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FORBES’S 2008 MUTUAL FUND SURVEY IS OUT
Forbes takes an intuitively and intellectually satisfying approach to rating mutual funds. Rather than trot out standard (bogus) measures like betas, or relative fund performance over arbitrary time frames such as three or five years, they look at performance during actual bull and bear markets. Wisdom gathered over decades, as opposed to strict calculation, has shown Forbes that funds often do well in bull or bear environments, but not both ... with some rare exceptions. If your primary goal is not to lose money (Warren Buffett's first rule of money management), then you will want to know how well a prospective fund has performed during market downdrafts.
And while performance comes and goes, costs come and stay with great reliability. Besides management fees, some of which are not obvious, there are also: (1) Trading costs, which derive from how actively the manager trades and how wide the bid/ask spreads are on the typical stocks or bonds traded; and (2) for taxable accounts, the costs imposed by turnover leading to realized capital gains. A long bull market can inure one to high fees, but they impart a definite drag on returns over time.
Two things distinguish the Forbes mutual fund ratings from what you are likely to see elsewhere. One is that we score funds separately in bull and bear markets (and have been doing that since 1957). The other is that we pay a lot of attention to costs.
What is wrong with looking at just a single performance number -- say, for five or 10 years -- in judging which funds are the best? The problem is that if your measurement period includes mostly bullish times, you are led down a garden path to the riskiest stock pickers, usually ones who like growth or technology stocks.
Separating the up- and down-market grades tells you a lot about a fund's risk. A high-risk fund like Fidelity Aggressive Growth will have an A for bull markets and a D or an F for bear markets. Buy a fund like that only if you can tolerate a sharp drop in your net worth. Conservative funds, those with (usually) bad grades in bull markets but an A in bear markets, are likely to make less money over the long run but will do less damage in a bear market (like the one we have had since October 31, 2007).
Unless you are a wizard at shorting investments, it is easier to make money in a rising market than in a falling market. Our mutual funds report will not only help you identify funds likely to increase the value of your portfolio during the good times, but will also show you how to preserve capital at times when investors are panicking. At Forbes.com you will find updated performance scores and evaluation tools on thousands of funds, advice on how to use these metrics and a wealth of analysis and profiles on fund investing.
Wherever you find Forbes discussing mutual funds, you are likely to see a serious discussion of costs. Funds state some of their fees and expenses in big, readable, numbers in their literature but hide other costs in obscure financial documents that most investors do not see. Pay attention to all these expenses, as they can make a big difference in how much money you have at the end of your investment.
Forbes also stands apart from other mutual fund rating services in that we create separate grades for bull and bear markets. From several decades of experience tracking mutual funds, it is clear to us that funds that excel in bullish markets often perform horribly in bearish markets, and vice versa. ...
We cannot guarantee that a fund manager's future performance will match his past performance, but if you believe that the market is in for several more quarters of choppy and negative results, it is definitely worth paying attention to our bear market grades.
Although we rate all funds -- provided that they have enough performance history -- over separate bullish and bearish cycles, we vary the specific methodology according to the type of fund. For example, we benchmark U.S. domestic stock funds against four full market cycles of the S&P 500, starting in June 1994.
Our grades reflect each fund's relative-to-market performance against its peers. Those with the very best relative returns receive an A+, while the worst receive an F. To receive a performance rating from Forbes, a domestic stock fund must have at least $25 million in assets and have been around for at least three bull and bear market runs. Funds without four full market cycles can only receive a maximum grade of A, not an A+.
We use a slightly different rating method for all bond funds, except junk bond funds. Our bond fund performance grades look at how the fund fared relative to its benchmark and to similar funds over the past five years, in which we look at each month during that period as bullish or bearish. We treat junk bond funds similar to stock funds, but we rate them over the course of four market cycles of the Merrill Lynch High Yield Master Index, starting in November 1994.
Our performance scores can give you a good idea as to how a fund might perform in a future bull or bear market, while our Efficiency and Risk scores can help you preserve your assets and minimize your tax bite regardless of the market environment or whether the fund manager lives up to his or her reputation. We base our Efficiency Scores -- Cost and Tax -- on a scale of 1 to 5, with 1 being the best. For Cost Efficiency, we factor in sales loads and fund expenses. Tax efficiency is measured by the difference between pre-tax and after-tax returns. We use the same 1-5 system for our Risk score, with funds that produce the best returns for the amount of risk that they take getting a score of 1. Janus Orion, Janus Enterprise and T. Rowe Price Latin America are among the funds that received the best score in all three categories: Risk, Cost and Tax Efficiency.
We encourage you to do thorough research before making an investment, but our Best Buy lists are a good way to get started and narrow down your choice of funds. Best Buys balance low costs (sales charges, expenses and trading commissions) with acceptable risk-adjusted performance over the past five years. We get that last bit of data, trading commissions, courtesy of Lipper, a fund data service that digs through obscure financial documents for this information. If you are looking for a performance superstar, it is probably best to look elsewhere. We believe, however, that our Best Buy methodology offers an acceptable trade-off, one in which you might "give up" a little in past performance -- something that the fund may or may not duplicate in the future -- in exchange for an investment that is less likely to hurt you over the coming years with excessive costs.
T. Rowe Price Capital Appreciation has been on our Best Buy list for eight years, while another Best Buy, the Bruce fund, has a 5-year annualized total return of 17.3% and rates an A in bull markets and an A+ in bear markets. This $223 million (assets) fund does have a few minor negatives: It lags the S&P 500 over the past 12 months, with a -13.6% return vs. -11.0% for the S&P. And it has a Tax Efficiency score of 4. Other notable Best Buy domestic stock funds include Stratton Small-Cap Value and T. Rowe Price Small-Cap Value.
For equity funds, we equally weigh risk-adjusted performance and costs in our Best Buy calculations. For bond funds, we give greater weight to costs, since the performance of bond funds with the same investment objective is due more to swings in interest rates, not management expertise.
There is not one fund that is right for all investors. That is where our ratings, evaluation tools and fund data can help you find the right fund or mix of funds for your specific investment needs.
The Forbes 2008 Honor Roll
Down-market standouts – and long-term investing stars.
Those looking to put the stock portion of their investment portfolio to work in mutual funds could do far worse than to use the Forbes "Honor Roll" as a starting point. As explained above and below, Forbes uses a rigorous screen that places heavy emphasis on capital preservation -- by favoring low fund management costs and good performance during bear markets.
Times like these drive home a fact that has formed the basis of our Honor Roll selection process since its 1973 debut: Capital preservation matters. As the saying goes, stock-picking genius is sometimes nothing more than leverage in a rising market. Far rarer are money managers who bull ahead in good times but also shrewdly navigate through bear markets without giving back their gains.
With our annual Honor Roll, Forbes strives to find the funds, and managers, who have proved they can grow -- and preserve -- assets across entire market cycles.
The 2008 Honor Roll class has a very familiar look, driving home the point that consistency of performance is a big part of our selection process. Six of the 10 funds from last year's lineup make repeat appearances. Two funds return to the cast after an absence of several years: Columbia Value & Restructuring (formerly known as Excelsior Value & Restructuring) and Wasatch Core Growth. Two newcomers: Meridian Value and T. Rowe Price Small-Cap Value.
There were four dropouts. Value Line Emerging Opportunities, a 2007 rookie, just missed the cut by coming in 11th in our ranking. The other three 2008 no-shows from last year's class did not quite keep up with the competition during a tough year: Honor list veteran Third Avenue Value Fund, onetime member Perritt MicroCap Opportunities and the roughed-up Muhlenkamp Fund, which ended a 7-year stretch on the Honor Roll. Ronald Muhlenkamp owned a lot of Countrywide Financial and AIG.
Keeley Small Cap Value Fund tops our chart in 2008, pulling ahead of its fellow Honor Roll classmate out of Chicago, the Bruce Fund. Keeley was runner-up to Bruce the two previous years. John Keeley has a keen eye for restructuring plays and companies in transition and has done well recently with Walter Industries and Petrohawk Energy. Newer additions to his portfolio include Hill-Rom Holdings, which makes hospital beds, and pharmacy manager PharMerica.
John Keeley was interviewed in the August 11 issue of Barron's. We posted the interview in last week's Financial Digest. At the time, we (and Barron's?) were unaware that he would top the Forbes Honor Roll.
Robert Bruce and his son Jeffrey direct an eclectic portfolio that includes shares of ATP Oil & Gas, Arena Resources and Amerco, U.S. Treasury Strips and convertible bonds. In troubled times it is what they consider a solid defense.
Mairs & Power Growth shows up for the 4th year in a row. Its long-term record is even better. This quintessential Honor Roll fund, hailing from Minnesota, has been a class member in 10 of the past 12 years. Strong suits: midwestern stalwarts like Medtronic, 3M and General Mills.
What distinguishes the Honor Roll from many other rankings is its emphasis on consistency. To rank funds, we gauge how well, or poorly, they have fared over four market cycles. The starting point for this latest survey is June 30, 1994. (The previous starting point was January 31, 1994; the current market downturn, dating from October 2007, shifts the beginning point forward.) The end point is July 31, 2008. Honor Roll funds must earn a B grade or better in down markets and a C or better in up markets. Capital preservation is key here. Eight of our 10 funds score either an A or an A+ for their bear market showings.
Honor Roll managers must have at least six years on the job. This eliminates the risk that a ranking will mask coattailing on a predecessor's record. We also require that candidates have diversified portfolios. This shuts out from consideration the many specialized funds that can do outstandingly well for a stretch, only to give back a lot of their gains when a commodity or a sector turns against them. Among the exceptional sector funds stricken from the candidate list are CGM Realty and Vanguard Health Care. Funds must also currently be open to new investors. That eliminates T. Rowe Price Mid-Cap Growth and FPA Capital, which are former Honor Roll members.
We calculate hypothetical investment results in dollar terms after factoring in any sales commissions and taxes paid by an upper-income investor who put $10,000 to work on June 30, 1994. We factor in the tax on distributed capital gains but not on unrealized appreciation of fund shares. By the end of July investors would, at minimum, have nearly quintupled their money in any of these 10 Honor Roll funds. The list-leading Keeley Small Cap Value Fund would have turned that $10,000 investment into $73,900. The same money in the Vanguard 500 Index Fund would have grown to only $33,022.
The Vanguard 500 Index Fund would have grown to only $33,022? That turns out to be an 8.9% or so annual average return over the 14 year period documented by Forbes. This is better than the alleged long-run average return for stocks of 7% or so, but way under the returns stocks delivered from 1982 to 2000. With stocks now trading below where they were eight years ago the longer-period average annual returns numbers are being dragged down.
The article ends with a table with various salient information and statistics on the 10 Honor Roll members. A particularly interesting column was "Maximum Cumulative Loss," defined as the greatest loss sustained during any unbroken string of monthly losses since June 30, 1994. The only truly major bear market during that time frame was during 2000-02. The worst market pounding since 1973-74, it was nevertheless a relatively good time for value investors -- whose relative performance had theretofore looked pitiful during the terminal phase of the dot-com mania. The "Maximum Cumulative Loss" for Honor Roll members ranged from 20% to 38%. Six of the 10 were in the 25-30% range. So beware: Even the best investors go through fallow periods where the drawdowns start to get nerve-racking.
Outside the Honor Roll, the Mutual Fund Survey base page includes links to "best buys," which balance low costs with acceptable risk-adjusted performance over the past five years, among these mutual fund types: Index, Balanced, Domestic (U.S.) Stock, Emerging Markets, Foreign Stock, Global Stock Natural Resources, Precious Metals, Real Estate, Health Care, Technology, Socially Responsible, Junk Bond, Municipal Bond, Target Retirement, Taxable Global Bond, Taxable Bond, and U.S. Treasury.
The Big, Bad News
The 25 largest fund families have little to brag about in their overall results for the past decade.
Size is inevitably a drag on investment performance. After a certain point, a fund essentially is the market of the asset class or sector it focuses on. Forbes found that of the 25 largest mutual fund families, only eight topped the returns on bonds over the last 10 years. The family which delivered by far the best results was the Royce Funds, which concentrates on smaller capitalization value stocks.
On July 31, 1998, the S&P 500 closed at 1120.67; 10 years later, it stands at 1267.38. That works out to an average annual price return of only 1.2% a year over the last 10 years. Factor in dividends and the total return does not look much better at 2.9%. On the other hand, the Merrill Lynch Corporate and Government Master Index averaged 5.7% during that time.
So, were the last 10 years a complete washout for U.S. equity funds? By calculating the performance of U.S. stock funds on a year-by-year basis and weighting each fund's return by its mid-year assets, we get a picture of how these funds performed. Since we measure performance for each year, funds that sponsors later liquidated or merged out of existence still count for the years they were around. Asset-weighting makes sure that the performance of larger funds counts for more than smaller ones that attracted fewer shareholder dollars.
So how did the 25 largest fund families as measured by the total assets in their domestic stock funds do? The results are not encouraging. True, no family posted a loss and the average asset-weighted performance of all but five of them would have beaten the S&P 500, but that is a low hurdle. Only eight of the fund families managed to top the returns on bonds. Royce, which tends to focus on smaller capitalization stocks, was the best of the lot, averaging 11.4% annually over the last 10 years.
Fidelity and Vanguard, the largest no-load fund families, land in the top half of our fund-family performance table. In 1998 Fidelity's Magellan was the largest mutual fund with $74.6 billion in assets; the next largest was Vanguard's S&P 500 fund with $64.3 billion. Ten years later, Magellan, at $35.7 billion, does not even figure in the top 25 funds. Today, no less than seven funds exceed $100 billion in assets. American Funds' Growth Fund of America is the largest of all, at $178.4 billion. The next largest fund is a bond fund, Pimco Total Return, with $129.6 billion in assets.
SELLING A FREE LUNCH
With interest rates low, seemingly safe funds with above-average yields have made for a successful sales pitch. But like many before it, this one has left investors fuming.
The "TANSTAAFL" principle -- There Ain't No Such Thing As A Free Lunch -- from economics applies equally to investing. In times of loose credit and low interest rates it is a foregone conclusion that various schemes to "enhance" returns will come out of the woodwork. Junk bonds and subprime mortgages are obvious and recent examples of such. Usually the "strategy" works for a while -- long enough to draw in a mass of credulous participants and opportunistic investment bankers -- and then it doesn't. At root there is a Ponzi finance dynamic that can only last until credit starts to contract. Like now.
James Lyle, 56, fought fires in Auburn, Alabama until a disability sent him into retirement 14 years ago. Looking for a safe place to park his cash, he put $65,000 into the Morgan Keegan Select Intermediate short-term bond fund in 2006. Fund sales literature promised "capital preservation and income" and "greater stability in principal value than that of long-term bonds."
All went well until the mortgage market began melting down last summer. To eke out high yields, Select Intermediate had invested heavily in collateralized mortgage obligations and other housing-related paper, which tanked. The fund's share price has fallen from $9.60 a year ago to 97 cents. Lyle invested in two similar Morgan Keegan funds promoted as safe fixed-income investments that suffered similar fates, bringing his total losses to $150,000, representing 35% of his net worth.
"I was lied to," says Lyle, who blames Morgan Keegan but not his broker. "Especially when I bought in, my broker was telling me exactly what is in print."
Lyle has plenty of company. Retirees Martha and Aubrey Wright of Marietta, Georgia have lost 68% of their investment, or $109,000, in such Morgan Keegan funds. They have returned to work and cut back on prescription medication to make ends meet. Vincent McCormack, 71, and his wife, Marie, lost $558,000, which is 90% of their investment and close to a third of their retirement savings. All of these investors have accused Morgan Keegan of fraud in claims filed with the Financial Industry Regulatory Authority (FINRA). Morgan Keegan declines comment.
The mutual fund universe has 6,700 funds competing for attention, not counting money markets. They garner it by running glossy ads and distributing spiffy sales literature to brokers and financial planners. To the industry, it is all about one thing: gathering assets to generate fee income.
Unfortunately, the safety net that is supposed to protect mutual fund investors from efforts to do this with false and misleading promotions is full of holes. It always has been.
In the late 1980s and early 1990s adjustable-rate mortgage funds were touted as higher-yielding proxies for money market funds. By 1992, 37 had sucked in $20 billion -- just in time to collapse along with the real estate market, as industry scold (and Vanguard founder) John Bogle recounts in his book Common Sense on Mutual Funds. Most then either closed or changed their names and objectives.
Piper Jaffray paid $67 million 13 years ago to settle a class action after a fund it had promoted as a safe place to park cash lost 30% of its value. It, too, was loaded with mortgage-backed securities. Piper Jaffray was then fined $1.25 million by FINRA's predecessor.
"Suggesting a bond fund instead of a CD is not necessarily a bad thing, as long as you explain the risks," says Russel Kinnel, director of mutual fund research at Morningstar. "It's not that you have to tell everything, but you should give people a realistic expectation."
A fund's marketing materials, including its ads, Web site, brochures and mailings, are supposed to fairly balance risks and potential rewards as described in the prospectus. But prospectuses often run to dozens, or hundreds, of pages, meaning they go unread. That leaves plenty of opportunity for the more accessible statements -- in brochures or brokers' spoken pitches -- to tout the positives and play down, or leave out, the negatives.
Often the problem is not that cautionary information is undisclosed but that investors are too overwhelmed to grasp it. At least some of the blame goes to the Securities & Exchange Commission, which oversees the fund business. SEC lawyers, it seems, are so obsessed with the long-winded and confusing prospectuses that they do not have time to revamp the ads and the brochures.
The SEC did amend its advertising regulations five years ago amid concerns that fund sponsors had created "unrealistic investor expectations" during the tech bubble by playing up eye-popping performance data. The new regs require ads to include a toll-free number to obtain performance data through the most recent month and the bromide that "past performance does not guarantee future results."
Another reform would go further. It would require fund vendors to boil down fund essentials -- including risks -- to an easily digestible summary that appears on its own or at the front of a prospectus. The SEC staff proposed this rule last November, but the industry has so far fought it off. Instead of a CliffsNotes-style summary, investors are being treated to enriched detail about two hazards that have almost vanished: rapid-fire market timing and after-hours trading. This represents the SEC's response to fund industry scandals of a few years ago.
"It is unreasonable to expect an investor to read all of the pages of a prospectus and fully understand and interpret the disclosures. That's why investors look to marketing material," says Steven Toskes, a securities lawyer in Boca Raton, Florida.
FINRA, which is supposed to enforce the SEC's promotional regulations, reviews marketing materials with the aim of ensuring that claims fairly reflect the risks laid out in the prospectus. But it does not determine the validity of the prospectus, which can also be an issue.
Investors have charged Wachovia's Evergreen Investments of securities fraud in a Massachusetts federal court for allegedly failing to fairly represent risks in the prospectus for its Ultra Short Opportunities fund. The complaint acknowledges that the prospectus lays out risks arising from interest rate moves, derivatives and mortgage-backed securities. But it claims the prospectus fails to explain that those risks "entirely undermined the fund's stated investment objective" of preserving capital and minimizing fluctuations in value. (Wachovia does not comment on pending litigation.)
Charles Schwab asked visitors to its Web site in 2006 if they were "Looking for a way to earn better yields on your long-term cash without taking on significantly higher risk?" Its answer was YieldPlus, an ultrashort-term bond fund, which that year became the 18th-fastest-selling mutual fund and at its peak had $13.5 billion in assets.
Only those investors who waded to page 3 of the 30-page YieldPlus prospectus discovered warnings that problems in the mortgage market could cause the fund to lose money. That September Schwab amended the fund's so-called Statement of Additional Information, essentially the even less read second part of the prospectus, to state that the fund could invest more than a quarter of its assets in mortgage-backed securities.
With nearly half its assets in such securities, the fund fell 18% in March and is down 35% in the past year. Investors have filed FINRA complaints, alleging misrepresentation and omissions, as well as class actions. You cannot "Talk to Chuck" about this one, however. A Schwab spokesman says neither the man, nor the firm, cares to comment.
“The odds of a significant bout of inflation now are about the same as they were in 1929. Next to none.”
"We are in deflation now. Most do not see it because they do not know what it is." So writes Mike "Mish" Shedlock, former contributor to Whiskey & Gunpowder. (His last piece for them was in January, so "former" is our presumption.) In an article which could have -- and basically has -- been written by Bob Prechtor, Shedlock argues that besides Peak Oil and peak whatever else, we have witnessed Peak Credit. The housing bubble was the last hurrah of the post-Great Depression credit inflation, and there are no more bigger bubbles to paper over the housing aftermath. Credit is out, paying down debt is in. This is deflation.
The Marlin Company 14th annual Attitudes in the American Workplace Poll reports the following results on June 24.
More than one third (41%) of U.S. workers are cutting back on utilities, nearly half have reduced food purchases (48.5%) and a large percentage are buying less clothing.
The national survey of U.S. workers, conducted May 12-14, 2008, also found that younger workers (between the ages of 18 to 29) are being hit the hardest by the economy and are the most desperate about their economic future. More than one third (34.3%) of young American workers say their financial situation has caused them to "feel hopelessness or despair about their economic future." That compares with 28.8% of workers age 30 to 49, 23.5% of workers 50-64 and 17.9% of workers 65 or older.
Nearly a third (31.4%) of workers report being occasionally kept awake at night because they worry they will not meet housing payments, credit cards, or other personal expenses, 36.8% of whom were between the ages of 18 and 29.
And nearly one fourth (23.4%) of U.S. workers say their financial situation has distracted them on the job, with the most distracted being young workers, age 18 to 29 (36.8%).
"U.S. workers are hurting on multiple fronts, and their pain is growing," stated Kenna.
"This year's poll clearly illustrates exactly how damaging the current state of the U.S. economy is to its workers." In particular, with gas prices topping $4 a gallon this summer, more than a quarter of workers (25.7%) are already choosing alternatives to driving into work -- such as carpooling or public transportation; 35.9% were between the ages of 18 and 29, with more females (32%) than males (23.1%) conserving.
... There is a secular attitude change happening right now. Boomers close to retirement are now (finally) scared to death as the equity in their houses has been vaporized. School age children are seeing homes foreclosed, and families destroyed over debt. The American consumer, who nearly everyone thinks will be back as soon as the economy picks up are mistaken.
Secular shifts like these come once in a lifetime. Sadly it is too late for many cash strapped boomers counting on equity in their houses for retirement.
The lessons of their great grandfathers who lived in the Great Depression era were forgotten. Over time, everyone learned to ignore the dangers of debt, risk, and leverage. Belief in the Fed and the government to bail out any problem are ingrained. Bank failures are distant memories.
Anyone and everyone who wanted credit got it, and on the easiest of terms: subprime, pay option arms, reckless leverage, and covenant lite debt and toggle bonds that allowed debt to be paid back with more debt. That is what it takes to hit a peak.
Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.
It took nearly 80 years for people to get as reckless as they did in 1929. 80 years! Few are still alive that went through the Great Depression. No one listened to them. That is the nature of the game. The odds of a significant bout of inflation now are about the same as they were in 1929. Next to none.
Children whose parents are being destroyed by debt now, will keep those memories for a long time.
Deflation Is Here
If you do not know what inflation is, or if you think it is about prices (it is not, and it is not about a falling or rising dollar either) then please read Inflation: What the heck is it? and Interview With Kasriel.
Right now, China, India, Brazil and other countries are on a different credit cycle than the U.S. Growth in China is providing huge strength in the commodities sector. In addition, horrid economic policies in the U.S. are weakening the dollar.
Those two factors are causing those who do not know what inflation is to scream inflation or stagflation. The real wackos are screaming hyperinflation. They are all mistaken. We are in deflation now. Most do not see it because they do not know what it is.
PONZI FINANCE DYNAMICS STILL AT PLAY
Doug Noland argues that, all wishful thinking to the contrary, the recent stronger-than-expected U.S. economic numbers are (a) not accurate and (b) a result of continued credit inflation. He points out that calls for further government stimulous overlook the fact that with the pending nationalization of Fannie Mae and Freddie Mac it now turns out, we see, that government guarantees and spending were integral to the whole post-2002 economic recovery (if what happened deserves to be labeled as such).
As any idiot can see, this continual reinflating of credit to keep the would-be roosting chickens airborne cannot continue forever, and continually makes matters worse the longer it goes on. But political expediency begats idiotic behavior.
Second quarter GDP expanded at a 3.3% pace, the strongest since Q3 2007's 4.8%. Durable Goods Orders, Existing Home Sales, and the Chicago Purchasing Managers' index were all reported "stronger-than-expected". And with commodity prices almost 20% off July highs -- and crude oil notably unimpressive this week in the face of a major Gulf hurricane -- the markets seem to lend support to the waning inflation viewpoint. The dollar rallied further [last] week. Meanwhile, despite today's downdraft, Freddie Mac gained 60% this week and Fannie Mae advanced 37%. Monoline insures MBIA and Ambac surged 59% and 35%, respectively. MBIA saw its stock price more than double during August, to surpass $16. The Bank index jumped 3.1% ... and the Broker/Dealers rallied 4.0%. Homebuilding stocks were up 9%.
Investors are increasingly willing to accept that the worst of the credit crisis has passed. Talk that the nation's housing markets are bottoming becomes louder each week. And every day market participants seem more receptive to the "economic resiliency" thesis.
First of all, I am certainly of the view that the economy is much weaker than the headline 3.3% growth rate. At the minimum, I am skeptical that the 1.2% annualized increase in the GDP price index accurately captures what I believe is a significant inflationary component in current "output". It is worth noting that the favored inflation gauge of Greenspan and the Fed, the PCE Deflator, was up 4.5% from a year earlier, the strongest year-over-year increase since 1991.
There is bountiful wishful thinking when it comes to our nation's mortgage and housing crises. Granted, many of the burst bubble markets -- including some spectacular busts throughout California, Florida, Nevada, and Arizona -- have in some cases seemingly reached somewhat of a "clearing price". Transaction volumes are up significantly in many of the locations with the greatest y-o-y price declines. I will suggest, however, that it is unwise to extrapolate trading dynamics in these burst markets to national housing trends more generally. I believe the vast majority of markets around the country are more aptly described as bubbles leaking air, as opposed to the collapsed markets that garner the greatest media attention.
I will turn more constructive on home prices and housing markets generally when mortgage credit availability begins to loosen. It remains my view that credit continues in a tightening dynamic. Notably, the growth in Fannie and Freddie's Combined Books of Business slowed sharply to a 3.7% rate during July, the slowest pace in two years. And while there is nothing really in the works to compare to the abrupt credit tightening that emanated from collapsing subprime and Alt-A securitization markets, I will argue today's tighter credit is a more subtle dynamic resulting from various types of lending institutions restricting, on the margin, loans to even prime credits.
From the Wall Street firms down to the small community banks, tighter lending terms are leading to higher downpayments and less flexible payment terms for even high quality borrowers. And while the nature of this dynamic specifically does not lead to collapses for the relatively stable housing markets around the country, it nonetheless will definitely continue to pressure prices. And downward home prices will, over time, lead to only more lender nervousness and restraint.
And despite the lull, vulnerable housing markets remain acutely susceptible to any worsening in the GSE crisis. With Mortgage Backed Security spreads having tightened somewhat during August, I will assume Fannie and Freddie resumed aggressive mortgage purchases in the marketplace after somewhat slowing their buying during July. Importantly, overall marketplace liquidity has deteriorated to the point where the GSEs must expand aggressively in order to forestall another major leg down in the ongoing housing crisis. As such, the marketplace of late is involved in a dangerous game of "chicken" with both the GSEs and Treasury. These days, any time the GSEs slow their marketplace buying of mortgage paper (back away from their "backstop bid"), spreads widen sharply and fears of a liquidity crisis -- and forced Treasury bailout -- intensify. So, I will assume the GSEs have resorted again to ballooning their exposure aggressively -- recklessly.
There has been a lot of talk about the GSEs being "privatized." As the thinking goes, Fannie and Freddie should be temporarily "nationalized," recapitalized, split up and then released as responsible participants in the free marketplace -- credit providers no longer posing a risk to the American taxpayer. This all sounds wonderful in theory -- yet is completely impractical in reality. I fully expect the GSEs to be nationalized. But I suspect the federal government will be running -- and recapitalizing -- these institutions for many years to come.
The private mortgage marketplace self-destructed, and now the entire "prime" mortgage/housing market is dependent upon ongoing cheap mortgage finance available only through American taxpayer backing and subsidies. The private sector simply cannot today -- or at any time in the foreseeable future -- provide the hundreds of billions of cheap ongoing new mortgage credit necessary to forestall a systemic housing/economic/financial collapse. There will be no happy "recapitalize and privatize" ending to this saga. The bill to the taxpayer is now growing rapidly -- along with GSE exposure -- and will balloon into the trillions over the coming years and decades. And for how long the holders of GSE debt and MBS will be allowed such handsome returns at taxpayer expense is a quite intriguing question.
I also read and hear too much about the continued need for "Keynesian" stimulus. Regrettably, the system has been in non-stop government (fiscal and monetary) stimulus mode for years now. It may have been indirect at the time, but it is now apparent that GSE obligations should be included today right along with debt owed directly by the Treasury. And before all is said and done, the taxpayer will also be on the hook for enormous losses from various federal guarantees of deposits, student loans, pensions, and the like. The bottom line is that a whole range of direct and indirect federal guarantees -- especially since the 2001/02 recession -- have played an integral role in spurring credit and economic bubbles. "Keynesian" ammunition -- fired way too early and freely in order to sustain multiple bubbles -- has definitely buoyed the U.S. bubble economy, although such measures will have only limited effect down the road when they are sorely needed.
Returning back to my initial paragraph, these days the economy and markets do not appear all that bad -- certainly nothing as nasty as we dour prognosticators have been forecasting. I will warn, however, that there are some very dangerous "Ponzi Finance" dynamics still very much at play. The most obvious resides with the GSEs. And there are closely related bubbles throughout the agency and Treasury bond arena. Meanwhile, a view has gained adherents that the U.S. economy is actually in much better shape than Europe and elsewhere. The reality that Europe is not buoyed by their own government-sponsored mortgage behemoths and that their economies are more manufacturing based (and thus vulnerable to cyclical downturns) are only short-term relative disadvantages.
The overshoot phenomenon means we are not yet halfway through the current downturn, even in housing.
Martin Hutchinson notes that financial markets do not tend to stabilize around their theoretical "equilibrium" values. A quick glance through history suggests instead that overshooting on the way up and down is the norm.
For instance, the average ratio of U.S. house prices to individual earnings was 3.2 over the last 30 years, versus its 4.5 peak of a couple of years ago. Now it is back down to 3.2. End of decline? Never mind the worsening credit conditions and profound change in buyer psychology, overshoot alone would suggest the ratio keeps falling from here. The model could be Japan, Hutchinson suggests, where countrywide real estate prices dropped around 60% from the 1990 high. Similarly, a fall in the Dow Industrials to 7,800 would wring out the 1995-2007 asset price bubble, but overshooting could bring it lower still.
In effect, we saw all kinds of historical excesses on the upside, so it would be optimistic in the extreme to expect a gentle reversion to mean on the downside.
The Case-Shiller Index of U.S. house prices announced this week, down 17% in the top 10 markets, was greeted with rapture by the stock market, because its rate of decline had slowed somewhat compared to the previous month. Reams of analysis were written about how house prices were nearing the bottom, which was taken to be the level at which the ratio of house prices to individual earnings was the 3.2 times average over the last 30 years, rather than the 4.5 times shown at the peak. However, analysts were as usual over-optimistic -- haven't they ever heard of overshooting?
Wall Street analysts and the media generally have a poor sense of how the business cycle works. Thus the optimistic revised figure of 3.3% for second quarter GDP growth was described by several commentators as the "top for this cycle." What cycle? The 3.3% growth figure, caused largely by the tax rebates paid out during the quarter, was preceded by two quarters of almost zero growth and will almost certainly be followed by two quarters of very low or negative growth. There is no cycle there; it is just a blip. The $115 billion growth in real GDP during the quarter was less than the $120 billion of tax rebates handed out during the quarter, a large portion of which were spent. In the third quarter, there will be no such tax rebates, so GDP growth is likely to be negative.
Housing numbers announced this week caused similar optimism. The Case-Shiller price index, down 17% over the last 12 months, was down only 0.6% over the last month, leading analysts to chortle that the housing market decline was coming to an end. After all, with a 20% decline in house prices and 10% rise in general prices (normally a close proxy for wages) over the last two years, the ratio of house prices to earnings must have dropped from its peak of 4.5 times to quite close to its long term average of 3.2 times.
A moment's thought should convince us that this trajectory is unlikely. Mortgage conditions are not those in which the long term average was attained. Not only have subprime mortgages as a category disappeared, but so has much of the mortgage securitization market as a whole. The government-backed mortgage behemoths Fannie Mae and Freddie Mac have subsided effectively into bankruptcy, and will not be buying mortgages aggressively in the future. Mortgages have become very difficult indeed to obtain for anyone with a credit score of under 700 or so and generally require a down payment of a full 20% of the purchase price.
On the other side of the equation, home buyer psychology has completely changed. No longer is it expected that house prices will continue a steady and inexorable rise, without significant downdrafts. Buyers now know that if they need to move again in a hurry, they may well be lumbered with an asset that will prove impossible to sell except at a price that wipes out of most or all of their original investment.
With mortgage markets much more difficult than their long term average, and home buyers much more nervous and pessimistic than their average, it is hardly to be expected that house prices will stabilize around their long term equilibrium level. Only interest rates, still exceptionally low in real terms, will tend to hold them up. However since interest rates will eventually need to be raised to combat inflation, that sustaining force also will be removed from the market.
At that point, house prices will decline, not to their equilibrium level but to some much lower nadir. The further drop will itself tend to depress mortgage activity and investor sentiment. The model could be Japan, where real estate prices dropped around 60% from the 1990 high, with further drops extending to 80% in downtown Tokyo. Since Japan is an island chain of dense population and limited buildable land, real estate prices should always be high and might be thought immune to such fluctuations. The experience of 1990-2005 proved that if a deep recession took hold, there might be very little restraint on the downside.
Some areas seem more likely to suffer such a prolonged downturn than others. In Britain, there seems little reason why the top end of the London property market should not drop by 50%, or even 75% -- the latter would be an overshoot, given London's attractions as a commercial and financial center, but only a modest one. Needless to say, any such drop would take place only over a decade or so, and would be accompanied by enormous pain in the home mortgage market and indeed in the lives of London homeowners, who would have sunk their entire future into an overpriced and declining asset.
A movement of similar depth seems likely in the United States only in the most speculative areas. One could imagine, for example, Manhattan and the fashionable San Francisco suburbs suffering such a downturn, as the financial services sector suffered its inevitable lengthy cutbacks (and leftist Manhattan mayors pushed up real estate taxes inexorably) and the technological leading edge moved from tech to biotech, which is much less concentrated in the San Francisco area. However, it seems unlikely that Washington, for example, will suffer more than a moderate downturn, as the growth of government and its accompanying miasma of corrupt lobbyists, lawyers and contractors is more or less everlasting.
Nevertheless, a national price decline of 30-35% seems easily possible, taking the house price to earnings ratio below 3.2 times to a bottom in the 2.5 times range. At that point, unlike in the more crowded Japan and Britain, the availability of attractively priced real estate in outer suburbs and the heartland, where prices had remained much more affordable, will bring new buyers into the market. These new buyers will be easily able to fulfill the prevailing tighter mortgage standards and will see home ownership as a financially attractive alternative to renting, whatever the behavior of house prices.
Overshooting need not be confined to the real estate market. It already seems to be happening in some bond markets, as prices of apparently solid housing related assets decline to 25% or less of their principal amount. Now we are seeing a broadening of spreads in the emerging market bond market. Unlike emerging market stock markets which include the world's most exciting growth stories, emerging market bond markets contain primarily credits to whom a sensible person would not lend. Over two thirds of the Morgan Stanley Emerging Market Bond Index is devoted to Latin America or Russia, all highly doubtful credits with bad political management, with the exceptions of Brazil (still over-borrowed and vulnerable to a commodities downturn, but with competent economic management) and Colombia (highly competent management, but continued political risk from both the FARC guerillas and the elections due in 2010.)
Even removing Brazil and Colombia, almost half the EMBI bond index is of poor quality; hence it is reasonable that spreads are finally widening. It is also reasonable to expect a cascade effect on credit quality, as the wider spreads begin to restrict loan availability and the restricted availability of new money begins to cause economic difficulties among borrowers. In the end, it is likely that the market will again overshoot, as it did in the early 1980s, so that even well run countries like Brazil and Colombia, or adequately run non-Latin countries like Turkey and Indonesia, will be forced into default simply by the absence of new bond market financing. In 1982, Mexico was poorly run and deserved to default but Brazil was quite well run, and could have survived default had the bond market remained open.
Needless to say, the world's stock markets will not be exempt from the overshoot phenomenon. So far, only a few emerging markets, notably China, have experienced any significant downturn. In the West, stock prices are generally still well above those prevailing in 2006, considered at the time a boom year. However, when the decline does finally come, it will be severe. Inflating the early 1995 Dow Jones Industrial Index level of around 4,000 by the increase in nominal GDP since then gives a value of 7,800 today, which may be considered the stock market equivalent of the 3.2 times house price to earnings ratio that is considered equilibrium in the housing market.
Needless to say, even a drop to 7,800 would cause consternation and hand-wringing among Wall Street and investors generally. It should be noted however that 7,800 is the equilibrium level for stocks, not a prediction for the bottom, which must of necessity be much lower, as price declines reinforce negative investor psychology and pessimism. 5,000, or even 4,000 would seem reasonable predictions for the Dow's low. Given the economic changes involved, the market may well take close to a decade to get there. After all Japan, subject to a similar bubble in 1990, took 13 years to reach its low on the Nikkei, which at 7,603 in April 2003 was 81% below its December 1989 high of 38,916. The 13 years and 4 months of the Japanese downturn would, measured from the true peak in market psychology of March 2000, take us to July 2013.
The overshoot phenomenon means we are not yet halfway through the current downturn, even in housing. It is most unlikely that deflation of the 1995-2007 asset price bubble will be accomplished in less than 5 years, since its deflation will be fought every inch of the way by politicians and Wall Street. Maybe we should start buying in summer 2012, but 2013 would be safer.
LET’S GET REAL ABOUT REAL ESTATE
Peter Schiff notes that those calling for a bottom in real estate are (a) engaging in wishful thinking, and (b) ignoring the fundamentals. Once automatic gains can no longer be assumed from buying a house, the buyer has to compare mortgage payments plus taxes owed plus maintenance costs plus foregone returns on the down payment to the value they get from ownership, or to the cost of renting an equivalent house.
While slightly disjointed, the essential point appears to by that by Schiff's rough and ready calculation the average house went for twice what it would have gone for absent the embedded capital gains assumption. So on that point alone houses needed to fall 50% to re-equilibrate. In addition, putting our own spin on Schiff's commentary, the adjustment process involved in getting back to a rational purchasing and lending market may involve more pain than is implied by that number alone. Bottom line: The real estate bottom is not just around the corner.
Once again, real estate market watchers have pounced on a shred of seemingly positive news to proclaim that the long sought "bottom" is in sight. The routine is becoming extremely stale, but somehow the media never seems to tire of it. This time the "good" news was that the percentage declines in national home prices (according to Case-Shiller) in July were not as large as they were in June. Although the report contained many other negative data points, including increased inventories and a spike in foreclosure sales, it was the slowing declines that got spotlight. Talk about grasping at straws. The truth is that real estate has been grossly overvalued for years, and the adjustment process back to realistic pricing has only just begun. The problem is few among us seem to appreciate the magnitude of this adjustment and its implication for an economy dependent on inflated assets values.
By most accounts, the decade long housing boom began in 1996 and finally went poof in mid-2006. In January 1996, the Case-Shiller 10 city composite home price index stood at 76. By June 2006 it had tripled to 226, by far the largest increase in U.S. history. Since then, the index has pulled back by 20% to 180. For those who believed that home prices could never retreat nationally, this 20% correction is more than enough. In reality, it is just the down payment.
When real estate prices were expected to rise in perpetuity, the price of a house had two components, one representing shelter and the other investment. The shelter component was the actual utility and desirability of the house and the investment component was the expected future appreciation. My guess is that at the peak of the real estate mania, a $500,000 house might have been comprised of $250,000 for the shelter component and $250,000 for the investment component.
In effect, the appreciation potential, and the ability of the homeowner to tap into it though refinancing and home equity loans, offset the real costs of home ownership, such as mortgage payments, taxes, insurance, and maintenance. So the main reason a buyer would commit to a mortgage that would soak up 50% of his disposable income was that he expected to recover most of that outlay through future appreciation. Absent the expectation of that windfall, buyers would not have been willing to pay such staggering prices for houses or commit to burdensome mortgage payments.
This is your basic bubble ingrediet, when the assumption of capital gains gets embedded in an asset's price. We recall seeing something to the effect, long long ago, that the difference between speculation and investment was that the former depended on capital gains to get the anticipated return while the later only depended on income. Applies here.
Lenders were caught in the same delusion. Since they too believed prices could only rise, lending standards were thrown out the window. If the collateral (the house) were to always rise in value, what difference would it make if the buyer made the payments? In effect, instead of relying on the borrower's ability to pay to mitigate its risk, lenders merely relied on the house's ability to appreciate.
However, now that real estate prices are falling, lenders are beginning to rely solely on the borrower's ability to pay. As this trend continues, lending standards will tighten and mortgages will be brought back into line with the incomes of borrowers. In addition, down payments will be larger to reflect the greater likelihood of losses should loans end up in foreclosure. When prices were rising the foreclosure risk was negligible. However, now that foreclosures are soaring and recovery rates are less than 50 cents on the dollar, those risks are enormous.
So with falling real estate prices, mortgages are much less appealing to both borrowers and lenders. The only solution is for home prices to fall to where they are cheap enough for buyers to afford the mortgage payments (both interest and principal) without relying on appreciation, teaser rates, or negative amortization, and save enough for a down payment that would protect a lender in the event of default. In addition, the collapse of the mortgage securitization market means houses must be cheap enough for our limited pool of domestic savings to supply the funding, as we will likely lose access to much of the foreign funding that fueled the bubble.
Of course we need to be honest about the winners and losers of this credit crunch. Just because mortgage money becomes scarce and lending standards tighten does not mean people will not be able to buy houses -- it simply means they will pay a lot less for them and that fewer new houses will be built. Therefore it is sellers, builders and those holding or insuring existing mortgages who lose, while buyers win big. That is because despite higher interest rates and larger down payments, they end up borrowing a lot less money. In the end they will become true homeowners rather than indentured servants. If home ownership is truly is the American dream that so many realtors profess, then the ongoing collapse in home prices will be a dream come true.
REITS THAT WORK
For those who feel they need some exposure to real estate -- and it is a huge asset class, so an all-markets index would require some -- Peter Slatin, who writes on real estate for Forbes, recommends looking at apartment and industrial property REITs. As he says, "... in the end people and goods will still need buildings to sit tight in." His reasoning appears to be, well, reasonable.
The commercial real estate world has at last begun to face a fact that should have been obvious long ago: The housing market debacle is not hurting only those involved with single-family homes. Commercial real estate, a lagging indicator of hard times, is now showing the strains of a straining economy, even though stocks in the field continue to outperform the broader indexes. Through August 18 the MSCI U.S. REIT Index, tracking real estate investment trusts, was down 4% this year, while the Dow, Nasdaq and S&P 500 had each lost 10% to 15%.
The relative strength of REITs has seemed to make sense because commercial real estate fundamentals -- supply, occupancy levels and rent growth -- have until very recently appeared stable, even strong. Now, though, the commercial markets are feeling shaky in ways that all seem to trace back to the evaporation of consumer credit. Localities that have been heavily dependent on financial services and the mortgage world, such as Orange County, California and Tampa, Florida, are having an especially hard time. Their rental growth rates have flattened or fallen. Retail malls and strip centers are suffering from tenant bankruptcies as consumers spend less. Hotel owners, coming off of a sweet multiyear growth binge, are carrying too much new supply while occupancy dips. And industrial real estate, predominantly warehouses, depends on a robust economy to maintain the flow of goods.
What about apartment buildings? You would think they would be benefiting from hordes of foreclosed former homeowners seeking rented shelter, but that anticipated influx has not really materialized. Ultimately job creation is what fills apartments and sells homes, and today's sickly employment scene just is not churning out households.
Virtually all of these negative trends are almost sure to deepen, even after the economy turns a corner. It will take time for any recovery to make itself felt in stronger leasing activity. Despite this, apartment REITs, after turning in the worst performance of any REITs in 2007 -- a bad year for the entire group -- have had the best results so far this year, wiping out all of last year's 15% loss.
A handful of strong performers stand out. AvalonBay Communities (98, AVB) and Essex Property Trust (119, ESS) are both profiting from good management and a history of selecting locations that yield both rising rents and occupancy growth. AvalonBay, a savvy developer, is prudently curbing its plans for the next few quarters as financing stays tight. Essex, a West Coast-focused apartment REIT, has consistently turned in excellent year-over-year growth, and I expect it to continue doing so.
Neither of these companies is poised for a breakout -- but that is the point. Their access to steady earnings streams and their defensive stances suggest few surprises on the downside and the prospect of solid continued growth in a turbulent market.
Warehouses have not held up as well as apartments. Industrial REITs have lost 21% as of August 18, on top of a 10% decline in 2007, pushed down by weakness in retail sales. Also, the way these companies tend to grow -- developing and selling new buildings as merchants expand -- spooks investors. Constructing buildings in a rising-cost, deteriorating-price environment is hardly an irresistible business model.
But that is not all they do. They also lease existing space, and they are moving into new markets outside the U.S. The two leading industrial REITs have both been slapped down pretty hard after stints as market darlings but have been expanding their international portfolios and fund- and asset-management businesses. AMB Property Corp. (46, AMB) and ProLogis (45, LPD) both have the same smart management, access to capital and international reach they had when they were in the sun -- and they are a lot cheaper now. With global trade growth sure to continue but to remain highly fragmented, these two companies can resist market instability in any one region and outlast the current poor environment for build-to-sell. They are both yielding better than 4%. Both trade at less than 12 times funds from operations (net income plus depreciation).
Investors have backed away from every kind of real estate in the past 12 months, but the two areas that have seen the least fall-off -- less than not only homes but also hotels, offices and retail -- are apartments and industrial properties. Those hardworking, unsexy places will see some tough times, too, but in the end people and goods will still need buildings to sit tight in.
PLATINUM INVESTORS DOWNSHIFT
Global car industry’s woes hurt the metal.
We are not big followers or fans of platinum. We see it as a precious industrial metal, not a monetary metal such as gold and, to a degree, silver. But this short summary of the state of the market caught our eye.
Platinum is nothing if not volatile. It is interesting how shortages as far as the eye can see can suddenly turn into surpluses. It just takes a slight fall in demand and the failure of "peak platinum" forecasts to materialize, for the present at least. And, oh yes, speculators going from being net buyers to net sellers. That will do it.
The platinum market has been choking on the fumes of speculators racing out of the precious metal as auto demand sputters.
Prices slid as much as 43% after setting a record high in March of $2,299 an ounce in the spot market, a price that will probably stay in the rear-view mirror as supply moves from deficit to balance. In 2007, platinum was facing a net supply deficit of 480,000 troy ounces. And demand was forecast to outstrip production again this year, according to the spring forecast of London-based metals fabricator Johnson Matthey. ...
And the platinum gap could close, as supply stabilizes and demand from auto makers falls; 60% of platinum goes into vehicle-pollution controls. On the year, total consumption is down 3% to 4%, mostly because global car sales have fallen, says JPMorgan analyst Michael Jansen. A surplus could develop if demand slips by 6% to 8%.
Car sales in the U.S. account for about 5% of total global platinum demand, and auto catalysts account for roughly half of consumption in Europe. Demand seems likely to stay soft, given that annualized car sales in the U.S. are down 19% and that European vehicle sales slid 8% in July, with weakness likely to continue.
Meanwhile, output is recovering in the largest producing nation, South Africa, which mined 70% of world platinum in 2007. The energy problems that dented output in 2008's first half have stabilized. Anglo Platinum (ticker: AMS.South Africa), the world's largest producer, said recently that it expects a significant rise in 2nd-half mine output. "There is a realization in the market that the doomsday scenario of a massive decline in South Africa is not going to materialize," says Peter Ryan, a senior consultant at London-based precious-metals consulting firm GFMS.
Even consumers have become sellers in the rush to capitalize on the metal's high price. Jewelry recycling, especially in Japan, helped to replace lost mine production earlier in the year. In 2007, Japanese householders sold some 200,000 ounces of platinum trinkets for cash, and Johnson Matthey Analyst Peter Duncan says the total is expected to be "much higher" this year.
Now investors in the ETF Securities platinum exchange-traded fund are speeding for the exits -- platinum holdings fell 50% last week from July's high to Aug. 26, the lowest level for more than six months.
"The recent disinvestment from [ETFs] is bringing the market closer to balance," says UBS analyst John Reade, who estimates that about 1 million ounces were sold by investors and speculators in the past two months. "Barring a turnabout in the auto sector or renewed supply worries out of South Africa, it is hard to see platinum regaining the giddy heights of early in the year," Reade says. Still, he sees spot platinum at $1,550 an ounce in one month and at $1,700 in three months.
THE RELUCTANT BULLS
U.S. stocks probably will not make much progress before year’s end. But they are a better bet than most, say leading Wall Street strategists.
The concensus that emerges from a polling of 10 Wall Street strategists by Barron's is that we are late into a cyclical bear market in stocks. Stock values are "cheap" at 15 times estimated earnings (for the S&P 500), and with an accommodating Fed we should expect more upside than downside from here. Fair enough, if you believe that "this time things are the same" -- or that it will be business as has been usual over the last 40 years.
The only dissenter from the comfortable concensus is Merrill Lynch, who is alone in expecting operating profits to weaken further in 2009. "The credit crisis is broad, deep and global, and it is not likely to end soon," argues Merrill chief investment strategist Richard Bernstein. Credit Merrill with being willing to go against the crowd.
The $64 question here is how do you take advantage of such advice? Let's say you believe Merrill is correct and there is more pain ahead and you would rather be 100% in cash right now. Then what would it take to make you change your mind and take a net long position in stocks? Increased 2009 operating profits would proove Merrill's thesis was wrong, but by the time those numbers were in the bag the market would probably be way up. Simply looking for stocks that are too cheap to pass up is simpler.
Denial. Anger. Depression. The bull market's passing has already put investors through several of the classic stages of grief. And if top strategists' opinions are any indication, the final stage -- acceptance -- is near.
A discernible chill has crept into Wall Street's autumn outlook, along with a readier acknowledgment of the economic peril ahead. No more premature articulation of a year-end rally. No gushing about stocks' potential. Among the nine strategists or chief investment officers surveyed by Barron's, the average forecast calls for the Standard & Poor's 500 to end the year at 1363, a mere 5% higher than [the August 28] close at 1301. A 10th strategist, Richard Bernstein of Merrill Lynch, has no year-end target but sees the 500-stock benchmark at a very modest 1381 a year later.
How wider credit spreads, bigger loss provisions, rising delinquencies and a stronger dollar will affect S&P 500 profit forecasts is still unclear.
The conservative tack is unusual for this vocationally bullish bunch, who could easily have accentuated the positives -- Hospitable interest rates! An obliging central bank! Dire investor sentiment! -- to call for a rollicking 4th-quarter rebound. But as home prices have continued to slip and credit constricts, strategists, like many investors, have spent the summer nudging down their estimates and postponing their expectation for economic revival.
"The global economy is slowing at a pace faster than the Street expected," says Robert Pavlik. The chief investment officer at Oaktree Asset Management ticks off a list of worries including surging inflation, 463,000 jobs cut this year, unemployment at 5.7%, gas prices 45% higher over the past year, consumer debt increasing by $14.3 billion in June to $2.59 trillion total, and home equity levels (the percentage of owners' equity) at their lowest since World War II.
"My biggest concern is the availability of discretionary spending -- mainly for consumers, but also for corporations," he elaborates. (To give our survey more balance, Barron's has included more seers like Pavlik from the asset-management side of the business this year.)
But if strategists see muted gains over the next four months, almost all see very limited further downside for a stock market that has already fallen 11% in 2008 and 16% from its October 2007 peak.
"With yields on cash and bonds so low, it will not take much for stocks to outperform both over the next 12 months" -- especially if investors regain enough confidence to deploy their cash stashes, says Bill Stone, chief investment strategist at PNC Wealth Management.
Morgan Stanley global-equity strategist Abhijit Chakrabortti is circumspect, but even he cannot see profits falling below $75 a share in 2008 or 2009, and he draws a line in the sand for the S&P 500 at 1150, against the year's low of 1200. "Investing is not just about fundamentals, but fundamentals juxtaposed against expectations," says Citigroup's Tobias Levkovich. "Fundamentals are poor, but who doesn't know that? Valuations are also very, very low."
It helps, rightly or not, that a majority of these strategists see inflation as a receding threat, now that crude oil has fallen more than 20% from its July peak near $147 a barrel. Many expect commodities to continue to deflate, which boosts companies' margins. Eight out of 10 expect the Fed to hold off raising interest rates in 2008. And everyone assumes the bond market will behave, with the yield on 10-year Treasuries hovering near a very benign 3.8% today.
For the first time in 15 years, François Trahan, ISI Group's chief investment strategist, believes "the U.S. is the best stock market to be in."
The U.S. was the first major economy to slow, and the first to aggressively cut borrowing costs in order to goose growth. Now, as Europe and the rest of the world begin to falter while still grappling with restrictive interest rates -- 4.25% in Europe, for example -- the U.S. may become the first to smell a recovery.
Oil is down; wage growth is waning; and the glut of unsold homes should help arrest rent inflation. Weaker inflation "combined with the lagged effects of policy easing should go a long way to reviving domestic economic prospects," Trahan says. He suggests buying "early-cyclical" stocks -- retailers, consumer services, transportation -- that thrive when inflation abates. "Growth may be subpar, and U.S. stocks will not be phenomenal, but they will be the best show in town."
James Paulsen, Wells Capital Management's chief investment strategist, thinks that traders who fret about the transience of the lift from recent tax-rebate checks are missing the bigger picture: the enormous boost from the aggressive interest-rate cuts that began last fall, and which can take up to a year to stimulate the economy. "It'll be very rare if that massive policy accommodation fails," he says.
Besides, any slowing in the decline of the housing or domestic auto industry will feel like a boost to an economy propped up by exports.
And while U.S. inflation hit a 17-year high of 5.6% in July, "core prices" that strip out oil and food costs are growing at just 2.5%. Against that backdrop, stocks are trading at less than 15 times forward earnings -- their cheapest since the early 1990s. "What has collapsed over the past year is not the economy; it is confidence," Paulsen asserts, and he thinks any number of triggers -- a robust jobs report, crude's continued ebb -- could restore faith.
The resolution of U.S. political uncertainty come November also could add some ballast, says Deutsche Bank's Larry Adam. "If McCain wins, gridlock is great, and if Obama wins, change is great." Since 1952, the stock market has rallied between Election Day and New Year's Day each time it sees a new White House occupant, producing an average gain of 3.7% (the exception was during the Gore-Bush gridlock of 2000).
But not everyone is sanguine. Christopher Zook, chief investment officer at Houston-based CAZ Investments, thinks the dreaded combo of stagnant growth and persistent inflation will prove difficult to shake, and expects "stagflation" to further compress margins. "We are in the sixth inning of a nine-inning game, yet the market will try to anticipate the turn," he warns.
Faced with flagging profits, companies will still try to pass on higher costs to customers -- one reason why inflation often flares late in an economic cycle. Chakrabortti thinks S&P 500 earnings estimates can come under pressure on multiple fronts. Slowing global growth lessens the demand for U.S. goods and services. Widening credit spreads, intensifying loss provisions and rising delinquencies can drive financials' estimates lower. Falling oil prices shake the pillar that is energy companies' profits. And the nascent dollar rally takes a bite out of the foreign earnings of U.S. conglomerates.
Still, Chakrabortti thinks the U.S. will outperform its overseas peers, thanks to the Fed's quick start. "Unlike 2000, the stock market is cheaper now," he says. "So you only have to absorb the earnings downturn and the increased risk premium -- but not the big valuation whack."
What is the catch? Everyone agrees a recovering housing market will repair confidence and spur spending, but the consensus doesn't see that happening before 2009. PNC's Stone, for one, expects little or no growth in the first half of 2009, with unemployment peaking in the second quarter. "But we know the economy will eventually recover," likely by the second half, he says. "And the market will look ahead and anticipate that."
Recent data offer a glint of hope. Home prices fell in June at an annual pace of 10%, far better than the 25% slide in February. Nine out of 20 cities even saw prices improve. But the glut of inventory will take 11 months to work off, and mortgage rates are not low enough to speed the rehabilitation.
Not surprisingly, the strategists predicate their market calls on a set of caveats: Inflation cannot be sticky, the credit crunch must neither widen nor deepen, and housing had better not take another turn for the worse.
"I think the market under appreciates the continued pressure on consumers, and the time it will take to repair consumer credit problems," says Goldman Sachs's investment strategist David Kostin. The firm's economists, for example, predict zero GDP growth for both Q4 and Q1 2009.
Merrill Lynch, meanwhile, is the only firm surveyed that expects operating profits to weaken further in 2009. Among other things, the firm argues that investors are underestimating the scope and extent of the credit bubble and the consequences of its pricking. "The credit crisis is broad, deep and global, and it is not likely to end soon," notes chief investment strategist Richard Bernstein. "Credit is the lubricant that keeps the global economy's engine working; as the markets tighten and restrict the flow of capital, the global economy slows."
So how should we position our portfolios in these treacherous times? The health-care sector's dependable earnings and secure yield hold obvious appeal. But favored by seven out of 10 strategists, it carries the ripe pong of a crowded trade. (Yet to be fair, different strategists emphasize different subsegments, from biotech to pharmacy-benefit managers.)
Technology also has won over seven of the 10 strategists: It has become the Meryl Streep of sectors, an all-purpose chameleon that can represent all things to all people: growth, stability (in the case of big tech companies), international clout, and distance from the credit rot. "If you have a slowing economy, one way to maintain output and improve productivity is to lean on technology," says Deutsche's Adam, who expects tech stocks to benefit from business-spending incentives in Congress' $170 billion fiscal-stimulus package.
Curiously, the most hotly debated sector earlier this year, financials, now provokes a tepid response -- only two favor the sector, and four suggest avoiding it -- with many strategists steering clear of the group, which has seen stock prices cut in half. "The valuation correction has occurred, but the business fundamentals have not improved," says CAZ's Zook, who thinks foreclosures and defaults will not bottom until well into 2009. "The ability of financial companies to earn a profit and add value is dramatically affected and is getting worse."
Instead, the crowd is most divided by the formerly-hot energy sector (three for, five against), and by consumer discretionary stocks (also three for, six against).
Goldman's commodity team, for example, sees crude oil returning to $149 a barrel by year's end and, thanks to constrained supply and tight refining capacity, expects positive earnings revisions this year and next. But Citi's Levkovich thinks low price-to-earnings multiples in the energy and materials sectors are a sign that cyclical earnings may have peaked -- and not of low-priced value. "As global growth weakens, good value can just become better value." That problem has caused investors no end of grief this year.
COMPARING BUBBLES: WILL HISTORY REPEAT ITSELF?
This piece from financial "infotainment" site Minyanville compares price charts from various markets going back 20 years, all of which demonstrate classic parabolic price spikes followed by collapses -- except for oil, which has fallen from its recent peak but cannot be said to have collapsed ... yet, anyway. Presumably we shall see soon enough whether oil follows the other markets.
On a related but different note, the author notes some worrying but more tenuous similarities between recent stock market action and patterns that preceeded precipitous declines in 1987 and 2001. Certainly food for thought for those who are thinking of selling but trying to be cute about it.
You know what they say: The more things change, the more they stay the same.
I like to point out "bubble comparison charts" a lot because, in my opinion, they show that human beings are an emotional bunch. I like to call the parabolic moves upwards in stocks and indices, "1-800-GET-ME-IN."
Whether it is tulip bulbs in the 1700s or the NASDAQ in the late 1990s, the ugly emotion of greed sets in once a really big move in the price of a security gets going. This always strikes me as odd because when I think about people buying truly important assets like a car or a house, they are always looking for a "deal," but when it comes to the market, for many there is just something about missing out on the big move.
Below I have updated a few of my bubble comparison charts from the past to drive home the point that, in my opinion, greed, followed by fear, is alive and well on Wall Street and, in fact, most corners of the world.
Of Coils and Crashes
- Bubble Comparison 1 -- Japan/NASDAQ/Homebuilders/China
- Bubble Comparison 2 -- NASDAQ/Potash (POT)
- Bubble Comparison 3 -- NASDAQ/Homebuilders/Inflation Adjusted Oil
In my opinion, the market has been consolidating, or "coiling," for the past month or so. Usually, the longer the consolidation, particularly when it occurs underneath resistance, the more "energy" is stored up in the coil. So I decided to go back and take a look at previous periods of consolidation that lasted this long and what the aftermath was. The examples I found were 1987 and 2001, neither of which had a particularly happy ending. [Compare with current.] See the charts below. Please note that I am not "calling" for a crash, just pointing out some obvious similarities.
As Mark Twain said, "History does not repeat itself, but it does rhyme." The coil/consolidation is built. We just have to wait and see if we get the similar flush.
The credit markets and fundamentals argue for it, but predicting crashes is a tough business. But I will say this. Risks are high ... in my opinion, very high.
RETURN OF THE SUPER DOLLAR!
The Super Dollar’s big bounce is either a fake-out, or the start of a genuine deflationary slump ...
The sub-headline encapsulates what might be the most important debate of the day. The total quantity, loosely speaking, of money and credit outstanding is a multiple of what could be called the monetary base, the most important constituent of which is bank reserves. During a credit deflation, such as is happening today, this multiplier goes down. Madly attempting to fend off the consequences of this, the Federal Reserve is doing everything in its power to expand the monetary base, by allowing commericial and investment banks to trade junk that is not part of the base for assets that are. What one thinks is going to be the outcome of these two countervailing forces determines what side of the inflation/deflation bet you take.
The recent strong U.S. dollar rally -- "the strongest turnaround versus its peers in well over 17 years" -- is consistent with deflationary forces being on the ascent. It could also just be that so many leveraged bets were made on a continuing weaker dollar that a small correction against that trend has snowballed into a huge margin debt unwind. Adrian Ash does not discount either possibility, but is sufficiently suspicious of the whole monetary system that he is choosing to continue to buy gold -- which is certainly cheaper at $800 an ounce than $1000.
"The market is super-bullish of the Dollar right now," notes Steven Barrow, currency analyst at Standard Bank in London. The question is, why on earth why?
Our take here at BullionVault is that the markets, as always, are doing whatever it takes to screw the most people the most. Given how crowded the oil-and-Euro trade had become in spring 2008 -- and given how badly the United States needs a weak dollar to start filling the chasm between imports and exports -- most people wielding power and/or leverage were betting the greenback would keep sinking.
Hence the bounce in the dollar ... just to spite logic, history and everyone else. It has sparked the strongest turnaround versus its peers in well over 17 years.
Hence the collapse in commodity and U.S. share prices, too. A flood of money back into ... well, back into money ... is undoing the Fed's latest reflation play. What the next move from Ben Bernanke will be depends on whether the slump in raw imput prices spooks him into spying deflation ahead. You know, the "it" he has sworn to make sure will not happen again.
Back on the currency desks, meantime, the new Super Dollar stands "ready to jump on any slide in oil prices," Barrow avers. "But more importantly, while U.S. employment might be falling, productivity is rising fast."
The latest data proves it. Productivity at non-agricultural U.S. businesses -- the value of what came out for every dollar of labor going in -- leapt during the April-to-June period. On the Labor Deptartment's second estimate, in fact, it rose twice-as-fast as first thought ... rising by 4.3% annually. Economists were expecting a 3.3% improvement, says a survey from Thomson Reuters IFR Markets.
"This means that GDP is not suffering as much as some other countries," Barrow goes on -- countries "like the Eurozone and Japan, where productivity growth is much lower."
Hence the fresh surge in the dollar against its currency cousins, or so everything thinks, even as manufacturing activity remains stuck on hold and U.S. unemployment rises still faster. This week's Productivity Report added to the strongest bounce in the U.S. currency since March 1991.
On a weekly basis, its trade-weighted exchange rate just put in the fastest gain in three decades, slaying foreign currencies, commodities, gold and even U.S. equity prices.
Only U.S. Treasury bonds are keeping pace with the dollar, achieving a gain of their own -- and therefore pushing bond yields lower -- as the almighty dollar destroys all other comers.
That only confirms our suspicion here at BullionVault that the new Super Dollar lacks a certain something. Namely, it lacks strong interest rates.
The phrase "Super Dollar" was coined to describe the U.S. currency's 50% surge of 1980-1985 ... a surge that came alongside a bull market in U.S. equities, bonds and real estate.
You will note from our chart ... how it came after the highest-ever U.S. interest rates. Every other significant turn in the dollar's trade-weighted value likewise followed a turn in U.S. interest-rate policy as well.
This is hardly surprising. Strong rates-of-return tend to push an asset's price higher. If that rate-of-return consistently outstrips inflation -- and by a wide margin, too -- then its real value will continue to rise. Quite literally, in the case of money, the price bid tomorrow is determined by the price that is offered today.
Right now, however, the Bernanke Fed is bent on keeping U.S. rates more than 3.5% below the pace of consumer-price inflation. History and logic dictate, therefore, that this new Super Dollar lacks the one heroic power needed to continue leaping tall buildings. The power to hold more value tomorrow than it holds today.
Whether this burst of "screw you!" from Mr.Market proves to be just a blip ... or it turns into a genuine deflation, with T-bonds and cash the only assets bid higher as the jobless soars and U.S. exports collapse ... we will continue to buy gold.
It does not promise a pay-off, or even try to keep pace with inflation via coupons or dividends. Yet it rose eight times over in the last three years of the 1970s. It doubled its purchasing power during the Great Depression as well.
There is trouble with money. Taking shelter in what preceded the "almighty dollar" might just get you through.
DOWN THE RABBIT HOLE
Reported real GDP is equal to nominal GDP, which can be measured, deflated by an GDP inflation index, which is a constructed statistic subject to theoretical and measurement problems no matter how you decide to fabricate it. Many government entitlement programs are indexed to the CPI, so government's incentive is to construct it such that low numbers result ... artificially and blatently low numbers according to many. The GDP deflator is a different inflation index than the CPI but, similarly, the incentive is for government to keep it looking as low as possible. Everyone knows inflation is bad and the lower it looks the better people will feel about those in power. Also, as noted, with real GDP growth equal to nominal GDP growth minus inflation, low inflation numbers enhances the capacity to announce soothing, face-saving growth statistics.
Notwithstanding that the CPI and GDP deflators are different measurements of inflation, it does not make sense that they should diverge widely more than temporarily. But the Q2 2008 government report states that the GDP deflator increase is running at a 10-year low while the rate of CPI inflation is at a 17-year high. Government statistical blarney? Peter Schiff thinks so.
A Mike Shedlock piece suggests an alternative explanation: The CPI number is artificially high because of the way housing prices are incorporated. If they were treated properly, Shedlock thinks the CPI increase would only be 1.3% rather than 5.6%. End of apparent contradiction. Of course this means CPI numbers reported through 2006 or so were artificially low ... but that was yesterday.
We are not disputing Schiff's contention here. We are using this example to point out that when you think you are right and the market is wrong -- especially when making short-term calls on big picture, macro, issues -- that perhaps you should take a closer look. We are aligned with Schiff's long-term view: The U.S. dollar is dead meat and the U.S. is in economic decline versus the rest of the world. But, as wise heads have said, just because something is inevitable does not mean that it is imminent. Trying to squeeze a square-peg long-term perspective into a round-hole short-term scenario is not usually a wise idea, in our experience. You end up losing money even when you are right.
In recent months, investors have been unjustly chastised for their lack of consistency. In truth, they have an unblemished record of drawing the wrong conclusions. Last week's 2nd quarter GDP report provides the freshest evidence of market cluelessness.
In its report, the Commerce Department stunned economy watchers by showing a 3.3% annualized increase in Q2 GDP. The robust growth apparently wrong-footed those expecting further recessionary signals, lent further strength to the current dollar rally, and encouraged previously cautious investors to take another look at U.S. stocks. The strong number also bolstered claims by the Bush administration and the McCain campaign that a recession is primarily a psychological phenomenon. These conclusions would be at least quasi-logical if they were not based on a complete misreading of the report.
Without raising an eyebrow on Wall Street or in the press, the GDP deflator, used in the report to downwardly adjust GDP to account for inflation, was shown at just 1.2% annualized ... the lowest deflator in 10 years. In other words, to arrive at a 3.3% growth rate, the government assumed that inflation is running at a 10-year low! In contrast, the latest reading on consumer prices (CPI) in the second quarter shows year-on-year inflation running at a 5.6% rate, a 17-year high! In fact, for the second quarter, the same time period measured by the GDP deflator, prices actually rose at an even faster pace of 8.0% annualized. How can it be that inflation is simultaneously running at a 17-year high and a 10-year low? Welcome to the Alice in Wonderland world of government statistics.
You would think that this statistical bombshell would raise the hackles of the press. Think again. Not only did the hawk-eyed media completely miss the story last week, they have totally ignored our subsequent attempts to show them the light (with the exception of the N.Y. Post's John Crudele -- who has long suspected a ruse). Although none of the reporters we spoke with could explain why inflation could run at a 10-year low and a 17-year high at the same time, they did not deem the anomaly sufficiently noteworthy. Having been ignored by reporters, I then tried the opinion pages. Unfortunately the piece that we prepared on the subject was rejected this week by all the leading national newspapers.
Reporter Michael Mandel did note the head scratcher on a Businessweek blog posting last Friday. As a partial explanation he pointed out the CPI measures the prices of what we buy, and the GDP deflator measures the prices of what we make. Although this certainly sheds some light, it offers no real explanation. Excluding imports and exports, both measures are determined by the same forces, and should move in relative harmony. If anything, the costs of what we make should be outpacing the costs of what we buy. Producer prices are now rising faster than consumer prices (the latest annual reading of the Producer Price Index "PPI" being 13.2% annualized from the 2nd quarter), which helps explain why corporate profits have fallen drastically. In addition, from July 2007 through July 2008 (the latest data available) import and export prices have risen 21.6% and 10.2% respectively. In other words, no matter what numbers you use, the 1.2% GDP deflator simply does not add up.
I have often argued that government statics are dubious, particularly those related to inflation. But here is an example where they are not even consistent! If we simply use Q2 CPI to adjust nominal second quarter GDP for inflation, the number would have registered a 3.5% annualized decline.
Such horrific GDP numbers are much more consistent with the anecdotal recession evidence that Wall Street and Washington want us to ignore (confirmed by today's weak jobs report which included the unemployment rate spiking to 6.1%, a 5-year high). However, with Orwellian propaganda, our government fabricates GDP growth out of thin air without the smoke and mirrors traditionally required for such an elaborate illusion. All that is required is to put out ludicrous statistics and hope no one notices. Given that this strategy appears to be working, expect future government numbers to get even more outrageous. After all, if they can get away with this, they can likely get away with anything.
Investors relying on this data and reacting to the global economic slowdown by buying dollars and other U.S. based assets while selling gold, commodities, and foreign assets, are jumping out of the frying pan right into the fire. My guess is that it will not be much longer before they feel the heat.
For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.
For brave and patient investors, there are bargains in the struggling European market.
Barron's interviews Bertie Thomson, an investment manager for London's Aberdeen Asset Management. Using a bottom-up investment process "that is anchored in two chief precepts: quality and value," he finds plenty of interesting ideas out there. Aberdeen's heaviest portfolio weighting is in financials -- over 36%. He is skeptical about the longevity of the "commodity bubble," and thus views some mining stocks as overvalued.
In another interview with an international equities fund manager, Barron's finds Harding Loevner's Simon Hallett bloodied but unbowed by the underperformance of international stocks vs. their U.S. counterparts this year. Hallett has been preparing for the current tought times by "putting money into companies that he expects will maintain profit margins despite the pressures of inflation, high commodity and energy prices and sluggish consumer spending."
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