Thursday, September 29, 2011

Red Sox, Black Swans, and Sure Things

Red Sox Nation is in mourning today.

Last night, the Red Sox just completed one of the worst - if not the worst - collapses in modern baseball history.

The Tampa Bays Rays - whose payroll is a fraction of the Red Sox, by the way - captured the wild card berth that only a month ago seemed as remote as snow in July.

The New York Times carried an interesting article this morning which put in statistical terms just how unlikely it was that Tampa Bay, and not Boston, would be the playoffs starting tomorrow.

Using data from a statistical sports service called, here's how implausible last night's outcome was:

The following is not mathematically rigorous, since the events of yesterday evening were contingent upon one another in various ways. But just for fun, let’s put all of them together in sequence:
  • The Red Sox had just a 0.3 percent chance of failing to make the playoffs on Sept. 3.
  • The Rays had just a 0.3 percent chance of coming back after trailing 7-0 with two innings to play.
  • The Red Sox had only about a 2 percent chance of losing their game against Baltimore, when the Orioles were down to their last strike.
  • The Rays had about a 2 percent chance of winning in the bottom of the 9th, with Johnson also down to his last strike.
  • Multiply those four probabilities together, and you get a combined probability of about one chance in 278 million of all these events coming together in quite this way.

    And yet there it is: the Red Sox are out.

    My point of mentioning all of this today is not to belabor the obvious pain that Sox fans feel, but more to point out that in investing, just like in sports, "sure things" often turn out wrong.

    At the beginning of this year, for example, interest rates were poised to rise, or so most economists believed. By early February 2011, the 10 year Treasury stood at 3.75%, and the sages nodded their collective heads with the wisdom that the bond vigilantes were administering a 2x4 to the US government and its profligate ways.

    So now, with the 10-year Treasury now yielding 2%, it would appear that interest rates have fallen against all odds.

    Economists like to call improbable events "black swans" after the economist Karl Popper. Popper's insight was that finding all available swans are colored white does not mean that there aren't any swans colored black. Instead, it just means that black swans are less likely than white.

    It is the unlikely events - black swan events, if you will - that create the most havoc in the world. By considering the possibility of an event that seems unlikely - a Red Sox collapse, or lower interest rates - opportunities can arise.

    Just ask Tampa Bay this morning.

    Wednesday, September 28, 2011

    What's Really Driving this Market?

    This has been a very frustrating market for managers who pay attention to fundamentals.

    Correlation of stock price movements now stand at record highs - nearly 0.9, according to some estimates. This means that the vast majority of stock portfolio returns are currently based on the beta (i.e. volatility) of your stock positions are relative to direction of the markets.

    Corporate fundamentals remain reasonably good. Most companies I hear these days are reporting that business trends are favorable. In addition, corporate balance sheets are in very good shape - in fact, one could argue that many companies have too much cash (e.g., Berkshire Hathaway).

    Dividend yields on stocks are attractive relative to bonds. Given the large number of well-capitalized companies trading at reasonable valuations and paying a healthy dividend, one would think there would be a rush to stocks.

    But that obviously hasn't been the case, because in today's market only one factor seems to matter: government policy.

    It has been slowly dawning on me that it could just be that most of the direction of the stock market in the next few weeks will not be driven by earnings or interest rates. Instead, the fate of the eurozone, or the direction of American fiscal policy, will determine returns.

    Put another way: if the euro collapses, or if the bailout package is seen as weak or too tepid, the world's stock markets are likely to move sharply lower. On the other hand, a more aggressive move by the major European players could lead to nice stock market gains.

    Yesterday, for example, I headed over to the local offices of Merrill Lynch to hear from their health care services analyst. He was accompanied by another Merrill analyst someone whose sole job is to follow Washington politics.

    The room was packed. Portfolio managers from all sorts of firms were in attendance: mutual fund managers, institution managers, hedge funds - you name it, they were all there.

    However, for nearly an hour, there was only one topic discussed: Washington.

    Although initially I was a little frustrated - I was there to hear about stocks - it also became clear most in attendance realized that the opportunity in the health care sector (as well as many other areas) will be dependent not on current company fundamentals, but rather on government reimbursement policies for healthcare.

    Here's the way that commentator Dan Greenhaus put it yesterday on the blog Business Insider:

    To repeat a story we have been telling for some time now, and repeated last night, market participants serve at the pleasure of policy makers.

    While some might argue otherwise, today was yet another example in our opinion... early market gains -- the S&P 500 was up by nearly 3% while the Russell was up by nearly 4.4% - were generated in part by European headlines but so was the late day swoon.

    The Financial Times reported in an article titled
    Split Opens Over Greek Bailout Terms that as many as seven Euro area countries were looking for larger private sector involvement (PSI) in the second Greek bailout.

    You can read the story for yourself but one thing is certain; the financials went from being among the market leaders to, ignoring a last minute rally, the worst performer on the day... Easy come, easy go.

    Tuesday, September 27, 2011

    Oh, C'mon Warren, Just Pay A Dividend, Already

    Berkshire Hathaway announced yesterday that it was instituting the first ever stock buy-back program in the company's history.

    Here' s an excerpt from a Bloomberg story about the decision:

    {Berkshire} is authorized to repurchase stock for the first time in four decades as long as its price is less than 1.1 times book value, or assets minus liabilities, according to a statement yesterday. The level is 29 percent below Berkshire’s average of 1.55 since 2000, almost the same discount investors are getting in the S&P 500, according to data compiled by Bloomberg. Shares of Omaha, Nebraska-based Berkshire fell to $100,000 for the first time in almost two years on Sept. 22.

    Not surprisingly, Berkshire's stock jumped over +7% yesterday on the news. After all, it's not often that you get a clear message from Warren Buffett that he thinks his company's stock is more attractive than many other alternatives.

    Now, far be it from me to question the The Oracle, but my clients and me (all of whom own shares of Berkshire) would have preferred the company to pay a cash dividend instead.

    Buffett has authorized a cash dividend only once since he took over Berkshire in the early 1960's. In 1967, Berkshire paid a $0.10 dividend to shareholders, but Buffett quickly ended the payout.

    Over the years, Buffett has joked about the decision to pay a dividend: "I must have been in the bathroom" he likes to quip. Since then, for a number of reasons - either tax-related or his own investment acumen - he has been steadfast in his refusal to reinstate the dividend.

    But times have changed, and so has his investor base. Yields are paltry everywhere you look, and while I know that his investors can always sell shares to raise cash, it might be just as easy to return a little cash to his loyal investors.

    Dividends are taxed at 15% currently - the same rate as long-term capital gains rate. True, in 2013, dividends are scheduled to return to ordinary income tax levels (meaning a maximum of 39.6%, at the highest income level), but at this writing the future of tax policy is uncertain at best.

    Berkshire is estimated to have more than $77 billion in cash and cash equivalents at the end of the second quarter (according to Whitney Tilson of T2 Partners, a hedge fund whose largest holding is Berkshire shares). This staggering sum is about 43% of Berkshire's market cap, and could very well be one of the reasons that Berkshire's stock has struggled (after all, why pay a multiple of earnings for a stock that has so much cash?).

    Look at this way, Warren: your shareholders will be able to contribute a little more to reducing the federal deficit.

    Monday, September 26, 2011

    The Pain of Low Interest Rates

    The Fed's announcement of "Operation Twist" has gotten mixed reviews so far.

    The Fed is attempting to boost the housing market by selling some of its shorter maturity holdings and buying longer maturity Treasury and mortgage-backed bonds.

    The hope is that lower mortgage rates will increase the affordability of housing, as well as allowing more homeowners to refinance their existing mortgages.

    Problem is, it not clear that mortgage rates are what ails the housing market, as the Washington Post notes this morning:

    ...Despite historically low interest rates, the very people most in need of the kind of relief that could come from refinancing their homes have found it difficult to qualify.

    Even as the Fed undertook new measures, a study released by the central bank this week found that tight lending standards and the continuing drop in home prices prevented 2.3 million homeowners from refinancing last year. A combination of high unemployment, stricter lending requirements enacted after the financial crisis and the sheer number of borrowers who owe more than their homes are worth continues to thwart many Americans from taking advantage of rock-bottom rates.

    Investors, meanwhile, are receiving incredibly paltry returns on their bond portfolios. For the life insurers, for example, this is a very serious problem, as Reuters points out:

    The Federal Reserve's latest move to stimulate credit for consumers and businesses, known as Operation Twist, is likely to threaten the earnings of some of the country's largest insurers for years to come...

    ...The problem is that returns on insurers' investment portfolios can't keep pace with the obligations they have accumulated from torrid sales of annuities and life policies over the past few years...

    Insurers were demonstrating sound financial management in purchasing long-term bonds with the premiums they collected to balance their long-term obligations. But if the Fed's Operation Twist is successfully executed it will push long-term rates lower and, according to some experts, force insurers to retrench on product sales.

    A long time ago, a very wise investor told me that markets move in the direction that causes the most "pain".

    Right now, lower interest rates would be a very painful scenario for most investors, so perhaps that is the direction we're heading.

    Friday, September 23, 2011

    Schizophrenic Markets

    It's hard to remember, but it was just last Friday that the S&P 500 closed up +5.3% for the week.

    You remember last week, of course. The papers were full of worries over the euro zone, U.S. political gridlock and slowing economies.

    The same worries that the market ignored last week and drove stock prices higher are now being blamed for stock prices moving lower. So which is it?

    Leave it to a journalist - Ezra Klein of the Washington Post - to put all of this in perspective.

    As he writes this morning:

    Why are stocks diving today? Oh, no reason in particular. Or maybe every reason in particular. Which is pretty much the same thing.

    Every major paper in the country is leading with the Dow’s fall. But not one has a good explanation for why the trap door opened today as opposed to, say, last Tuesday or next Wednesday....

    {Reuters journalist Felix} Salmon’s headline is that “there’s no reason why stocks are down today,” and perhaps that’s right... there’s no really good reason that stocks are down today as opposed to some other day. The squiggly line squiggled down. That’s all there is to it.

    Benjamin Graham - the Columbia business school professor who taught Warren Buffett investing - taught his students that the stock market was a voting machine in the short run, but a weighing machine in the long run.

    Buffett likes to say that the market is manic depressive. One day it's wildly euphoric, the next day in utter despair. Buying when the world is consumed with worry, and selling when everyone is overly optimistic, has allowed Buffett and other Ben Graham disciples to become incredibly successful investors.

    Value eventually wins out, but it doesn't go up every day.

    It's easy to get gloomy in weeks like this, but it's worth remembering that the concerns of today are no different than those of last week, when stocks had a nice move higher.

    It seems to me that all an investor can do is focus on fundamentals - which are knowable - and ignoring mass psychology - which is basically a crap shoot - is the best strategy for anyone who is looking to make money over the longer term.

    Oh, and one final thought: if you sell stocks now, where are you going to place the proceeds?

    Thursday, September 22, 2011

    "At Least Through mid-2013"


    The Federal Reserve's announcement of so-called Operation Twist yesterday left the world's stock markets unimpressed. Stocks fell sharply across the board, and overseas markets also nose-dived.

    The only securities rallying this morning are Treasury bonds, where traders are attempting to front run the Fed's buying of longer maturity bonds. 10-year Treasury rates now stand at 1.81%*.

    I don't know if this will work - it seems to me that rates are already pretty low for anyone that wants to borrow money - but it adds to the pressure on investors.

    Here's an excerpt from the Fed's announcement yesterday (I have added the emphasis):

    The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions...are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

    The Fed is pushing savers to make a decision: Invest in stocks (or other volatile assets), or earn close to nothing for the next two years.

    I believe that dividend-paying stocks remain essentially "the only game in town". Unless you're going to need the money in the next few months, large cap dividend-payers at least offer the combination of income and possible capital appreciation to offset future inflation pressures.

    Oh, and if you still have a mortgage, and have some equity in your house, by all means run to your local bank and refinance.

    *Whatever happened to the bond vigilantes, who were going to punish the profligate U.S. government with higher interest rates?

    Wednesday, September 21, 2011

    Making the Hard Decisions

    One of my favorite movie scenes is played by Al Pacino (playing a character named Frank Slade) in a movie called Scent of a Woman.

    Pacino won an Academy Award in1992 for his portrayal of a blind irascible Army veteran who befriends a prep school student named Charlie Simms (played by Chris O'Donnell).

    Here's the scene - please be aware there is some rough language in the clip:

    The part that really strikes home with me is when Slade says something to the effect:

    "Now, I have come to a crossroads in my life. In my life I have known the right path to take but I never took it. You know why? It was too damn hard."

    Making difficult decisions is easy to discuss but hard to implement. In the investment world, most investors realize that asset allocation is one of the most important decisions an investor can make - and yet, in my experience, it is largely ignored.

    James Montier has a good column in this morning's Financial Times discussing this phenomena. Mr. Montier notes that most investment committees focus on benchmarks such as the S&P 500 rather than discussing whether it makes sense for a particular investment strategy to be followed.

    To paraphase Mr. Pacino's character: most investment committees avoid asset allocation discussions because they're too damn hard.

    Here's what Mr. Montier writes:

    Perhaps this neglect of the importance of asset class decisions stems from the fact that such discussions are inevitably harder than discussing the relative merits of a beauty parade of managers. Discussions on asset classes often degenerate into debates over the economic outlook.

    Sadly this is largely an investment dead end. There is no evidence that anyone can read the economic tea leaves consistently well. As if that weren't difficult enough, even if you got the economics right, you still have to work out how the markets will react, and which assets will benefit.

    Tuesday, September 20, 2011

    The Case for Dividend-Paying Stocks

    As I have written many times on this blog, record low interest rates may be good news for borrowers, but they represent a huge challenge for investors and savers.

    In the traditional balanced portfolio, bonds typically act as a buffer against stock market volatility. In addition, up until recently, bonds offered investors a reasonable stream of income.

    Now interest rates have plunged to lows not seen for over 60 years. The 10 year Treasury yields less than 2%, and rates are well below 1% for maturities under 5 years. Meanwhile, core CPI is running at 1.8%, which essentially means that bonds offer little or no real return.

    In today's world, then, I continue to advocate that investors consider making dividend-paying stocks a larger part of their investment portfolio.

    True, stocks can have more volatility, and, yes, it is certainly possible that if today's current economic slowdown turns into recession that stocks could struggle.

    For an investor who needs to rely on their investment portfolio for at least a portion of their living expenses there are plenty of quality stocks that offer dividend yields above 3%.

    Yesterday, for example, I ran a screen of stocks in the S&P 500. I wanted to find stocks that paid at least a 3% dividend yield and were selling at a P/E of less than 10x.

    I came up with 24 different stocks that met this criteria. Names like Chevron; Eli Lilly; Raytheon; and Intel all met my measure. Moreover, most of the names I found had increased their dividends at least three times in the last five years.

    And it turns out that over longer period of time dividend-paying stocks tend to offer better total returns to investors, as an article in last Thursday's New York Times indicated:

    The key to building a dividend-rich portfolio, whether you buy individual stocks, mutual funds or exchange-traded funds, is to find companies that will pay consistently and increase their payments over time. This dividend growth strategy can partly offset inflation and dismal savings rates. Many dividend yields are three times or more what you’ll find in insured vehicles like money market accounts or certificates of deposit, albeit with some market risk...

    Over time, this strategy has rewarded long-term investors. In a notable study by Robert D. Arnott, then the editor of The Financial Analysts Journal, dividends contributed five percentage points of the 7.9 percent total return in holding stocks from 1802 through 2002.

    Oh, and one other point: if inflation were to start to creep higher, stocks could offer at least the possibility of capital appreciation to try to maintain real purchasing power.

    Monday, September 19, 2011

    Paul Volcker Warns On Inflation

    In late September, 1979, Federal Reserve Chairman Paul Volcker headed to Europe to confer with his European counterparts.

    It was not a pleasant trip. Across Europe, but particularly in Germany, centrals bankers were furious with American policymakers. Inflation was out of control, and the dollar was in a free fall. The Carter administration was perceived as weak and ineffectual, and Volcker was told in no uncertain terms that the U.S. had to get its act together.

    Although he was scheduled to stay through the weekend, Volcker flew home earlier to confer with his fellow Fed officials.

    Then, on October 4, 1979, Volcker announced that the Fed would no longer target interest rates, but instead focus on money supply. This change in policy - from a Keynesian approach to a monetarist stance - was adopted in a desperate attempt to stop inflation in its tracks.

    For the next three years, Volcker withstood fierce political fire and stayed with his monetarist approach. Interest rates soared, however, and the Prime Rate hit 21% at one point. The economy plunged into a deep recession, and unemployment rose over 10%.

    But it worked.

    Inflation was finally extinguished. The economy and capital markets revived, and the U.S. began to regain its competitive strength. Stocks began the gradual rise which, over the next 17 years, produced the greatest returns for investors in the history of the U.S.

    Volcker stayed Fed Chairman until 1987, when he was replaced by Alan Greenspan. However, the courage that Volcker displayed during the early 1980's - supported by President Reagan - was a marked contrast to our political leaders today.

    The battle that the Fed and Volcker waged with inflation has largely been forgotten now, or so it seems. Today there are numerous suggestions that, well, maybe a little inflation wouldn't be such a bad thing after all.

    Inflation favors the debtor, since debts can be repaid in currencies whose real purchasing power is steadily declining. In a world choked by debt, this has some appeal.

    Inflation also raises the value of hard assets such as real estate. With housing mired in a funk that now seems will last for years, inflation has a seductive appeal.

    However, as Paul Volcker reminded us this morning in the New York Times, "a little inflation" can be a dangerous tonic:

    What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate...

    At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

    Wise words from Mr. Volcker.

    Friday, September 16, 2011

    Will China Begin to Sell Treasurys?

    Over the years, as the Chinese government continued to invest its burgeoning foreign exchange reserves into our bond market, there have been repeated worries that the day would come that the Chinese would begin to sell.

    I have never put much credence in these worries, frankly.

    Our US Treasury represents the largest, most liquid capital markets in the world. In addition, our legal system offers significant protections to investors, which is not always the case elsewhere in the world.

    But lately I have begun to think that, well, maybe we shouldn't just take the Chinese investment in our government bonds for granted.

    Over the past year the Chinese have begun more vocal in their concerns over our political bickering. It must have caused some angst in Beijing at the end of July when only a last minute compromise prevented a default on US debt.

    Then there are the repeated calls from economists - notably Kenneth Rogoff from Harvard - that the Fed should work to restoke inflationary pressures in order to reduce our onerous debt burdens. While inflation would be a welcome respite for borrowers, the Chinese own trillions of dollars in US debt whose real value would be diminished if inflation were to increase again.

    The recent calls from Europe for China to move some of its reserves to the euro may resonate with finance officials in China.

    Not that the Chinese particularly care about the crippled state of the European banking system, but rather it is in their own trading interests to make sure that Europe stays afloat.

    In addition, buying euro bonds would also be a way for the Chinese to communicate to our leaders that our debt is not necessarily the only "game in town".

    Random Glenings fave columnist Ambrose Evans-Pritchard of the London Telegraph wrote a piece yesterday indicating that the Chinese are now thinking of moving out of Treasury notes into other dollar-denominated assets, including stocks. Here's an excerpt from his piece:

    A key rate setter-for China's central bank let slip – or was it a slip? – that Beijing aims to run down its portfolio of US debt as soon as safely possible.

    "The incremental parts of our of our foreign reserve holdings should be invested in physical assets," said Li Daokui at the World Economic Forum....

    ...So what Li Daokui said is not bad for the dollar as such. He said there is "$10 trillion" waiting to be invested in the US, if America will open its doors.

    It is bad for bonds – or will be. The money will go into strategic land purchases all over the world, until the backlash erupts in earnest. It will go into equities, until Capitol Hill has a heart attack. It will go anywhere but debt.

    Yet another reason to be careful of 10-year Treasuries and Bunds below 2pc yields. There is a big seller out there, just itching to let go.

    Thursday, September 15, 2011

    Emerging Market Equities or Treasury Bonds?

    GMO is one of the most respected money management outfits in the business.

    Managing over $100 billion for largely institutional clients, GMO is well-known for its disciplined and thoughtful approach to asset management. Its chief investment is Jeremy Grantham, who writes one of the best quarterly investment pieces (other than available on Random Glenings, of course!).

    So it was with some interest that I saw this quote on Bloomberg from Ben Inker of GMO, who does some of GMO's asset allocation work:

    With the likely returns for Treasuries so low, Inker believes that emerging-market stocks are actually less risky than Treasuries for long-term buy-and-hold investors. Emerging-market stocks, which have sold off sharply in 2011, will be the best-performing sector, he predicts. Inker expects such stocks to produce annual inflation-adjusted returns of 6.5 percent. The downside is that they may be much more volatile in any given year.

    "Emerging-market stocks now have higher dividend yields than 10-year Treasury bonds and their earnings are growing," says Inker. "Over 10 years, the odds of emerging markets losing to Treasuries are very, very low. But it's going to be a scary ride."

    I'm not sure I'm ready to swap bonds for emerging market stocks, but it does present an interesting counterpoint to conventional wisdom.

    After all, I doubt that three years ago I would have believed that Europe would be turning to China and Brazil to help with their banking crisis, but that seems to be the case. The emerging markets countries have amassed a huge sum of foreign capital, and now are in a position to help their profligate trading partners in Europe and North America.

    Wednesday, September 14, 2011

    High Frequency Trading

    I was reading the other day where high frequency trading (HFT) accounts for 60% of the volume on the New York Stock Exchange on any given day.

    This is an astonishing number.

    What this really means, among other things, that the wide swings in volatility that the market has experienced over the last few months have probably been exacerbated by computer-driven trading.

    The Europeans are trying to crack down on HFT, according to Bloomberg:

    The European Union is considering listing “specific examples of strategies using algorithmic trading and high-frequency trading” that should be banned and punished by regulators as market manipulation.

    The measures to increase investor protection and reduce volatility are part of plans to clamp down on market abuse in the region, according to a draft of the proposals obtained by Bloomberg News.

    HFT also has driven correlations of stock price movements to extremely high levels. As a recent newsletter from the firm ConvergEx wrote earlier this week (tip of the hat to loyal reader Bob Quinn):

    Disparate markets – stocks, bonds, currencies, and the like – have a lot in common lately. Whether they want to or not. Average correlations between the 10 major sectors of the S&P 500 have reached 97.2%, from 82.1% just three months ago. That’s the highest level of such common price action since the Financial Crisis....

    The difference between investing in Emerging Markets equities, Developed Markets equities, and High Yield bonds is now effectively zero. We think these high correlations will plague markets through the end of the year, since they are fundamentally caused by worries over European financial market solvency. Those aren’t going away any times soon.

    What this means to me, then, is that it will be nearly impossible to try to "time" the market. When markets are rising, the lower priced, more volatile stocks will outperform. When markets are falling, the opposite will be true.

    But if you truly have a longer term time horizon - which I certainly do - you can only focus on value, which in my opinion is mostly found in dividend-paying, large cap stocks.

    Tuesday, September 13, 2011

    Meanwhile, Across the Pond

    A couple of months ago I wrote about something that analyst Lazaro Birinyi calls "the Cyrano effect".

    Named after the fictional character Cyrano de Bergerac, the Cyrano effect simply means that when some particular piece of news is so well-known and obvious (like the nose on Cyrano's face) that the news is likely already priced into the market.

    Take the European banking crisis.

    On the surface, it would appear that the market is already well-aware of the problems facing some of the world' s largest banks, particularly those in France. Here, for example, is an excerpt from a piece in today's Wall Street Journal:

    "We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore," a bank executive for BNP Paribas, who declines to be named, told me last week. "Since we don't have access to dollars anymore, we're creating a market in euros. This is a first. . . . we hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore."

    Later this morning the French government issued an official statement denying the theme of the article, but clearly there is serious concerns among finance officials in Europe.

    Bank stocks throughout the world have plummeted as well. A price index published on The Economist's website shows that share prices for European banks are now back to the lows of the financial crisis in the fall of 2008.

    While the author of the piece suggests that perhaps bank shares are oversold, he also notes that modern banking is largely a game of confidence. Once the market believes there is a problem, investors withdraw crucial funding from banks, thus creating a problem where one might not have existed before.

    So the problem facing investors in mid-September 2011 is basically this: has the mood become sufficiently pessimistic amongst investors that the "bad news" is already priced into the market (i.e. the Cyrano effect)?

    Or are the problems only beginning?

    Let me give you one last thought, courtesy of one of my favorite columnists Ambrose Evans-Pritchard of the London Telegraph.

    Most news reports paint the political crisis in Europe as basically a story of the Greeks refusing to do the economic "right thing": rein in spending and raise more tax revenue. Yet as Mr. Evans-Pritchard points out, the Greek reluctance may be grounded more in economic reality than has been generally portrayed:

    Let us be clear, the chief reason why Greece cannot meet its deficit targets is because the EU has imposed the most violent fiscal deflation ever inflicted on a modern developed economy - 16pc of GDP of net tightening in three years - without offsetting monetary stimulus, debt relief, or devaluation.

    This has sent the economy into a self-feeding downward spiral, crushing tax revenues. The policy is obscurantist, a replay of the Gold Standard in 1931. It has self-evidently failed. As the Greek parliament said, the debt dynamic is "out of control".

    I continue to believe that dividend-paying, large cap US stocks make sense for most investors, but I also am watching events in Europe very closely - I've lived through too many difficult markets in past Septembers and Octobers to become complacent.

    Monday, September 12, 2011

    May You Live In Interesting Times

    This morning's New York Times has a good piece discussing the recent extreme swings in the stock market.

    And, as it turns out, the market really has been been considerably more volatile over the last few years than most periods of the last few decades.

    According to the Times' article:

    Since the start of this century, The Times found, price fluctuations of 4 percent or more during intraday sessions have occurred nearly six times more than they did on average in the four decades leading up to 2000. The price swings today may feel even more notable because the 1990s represented a relatively calm time for trading. In contrast, price fluctuations of 1 percent and more during intraday trading were more common in the 1970s and 1980s.

    The piece goes on to discuss many of the possible reasons for the higher level of volatility. For example, high frequency trading - where huge blocks of shares are traded in a nanosecond in an attempt to capitalize on tiny price changes - now accounts for 60% of trading volume in any given day.

    Economic uncertainty, of course, is playing a huge role as well. In particular, Europe each day seems to show more and more financial distress, and it is not overly dramatic to say that the fate of the euro will be decided in the next few weeks.

    Still, before one becomes too pessimistic, the Times article notes that huge declines in the market are rarely preceded by periods of stock market volatility:

    And volatility may not herald dips in prices — a study by Sam Stovall, a strategist at S.& P. Equity Research, found that markets since 1950 have typically been calm just before the highest consecutive price declines. But, he found, volatility goes up after prices start going down and the markets can remain nervous while prices recover.

    Friday, September 9, 2011

    Meanwhile, Back in the Real Economy

    I had the chance to hear from a number of consumer products companies earlier this week.

    At a conference sponsored by Barclays Capital here in Boston, I heard from senior executives from Colgate; International Flavors & Fragrances; Pepsi; Unilever; Dr. Pepper Snapple; Nestle; and J.M. Smucker.

    I won't go through all of their presentations, but there was one common theme: Things are not as bad as you might think.

    For example, in response to a question at a breakout session, Colgate CEO Ian Cook said:

    "Look, I know what you want me to say: that things are slowing, and that we're worried about the future. But that's not the case at all. Sales trends - particularly in the emerging markets - have been very good, and we have no reason to believe this will not continue."

    "So, sorry, if you're looking for a 'gloom and doom' comment, you're at the wrong place."

    These comments - which echo those I hear from managements at other multinational companies - underscore the conundrum that faces investors today.

    The markets act like we're on the verge of the Great Depression. The price of safety - gold, T-Bills, etc. - has soared, and there are few "safe havens" that also offer at least the prospect of reasonable investment returns.

    And yet the companies themselves - and remember that stocks are merely pieces of actual ongoing entities - are largely saying that business is actually not too bad.

    Investment legend Benjamin Graham famously said that markets are "voting machines in the short run, but weighing machines in the long run".

    Right now, market "votes" are that the world is rapidly turning into a very unfriendly place, but it is very possible that we will look back a year or so from now and find that schizophrenic investors have systematically undervalued profitable companies.

    Fed Chairman Bernanke yesterday also noted that unusually high level of gloom among consumers despite the fact that conventional economic data is much improved from the depths of 2009, as the New York Times reported this morning:

    Then {Bernanke} said something new: Consumers are depressed beyond reason or expectation.

    Oh, sure, there are reasons to be depressed, and the Fed chairman rattled them off: “The persistently high level of unemployment, slow gains in wages for those who remain employed, falling house prices, and debt burdens that remain high.”

    However, Mr. Bernanke continued, “Even taking into account the many financial pressures that they face, households seem exceptionally cautious.”

    Consumers, in other words, are behaving as if the economy is even worse than it actually is.

    Thursday, September 8, 2011

    A Bond Manager Begs to Differ

    A friend of mine manages bond portfolios, and she is tired of hearing me bash bonds.

    "All you seem to do is focus on yield for bonds," she noted. "The total return for bonds - coupon plus capital appreciation - has been been better than stocks for last decade. I know yields are low now, but at least bonds will return your money at some point in the future."

    She was only getting started.

    "You keep writing that we're not turning into Japan, but what if you're wrong? The return of the Nikkei for the last 20 years has been terrible - far below Japanese bond returns, which at least have given a positive return."

    "Why don't you write about that?"

    My friend is right on the past returns. With the exception of the last 12 months, bond returns have been far better than stocks for the last few years. For example, through the end of August 31, 2011, the total return of the S&P 500 for the past 10 years has been +31%, while the Barclays Government/Credit Bond Index has produced a total return of +68% over the same period.

    But here's my problem with the total return argument for bonds.

    Namely, the indexes assume essentially a constant maturity. Most individuals buy a bond, then hold it until maturity.

    Ten years ago, for example, the 10 year Treasury note was yielding 4.8%. If someone had simply bought the 10-year, they would have seen their principal value fluctuate up and down over the 10 year period, but at the end of the day their total return would have been around +48% (or probably less, since the coupon reinvestment rate during that period was less than 4.8%).

    The only way an individual would have gotten the return for the Barclays Intermediate Govt/Credit would have been if they would have bought a bond fund. However, a bond mutual fund offers no guarantee of principal return, which negates at least one of my friend's arguments.

    The other point I would make is this: True, bonds have outperformed stocks for the last 10 years, but what about the next ten?

    Take the same 10-year note example.

    The Treasury 10-year today yields around 2%. It is almost mathematically impossible for someone to buy a 10-year note today and get a total return of +68% for the next years unless reinvestment rates soar.

    In addition, if interest rates tick up only modestly - say 30 basis points, to 2.3% - your total return for the next year will be negative, since the principal value will decline by more than the coupon.

    So I remain unrepentant: Bonds offer stability and a (very) modest level of income, but I still think that the investment case for dividend-paying stocks for most people remains compelling.

    Wednesday, September 7, 2011

    Investing in Times of Low Interest Rates

    The 10 year US Treasury note ended yesterday yielding 1.94%. The last time yields were this low was 1950.

    Although I still believe that we can avoid Japan's fate of the past two decades (sluggish economic growth and massive deflationary pressures) it is worth considering what actions, if any, investors should be taking if we truly are evolving towards Japan.

    As a reminder, Japanese interest rates have languished below 2% for most of the past 14 years. And while there have been periodic rallies in the Japanese stock market, the Nikkei 225 now stands at less than a quarter of the peaks achieved in 1989.

    This is the question raised in the Financial Times this morning:

    "It is decision time for investors," says Rod Davidson, head of fixed income at Alliance Trust Asset Management in Edinburgh. "If you believe in a Japan-style situation almost all bets are off. Equities suffer, corporate credit widens and you would want to own long-dated government bonds. But there are question market over even that as you start to worry about the solvency of governments."

    And yet, if one looks at the Japanese stock experience, not all sectors do poorly when yields are falling.

    For example, utility analyst Hugh Wynne of Bernstein wrote a piece last year where he analyzed the performance of regulated utility stocks in Japan versus the broader market averages over the past two decades.

    What he found was that while the Nikkei produced negative total return of -29% from 1990 to 2010, Japanese utility stocks returned a positive +16% for the same period.

    Mr. Wynne went on to analyze the performance of U.S. regulated utility stocks during periods of declining inflation and falling interest rates, and the results mirrored the Japanese experience: namely, utilities offered positive real returns to investors during periods when other sectors were suffering.

    It seems logical that other areas would also be attractive to investors that are looking for income. Stocks in sectors like consumer staples and health care offer very attractive relative dividend yields, yet many are trading at low valuations.

    For investors not worried about "beating an index" like the S&P 500, stocks like Bristol Myers (dividend yield of 4.5%) or Procter & Gamble (dividend yield of 3.4%) might make investment sense.

    Again, I do not believe we turning into Japan, but even if my optimism is misplaced there still seems to be opportunities to add value in dividend-paying stocks.

    Tuesday, September 6, 2011

    Sayonara, US Economy?

    If you look at the markets for the last three trading days, one really has to wonder whether we've already morphed into a Japan-like economic malaise.

    Japan was brought down by huge debt burdens caused by overspeculation in real estate. The country is now starting its third decade of economic stagnation, and 10-year Japanese government bonds yield barely over 1%.

    Are we turning into another Japan?

    Well, I don't think so - recent economic data indicates a U.S. economy that is still growing, albeit at a slower rate than earlier this year - but the risks of a government policy mistake loom large.

    Treasury 10-year notes at this writing now yield 1.94%. With core CPI these days running at 1.8%, there apparently is a fairly large class of investors that are willing to lock in 0% real returns for the next 10 years.

    In today's markets, the price for security is high. For those pundits that suggest that the world is unaware of the risks that loom in Europe and the U.S., I would suggest looking at Treasury bill yields at 0% through the end of the year, and gold trading above $1,900 - there's plenty of fear in the markets.

    So how should investors be positioned?

    The S&P 500 offers investors a dividend yield of 2.1%, or slightly higher than longer maturity US Treasurys.

    The last time the relative yield advantage of stocks versus bonds was at this level was in 2009, in the depths of recession. Before that, you have to go back to the early 1960's to have stocks offer dividend yields as attractive relative to bonds as they are today.

    The earnings yield (the inverse of the traditional P/E ratio) of the S&P 500 today stands at nearly 7%. Compared to the Moody's Baa Bond yield of 5.40%, this is a spread of nearly 160 basis points. The last time this spread was as wide as today was in the mid-1970's.

    It seems to me that investors can only make decisions based on what sector seems to offer the best risk/return trade-off for the next year or so.

    If one is offered the choice of a yield of 9% for the stocks (earnings yield + dividend yield) or less than 2% for long maturity bonds, the choice seems fairly clear.

    Unless you think we're turning into Japan, of course.

    Friday, September 2, 2011

    Investment Lessons from My Father and John Bogle

    In the late 1970's, when I was first considering a career in investment management, I had a long talk with my Dad.

    My father was a good investor - he bought a boatload of stocks in 1974, for example, when the Dow dipped below 600 - but was puzzled as to my career choice.

    "I don't get it," he said, "Once you buy your stocks for clients, what would you do all day?"

    My Dad's thoughts reflected the way that investors looked at stocks a generation ago: namely, you were investing in a company, and usually with a multi-year time horizon. Trading was done infrequently, and Wall Street was a fairly sleepy place.

    Dividends were important, of course (why would you ever buy a risky asset like a stock without a high dividend yield?), but mostly you were betting on the long term prospects of a particular company.

    I recalled my conversation with my Dad as I have been reading John Bogle's book Don't Count On It: Reflections on Investment Illusions, Capitalism, "Mutual" Funds, Indexing, Entrepreneurship, Idealism and Heroes.

    At one point in the book, Bogle discusses on much the investment management industry has changed since he entered it in 1951. I won't try to go through all of the detail - I highly recommend you read the book - but here are a few points I wanted to highlight (quoting Bogle):

    • In 1950, mutual fund assets totaled $2 billion. Today, assets total more than $12 trillion, an astonishing 17 percent rate of growth. Then, equity funds held about 1 percent of all U.S. stocks; today, they hold a stunning 30 percent;
    • In 1950, almost 80 percent of stock funds (60 of 75) were broadly diversified among investment grade stocks...Today, such large-cap blend funds account for only 11 percent of all stock funds...;
    • In 1951, the average fund investor held shares for about 16 years. Today, the holding period averages a fourth of that...;
    • In 1951, management by investment committee was the rule; today it is the exception..A star system among mutual fund managers has evolved, with all the attendant hoopla, although most of these stars, alas, have turned out to be comets and hyperactive at that..;
    • In 1951, the typical mutual fund focused on the wisdom of long-term investing, holding the average stock in its portfolio for about six years. Today, the holding period for a stock in an actively managed equity fund is just one year..
    Ultimately the point that Bogle makes is that the investment process today has become too focused on trading and trying to catch the next "winner" rather than the simple idea of investing to make money.

    Numerous studies have shown that investors tend to be their own worst enemy. Rather than invest in a particular company or style and leave it alone, investors tend to react to news events or economic forecasts in allocating their hard-earned capital.

    Bogle's advice is well-worth remembering in these turbulent markets.

    And, oh by the way, my Mother still holds many of the stocks that my Dad bought back in the mid-1970's, and nearly all are worth multiples of what he paid.

    Thursday, September 1, 2011

    The Partisan Bickering Continues

    I have written several times over the last few weeks that I believe the big risk to the markets is not economic but political.

    After the fiasco over the debt ceiling, I was naive enough to believe that perhaps our political leaders would have returned home and heard from their constituents that enough was enough: just try to get along, from cripsakes.

    Moreover, with Congress sporting an approval rating of 18% (which makes President Obama's 40% approval look positively Olympian) surely, I thought, we would have at least a moderate change in tone in the political debate in Washington.

    Then I picked up the paper this morning only to find out that the partisan bickering only seems to have gotten worse.

    I'm sure you saw the story: the President wanted to make a speech to Congress on September 7 on jobs, but this is the same night as a Republican debate, so Speaker Boehner disinvited the President. After some wrangling, the President's talk is now scheduled for September 8.

    As it turns out, September 8 is also the beginning of the regular NFL season.

    Here's how Ezra Klein of the Washington Post in the blog Wonkbook expressed it:

    To paraphrase economist Brad DeLong, last night was one of those nights when you remember that even taking into account the fact that our political system is performing worse than you could possibly imagine, it's performing worse than you can possibly imagine. Washington has made many more consequential missteps than this one. But few of them have been so thoroughly depressing, so insistent on showing us us, with brutal clarity, what the greatest nation in the world has come to.

    Little wonder that global investors have continued to pull back on stocks, despite the improved tone in the market over the last few weeks, as Reuters reported:

    Global investors slashed their holdings of equities below 50 percent this month and piled into cash, reflecting what was lining up to be the worst August for world stocks since 1998.

    They also lifted exposure to bonds in North America, Britain and, to a lesser extent, the euro zone, where Germany is considered a safe haven.

    Reuters polls of 57 leading investment houses in the United States, Europe ex-UK, Japan and Britain showed the average stock holding in a balanced or model portfolio falling to 49.2 percent.

    It was the lowest since at least February 2009, when the current questionnaire was introduced. July's reading was 52.2 percent, the second month in a row that it had risen.