GM versus GMAC

The markets have clearly stabilized and are hopefully ready to move appreciably higher - at least for a time. Barron's reports that money is once more flowing back into equities. Enormous piles of cash sit on the sidelines. Some stocks are probably as cheap as they're ever going to get, though it pays to be selective. Junk bonds have never been more attractive, and (just as important) the high yield bond prices have begun to move up, as have preferred stock investments.

December opened to a national debate about whether or not taxpayers should bail out the Big 3 auto companies. I clearly see two sides to that discussion. The auto industry is a basket case where we pay unionized labor about twice the going rate to stay at home and not make cars, much as we have paid farmers in the past not to grow crops (and we're paying Citigroup bankers, apparently, not to make loans). The car companies have been dysfunctional for as long as I've been alive. They are managed for the benefit of unions and management, with shareholders often getting left out in the cold. Of all the bailouts we've made, this bailout is, to me, the one where we have the lowest likelihood of ever seeing our tax dollars again. All we've done, most likely, is push their bankruptcy date back a few months to early 2009. We've thrown good money after bad, and it's nothing but a corporate subsidy for organized labor and the state of Michigan.

On the other hand, GM, Ford, and Chrysler likely wouldn't be on the verge of bankruptcy if Wall Street hadn't essentially destroyed our banking system for a few months. The one-two punch of no car sales and an inability to find financing to roll upcoming bond maturities is what pushed them to the wall. Had normal financing been available, it is possible that neither of those situations would have occurred.

General Motors Acceptance Corp. (GMAC) is a separate financing company. GMAC did have some subprime loan problems, but they are a fairly small part of the overall company. However, GMAC is a huge borrower. When the bond markets closed down, GMAC had no way to roll over maturing debt. GMAC's assets (car loans) weren't in horrible shape. In fact, consumer loans are typically pretty easily sold assets, in a more normal market. GMAC wasn't upside down, with huge liabilities and deteriorating assets. GMAC just couldn't roll over its paper, and that threatened to bring the entire company down. GMAC isn't dysfunctional. It just got caught in the squeeze like just about every other big financial borrower.

Saving GMAC will help re-start car sales, but local banks have been providing car loans to other dealers, even during the worst of the crisis in mid-October. Saving GMAC, however, prevents a lot of bond funds and banks and pension funds from having to realize a loss on GMAC bonds had it gone bankrupt. Bankruptcy has its place - and is probably something the Big 3 need to use to restructure their costs. However, bankruptcy also destroys a lot of value. Some have estimated that Shearson Lehman saw about $74 billion in assets evaporate in its quickie bankruptcy filing. That's a lot of bling that creditors would like to have, but its lost forever. Had GMAC been forced to declare bankruptcy, the bond markets might still be closed. As it stands now, we've seen the high quality bond market show a dramatic recovery during December. Junk bonds are starting to recover as well. Hopefully that trend will accelerate in 2009.

There is a reasonably good chance that the market is poised for more gains. We're already almost 20% off the absolute lows hit on November 24. We may have another 20% to go. Our theme has been to "invest with imagination." The economy has begun to stabilize, albeit at a very low level. Still, we've stopped sliding toward the abyss, which is something.

Clients are fully invested, finally. We've been buying more junk bonds and fewer stocks than would be the case at a typical bottom. More to the point, I'm not sure we've actually seen the bottom, but I believe in the short-run this little Thanksgiving rally has some room to run.

Happy New Year. So long, 2008. Remember that a fast start doesn't guarantee a smooth ride.

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

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Market Set to Turn Up?

I’ve been watching half a dozen indicators for the past eight weeks. At first I was expecting them to signal an “all-clear” so we could jump back into the market. Optimism gave way to anxiety, however, and now I’m looking for them to signal that the upcoming Recession will, eventually, be followed by a recovery. The alternative – something worse than a Recession – is too frightening to name and not yet off the table.

• High Yield Bond rally

High yield bonds are often the first thing to turn up during a recession. Alas, I’ve been waiting for high yield bonds to rally since last February. Finally, during the week of December 15, junk bonds began to show signs of life.

• Oil Price rally

Lower oil prices help the consumer, but $35 oil also indicates a severe slowdown in global economic activity. Gasoline prices at $1.50 per gallon leave more discretionary spending power in the hands of folks who live paycheck to paycheck (these days, that’s about everyone). However, these low prices also discourage investment in energy supplies, renewable and alternative energy industries, and global capital spending. The global economy runs on oil. If the globe shuts down, $35 oil probably makes sense. I’m hoping that the global economy keeps working and a more robust demand for energy develops. I will gladly pay $2 per gallon if it means that we’ve avoided a worldwide bust. Fortunately, the energy industry seems to be more optimistic than the folks setting spot market prices. Oil futures for long-term delivery (out a year or more) are pricing oil around $50, and the majors are filling up tankers and parking them in ports around the world, convinced that prices will be higher down the road. I truly hope they’re right but at the moment, falling oil prices are waving a huge red flag for international investors.

• Banks start lending

Money keeps piling up on deposit at the Federal Reserve. Yesterday the Fed reported that total reserves have grown from $43 billion last summer to almost $828 billion this week. Bailout funds and a flood of new deposits are getting sucked into our black hole of a banking system and we taxpayers, via the Federal Reserve, continue to pay banks interest for the lenders who’ve stopped making loans. Think of it as a “job bank” for the pinstriped suit set.

Bank regulators are changing the rules, making it more difficult for banks to lend on real estate. Even existing projects with current cash flows may not be bankable on their own merits. The cow is gone and the regulators have securely locked the barn door, just in time to prevent a recovery. Main Street is paying for the mistakes made by the really smart guys whom Alan Greenspan trusted to know what they were doing. His bad.

• Bond market starts working again

For things to really get back to normal, the high yield bond market needs to be a viable place for companies to make money again. To avoid a depression, the high quality bond market needs to be functioning. Fortunately, finally, in recent weeks the high grade market has begun moving back to almost normal levels. Though yield spreads compared to Treasury bonds are still wide, part of the dysfunction is in the treasury market, not in the world of corporates. The broad bond market exchange traded fund (LQD) started the year around $105, and fell to $76 during the recent market turmoil, has recently recovered to almost $99. Much of the progress has come in the last week. This is a very strong signal that at some level, the capital markets are starting to function again.

• Volatility declines

The VIX index is a measure of intra-day price swings in the stock market. It increased 8-fold as the bank panic unfolded, resulting in swings in a single day that are nearly equal to an entire year’s typical performance. No one is comfortable investing when the market soars or plunges 10% in a day. The VIX has started to decline. It is nearly half of what it was at the peak of the crash, though it remains double or triple normal levels. As volatility continues to decline, stock valuations should appreciate.

These are five of the indicators which I’ve been watching for the past two months. I really thought that they would have turned up…in late October. It is extremely worrisome that they took so long to begin to improve – and in some instances still haven’t improved much. The excessive volatility and anxiety, and the lack of available capital in the system, is much like the economic “heart attack” that Warren Buffett described in his Charlie Rose interview. These things are causing damage, even today. The more damage we suffer, the longer it will take to turn things around.

We remain short-term optimistic. Especially as this week came to a close, the market looks capable of sustaining a rally. Psychology couldn’t get much worse. I would normally be pounding the table, encouraging investors to buy stocks.

The economic fundamentals, though, remain really bad. My economic weather forecast is for current weakness, with not much hope of a turnaround in the future. The stock market can rally, even if economic fundamentals continue to decline. As credit continues to ease, which I continue to think and hope that it will, we should gradually move past fears of a depression and onto a different set of expectations. That will help the rally in the short run.

When we get that rally, investors need to take a gut check. Are you really long-term investors? Are you really willing to risk another 40% decline in order to get the upside from stocks that is available to long-run investors? Cashing out, at that point, will still require accepting a loss for many investors. For some, however, it will be the right thing to do. Others will hang in there with me, for better or for worse, in order to try to take advantage of the profit opportunities that arise from volatile markets. It won’t be an easy call and investing in 2009 (and 2010?) will require more imagination than usual.

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

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10 Things to Own in this Market

"This time is different" is said to be the four most dangerous words in the world of investing, but with so many investment news articles describing one "unprecedented" event after another, we have to reconsider tried and true investment maxims as we prepare portfolios for the future. We’ve never believed investors should buy and hold stocks for the long haul, but after a career of being taught (mostly through experience) to "buy the dips," the economic consequences of the recent 100-year crash have forced us to reconsider even our most contrarian habits.

If your time horizon is 10 years, today’s market almost certainly presents a terrific buying opportunity. However, what if capturing that opportunity requires holding stocks through another 35% dip in a market where each day the market moves up, or down, equal to what used to take place over the course of a year. Today’s volatility, combined with unstable economic prospects, might mean that it really is (dare I say it?) different this time.

• 10 Things To Own

BIOTECH – Biotech stocks haven’t moved up in a decade, but industry earnings are up roughly 5-fold since the stocks peaked in 2000. Earnings haven't historically been tied to the business cycle and valuations are very reasonable, making these companies attractive merger candidates once corporations can access the capital markets to finance acquisitions.

PHARMACEUTICALS – Traditional pharma companies, like their biotech brethren, have been able to keep raising prices even in the midst of a recession. A renewed focus on cost controls has enabled the industry to boost profit margins. Industry earnings have more than doubled during the past decade while the stock prices for stocks in the industry have been cut in half. Non-cyclical earnings support high dividend yields and make this steady growth group a reasonably safe place to invest while waiting for the broad market to turn up.

NATURAL GAS EXPLORATION – Natural gas prices have fallen, but not as much as crude oil and demand for relative clean natural gas supplies may rise if the new Obama administration were to push for fleet vehicle use of condensed natural gas vehicles. We’re also heading into the part of the year where a cold winter can quickly decimate heating oil inventories, and these companies have real assets in the ground that make it much cheaper to buy future supplies than it is to drill for them.

ENERGY SERVICE – Despite significant improvements in drilling technology, gas well productivity has fallen from 150 cubic feet per day to below 125 cubic feet per day. Lower productivity means that the global rig count is increasing even though energy produced (and inventories) are on the decline. These are legitimate companies selling services that are required in order to keep our homes warm and electricity running. At roughly 8.5-times earnings, it means that investors are receiving an 11.7% return on an investment that has excellent built-in inflation protection.

CONSUMER STAPLES – Procter & Gamble, Coca-Cola, PepsiCo, CVS Caremark, and Wal-Mart Stores comprise roughly 45% of the holdings in the Fidelity Consumer Staples fund. Wal-Mart is one of a very few stocks which is actually up this year. If we knew that the market is headed lower, we’d go to cash. Unfortunately, perfect foresight is in short supply. Until things turn, however, we think that traditionally defensive holdings will outperform the broad market, yet still provide upside in case the cash flows out of equities reverse and the market starts moving in the right direction.

SOFTWARE – Software companies like Microsoft and Oracle are cash cows with quasi-monopolies, little debt, and products that are not particularly cyclical. Though software companies traded at ridiculous valuations during the tech bubble, now they sell for less than half their 2000-era prices while industry earnings have more than doubled. The current industry Price/Earnings ratio is 11X, more like where you’d expect a steel company to be valued, but software companies in the Fidelity fund have double-digit projected earnings growth, nearly 33% historical earnings growth, sales growth of nearly 25% and extremely high growth in cash flows. If leveraged financial companies are at "Ground Zero" in this crisis, the software companies are about as far out in left field as you can get.

IT SERVICES – We had been comfortable owning this sector because going into the Fall we were of the opinion that the recession (which was finally, officially recognized today by the National Bureau of Economic Research) was about to end. Shearson Lehman ended instead, and the rest is financial history. We felt like any turnaround would likely involve, and perhaps be led, by companies in the technology sector. Indeed, some of the main holdings in our fund (Visa, Accenture, and Automatic Data Processing) have held up reasonably well. What has changed, mostly, is that the market crashed and the recession will be longer and deeper than we’d originally envisioned. Moreover, many customers of the companies in this sector are financial companies needing to cut back in every conceivable area of spending. While normally a recession is a time when IT services companies pick up new customers as companies automate functions in order to cut costs, I fear that "this time is different" and the bloodied customer base puts the top line (revenue) growth for these companies at risk. We would like to sell this fund "on a bounce," but we may not get that luxury.

HIGH-YIELD BONDS – We’ve often described "junk bonds" as the canary in the mine that signals its safe to re-enter the stock market during a recession. Unfortunately, day after day during the Spring and Summer the canary went down into the mine but never came back up. Worse, at the height of the panic in October, junk bonds were selling off as much as stocks. That, fortunately, is no longer the case. The result of the carnage is that the sector now offers stock-like returns without taking stock-market type risks. The high yield exchange traded fund owns bonds which, if simply held to maturity, will return 18%. That’s better than stocks have historically returned. This is either way too cheap, or bond defaults are headed to levels not even experienced during the Depression. (And if defaults are headed that high, then the stock market sell-off has further to go.) We will likely own more high-yield bonds as time goes by, but we’ll reclassify them as "stocks" because they failed to preserve capital when the sell-off unfolded.

PREFERRED STOCKS – Like high-yield bonds, preferred stocks are trading as if their dividends are going to be eliminated, which is unlikely given the massive bailout that these companies have just received. Like the government, and Warren Buffett, we own preferred stocks which are fixed, unlike a common stock dividend which can be cut in order to conserve cash flow. When we bought the preferreds, the financial sector was rallying. We chose to invest in the recently bailed out financials, not through the common stock (which has subsequently crumbled), but by investing higher up in the capital base, where we won’t be diluted by the capital raising efforts that are now required of companies in the financial sector. We hope to achieve equity-like returns while taking less-than-equity market risk. Furthermore, with double-digit dividend yields, we will be paid to wait while the market takes time to stabilize.

CASH/MONEY MARKET FUNDS – We still have a little dry powder waiting on the sidelines. Despite years of being told not to "time the market," this year market timing is about the only thing that worked. Diversification didn’t work; everything went down. Not even corporate bonds zigged when the market zagged. Everything got zapped. We used a portion of our stash of cash to buy energy service stocks when the market dipped into "incredibly cheap" territory. That was about 9,600 on the Dow, a level we’re still hoping to see again. From this point, we’ll wait until the market proves itself before putting any more cash to work, especially since it’s our last bit of dry powder. We’re watching several indicators to evaluate when we should put this last bit of capital to work, and even then I suspect it will be for a quick rally and then we might be taking money off the table once more. I could pontificate about the indicators we’re watching, but Chris just called and is putting cheese on my hamburger so I think I’ll Pilot my way home and save that topic for another day, and another blog.

Today was "trading day," but we haven’t been able to operate with our normal regimen of monthly trades since mid-July. The volatility is too great. We’ve had to make several mid-month corrections to the portfolio since the daily price swings can make or break a month. No trades were made today. We’ll stick with these 10 things to own, at least until tomorrow. Both our typical fund portfolio and the individual stock model have positions in the types of investments I’ve described. If I am any more specific, the regulators will probably insist that I fire myself, so I’ll stop here and go grab a burger.

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

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