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

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

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

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

Is Anyone Not Bullish On Stocks?

If so I am having trouble finding one.

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

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

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

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

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

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

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

Volatility reduction on the mind…

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

…but rate triggers will ultimately determine moves

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

Forecasts imply increasing long-end rates…

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


Consensus Views (cont.)

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

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

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

Is the Oracle of Omaha Turning Cautious on Stocks?

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

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

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

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

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

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

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

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

But here was the part I found more interesting:

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

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

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

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

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

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

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

The "I" Word

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

However, the most favorite topic these days is inflation.

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

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

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

But then I ran across these paragraphs:

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

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

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

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

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

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

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

http://www.nytimes.com/2011/02/15/business/15prices.html?pagewanted=2&_r=1&hp

Questions for The Economy

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

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

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

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

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

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

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

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

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

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

http://www.nytimes.com/2011/02/14/business/economy/14dip.html?_r=1&hp

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

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

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

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

http://www.nytimes.com/2011/02/15/us/politics/15obama.html?hp

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

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

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

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

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

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

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

http://washpost.bloomberg.com/Story?docId=1376-LGKVG80D9L3501-5RC92R733D6K8CDMFAOMUUP5GL?hpid=sec-business

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

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

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

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

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

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

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

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

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

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

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

Mr. Kalish goes on to note:

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

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

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

Deflating Inflation Expectations

Talk of inflation seems to be everywhere these days.

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

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

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

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

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

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

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

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

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

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

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