longer maturity bonds offer more yield, but could also drop in value if rates rise just a little bit.

10-year Treasury notes now yield 3.18%. If rates rise just 40 basis points - and the 10-year yields around 3.6% - the total return (price change + income) will be negative.

And rates were 40 basis points higher just a month ago, in early April.

Now, if you're a "buy and hold" investor, this shouldn't be cause for alarm - after all, if you're just holding a bond for income and price stability, fluctuations in market value prior to maturity is really more of an academic exercise rather than cause for concern.

But if you are the type of investor that likes to look at performance fairly regularly - and likes to make comparisons versus benchmarks - the vulnerability of bonds to even small changes in interest rates should be something that you're aware of.

I'm going to do more work on this subject next week, but my initial work would suggest that upping ones allocation to dividend-paying stocks in lieu of bonds (especially relative to shorter maturity high quality bonds) might make more sense for investors, even ones that consider themselves "conservative".

Thursday, May 12, 2011

Housing Woes Continue

I don't know about your neighborhood, but in my town "for sale" signs are sprouting up in front of houses faster than the dandelions are appearing.

Spring, of course, is historically the best time to sell a house, since families want to be able to be able to move into a new home prior to the start of school next fall.

Problem is, housing sales are tepid at best, and with so much inventory on the market is hard to see how house prices will be increasing any time soon.

Buyers are reluctant to buy when there is so much downward pressure on house prices, and are instead renting.

As I have written on numerous occasions, borrowing to buy real estate is the largest part of credit demand. If housing and commercial real estate sales are sputtering, demand for credit will also remain weak, and interest rates will stay at historically low levels.

Yesterday's Financial Times wrote that the home price tracking company Zillow reported that:

...house prices dropped -3% in the first quarter and more than -8% year on year - their steepest rate of decline since the months after Lehman Brothers collapsed.

Oh, and in other good news, Zillow estimates that 28% of US homeowner have mortgages that are higher than the value of their homes, i.e "negative equity".

As the FT noted:

For perspective, in the UK during the mid-1990's, a period often remembered as the slump of housing slumps, 11 per cent of mortgages were in negative equity.

So its not surprising that anyone connected with the housing market is reporting very slow business.

Yesterday the New York Times carried an article discussing the reduction in support that the federal government is planning for higher end houses:

For the last three years, federal agencies have backed new mortgages as large as $729,750 in desirable neighborhoods in high-cost states like California, New York, New Jersey, Connecticut and Massachusetts. Without the government covering the risk of default, many lenders would have refused to make the loans... But now Democrats and Republicans agree that the taxpayer should no longer be responsible for homes valued well above the national average, and are about to turn a top slice of the housing market into a testing ground for whether the private mortgage market can once again go it alone. The result, analysts say, will be higher-cost loans and fewer potential buyers for more expensive homes.

Fed Retreat on Big Mortgages May Hurt Upscale Housing - NYTimes.com

If you live in the most parts of the country, the government's move seems logical - why help out houses priced far above what most houses in their region sell for?

But on the coasts the reduction in government support for housing seems premature.

Wednesday, May 11, 2011

"Keep Your Eye Clear, and Hit 'Em Where They Ain't"

Back in the early days of baseball there was an extraordinary hitter named William "Wee Willie" Keeler.

Playing in the years 1892 to 1910, mostly for the Baltimore Orioles, Wee Willie compiled quite a baseball career. According to Wikipedia:

{Keeler} compiled a .341 batting average over his career... He hit over .300 16 times in 19 seasons, and hit over .400 once. He twice led his league in batting average and three times in hits. Keeler had an amazing 206 singles during the 1898 season, a record that stood for more than 100 years until broken by Ichiro Suzuki.

Keeler reportedly said that the secret to hitting was to "hit 'em where they ain't"; that is, to hit the ball where the opposing fielders were not.

The analogy to investing, it seems to me, is that successful investing is also looking for areas that other investors are ignoring, and avoiding potential blocks to successful investment returns.

For example, I posted a note yesterday featuring Bill Miller of Legg Mason yesterday.

Mr.Miller noted that three sectors of the market - technology; healthcare; and financial - are trading at very inexpensive valuations relative to historic averages. For whatever reason, investors apparently are shunning these areas.

On the other hand, the commodity sector seems to be a very crowded trade; there is huge speculative and investor interest in commodities such as oil and gold.

Mr. Miller forecasts - and I agree - that history suggests that investing in sectors where there is already large investor and media attention will probably not yield good returns.

Today I would like to add another sector that seems overvalued: social media.

Exhibit A would be the upcoming IPO for LinkedIn.

I am a big fan of LinkedIn, and have found it a great way to get in touch with professional contacts.

But I would strongly advise anyone thinking of investing in LinkedIn cast a careful eye on the prospectus.

The LinkedIn indicative price range of $32 to $35 a share values it at between $3 bn and $3.3 bn - about 13 times last year's sales. You would have to assume very optimistic sales and earnings growth rates in order to have this valuation make sense.

Apparently even the offering prospectus notes that these assumption are aggressive.

Then there's this (quoting from this morning's Financial Times):

Potential shareholders should also remember that they are wanted only for their money. They can buy "class A" shares but 99.1 per cent of the voting power sits with "class B" shareholders, such as the founders and key executives.

Tuesday, May 10, 2011

"Buy What's Out of Favor" - Bill Miller of Legg Mason

Good column in this morning's Financial Times from Bill Miller of Legg Mason.

Bill Miller, of course, is famous for beating the S&P 500 index for 15 years in a row. His streak ended in 2008, but he remains one of the best investors out there, and is always worth a listen.

Much of his piece today discussed commodities. Historically, writes Mr. Miller, returns from investing in commodities are cyclical, and he suspects that today will be no different. High commodity prices almost always reduce demand, making continued strong returns unlikely.

Bill Miller is a "value" investor, which means that he looks for opportunities in stocks and sectors that appear very cheap relative to both their growth prospects as well as their historic norms:

Where is the value in the market today? In the assets people do not want, that have no momentum, and that are cheap. Three broad sectors and two broad themes stand out. The S&P 500 sectors are: financials, technology and healthcare which are in the bottom decile of their historic valuation ranges. This means they have been more expensive 90 per cent of the time over the past 60 years or so. The themes are US mega cap, and deep value, meaning low price to book value and high free cash flow yield.

FT.com / Markets - A good time to snap up healthcare and tech stocks

In general I would agree with much of Mr. Miller's comments, although I am still nervous that there is "another shoe to drop" in the financial sector. Our financial sector remains clogged with huge amount of debt mostly related to housing that has yet to be recognized, and so valuation metrics might be slightly misleading.

Bank of America, for example, has already written off $17 billion in bad loans largely related to mortgage debt, and yet B of A CEO Brian Moynihan noted this morning that the banking behemoth has billions more in loans that have turned sour.

And as for tech: well, yesterday I posted a note on Microsoft, noting the huge pile of cash reserves the company is sitting on. Today the company is apparently going to use $8.5 billion of this cash hoard to buy Skype, the internet phone service. Given that Skype was valued at less than $2 billion a couple of years ago, I must confess that I am scratching my head on this one.

Monday, May 9, 2011

What To Do About Microsoft?

I went to go hear analyst Brent Thill last week. Brent follows the enterprise software group for the brokerage firm UBS, which includes Microsoft (ticker: MSFT).

Brent is one of the better analysts in the space, in my opinion, but his "buy" recommendation on Microsoft has not worked out particularly well, as he noted with some frustration.

Over the last year, for example, Microsoft has declined by -11% while the S&P 500 is up +19%.

It's also been the same story for the last few years: despite a very attractive valuation; a decent dividend; and monopoly pricing power over products that nearly all of us use on a daily basis, the company has been struggling to figure out it way in the new world of cloud computing, and so its stock has lagged the broader market indices.

In some ways, the company is typical of many other "big tech" stocks. In the 1990's, if you didn't own tech stocks like Microsoft, Oracle, IBM, etc., you risked lagging the market significantly.

Lately it has been the opposite for investors in technology stocks. While the larger technology stocks have languished, volatile stocks like Salesforce. com; VMWare; and Red Hat have soared.

Microsoft today offers investors a 2.5% dividend yield, and a free cash flow yield of 13%. It's price/earnings is less than 10x, and sits on more than $40 billion of cash. For the patient investor, it would seem an opportunity, but, boy, it's been painful to sit with the stock.

About a year ago there was an interesting piece in the New York Times written by a former Microsoft executive named Dick Brass. Mr. Brass discussed the innovation and cultural problems at the company that are contributing to its problems (tip of the hat to columnist Luke Johnson of the Financial Times). Here's an excerpt, with the full link below:

Microsoft’s huge profits...come almost entirely from Windows and Office programs first developed decades ago. Like G.M. with its trucks and S.U.V.’s, Microsoft can’t count on these venerable products to sustain it forever. Perhaps worst of all, Microsoft is no longer considered the cool or cutting-edge place to work. There has been a steady exit of its best and brightest.

What happened? Unlike other companies, Microsoft never developed a true system for innovation. Some of my former colleagues argue that it actually developed a system to thwart innovation. Despite having one of the largest and best corporate laboratories in the world, and the luxury of not one but three chief technology officers, the company routinely manages to frustrate the efforts of its visionary thinkers.


Friday, May 6, 2011

Commodities Plunge, Yields Move Lower - What to do about Stocks?

There seems to be increasing evidence that the world's economy is turning a little weaker.

Jeremy Warner writing in today's London Telegraph does a good job at summarizing some of the recent signs that would suggest the recent trends are turning less favorable.

He lists 10 different reasons for his pessimism, which can be found by clicking on the link, but the general idea is that the plunge in bond yields and commodity prices are indications that investors are turning cautious.

Ten reasons for thinking the world economy is turning soft – Telegraph Blogs

I've received a few calls today from clients wondering what changes they should make, if any, in their portfolios.

Mostly I've been saying to just be patient. There is no doubt that the old stock trader's axiom of "Sell in May and go away" is being repeated by many investors as justification to head to the exits.

That said, the problem with any short term trading strategy is that you really have to make two decisions: first, when to sell; and, second, when to get back into the market.

Last year, for example, selling in May looked pretty smart until the end of June. However, the market jumped by nearly +25% during the second half of 2010, so you would have had to be pretty nimble.

So, what I keep referring back to the three rules of trading that veteran market strategist Ned Davis that I first wrote about back in March (please see blog post dated March 11, 2011)


If Ned's rules are right, we're still OK on stocks. Here they are again, and my comments on the current situation:

1. Don't fight the Fed - the Fed's QE2 program will be ending at the end of June, but I don't get the impression that monetary policy will be tightening any time soon. In fact, even the European Central Bank (which raised rates a month ago) gave strong hints that it too will be slow to tighten any time soon;

2. Don't fight the Tape - the tone of the market remains positive, despite a rocky few days earlier this week. Investors might want to reduce stock positions, but the investment alternatives aren't all that interesting;

3. Be Wary of Crowd Sentiment at Extremes - bullish sentiment had been very strong a few weeks ago, but the buzz seems have lessened, and there are more calls for caution. This is good - too many bulls usually translate into mediocre returns.

So, while I too am a little concerned about the economy, I don't see any compelling need to change my basically bullish stance on stocks at this point.

Thursday, May 5, 2011

Bond Yields Falling

World food prices continue to spiral higher!

Inflation is just around the corner!

Our government is gridlocked !

The Fed's QE2 is ending!

The dollar is plummeting!

And yet yields on Treasury bonds are moving sharply lower - again.

Since peaking earlier this year at 3.75% in early February, 10-year Treasury notes at this writing now stand at 3.18%. Today's rates are also more than 30 basis points lower than a year ago.

Oh, and for the uber-bears on municipals, please note that yields on municipals have been falling even faster than Treasury yields. A dearth in new issue supply, plus an increase in state tax revenues, have returned some luster to municipal bonds.

We had a long discussion about bonds yesterday at our weekly investment policy committee meeting. Most managers are skeptical about bonds. They continue to believe (as they have for the last three years) that bonds are trapped in a "bubble", and rates will rise soon.

As I have been writing for the last couple of years, I don't agree.

I think that we are close to being mired in a Japan-style liquidity trap, and rates are going to surprise investors by staying lower longer than most expect.

The world is awash with liquidity. Credit-worthy corporations may be borrowing, but most are just socking the money away in Treasury bills. The memories of 2008 are still too fresh, when the credit markets were essentially closed.

Most of the surge in M&A activity recently has been done either with cash or in combination with common stock. Leveraged buy-outs have disappeared from Corporate America, at least for now.

Housing prices are poised to take another leg lower. Mortgage credit remains the largest source of borrowing demand in this country, so weak housing activity translates into low demand for mortgage borrowing.

There has been an increase in prepayment activity among homeowners. With interest rates so low, there is little incentive to leave your money in short-maturity bonds yielding less than 1%.

I still think the trend in interest rates is lower, not higher.

Wednesday, May 4, 2011

Dow Two Million

The United Nations came out with a report yesterday indicating that it expects the world's population to top 10 billion by the end of this century. Reading the news reports got me thinking about the power of compound interest.

I don't view the United Nations report as necessarily gloomy. It really just reflects a very modest global population growth over the next century.

The world's population today is roughly 7 billion. Reaching 10 billion by 2100 implies a compound growth rate of just 0.40% per year for the next 89 years.

That said, this forecast has potentially a number of implications for our planet and our limited natural resources. Commodity prices, for example, will almost certainly be moving sharply higher unless we change the way we power our cars and feed ourselves.

From an investor's standpoint, population growth can also represent an opportunity, especially since historically demographics seem to play an important role in determining the longer term trend of capital markets.

Much of the forecasted population growth is expected to occur in Africa, where there are already numerous countries struggling to provide even the most basic needs of food and water. Large investments in food and infrastructure will be needed in many African countries.

Compounding even small increases over long period of time can lead to some fairly startling results. And while doomsayers since Malthus have projected that population growth will overwhelm mankind's ability to cope, I am optimistic that it is also possible that we will develop better ways to use our limited resources so that basic needs can be met.

For example, the great investor John Templeton used to say that he would not be surprised to see the Dow Jones Industrial average hit 2 million in the next century.

How did he come up with this? Well, historically, stocks have returned about 6% per year, not including dividends.

The Dow Jones Industrial Average today is trading around 12,700. If stocks follow the historic trend of the last century, a 6% compound growth rate for the next 89 years implies the Dow would be trading around 2,000,000.

U.N. Forecasts 10.1 Billion People by Century’s End - NYTimes.com

Tuesday, May 3, 2011

What It's Like to Work At Pimco

Pimco is one of largest and most widely-followed investment companies in the world.

The head of Pimco - Bill Gross - is probably the best known bond investor in the world, and for good reason: He manages the $237 billion Total Return bond fund for Pimco, which has consistently been one of the top performing bond mutual funds.

Bill Gross made headlines last month when he declared that yields on U.S. Treasury bonds are set to rise significantly once the Fed ends its quantitative easing program. While Random Glenings does not agree with Mr. Gross's view - I think that rates are more likely to move lower, not higher, as our economy deleverages - there is no doubt that Pimco is one of the most respected investors today.

So I read with interest a long article in this morning's Financial Times about Pimco.

In total Pimco currently manages about $1.2 trillion, but most of this is in fixed income securities. The company is attempting to diversify into equity management, but so far equities represent only $4 billion of their total assets under management.

According to the article, Pimco believes in rewarding portfolio managers for their contribution to the firm's overall performance, rather than paying for how much their particular fund produces in revenues.

They are ruthless in weeding out managers who they believe are not up to snuff: two-thirds of managing directors have held the job for less than 5 years. The constant demand for innovation and investment ideas creates a culture that Pimco calls "constructive paranoia".

Years ago a senior portfolio manager pointed out that portfolio management is relatively straightforward, but the research is hard.

Pimco's process recognizes this; either Bill Gross or Pimco CEO Mohamed El-Erian chairs Pimco's central decision-making investment committee. This group meets daily for two or three hours a day - an extraordinary commitment to investment research, which has clearly paid off.

I don't know whether they will be successful in migrating their investment process to equities - stocks are less amenable to collective thinking than bonds, regardless of the intensity of the process - but it would be hard-pressed to bet against them.


Monday, May 2, 2011

Is Housing A Good Investment?

This past Saturday's New York Times carried a story about the investment value of owning a house.

Writing in the column titled Bucks, Times blogger Carl Richards penned a short piece titled "Home, Sweet Investment".

Mr. Richards noted how, despite the housing downturn of the last few years, most people consider their home their "best investment".

And it's true, in some respects: many people who are selling their homes today are receiving prices far in excess of what they paid decades ago.

However, to Richards, that's precisely the point: housing has been a good investment relative to, say, a mutual fund because they have been held for a long period of time:

So when people who lived in the same house for 30 years say their home was their best investment, consider this: It was probably the only investment they actually held for 30 years. For comparison, look at stock mutual funds, which are meant to be held for a long time but often are not. According to the research firm Dalbar, the average investor holds on to a mutual fund for just over three years.

I like the 30 year time horizon since, coincidentally, I have been involved in the investment business for nearly 30 years.

When I started professionally managing money for institutions in early 1982, the Dow was languishing around 1,000, while today the Dow is nearly trading at 13,000. This represents a compound return of nearly 9% per annum - not including dividends.

And all you had to do was hold on.