This Week in Barron's

Alan Abelson (the only reason anyone actually subscribes to Barron's) notes that the Chinese have just entered a new year, the Year of the Pig, probably in tribute to America's Wall Street investment professionals. In describing the competitive advantage that Chinese manufacturers have over locals in a post-NAFTA world, he points out that "the average toiler in a Chinese factory is (paid) about 3%...of the hourly wage of the average Joe doing the same job in the good old USA. Including benefits, U.S. workers probably earn about $20 per hour (including benefits), while Chinese workers are happier to have their job, but receive only about 50 cents an hour. I tried to compare both of these with Euro-worker rates of recompense, but everyone was on vacation and I finally had to abandon the effort.

Barron's cover story (The Last Laugh) is particularly interesting to LeapIntoRetirement readers since it focuses on the financial importance of spenders in the over-50 crowd, which now comprises over 40% of all U.S. households, controls 50% of all U.S. discretionary spending, supervises 65% of America's household net worth, and accounts for 75% of all prescription and drug spending (mostly, it would seem, in an effort to maintain sexual performance and to treat diseases accumulated through years of practicing in the same arena). Barron's talks about several major companies and their attempts to woo the baby boomer demographic.

Barron's writes about a trend called, "aging in place," where empty nesters turn their kids' rooms into dens, install larger door handles and light switches, and wander through their wider halls on non-slip floors practicing mental games and taking "brain age" games. In fact, Barron's reports that aging may even be good for your game, referencing studies by the AgeLab and the American Assn. for the Advancement of Science studies and resources.

Barron's also revisits the debt problem unfolding in the "sub-prime" lending market, which we've talked about before and which got worse, last week, with the bankruptcy filings of ResMae Mortgage and the stock of Kansas City-based Novastar plunging 42% on an earnings impairment announcement. Sub-prime loans are loans made to folks who really can't afford to pay them back in the first place, often at artificially attractive terms that eventually ratchet up to less attractive rates, hopefully after the original lender has had a chance to pawn the loan off to an institutional lender or mutual fund manager who happens to have their head in the sand and is desperately seeking a yield advantage over his more experienced peers. The strategy is a little like a ponzi scheme in that it works for awhile, but then it doesn't work at all and by the time that everyone wants out, there isn't much left. For America the last few years, as real estate speculators reached too far to buy homes they couldn't possibly afford, it's been a way to keep the bubble going and prolong the party. It looks like the punch bowl is gone.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Is A Tontine In Your Future?

Investment News describes a Tontine as an investment pool that pays dividends only to a pool's surviving members. Tontines were used 350 years ago, but are banned in many countries today because of an unfortunate side effect; tontine members had an incentive to kill one another off in order to increase the dividend payments to remaining members.

And you thought that there was a lot of back-stabbing in your investment club!

Ralph Goldsticker, CFA, in a recent Financial Analysts Journal article (January/February 2007) has suggested that a mutual fund sponsored tontine-like vehicle might provide a cost effective alternative to the traditional annuity. Both are designed to provide retirement income and protect individuals from outliving their resources. By spreading the risk among thousands of individuals, a mutual fund company could lessen the benefit to one individual of killing his or her fellow shareholders.

The new-fangled Tontine Fund would invest in fixed income securities, use an actuary to annually adopt a payout structure appropriate for that group of shareholders, diversify investment risk and provide higher potential payouts - partly because tontines would likely be lower-cost vehicles and also because "payments would be based on average life expectancy rather than the maximum life expectancy.

Although financial product providers often add bells and whistles, usually in an effort to confuse consumers, true innovation in the financial arena doesn't happen often enough. Schwab's invention of the "mutual fund supermarket" was a consumer friendly innovation, for example, as was the more recent creation of ETFs (exchange traded funds).

Hopefully one of the large fund complexes had a chance to read Goldsticker's article. Vanguard, Fidelity, are you listening?

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Default Risk Hurts Financial Stocks

People have been talking about the debt problem for years, and the mortgage debt problems that stem from rising adjustable mortgage rates for months, but last week (finally!) financial sector investors were forced to acknowledge something might be amiss. California-based sub-prime mortgage lender, New Century Financial, securitized millions of dollars of these sub-par loans but couldn't get rid of the paper fast enough. The fine print on those securitizations forced New Century to take back loans that went into default within six months of issuance, and as a result the company reported it will have to report a loss in 4Q 2006. As a result, the stock tumbled 36%. Barron's reminded its readers that it first highlighted the risks New Century was taking in an October 11, 2004 article. The stock has lost 67% of its value since then.

HSBC, the UK's biggest bank, acquired Household Finance in a distress sale a couple of years back, and then used Household to make all number of risky mortgage loans to borrowers who didn't used to qualify for mortgages based on the borrowers' poor track record of paying people back, paltry income, and the over-sized price tags on the homes involved.

Last week, HSBC was forced to admit that over $10 billion of shareholder money lent to sub-prime borrowers in the U.S. mortgage business wasn't likely to get paid back after all, even after reposessing and re-selling the homes in question. The Sydney Morning Herald reported on "How HSBC Bet the Household and Lost." Not all is lost, though. HSBC bought Household in 2003 for $27.7 billion, so last year's misadventures only cost HSBC about 37% of the purchase price.

HSBC executives believe they've got their arms around the problems at Household, while still admitting that the problems were about 20% worse than they'd calculated a couple of months back. CEO Michael Geoghegan vowed that, "the buck stops with me" and then fired the CFO of HSBC Finance Corp. Let's hope HSBC doesn't hold the mortgage on the recently departed CFO's house.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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High Yield ("Junk") Bonds

Junk bonds, and the mutual funds that own them, are an often misunderstood asset class. These high yield bonds offer higher yields (returns) to investors because of the higher risk of default that accompanies them. In general, though, they still stand senior to common stock, so in theory they are less risky than stocks, and are almost certain to have less risk than stock in the issuing company.


Are these appropriate investments for conservative retirees? They are at least as appropriate as stocks. Any investor who is willing to take market risk and be in the stock market, ought to be familiar with opportunities to invest in junk bonds. On the other hand, like most asset classes, the timing of purchases and sales is the most important determinant of investment returns, so investors need to be wary.


Particular now, as 2007 begins, junk bond investors ought to go in with both eyes open. High yield investors get current income, from bond coupons, and the potential for capital gains or losses resulting from price moves of the underlying bonds. If a bond is at risk of defaulting, the price of the security falls. If this credit risk declines, the price of the bond may rise. Changes in the underlying price of the bond can provide investors with equity-like gains on the upside, and losses that more than wipe out coupon income in the event of a default.


As 2007 begins, the extra income associated with buying a junk bond (the so-called "yield premium") is very narrow. Junk bond investors aren't requiring much extra yield for accepting the higher default risk. In the January 2007 issue of Institutional Investor, Carnegie Corp. Chief Investment Officer, Ellen Shuman, notes that we're "seeing a lot of triple-C debt issuance. People have forgotten that 50% of triple-C debt defaults over a 10-year period."


If defaults rise, the price of all junk bonds might fall to better reflect the risks, and the extra income that junk bond investors receive could quickly be offset by capital losses. We're already seeing sub-prime lenders increasing loan loss provisions. It shouldn't come as a shock to high yield investors if junk bond prices get hit as well.


Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Bill Introduced to Eliminate Estate Taxes

Representative Mario Diaz-Balart (R-Florida) introduced House Bill 411 which would make permanent the current Estate Tax provisions, including ultimately the elimination of Estate Taxes, by deleting the sunset provisions reference to the Estate Tax in the original legislation. Introduced in the House on January 11, 2007, the bill was sent to the House Ways and Means Committee where it will no doubt languish and die after a bitter partisan fight.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Hard Assets

Commodity investments can be hard assets to figure out. The value of the dollar impacts their price. Oil, for example, is quoted (priced) in dollars. If the value of the dollar declines relative to other currencies, but world demand remains constant, then the price of oil will go up – all other things being equal. So a weak dollar stokes energy industry profits. On the other hand, energy is a key input for industrial commodities, like aluminum. As energy prices rise, so do manufacturing costs; profit margins in the aluminum industry can get squeezed.

The Scout Partners (now May-Investments)investment process often looks at commodity investments as an alternative to traditional stocks. In 2001-2002, while the U.S. stock market was losing 33% of its value, commodity stocks were off only modestly and managed futures portfolios were typically appreciating. Investors who employed a flexible asset allocation approach could have side-stepped parts of the bear market and employed their capital much more effectively by considering a wider range of asset classes.


The Scout Partners' ETF model follows two commodity-based ETFs at the moment, though many more exciting options are coming to market as the ETF industry matures. The iShares Natural Resources Index Fund (IGE) tracks stocks represented in the Goldman Sachs Natural Resources Index, including companies in extractive industries, energy companies, owners and operators of timber tracts, forestry services, producers of pulp and paper, and plantation owners. We also use the State Street Materials SPDR (XLB), to represent the domestic basic materials industry – as part of the U.S. stock market. However, the natural resources index (IGE) is more energy intensive than we’d prefer. There’s too much overlap between IGE and the domestic energy portfolio (XLE).

In time, we would expect to find a commodity-based ETF that is more broadly based with less energy exposure and a lower correlation with the U.S. stock market.

The innovative ETFs coming to market will provide us with a better option, but next month we’ll take a look at why investors need to look closely before adding just any ETF to their portfolio.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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