Friday, June 29, 2012

How Can You Invest In Stocks When You Don't Trust the System?

"You Want a Friend, Get a Dog"
Professor Brad DeLong of the University of California at Berkeley wrote an excellent essay last month discussing why investors continue to flee stocks in favor of bonds. 

First, he sets out the incredible valuation difference between stocks and US Treasury Inflation-Protected Securities (TIPS):

The S&P stock index now yields a 7% real (inflation-adjusted) return. By contrast, the annual real interest rate on the five-year United States Treasury Inflation-Protected Security (TIPS) is -1.02%. Yes, there is a “minus” sign in front of that: if you buy the five-year TIPS, each year over the next five years the US Treasury will pay you in interest the past year’s consumer inflation rate minus 1.02%.

So, just doing the math, an investor who puts $10,000 into a S&P 500 index fund today has a reasonable chance of having roughly $14,200 five years from now.

Buying a intermediate maturity TIP, on the other hand, locks in a loss.  In five years, $10,000 in a TIP will be worth around $9,500 - guaranteed.

So why would anyone prefer a certain loss to an investment with a pretty high probability of gain?

Dr. DeLong cites many several reasons - economic uncertainty; memories of the "lost decade" in stocks; Europe, etc. - but he also mentions something that really hadn't registered with me until I read it.

Namely, that most investors have lost faith in our financial institutions.

There's something to this, I believe.  Just think of the three events in the past few weeks:

  • A month after dismissing questions as "a tempest in a teapot", JP Morgan is now facing the possibility of a $9 billion trading loss in Morgan's London office. Morgan CEO Jamie Dimon, meanwhile, continues to rail at the thought of any new regulations;

  • Barclays Bank faces huge legal and financial sanctions after regulators uncovered widespread manipulation of the LIBOR benchmark by some of its internal traders in order to generate trading profits;

  • Facebook comes to market with much hoopla, and prices its IPO at $38 a share after initially indicating a price of $28 per share.  Meanwhile, Facebook management quietly lets major institutional investors that recent trends in its business have slowed, and that Facebook shares are probably overpriced.
Stories like these coming so soon after the taxpayers had to bail out Wall Street and the banking sector leave a bad taste in everyone's mouth.

And so is it any surprise that investors continue to pull money out of the stock market?

Thursday, June 28, 2012

Retirement Planning In A World of Low Returns

In an interview in Money magazine last month, famed Yale economist Robert Shiller gave a long term outlook for stocks for the next few years:

You have become famous for your cyclically adjusted 10-year price/earnings ratio. What do the latest numbers say about future stock market returns? 

When my former student and I did the original analysis -- I was working with John Campbell, now economics department chairman at Harvard -- we found a correlation between that ratio and the next 10 years' return. 

If you plug in today's P/E of about 22, it would be predicting something like an annualized 4% return after inflation. Not so bad when you look at the 20-year Treasury bond yield of 2.8% and the likely capital losses if interest rates go up.

Shiller goes on to say that risks are probably more skewed to the downside - that is, stocks return less than 4% - than upside possibilities, mostly because of today's economic backdrop.

That said, it seems to me that earning a 4% real return from stocks is actually not all that bad when you consider that high quality bonds are currently yielding less than today's inflation rate (i.e., negative real returns).

So in terms of retirement planning, then, it seems logical that common stocks should continue to play an important role in investors' portfolios.

It makes even more sense to emphasize stocks over bonds when you try to figure out how much it will take to maintain your current lifestyle.

The New York Times this morning had a short piece on retirement planning.  Quoting a study by retirement consultant Aon Hewitt, here's what they figure a new retiree needs:

Eleven times your final working salary.

That’s how much an average worker needs beyond Social Security payments, from sources like personal savings and employer benefits, to pay for retirement at age 65, a new analysis from the benefits consultant Aon Hewitt finds. The estimate takes into account inflation and post-retirement medical costs. And it is based on the retiree continuing to maintain the same standard of living.

Delaying retirement to age 67 reduces the amount to 9.4 times pay, while retiring earlier, at age 62, increases it to 13.5 times pay, the report said.

This seems to me to be reasonable number, but fairly daunting number, especially given the fact that the real wage growth for most workers over the past decade has been negligible.

Wednesday, June 27, 2012

What If the Doomsayers on Europe Are Wrong?

Predicting dire scenarios for the euro zone has become a cottage industry.

Each day I read opinions from well-respected economists and investors which patiently explain why the collective economies of Europe are doomed - it's only a matter of time.

Billionaire investor George Soros set a new standard for drama in his interview last Friday with German news magazine Der Spiegel.

Mr. Soros not only believes the euro is doomed, but that The End is coming soon:

SPIEGEL ONLINE: You said a few weeks ago that there were only three months left to overhaul the structure of the currency union.

Soros: Well, we are down to three days now.


Soros: Europe's leaders need to take bold steps at the EU summit on Thursday and Friday. 

SPIEGEL ONLINE: Do you think Angela Merkel is prepared to take such steps?

Soros: She is trapped. Merkel has realized that the euro is not working, but she cannot change the narrative she has created because that narrative has caught the imagination of the German public, and the German public has accepted it.

OK, I'm not a billionaire, and George Soros has been an incredibly successful investor for a long time, but does he really believe that we are on the verge of financial catastrophe by the end of this week?

There's a couple of reasons that becoming too gloomy on Europe might be the wrong approach.

The first is the fact that the situation is well-understood by all involved.  The necessary resources are available, and potential solutions available; it's just the political will that's lacking.

For example, Eduardo Porter writes in today's New York Times why many believe that, in the end, Germany will pony up the necessary funds to bail out the situation.

It's not that the Germans like the idea - Mr. Porter notes that most Germans surveyed would love to get rid of Greece from the euro block - but rather it is in their own self-interest, and they might make a profit besides:

While Germany has committed a few hundred billion euros to rescue the currency, if the rescue succeeds, it should recover all of it. And it can readily do more. William R. Cline, an economist at the Peterson Institute for International Economics, told me that covering the entire financing needs of Greece, Ireland, Portugal, Spain and Italy through 2015 would cost about $1.6 trillion. 

If the International Monetary Fund contributed one-third, Germany and other rich euro area countries would be left to put up the rest. But even if Germany’s share reached $500 billion, it would not forfeit this money. After all, the goal of the bailout would be to prevent defaults. Germany could even turn a profit. 

Think back to our own economic disaster a few years ago.  The idea of lending huge sums of money to bail out the banks - not to mention AIG, General Motors and Chrysler - was anathema to many politicians and economists.

But in most cases the bailouts worked, and most of our government's funds were repaid at a handsome profit.

Then there's the real economy of Europe.

It's hard to remember, perhaps, but first quarter GDP in the euro zone was essentially unchanged from the prior year. 

True, the growth was uneven - Germany is clearly prospering, while Greece and Spain are suffering - but fundamentally there is alot going on in Europe that is working.

The most concrete proof of the continued strength of many parts of Europe comes from the investment community.

Taking advantage of some of the most depressed stock market valuations in years, foreign investors are buying up European companies.

Yesterday's Financial Times highlighted the increasing interest of global investors in European companies.  The article notes:

A series of high-profile deals this year highlights the growing interest of emerging market companies in making acquisitions in Europe...

For European pessimists, {large profile foreign acquisitions} is another reflection of Europe's economic crisis and/or terminal economic decline.  For optimists, they may be a sign of better things to come, just as a wave of Japanese investments 25 years ago helped reinvigorate key parts of the European economy, notably the British car industry.

I'm not denying that the euro problems are real, and the resolution will doubtlessly be difficult, but I continue to believe that the ultimate resolution will be positive.

Tuesday, June 26, 2012

Take the Summer Off

Earlier this year, after the stock market posted very strong results for the first quarter (up over +12% for the S&P 500), a number of pundits suggested that the most prudent approach at that point was to "Sell in May, and Go Away".

It's too early to tell whether this advice was correct - although the market has fallen by about -5% since the end of March - but there may be another reason for caution heading into the fall.

Yesterday's Free Exchange blog (courtesy of the Economist magazine) discussed  the work of economists Luc Laeven and Fabian Valencia, who both work at the International Monetary Fund. 

The two examined 147 banking crises dating from 1970, and found that September is typically the month in which most banking crises occurred. 

As the chart above indicates, the most dangerous times in the banking sector tend to occur in early fall. Why this is so is not clear, but the authors are not particularly cheery when they describe what happens:
In terms of the real effects of banking crises, we find that advanced economies tend to experience larger output losses and increases in public debt than emerging and developing countries. These larger output losses in advanced economies are to some extent driven by deeper banking systems, which makes a banking crisis more disruptive....

If history is any guide, then, the best advice for the summer might be to rest!

Monday, June 25, 2012

How Soccer Explains the World

How Soccer Explains the World: An Unlikely Theory of Globalization

A few year ago, I read a book titled How Soccer Explains the World:  An Unlikely Theory of Globalization.

Written by Franklin Foer, the book described the importance of soccer to most of the world, and how integral the sport has become with global economic activity.

 Here's how the thesis of the book was described on the website:

Soccer is much more than a game, or even a way of life. It's a perfect window into the crosscurrents of today's world, with all its joys and sorrows...Franklin Foer takes us on a surprising tour through the world of soccer, shining a spotlight on the clash of civilizations, the international economy, and just about everything in between... 

I was reminded of the book over the weekend, when I read about the match between Germany and Greece in the European soccer championships going on in Poland.

Although the focus of most of the crowd was on the pitch (Germany won 4-2, by the way, and is favored to win the Cup), the chants coming from some of the spectators was partly focused on economic events.

Here's how the New York Times reported it on Saturday:

GDANSK, Poland — The giant blue-and-white flag blotted out the overcast Baltic sky on Friday as the Greek fans pounded their drums and cheered at the foot of the centuries-old City Hall here. The Germans took up a chant in honor of their chancellor, Angela Merkel.

“Without Angie, you wouldn’t be here,” bellowed the German fans, referring to the multibillion-dollar bailouts Greece has received from European partners, first and foremost Germany

“We’ll never pay you back,” countered the Greeks. “We’ll never pay you back.” 

One can only imagine what Chancellor Merkel was thinking, who was in attendance at the game.

Friday, June 22, 2012

Has Procter & Gamble Turned into a Utility?

 source:  FactSet

Earlier this week, Procter & Gamble announced some bad news.

Despite an aggressive expansion plan that started a few years ago, P&G's sales and earnings are running below earlier expectations. Management told its investors and the Wall Street community to lower its revenue and earnings forecasts for the coming year.

The stock took a hit on the news, dropping almost 4% in one day, and is now trading at roughly the same level that it had been five years ago. Analyst reaction has been mixed - many had already anticipated the weak results, while others are calling for more drastic actions to take place. 

For years, P&G had been a "one decision" stock.  Management was highly regarded, and business schools paid close attention to the disciplined approach that P&G brought to bear on its widely diversified consumer product portfolio.

For the 10 year period ending in June 2002, P&G stock returned +250%, or more than +50% than the broader market averages.  Not surprising, P&G was among the most widely held stocks in institutional as well as individual portfolios.

The last decade has been different, however.  P&G has struggled to maintain its earlier growth rates. Although its stock price has kept up with the broader market averages, P&G's stock has lagged many of its competitors, and some are wondering whether the company has simply become too big to be anything more than a market performer.

But still:  Where there is skepticism there is opportunity.

I don't know whether P&G will ever return to its former self.  However, for investors starving for yield in this era of financial repression, the stock might not be a bad place to hide.

Let's start with the dividend yield.  P&G sports a 3.8% dividend yield which is almost certainly safe. The company has one of the strongest balance sheets in Corporate America (AA rated by the rating agencies) and its businesses are not particularly capital-intensive.

By comparison, utility stocks have been a favorite among investors looking for yield. As a group, utilities pay a dividend yield of 3.9% (I am using the utility exchange-traded fund - ticker XLU - for comparison).

The valuation of P&G and XLU are nearly identical:  15x trailing 12 months earnings. No one is particularly excited about the growth prospects for either, so valuation is also a draw.

But here's where I think that P&G comes out more favorably than utilities:  The relative valuation of utility stocks versus the S&P is at its historic high.  The group trades at a +20% premium to the market which seems to be to be pretty aggressive given the nature of the utility business.

P&G, on the other hand, is trading below its historic valuation versus the broader market over the past 10 years.  True, it traded lower - in 2009 - but for the most part investors were historically willing to pay a higher premium for P&G's combination of high dividends and consistent (albeit slowing) business results.

The chart I have posted above suggests that if we are truly in a low market growth environment - which seems likely - that high dividend, low expectation stocks like P&G are worth a look.

Thursday, June 21, 2012

Meeting Client Objectives

Last night I met with the investment committee of an endowment fund here in Boston. The fund has been a client of my bank's for several years.

I like meeting with this group.  Their focus is far removed from the financial world; instead, much of their daily lives are focused on helping others, especially those that are going through difficult times.

Their endowment fund provides a good portion of the resources necessary to do their important work in the community.

The focus of the endowment, therefore, should not be a benchmark like the S&P 500 or the Barclays Government/Credit bond index; instead, they simply need the endowment to provide the income and growth necessary to fund their outreach activities.

At the time I started working with them, they had allocated about 55% of their portfolio to stocks, with the remainder in fixed income. 

This is a fairly typical endowment approach, since historically an allocation of roughly 50/50 between stocks and bonds has proven to be a good balance of risk and return.

Problem is, with interest rates at multi-decade lows, allocating a large chunk of a portfolio to bonds may satisfy the desire for risk reduction, but offers little opportunity for growth.

Moreover, as older higher coupon bonds mature, reinvestment rates in investment grade bonds are unappealing.

For groups like the one I met with last night, lower income levels could mean that some of the work they are doing in the community might have to be curtailed, which is obviously undesirable at a time when so many are in need.

So last summer I recommended - and they approved - changing their allocation to stocks from 55% to 70%, with a particular focus on dividend-paying stocks.  This increase in stock allocations would doubtlessly mean more volatility, but would accomplish several important objectives.

First, buying high quality stocks that offer attractive dividends would gradually increase the income being generated by the portfolio.  In many cases today, stocks are paying higher dividend yields than bonds issued by the same corporations.

Second, investing in stocks of companies that were gradually increasing their dividends would mean more income in the years to come. 

Finally, increasing the opportunity for growth in the portfolio is an important consideration for the future.

Inflation may be muted but it is not dead.  If inflation runs at its current 2% rate for the next ten years, the fund will need to be worth roughly +22% more than today's value in order to maintain its real (i.e., inflation-adjusted) spending power.

The result?

Well, here's how I started the meeting:

I have some presentation material that will show how your portfolio has done versus the various benchmarks.  However, I can tell you that your investment strategy has been a success.

The income from your portfolio is up roughly +5% from what it was in 2011.  Since so many of the companies in your portfolio are increasing their dividends, I anticipate that income in 2013 will be even higher than in 2012.

The value of your portfolio has also increased, even after significant withdrawals to fund your activities in the community. 

In short, your decision to increase your allocation to dividend-paying stocks may have seemed slightly more risky at the time, but it accomplished the important objectives of more income and increased principal growth.

But after the material was distributed, I also observed:

You might notice that your stock portfolio has lagged the S&P 500 so far this year. While as your stock manager this obviously does not make me happy, I would also argue that it is somewhat irrelevant in light of the fact that your portfolios is meeting your objectives.

No one on the committee disagreed.

Wednesday, June 20, 2012

The Importance of the Boring World of Corporate Bonds

Years ago, when I was involved in managing corporate bond portfolios, I was interviewed about the bond market by the Wall Street Journal.

I had recently gotten married, so when I got home that night and told my wife that I had been interviewed she said that she would make a point of reading the article when it appeared.

But when I showed her my interview the next day, and she started reading, her attention quickly waned.

Finally she looked up from the paper and said with a sigh:

"God, this is boring."

Active management of bonds is a relatively recent phenomenon.

When I started in the investment business in 1982, bonds were mostly held to maturity, as they had been for decades.

Trading or selling bonds was a relatively clunky activity, mostly done over the phone with a handful of dealers.  Bid/ask spreads were wide, and the concessions to sell smaller bond positions could be significant.

This changed in the next couple of decades.  Billions of dollars of bonds are traded easily on a daily basis with a variety of different dealers.

As technology enabled bond settlements to be handled as simply as equity trades, institutional bond managers actively managed their clients' portfolios, and were judged against a wide variety of bond market benchmarks that had only recently been developed.

However, as my post yesterday indicated, secondary bond market liquidity is gradually disappearing, especially for issuers whose credits are either less stellar or businesses are less well known.

The Financial Times had a long piece about corporate bonds this morning.  Here's an excerpt:

The problem centres on large investment and asset management companies, known as the "buy side". These are flush with cash and have sought to expand their massive portfolios with corporate debt.  However, they are finding harder to purchase or sell bonds from "dealer" banks that act as the middleman, the so-called "buy side".

If investment funds have to spend more to trade, they could ultimately pass on their increased costs to companies whose debt they buy.

The banks cannot satisfy the buy-side's needs because they are reducing their own holdings of corporate bonds, partly because of a raft of new regulations proposed in the wake of the financial crisis.

Now, to be sure, the subject of bonds is probably no more interesting to most people than it was to my wife a couple of decades ago.

But it is important. 

Higher corporate borrowing rates can obviously have a negative impact on economic activity.

In addition, bonds of all types play an important role in millions of investment portfolios.  Most investors holding bonds or bond mutual funds today assume that their positions could easily be liquidated in the need arises.

But what if there is no bid?

Tuesday, June 19, 2012

Should I Worry About The Corporate Bond Market?

In 2008, well before the stock market collapsed in the aftermath of the Lehman Brothers bankruptcy, the corporate debt markets were signalling trouble ahead.

Corporate spreads (i.e., the yield premium of corporate bonds relative to U.S. Treasury obligations) started to widen in early 2008 as bond buyers nervously asked for more yield concessions in order to take on new positions, and continued to gap higher right into the Lehman failure.

Ultimately the credit markets froze in October 2008, and a full-fledged credit crisis ensued. It was not until March 2009, after aggressive intervention by the Federal Reserve and the U.S. Treasury, that some sort of relative calm returned to the capital markets.

So it was with some concern that I read an article in this morning's Financial Times titled "Investors demand big yield premiums on corporate bonds".  Here's an excerpt:

Investors are demanding significant yield premiums to buy new corporate debt being sold in the U.S. as compensation for the rise in market volatility stemming from the worsening of the debt crisis in Europe.

Bankers estimate that for investment-grade bonds, investors are asking for yields that are on average 20-25 basis points higher than where existing bonds by the same issuer are trading in secondary markets.

That is the highest so-called new issue concession since the start of the year.

The piece goes on to note that new corporate bond issuance is running at just $28 billion this month, compared to a monthly average of $88 billion, according to Dealogic.

After reading this article, I walked down the hall to talk to my friend Barbara Cummings about what's going on in the bond market.

Barbara runs the bond area here at Boston Private Bank, and is particularly knowledgeable about corporate bonds.

Barbara told me that while things are not great in the credit markets - everyone is nervous about Europe - we are not yet in conditions similar to 2008.

Apparently there are a couple of factors influencing the debt markets today.

First, investors are reluctant to give up their existing bond holdings for new issues because of today's lower rates.  They would rather hold onto an older issue with, say, a 3% coupon, rather than swap into a new issue with a coupon of 2% or less, regardless of yield-to-maturity.

And, second, current bids for older corporate bonds in the secondary market also weak.  This is the result not only of investment concerns, but also because new stricter capital requirements make banks less eager to tie up capital in low margin fixed income business.  Thus bond swaps - selling older issues for new ones - are less easily accomplished.

So I asked Barbara:

"Should I worry?"

"Oh,"Barbara replied with a smile, "you can worry about lots of things - you always do - but I wouldn't read too much into the current corporate bond markets."

Monday, June 18, 2012

If You Haven't Already Read Enough About Greece...

Like many financial analysts, I've been scratching my head this morning trying to figure out the meaning of the Greek elections held last weekend.

It appears that the party that most of the financial community wanted to win - the New Democracy party - won a narrow victory over Syriza, whose platform was anathema to the euro zone.  Still, it appears that Syriza won enough seats in Greek's parliament to remain a very influential part of the political scene, which means we will be reading lots more about Greece in the weeks ahead.

Fortunately, one of my favorite columnists Ambrose Evans-Pritchard of the London Telegraph succinctly summed up what just happened in Greece:

Greece’s new leaders have a mandate from Hell. Almost 52pc of the popular vote went to parties that opposed the bail-out Memorandum in one way or another. There is no national acceptance of the Troika’s austerity policies whatsoever....
This is what Professor Vanis Varoufakis from Athens University has to say about the Troika policies (via Naked Capitalism):

"Consider what they are telling the Greek people: They are saying that Greece, to remain in the Eurozone, must,
(a) carry on borrowing from the EFSF at 4% (and thus adding to Greece’s public debt) in order to pay the ECB (which will be making a 20% profit from these payments, courtesy of the fact that it had previously bought Greece’s bonds at a 20% to 30% discount)
(b) reduce public spending by 12 billion euros in order to be ‘allowed’ to borrow for the benefit of bolstering the ECB’s profits from these transactions involving bankrupt Greece.

If the Devil wanted to guarantee that Greece is pushed out of the Eurozone, he and his evil handmaidens could not make up the above, satanic, scenario...

So what should the investor do?

Here's one interesting, very contrarian thought:  Buy Greek Stocks.

I'm not sure I have enough courage to dive into the Greek stock market, but Jacob Walinsky writing in the blog ValueWalk makes some interesting observations.

..It is possible that the {Greek} stock market is trading at 3x, 2x or even 1x 2014 earnings.

On every metric, this is cheaper than the US stock market has ever been going back to 1870... 

The country still remains a popular tourist site, being the 16th most visited in the world. If Greece adapts the Drachma and the currency is cheap, expect a lot of tourism. Greece has a large shipping industry. The country is strategically located in the Mediteran. Despite the country being in a recession for several years, GDP per capita is number 32 in the world, just two places behind South Korea.

Greece was not always known as a ’lazy country (which itself is not accurate). The economy had rapid growth until the past few years. Between 1960 and 1973, the Greek economy grew by an average of 7.7%. Even under the Euro, The Greek economy was growing rapidly. Annual growth from 2001-2007 was over 4%.

The economy clearly can boom again, and this would be a big catalyst for Greek stocks. Greek stocks could repeat performance of post-war German equities.

I'm not sure I totally agree with Mr. Walinsky, but I like the idea of looking for opportunity where others fear to tread.

Thursday, June 14, 2012

Retirement Blues

From 1979
One of the ways to tell if we are approaching the end of the secular bear market for stocks is to gauge investor sentiment.

Market bottoms are never made when sunny optimism abounds.  It is only when investor sentiment is approaching utter despair, and when all hope seems lost, that opportunity for serious gains arise.

I don't know whether we're at that point yet, but anecdotal evidence suggests that we are approaching bearish sentiment levels that often mark an important inflection point.

First, money continues to flee domestic equity mutual funds, as it has been doing for the past 5 years. Here's what  Bloomberg noted yesterday:

Investors withdrew $7.2 billion from American equity mutual funds during the five days ended May 23 after $178 billion of outflows in the previous 12 months, data from the Investment Company Institute in Washington show.

Bond yields are at historic lows, and the possibility of capital loss on longer maturity bonds is very real.

For example, a buyer of a 10 year Treasury note at 1.6% yield will have a negative total return for the year if rates "soar" to 2%.

Yet the stock market continues to scare investors, despite rising earnings expectations, reasonable valuations, and dividend yields that in many cases are far higher than bonds issued by the same corporations.

I think this article written in Toronto's The Globe and Mail newspaper sounded just depressing enough to merit attention from a contrarian standpoint.

Titled "The Sad End of Saving and Investing", the article reflects the utter despair being felt by investors around the world. Quoting a 55 year old investor named Murray Eastwood, the article notes the following:

Mr. Eastwood has a background in risk management and underwriting, which means he’s well equipped to understand why the global economy is in such bad shape today. His main points are as follows:
  • Bonds and guaranteed investment certificates offer returns below the inflation rate, and the differential has grown in recent days.
  • People who try for higher yields with longer-term bonds could get hurt if interest rates rebound.
  • The stock market is being pounded by the European banking crisis and a poor global economic outlook that has reduced demand for the resources so important to Canada.
  • Our energy industry is under pressure as a result of rising production of oil and gas in the United States.
  • Tax relief, at least in Ontario where he lives, is unlikely.
“It is very hard to remain positive about the magic of finance with this experience and the current outlook,” Mr. Eastwood wrote in his e-mail.

(The author noted that he contacted Mr. Eastwood to tell him that his thoughts were among the most depressing that he has read recently).

My contention is that eventually investors who are parking their retirement assets in bonds will realize that they are being played for a sap by governments around the world.  Low interest rates have allowed deficits to balloon with only a modest budget impact.

Wednesday, June 13, 2012

Europe Squabbles

Your Move, Greece
I liked this quote that appeared in Gideon Rachman's column in yesterday's Financial Times.  I think it nicely summarizes some of the reasons behind the current angst in Europe right now (my emphasis):

Consider just one of the proposals on the {euro bailout} shopping list:  a Europe-wide bank deposit insurance scheme.  As a senior Dutch politician  who shares the German view, puts it: "We cannot push through a banking union when the French have just cut their retirement age to 60 and we have raised ours to 67." From the Dutch and German point of view, it is unfair for their citizens to underwrite the banks of countries using their own money to pay social benefits that are more generous than those on offer in Germany or the Netherlands.

The New York Times this morning carried an editorial that also highlighted the German frustration at being asked to make the euro work.

Authored by Hans-Werner Sinn from the University of Munich,  the article notes that the German efforts at stabilizing the euro have already been substantial, particularly when it comes to Greece:

Some critics have argued that Germany, having benefited from the Marshall Plan, now owes it to Europe to undertake a similar rescue. Those critics should look at the numbers. 

Greece has received or been promised $575 billion through assistance efforts, including Target credit, E.C.B. bond purchases and a haircut after a debt moratorium. Compare this with the Marshall Plan, for which Germany is very grateful. It received 0.5 percent of its G.D.P. for four years, or 2 percent in total. Applied to the Greek G.D.P., this would be about $5 billion today. 

In other words, Greece has received a staggering 115 Marshall plans, 29 from Germany alone, and yet the situation has not improved. Why, Mr. Obama, is that not enough? 

Still, I continue to believe that the most likely outcome for Europe will be to "muddle through".  Reports from European companies (especially in Germany and France) continue to indicate that business trends remain positive, despite the high levels of unemployment throughout much of the euro block.

Tuesday, June 12, 2012

Possible Investment Strategies for the Coming Fiscal Cliff

One of my very smart clients called me last  Friday.

He wanted to make sure that I had seen an editorial in that morning's Wall Street Journal that highlighted some of the potential changes in tax rates that could occur in 2013 if Congress does not act.

The piece - titled "Bernanke's Cliffhanger" - was accompanied by a table that summarized some of the different scenarios:


These changes, of course, are the result of the expiration of the Bush tax cuts, originally implemented in 2001.  Most observers are calling the event a "a fiscal cliff", although opinions vary widely as to the actual economic impact that will be felt.

The Journal, naturally, sees higher taxes as a road to economic ruin:

Meanwhile, the cliff that could break the economy's neck is the scheduled tax hikes. These include a tripling of the tax on dividends, a near 60% increase in the capital gains rate, a 20% increase in personal income-tax rates that will hit small businesses, and the repeal of tax breaks allowing businesses to write-off capital purchases. (See the nearby table for the comparisons.) 

Even if the lower rates for those earning less than $200,000 are extended, the rise in rates for high-earners will hurt the incentive to invest or take risks—and may already be doing so. As Mr. Bernanke put it, "Uncertainty about the resolution of these fiscal issues could itself undermine business and household confidence."

I am in the process of trying to gather more information and thoughts from various sources as to what changes, if any, should be made in my current investment thinking.

However, here are a few initial thoughts:
  1. Dividend-paying stocks could be hit fairly significantly. Tripling the tax rate on qualified dividends obviously reduces the after-tax yield;
  2. On the other hand, my client pointed out dividends from non-qualified sources (e.g., REITs, or MLPs) could be helped, since they tend to offer higher yields;
  3. My client also questioned whether it might make sense to realize any long-term capital gains in 2012.  The idea here is that it is unlikely that capital gains rates will ever be as low as they are currently, and next year's increase only represents the start of future rate increases;
  4. On the other hand, loss-harvesting strategies probably should be delayed until next year.  At higher tax rates, realized losses have more economic value;
  5. Estate planning, however, will be essentially impossible until after the election, given the wide differences in estate taxes from Obama and Romney.
It doesn't seem likely that we will get any clarity on next year's tax policy until the last few weeks of this year.

One final cynical observation: 

The fact that dividend rates will be much higher than capital gains tax rates is a wise move; after all, most would agree that we should encourage long-term investing strategies.

On the other hand, most hedge fund managers are paid via a so-called "carried interest" method, which is taxed at capital gains rates. 

No matter what happens, then, the managers of hedge funds and private equity companies (such as Romney's old firm Bain Capital) will continue to enjoy historically low tax rates on their income.

Monday, June 11, 2012

More Public Pension Chicanery

Yesterday's New York Times Business section carried a long article written by Julie Creswell about some murky doings at the South Carolina Retirement System.

Ms. Creswell described how South Carolina hired a man named Bob Borden to act as chief investment officer for its retirement system pension plan.

Borden started his job in 2006, and immediately set to work to transform the conservatively run plan into something more in tune with the latest thoughts from Wall Street.

Here's how the trade publication Pension & Investment Age described the changes at at the end of last year:

When Robert L. Borden became the CIO of the South Carolina Retirement System Investment Commission in 2006, the fund had 52.6% in domestic equities, 46.6% in fixed income and 0.8% in cash. For the five-year period ended March 31, 2006, the fund returned 20 basis points above its policy benchmark. During his tenure, Mr. Borden transformed the asset allocation.

The equity component now represents a world opportunity set with 15.6% in domestic equities, 8.4% in developed international equities and 8.1% in emerging markets equities as of June 30. The fund also has substantial exposure to alternative investments with 28.7% in opportunistic credit, hedge funds, private equity, commodities and real estate. For the five years ended June 30, the fund outperformed its policy benchmark by 83 basis points. Only time will tell if Mr. Borden's changes will benefit participants over the long term.

Think of it:  the Fund was invested roughly 50/50 between stocks and bonds when Borden started.  Boring, yes, but very effective.  Had he kept this allocation, the fund would have grown by nearly +15% for the 5 years ending December 31, 2011, despite the horrific bear market of 2008.

But that's not what Mr. Borden did, as P&I wrote.  And yesterday's New York Times piece suggests that the only ones that truly benefited from the asset allocation changes were Borden and the managers of the alternative investment choices.

Here's what Julie Creswell wrote:

What is sure is that while he was running things, South Carolina ended up paying hundreds of millions of dollars in fees — $344 million last year alone — to a Who’s Who of hedge fund managers and private equity deal makers. In return, it got a trove of investments that haven’t really provided the bang that people here had hoped for. Today, the pension fund has a higher share riding on private-equity and hedge-fund plays — called “alternative investments” in some circles — than almost any other state’s: $13 billion, or more than half its total.

According to the article, the year prior to Mr. Borden's arrival, South Carolina paid $22 million to the managers of its $24.5 billion investment fund - a fraction of the $344 million it now pays.

The additional fees that it paid managers of alternative investments would total roughly $1.5 billion over 5 years, or about 6% of the value of the fund.  And so far at least South Carolina has very little to show for it.

Borden, meanwhile, was earning nearly $500,000 a year for his leadership, and is now - surprise, surprise - working for a private investment company.

Eventually, of course, if the changes in asset allocation that Borden implemented do not pan out, South Carolina taxpayers will wind up picking up the tab.

I hope the Times article gets the attention of taxpayers everywhere.