Still Bottoming

On December 19 our blog post identified five indicators we’re watching to see if the market is set to turn up. We’re still not happy about what these indicators are signaling and the portfolios remain, not coincidentally, more conservatively invested than we would normally be, given the size of sell-off that the markets have experienced.

It’s almost as if there’s no question of whether the market is cheap. It is. Today investors can buy for 50 cents what cost $1 only 16 months ago. The question remains, however, as to whether it deserves to be priced as cheaply as it is.

In the weekend issue of Barron’s, Ron Meisals and Olaf Sztaba’s NA-Market Letter observed that, "bargain hunters should note that a bottom is not a place – it is a process… At the moment, there is no evidence that a process of repair is taking place." The quote reflects my sense that there is not a particular level on the Dow or the S&P 500 at which point the market becomes a "buy." I’m waiting for the market to start going through a process of bottoming, and the economy to begin showing signs of recovery.

We said, in December, that we were waiting for:

• High yield bonds to rally. They did, but in the recent sell-off virtually all of the December and January gains were retraced, so highly leveraged companies still have little or no access to the bond market and have virtually no means of rolling over debt. For most, the bankruptcy courts (distributing equity to creditors) remains the most viable restructuring option.

That the high yield market still hasn’t been able to sustain signs of recovery is my biggest concern about this market. If this financial mess is really turning around, then presumably the threat of bankruptcy is on the decline and junk bond yields should start coming down. The fact that junk bond yields still hover near 20% tells me that the fixed income guys don’t believe that the bank bailout is going to have the desired effect.

• Oil prices to rally. Oil prices have rallied, above $50, which is a reassuring sign that the global economy may be stabilizing. Then again, it may just be signaling that the value of our currency has already begun to falter in the eyes of commodity traders.
• Banks start lending. I believe the doors are still closed. While the guilty parties in the Senate and House reiterate empty promises that the banks are starting to get money flowing again, examiners and regulators on the ground are increasing capital and collateral requirements. Excess reserves – the amount of money being held by the Federal Reserve instead of being invested in the real economy, have climbed back up to $771 billion, almost to the high levels first reported in late November, indicating that the cash injections from taxpayers and deposit flows still coming out of the stock market are not yet finding their way back into the real economy. In just the past two weeks, another $150 billion has found refuge at the Federal Reserve, while real businesses scale back and lay off workers in a desperate struggle to survive. While Washington fiddles, the Chamber of Commerce is burning to the ground.
• Bond markets start working again. In stark contrast to the stock market, equity flows into the bond market are beginning to make a positive impact. Investment grade interest rates have declined, somewhat. More importantly, more creditworthy borrowers have been able to raise money in the bond market to fund bank debt maturing later in the year. This, along with the rally in oil prices, is a clear indication that things are better in the spring of 2009 than they were at the nadir of the crisis in November/December of 2008. We continue to stabilize at recessionary levels, but that remains far preferable to the freefall in which we found ourselves last autumn.
• Volatility to decrease. Unfortunately, volatility remains high. The Volatility Index (the "VIX") measured about 12 in 2005 and 2006, before surging to about 20 in the fall of 2007 and then to nearly 100 during the panic of 2008. The VIX remains elevated, above 40, indicating that markets remain extremely jumpy. A stock market rally would require some normalization of volatility; it must retreat back to less dangerous levels before many investors would even consider coming back into the market.

Instead, equity funds continue to experience outflows, in contrast to normal seasonal trends. Typically, money flows into markets during the first few months of the year, and then dry up during the summer and early fall. During the past four weeks (ending Wednesday, March 25), however, equity funds had outflows averaging $6.8 billion per week according to AMG Data Services. Low prices have not yet enticed investors to return.

The sense that the market is rigged to favor the Goldman Sachs of the world, the fears that business prospects are forever dimmed by regulatory ineptitude, and the need to hold onto cash because the availability of credit has dried up (especially for corporate borrowers) have worsened the situation.

Details of Geithner’s latest Wall Street bailout plan are making the rounds. Optimism surrounding the plan’s ability to benefit anyone (other than the same Wall Street derivatives traders who got us into this mess) is waning. Instead of helping provide credit to the thousands of companies across America who need it, the latest attempt at financial engineering is more oriented to taking lousy assets off the balance sheets of inept bankers in a twisted attempt to provide hedge fund firms with financing. The hedgers get a lopsided risk/return investment opportunity where they benefit from leveraged upside and relatively little downside in order to entice them to manage the government’s "bad bank" portfolio of assets. The government has decided to keep the shell game of securitization going, by inserting itself into the void of lenders willing to finance this activity, instead of letting the shell game draw to a close so that lenders are forced to keep the loans that they underwrite.

He compounded his public policy gaffe by going on "This Week" with ABC’s George Stephanopoulos and creating the headline that "some banks are going to need some large amounts of assistance." Even though he was arguing against the notion that banks needed to be nationalized, now the headline is out there to suggest that a number of banks aren’t going to be able to pass the Treasury’s stress test so the bottom fell out of the sector, again. The markets fell -3.5% today (Monday) on the news, led on the way down by another -8.4% decline in financials.

Many of our client portfolios recently added gold companies to the mix. Like our existing investments in gas exploration and drilling, we believe these gold investments would likely benefit from the administrations’ inflationary policy response to the ongoing banking crisis. The nation continues to print money and increase indebtedness in a fiscal madhouse that must certainly be making our creditors cringe. If we make it through this, it will only because we’ve become the bank customer who is so large and owes the lender so much money that the lender can’t afford to foreclose and send us into bankruptcy.

In addition to gold, we continue to own energy assets. Like gold, they should benefit if the value of the dollar continues to decline. In this week’s Barron’s, the "Safe Harbor in Deep Water" article discusses the prospects for deep water drilling companies like Transocean, Diamond Offshore, and Noble Drilling. Barron’s interviewed Peter Vig, manager of the RoundRock Capital energy hedge fund, who is looking for oil to continue rising to $60 - $65 in 2009 and $65 to $70 in 2010. Demand for gasoline jumped 2% year-over-year last month, even with the market panic late in the year, while oil production has declined in the North Sea and Mexico, and is starting to contract in Russsia.

Our traditional stock market investments comprise a relatively small part of the total portfolio. Excluding our inflationary energy/gold investments and the "muddle through" high yield and preferred investments, perhaps a third of the total portfolio is invested in more traditional stocks, mostly in the technology and biotech industries.

Paul Wick, portfolio manager at Seligman Communications and Information Fund (SLMCX), told Barron’s Eric Savitz that the semiconductor and semi-equipment companies have rallied to the point where they are very risky. "Why stick your neck out with Lam, or ASML or Varian Semi, hoping that 2010 or 2011 will be really good – and [the stocks] might be worth 11 or 12 times 2011 earnings – when you can own Oracle (ORCL) at 10x free cash flow," he asks. "Oracle is Fort Knox. Half the business is recurring maintenance. It’s not ever going to blow up." Oracle was recently the third largest holding in the Fidelity Select Computer Software Fund, owned by our mutual fund model at the time this is being written, behind cash-rich Microsoft and innovative Google, Inc., with those three positions making up nearly 40% of the fund’s holdings.

I continue to pray for 20/20 foresight, but alas that prayer has yet to be answered (and I doubt that it will be answered with a "yes"). Lacking that crystal ball, I continue to see enough danger not to want to be fully invested. However, sentiment is so negative and prices have fallen so far that I think it is foolish not to be making some investments amidst the uncertainty.

It feels to me like we are still early in a bottoming process, waiting for the economy to stabilize, banks to want to lend money to corporate borrowers who desperately need liquidity, and for volatility to take a much needed vacation. I still believe that a recovery will come, but that it’s not here yet.

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

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Preferred News

Our portfolio investment in the financials sector has come through investment in high yield bonds and preferred stocks. Most preferred securities are issued by financial companies, and many of them by the banks and insurance companies at the center of the current panic. How does the current news surrounding the treatment of preferred securities in the bailout process impact preferred share pricing?

Preferred shares are "senior" to the common stock. Whereas the common stock dividend is based on corporate profitability, the preferred shares have a fixed dividend that is based on the company’s ability to pay dividends at all. This means that the common stock has much greater upside. In a bankruptcy, preferred shares are "junior" to corporate debt. In a liquidation, if the proceeds from asset sales aren’t enough to cover the debt, then preferred holders get nothing. If there is a surplus, then the preferred holders should receive par value (usually $25) before common holders get anything.

Given that preferred have all the downside of stock, with much less upside than common shares, why would anyone buy them? The traditional buyer is actually a bond fund. Since preferreds often have no maturity date, they sometimes provide terrific sensitivity to falling interest rates. Investors can lock in a rate "forever." In addition, many preferred stocks are taxed at a lower rate than a corporate bond.

Indeed, one reason for today's unique opportunity in this sector is a result of traditional buyers not wanting to go anywhere near these hybrids, while traditional stocks investors are generally uninformed about them. Add to this a general lack of liquidity in the sector, and we believe there is ample opportunity for quick upside as this niche market begins to right itself over time.

We believe that today’s lower price, combined with high current income yields, make the preferred stock sector a very attractive place to invest in the muddle-through economic environment that we envision for the next few years. Preferred stocks are selling at below 50 cents on the dollar. At the end of February, the preferred stock ETF (ticker symbol PFF) had an income of over 14%. Given the lengths to which our taxpayers have gone to keep these banks and insurance companies solvent, the 14% tax-preferred dividend that shareholders earn certainly seems preferable to the 1% taxable return being paid to depositors. As the panic subsides, preferred yields should decline as a function of preferred stock prices rising from current levels. The total return to investors, combining the income yield with potential appreciation, is very attractive yet investors need only assume that the banking sector survives in order to receive this payoff. For common stock investors, the industry actually needs to turn around and become profitable, which is a much higher hurdle to clear.

Citigroup is the poster child of banking clowns in the current panic (as well as many prior bank panics, come to think of it). For individual accounts, we steered clear of Citigroup and AIG which were clearly going to be ground zero for the financial bust. Citigroup preferred shareholders have almost been "made whole" even in spite of Citi’s incredible showing of incompetence and the ensuing serial government bailout.

A Citigroup preferred share issued in January 2008 had a $25 par value and a dividend rate of $2.03125, for an 8.125% yield to the original buyers. As the panic unfolded, some preferred shares fell below $4 as the Treasury tried to figure out how to save this former Master of the Universe. In the latest round of Citigroup’s downward spiral, the government agreed to convert its preferred stock position into common shares, and the company announced it would no longer pay preferred dividends for the foreseeable future, but offered preferred shareholders an exit strategy of also converting $52 billion in preferred shares into common stock. This was done as an exchange offer. It was not mandatory, however a preferred stock with $25 par value, but no dividend, is of questionable value. For every $25 par value, a preferred holder would receive 7.7 shares of common stock. At today’s price for Citigroup, those 7.7 shares would be worth $20, so preferred shareholders have seen their stock prices quintuple as a result of Citigroup’s ability to muddle through the panic.

These are serious times. Our "invest with imagination" mantra stems from our belief that a simplistic "buy the dip" mentality may not pay off as well as it has during the 1982 – 1999 bull market. Our investment in preferred stocks is part defensive (fixed income) and part opportunistic (looking for significant upside potential). In a muddle through, high inflation scenario, the best investment strategies will probably look quite different than they have in the past.

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

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Where's the Bottom?

"Where’s the bottom," is the $8 trillion question. ("Where’s the top" was a $17 trillion question!)

As I write this, the market has fallen -24% thus far in 2009, following the -37% plunge in 2008. Investors worldwide are enraged, demoralized, and fearful. It feels as though investor sentiment couldn’t be any worse, and a turnaround in sentiment is one of those "potential positives" that investors need to consider. A reduction in the level of fear could fuel a tremendous rally.

• But from what level will it come?
• How long will it take?
• And what will transpire between now and then?

Most of the marketing mouthpieces are encouraging investors to stay the course and reminding them that the biggest moves up typically occur during the first months of a rally. We also hear, ad nauseum, that if you just miss the best 10 days of the year, market returns dwindle to the level of T-Bills.

In a bear market, however, the largest moves down usually occur in a panic at the end of the sell-off. Taking money out of the market, prior to the bottom, may preserve capital on the downside that more than make up for the missed opportunity cost when the market finally turns up.

Missing the worst 10 days of the year typically makes a bigger impact on portfolio returns than does missing out on the 10 best days. An investor offered the chance to miss the worst 10 days, even if it also means forfeiting the best 10 days’ gains, should probably take that deal in a heart beat.

We began raising cash last week and early this week. Both in the fund accounts and in the individual stock portfolios, we have sold off positions to reduce our vulnerability to a continued sell-off in the market. The key question, of course, is "where’s the bottom?"

It’s hard to set a level at which the market is so cheap that value investors will be forced to come in, which is how most bottoms are formed. In our January economic forecast, I said that the market was headed lower, and gave the 7,000 figure for the Dow Jones Industrial Average. That level was based on earnings for the S&P 500 Index companies falling to $60 (from over $100), and the Price/Earnings multiple falling to 11-times those earnings.

We’ve fallen to that level, but is it enough?

We don’t know if it’s low enough or not. The 7,000 level on the Dow (and 660 level on the S&P 500) was only intended to indicate that at some point during the course of the year, we believed the market would trade much lower than where it traded in January. At the moment, earnings are a very poor indicator of value because things are so unstable. If we only experience a severe recession, which is what we’ve experienced thus far, then today’s levels could hold. We continue to be plagued by legitimate worries that we’re headed for a full scale Depression. If we are, then the earnings collapse has just begun and the market can still go lower.

I wish I didn’t have to be so negative, but signs of a turnaround are not as strong as I would wish. Unfortunately, our government leaders are aligning the vast resources of the government against the millions of business owners, without whom an economic recovery will not be possible. I don’t know if these de-stabilizing moves are preventing a recovery, or the monetary stimulus associated with bloating the nation’s money supply is just requiring more patience than I can muster.

Typically it takes about a year for increases in the money supply to accelerate the rate of economic growth. The money supply began expanding late in 2007, so some signs of recovery ought to be visible by now, but the traditional stimulus of 2008 was more than offset by the implosion of our banking system. Perhaps the huge explosion in money growth, beginning in September of 2008, just hasn’t had time to work its way through the system. A global surge in monetary stimulus also didn’t begin until late in 2008. The impact of these moves, as well as that of the fiscal stimulus package recently passed, are still ahead of us. It would be reasonable to see early signs of recovery, any day now.

What transpires between now, and then, will determine whether our latest moves to raise cash come to be something we regret. With the market in a free fall, and signs of distress certain to outnumber potential early indications of recovery, it became too risky to be anything but minimally weighted in the market.

To generalize about the portfolio, we currently have about 20% in cash equivalents, 30% in high yield fixed income securities, 20% in inflation-oriented investments, and 30% in more traditional stocks, tilted toward technology but also including stocks in the biotech sector. We typically have at least 60% in equities, so some would consider us underweighted, to the point of being below our minimum required commitment as outlined in our client profiles. The main reason for being so conservative is that it is working. Owning just about any equity has led to further losses, so by having money in non-equity asset classes we have been able to significantly reduce losses for clients thus far in 2009.

The other reason for reducing stocks below our stated minimum is that our fixed income (high yield bond and preferred stock) investments are experiencing volatility, up and down, more like what stocks traditionally deliver. On days when the market is selling off, the portfolio is not performing like one that has 40% in "safe" assets, so we decided to scale back even more on the amount invested in traditional stocks.

At this point, I believe the market could move 1,000 points in either direction. The current trend is down. If a Treasury auctions fails due to the bloated amount of treasury issuance which current deficits require, the dollar could plunge and rates could soar, sending investors reeling even more. If the recent stimulus fails to gain traction and the economy keeps heading down into a Depression, then I think the pundits calling for a 4,000 or 5,000 Dow could get their way. Stock market volatility is still very high, though below the peak levels experienced in November and December. In a typical bottom, prices plunge to new lows and volatility spikes at the same time. Is that sort of washout still in our future?

On the other hand, the accounting geeks could revise mark-to-market accounting rules as early as next week, which might send financial stocks soaring in a relief rally. Oil and natural gas stocks could add to recent gains as falling production and lean inventories work to change the supply/demand fundamentals. A restructured auto industry and an aging auto fleet could prompt buyers to return to automotive showrooms, which could help restore consumer confidence. Overseas stimulus could start having an impact, which would probably be reflected in higher commodity prices. New tax breaks for homebuyers might prompt more home sales, which would help bring housing inventories into balance. There is no shortage of things that could be better, tomorrow, than they are today.

The odds-on bet is still that things improve from where they are today. A friend of mine who has been managing money in Denver for 35 years firmly believes that values are as cheap today as they were in 1982, at the last fantastic buying opportunity presented to investors. He has been telling his clients that even if Obama’s economic model for this country IS France, which might give most of my readers pause for thought (or worse), even French companies have profits, and stocks on the Bourse de Paris that go up and down to reflect their future prospects. This, too, shall pass.

But from what level? I wish I knew.

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

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Slumdog Capitalist

Slumdog Millionaire hauled in multiple Oscars with a story about a poor “slumdog” Indian boy who was about to win a TV game show by answering a string of questions with such surprising accuracy that the government, suspecting he was cheating, tried to torture a confession from the young boy.


In Washington D.C., bankers and Wall Street types are being subjected to the same government torture. Bank CEO’s who were (in a few cases) forced to take TARP money are lectured on responsible lending by the same Senators and Representatives who demanded that Freddie Mac and Fannie Mae make loans to borrowers who had no plausible means of paying back the loan. Congresswomen who fly personal jets at the expense of taxpayers lecture CEO’s with plants and employees across the globe about why they should fly commercial.

The same government which created the Department of Energy, 32 years ago, to wean the nation of our dependence on foreign oil is now hell-bent on making the domestic energy business as unprofitable as possible in an effort to somehow make solar energy relatively more cost effective, despite the fact that solar and other renewables cannot begin to close the gap in the near future, whereas gas and nuclear could have allowed the U.S. to be energy independent years ago.

The same government which failed to regulate banks adequately during the heyday is now thought to be competent to run them after they are nationalized. The government that turned social security into a $52 trillion unfunded liability now wants to take over the healthcare system in order to protect taxpayers. The same government that created an enormous illegal immigrant problem by neglecting for decades to develop a legitimate process for documenting foreign workers is expanding its programs of paying people for not working instead of stimulating the economy so that businesses can keep people working in their jobs.

In Colorado, a quick look at the “shovel-ready” projects includes bike paths for Boulder, but now that judges can cram down new loan terms against the lenders’ wishes, tossing private property rights out the proverbial window, the capital markets remain so locked up that charter schools can’t have access to fund building programs that would take kids out of the modulars and give them a brick & mortar building in which they can study.

Capitalists are running for cover. Stocks continue to plunge. The nation elected a President who is slightly to the left of socialist Bernie Saunders when it comes to his voting record, and our system of allocating capital has seized up. In “The Ascent of Money,” Niall Ferguson demonstrates that a sound banking system is a prerequisite for social prosperity. Under Bush, and Clinton before him, big government failed to protect our banking system from managers and directors who were value-less in more ways than one. Under Obama, policies designed to transfer profits from capitalists to “the people” will find that neither profits nor capitalists can long endure the assault.

The bankers who plundered are guilty. Kudos to Andrew Cuomo for going after those individuals. Why aren’t the Republicans equally roused? However, the banking system needs to be saved, not punished. That is why the TARP bailout was necessary. Prosperity depends on accountable management, a respect for private property, responsible accounting standards, and a Securities and Exchange Commission that is capable of rooting out mis-deeds and punishing the evil-doers, rather than just chasing paper while Rome burns. Individual companies should be allowed to fail, unless they would take the rest of the system down with them.

There are many democrats, though not in leadership positions, who believe in freedom and enterprise and small government. Where Republicans have shown little compassion for problems in our inner cities, there are democrats who have both a heart for “the people” and are smart enough to be outraged by the current attempts to dismantle the free and capitalistic ways that allowed America to become the envy of the world. Moderate democrats, unite! Save us from ourselves.

There is a lot of discussion, these days, about how Obama’s bold and courageous policy shift is trying to re-make a culture that has benefited, mostly, from the cultural shift toward Reaganism in the early 1980’s. People forget that Reagan had a compassion for “the people” that allowed him to be a great communicator. Reagan believed in a moral America and, I believe, would have been deeply disappointed by the antics of today’s CEO crowd. Reagan, the former union leader, believed in people getting paid a fair day’s wage for a fair day’s work – and would have been aghast at today’s policies of paying people not to work, paying bankers not to lend, and paying government staffers for working against the very cause that their department’s were created to pursue…all at the behest of special interest groups.

President Obama, we do need change. And, yes, you did win the election. However, the election was about reforming the healthcare system, not trying to expunge profits from the system in an ignorant attempt to appropriate profits in order to make sure illegal aliens don’t suffer discomfort while on our soil. The election was about making the capitalistic system start working for everyone rather than just the managers who feel entitled to pillage companies for their own benefit, not abandoning a hundred years of property law in order to pay for the promises made to voters during the campaign.

Our government leaders are aligning the vast resources of the government against the millions of business owners, without whom an economic recovery will not be possible. After inciting the masses with promises of unearned material gain, taken from the vast stores of wealth that belong to capitalist dogs, the socialists-in-charge are going to find out the hard way that as 401(k)’s become 201(k)’s and then 101(k)’s, the end result is that we are all slumdogs in the end.

The nation is following California’s lead. Our government over-spent during the good times, only to find that unwise governance leads to economic difficulty. During the tough times, California borrowed more and continued to build a state-run politically correct republic, self-righteously looking down on the rest of the country for not getting in line, only to find that it couldn’t begin to fund the promises made to its people. Now California is sending IOU’s to its taxpayers and begging flyover country for a bailout.

At the national level, we have learned nothing. To paraphrase JFK (in Berlin), “we’re all Californians, now.” But who will bail out the US?

I don’t know if we’re headed into a Depression or not. This is the first time in 27 working years that this has ever been a legitimate worry for me. America, the old America – Reagan’s America, is a great and resilient country. I hope that America can withstand even this latest regime change. But if we are going into a Depression, I can tell you that I know of no good strategy for capitalists or the people they employ. There are no winners. There is only extreme pain, often followed by abuse from arrogant powers in the government and, ultimately, the atrocities of war.

In the short run, the market is a voting machine. In the long run, it is a weighing machine. Every time our policymakers open their mouths, the markets have been voting “No!” Let’s hope that in the long run, these policies don’t leave the nation’s storehouses empty with nothing left to weigh.

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

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