This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, June 30, 2010

Double –Dippers Reject Reality

Despite the market’s recent behavior, it is our growing opinion that the chances of a double-dip are extremely low, and continuing to fall. This idea, as overly-optimistic as it may sound, is not without evidence. Just last week an article appeared in the Wall Street Journal stating that many corporations are beginning to spend money on capital investments (Lahart and Maher, Seeing Economic Rebound, Firms Step Up Spending).

However, this recent spending has – for the most part – not been financed by debt, but paid for in cash that companies have been hoarding since the 2008 financial crisis. In addition to investments in production, there has also been a small wave of corporate acquisitions as of late, serving as further evidence of confidence among business leaders.

Despite this recent increase in the flow of money around the US economy, broad money supply numbers have continued to slip at an alarming rate. We consider this to be mostly a flash in the pan, mostly because a great deal of this so-called ‘deflation’ is due to default rather than traditional deleveraging.

Our anticipation is that once company’s gain additional confidence that they can benefit from investing in production and expansion, the corporate appetite for debt (and risk) will likely increase. Once that happens, money will begin flowing through our economy at a quickening pace, and deflation will cease to be a concern.

In fact, quite the contrary may occur. Given the amount of new money that has been created through government stimulus programs, there is a very real possibility that inflation may become a problem, once that new money starts making its way through the economy.

Examining at the market, it is apparent that investors have become extremely negative extremely quickly in last few weeks. In fact, last week we saw multiple 90% down days, during which more than 90% of all trading volume was down (for every 100 shares of stock traded, more than 90 were at a lower price than the previous trade). Unfortunately this is hardly unusual; it’s typical of the investing public to overreact. In reality, the market is more likely close to a relative bottom rather than a top.

Stepping back to look at the market over a long-term, we can see that stocks remain trading within a range it entered in October of 2008 during the collapse. Those long-time readers may recall that this is precisely what we called for at the time.

In fact, during the fall of ’08 we said that after their precipitous decline stocks would recover, and that once they peaked they would like stay within a trading range for an extended period of time. At the time we equated this to the period from about 1975 until roughly 1982, during which time a similar trading range existed. However, we do not expect the current trading range to exist for that long.

Our anticipation is partly due to the fact that we’re now coming down to crunch time in the political world. It is our clear expectation that political profligates in Washington will likely lean on the Treasury and Fed to boost conditions of the US economy and financial market coming into election season.

After all, in mere months these grandstanders will need to be able to go back to their constituents and claim that all is well. At that time they need things to at least appear to have resumed some state of normalcy, at least in the eyes of the American public.

The last few years have been extremely volatile in the markets, and the situation today is hardly different. We live in a world of constant flux. Unfortunately, there is little that investors can do except get used to it. The fact is that there is now, always has been, and always will be a lot of uncertainty in the markets.

When it comes to the markets, there’s no such thing as a free lunch; no golden key that will unlock the secrets of the world. That’s why we spend countless hours of each and every day, week after passing week studying the markets and keeping up with its most minute developments. Hard work and perseverance are the only way to survive the maze of global markets.

Wednesday, June 23, 2010

Re-Emerging Markets Paint Pattern

For the last several decades, emerging markets have been the fad for business and investing. During that time, little was heard of US industry, which sat mostly on the back burner, away from the limelight. All we heard about was the new global economy and the world’s increasing flatness. American businesses began outsourcing production, then back-office administration, and even some engineering capabilities (typically considered our advantage over other, less-developed countries).

Now, after years of increasing momentum, attention, and investment, the emerging markets wave is finally coming dying down. Why? Quite simply, the world has changed. For example, while China was the long-time leader in cheap manufacturing, it recently lost that title to India and Mexico, according to a May, 2009 article from Industry Week (China Loses Low-Cost Manufacturing to India, Mexico, Agence France-Presse).

In fact, that same article cites a study from AlixPartners which revealed that, at the time, the cost of manufacturing a car in a Chinese plant was just 6% lower than its American counterpart. Moreover, recent stories abound of companies finding out the hard way that there are still difficulties in sending business overseas, and not just from a logistics standpoint.

Almost a year ago we observed that companies like Farouk Systems had to incur significant expenses month after month in their ongoing battle to prevent knock-off versions of their own products being produced in China right alongside their legitimate goods (Recovery in the Making, Danger Still Abounds). The same article reference Carlisle Wheel and Tire as one of many companies that have had major problems controlling the quality of offshore production.

What all this indicates is that the long-time trend of outsourcing is, as we’ve written before, most likely coming to an end. In fact, the flow of production may be getting ready to reverse course and actually start flowing back into the United States. This would be admittedly a very subtle, long-term trend that may not garner any significant attention for years.

The real underlying principle here is that everything in the world of business, economics, politics, et al, and hence, everything that has implications in the investment world, cycles. Some cycles are certainly longer than others. One example of a shorter term pattern comes from the old saying popular among traders, “Sell in May and go away,” which refers to the stock market’s natural tendency to slow down over the summer (which is very apparent at present) and for trading to traditionally pick back up again in the fall.

Just as market activity and trading volume cycle, so too do economics, including everything from inflation and interest rates to government spending and consumer confidence. All these things cycle, albeit with varying lengths, severities, and implications.

This idea that everything cycles is, consequently, one of our key arguments for why investors need to take an active approach to portfolio management. For those who want to do it themselves, this means the commitment of sufficient time to the study the economies and markets so that they are perpetually updating their holdings based on a changing economic environment.

For those who do not wish to dedicate the time, energy, and focus to this continual (and sometimes mundane) task, the consequence is that they need to look for (and hopefully find) an asset manager who is willing to do this work for them.

While such services certainly aren’t free, they are an absolute necessity for investors unwilling to do the legwork themselves. I’m sorry to say, but investing is no easy task. American’s access to financial markets and instruments make our country one of the greatest one the world. It’s important to understand that this does not in any way entitle us to a free lunch.

Wednesday, June 16, 2010

First Real Estate, Next Bonds: The 1-2 Punch

Risk is one of the most ambiguous terms existing in the financial world. Though its commonly accepted definition almost always includes complex mathematics, it has recently been acquiring increasing subjective meanings.

For example, the ‘risk’ inherent in bonds is, in theory, reflected the bond’s yield. If an investor adds up the separate forms of risk found in a given bond, including those risks associated with liquidity, default, reinvestment, inflation, they will supposedly arrive at the bond’s yield to maturity.

However, it is becoming increasingly apparent that investors in fixed-income securities, both corporate and government-issued, have become increasingly lax in considering various forms of associated risks. This failure to recognize risk is nearly identical to what occurred toward the end of the real estate bubble, when investors failed to recognize the possibility of property values declining, mortgages defaulting, etc.

Surveying the market today, there are countless bond issues whose prices hardly justify their investors’ risk exposure. This has led us to the leading us to the ironic conclusion that bonds, typically thought to be among the safest investments, are in fact among the most dangerous to be found in today’s market.

Consider first the risk of default that remains for bonds from both the private and public sectors. Despite the recovery in share prices that has taken place since the stock market bottomed last year, companies are hardly out of the woods. As discussed in previous articles, the economic recovery hardly justifies current high prices, nor do they reflect the difficulties still facing corporations, both in U.S. and abroad.

These difficulties include uncertainty regarding government regulation, credit that has remained tight since the financial crisis, and big businesses encounters continual criticism in the court of public opinion.

The default risk associated with bonds issued by many municipalities and sovereign nations has certainly been increasing as governments have struggled to service mounting debts. This is especially dangerous, as government bonds are typically considered the safest of the safe investments.

However, even if issuers don’t default, fixed income securities still pose a serious threat to investors’ portfolios.

As we have written several times before, interest rates are currently at generational lows. In fact, in an effort to spur the flow of money around the economy, the Bank Prime Loan rate has been pushed down to at levels not seen in more than half a century.

At one point in 2008, the market saw investors buying short term Treasury securities with NEGATIVE interest rates. These poor souls were essentially using Treasury debt like safety deposit boxes, but for larger sums. They were willing to buy these securities KNOWING that they would lose money, and were happy to control their losses.

With interest rates so low, any rational investor should be asking themselves how much lower can they possibly go. Bond yields can only fall so far before demand simply dries up. The dangerous part of this equation is what happens after interest rates bottom.

When interest rates start back up – and they WILL start back up at some point – investors who buy bonds at such low interest rates will see their principle deteriorate extremely quickly. Bondholders who sell before maturity, but after interest rates have risen, will be forced to sell at a severe discount. Those who don’t sell, but hold to maturity, will be paid the full face value of their bonds, which is nice.

However, they will likely experience a tremendous loss of purchasing power, as a result of inflation that occurs between now and then. Moreover, these investors face substantial reinvestment risk, as they will be earning a below-market return for an extended period, as they wait for their bonds to mature.

Inflation, though a near-certain problem in the economy down the road, is unlikely to be nearly as bad as Glen Beck would have you believe. Many doomsday theorists point to the recent appalling expansion of the US monetary base as a signed death sentence by inflation. However, there is a way for governments around the world to avoid the hyperinflation that many consider inescapable.

Let’s revisit, for a moment, the risk bonds pose to investors’ principle, should interest rates rise. This aspect of bonds, though typically confined to a day or two of lectures in university finances classes, may deserve a place in political science curriculum in the near future. It is our contention that, through a form of defeasance, the government can successfully refinance a large portion of its debt after interest rates rise, thereby eliminating a significant portion of the national (Treasury) debt outstanding – by shifting the cost to bond investors in the form of mounting losses.

We all know that the government expanded the US monetary base (and in grotesque fashion) after the financial crisis began tearing through the economy. However, interest rates were already low when the government issued substantial amounts of new debt to fund new emergency facilities. Looking at a Monthly Statement of the Public Debt of the United States from the end of May, we can see that the vast majority of outstanding debt has a yield under 5% (United States Treasury).

Now, when the Federal Reserve under Jimmy Carter (and to a lesser extent Ronald Reagan) increased the US monetary base by 30%, the prime rate wound up peaking at over 20% when Paul Volker finally killed inflation (St. Louis Fed). This time around, the monetary base more than doubled. However, if prime rate ends up at just 15% (a conservative estimate, in our opinion), a good deal of Treasury debt issued at low interest rates could lose 66% of its face value.

The boys in Washington, after years of trial and error, seem to have finally perfected a system of paying for massive public debts, without ever sending the American people an invoice. Without raising taxes or tariffs, the government has been able to get the American people to pay for its absurd spending through losses and inflation.

In light of these revelations, and in view of recent controversy surrounding the secrecy of the Federal Reserve, it’s important for investors to remember that old quote from Mayer Amschel Rothschild, which we have used before and will certainly use again: “Give me control of a nation’s money and I care not who makes the laws.”

Wednesday, June 9, 2010

The Birth of a New Bull Market

After my articles the last few weeks, many out there probably think of me as pretty bearish on stocks. However, friends, I’d like to clarify that point. In the short term, it is still my view that the market has some tough times ahead. However, taking a longer term perspective, I don’t think it’s possible to be more bullish. In fact, in our humble opinion, we are about the witness the birth of a bull market from the ashes of a bear!

To clarify further, I am not saying that the tough times are over and investors need to rush out and buy stocks. While the market has corrected, as anticipated, we are not of the belief that the correction is over, or that the market is now fairly priced. We do, however, have a very different opinion on where the stock market is currently in its life cycle.

Many today argue that after the market’s peak in 2007 and subsequent decline, investors have another eight to twelve years of bear market to look forward to before the correction is over. Our view is substantially more optimistic.

Looking at stocks over the past fifteen years, one will notice that neither the Dow Jones Industrial, nor the S&P 500 (a much better sample) have gone anywhere in more than a decade, since 1998. In fact, an investor who bought either of these indices at that time would actually have losses – significant losses – in real terms (when inflation is considered).

This brings us to the startling realization that stocks have not been in a bear market since 2007, as many would believe, but since 1998. In other words, we are likely much, much closer to the end of this bear market than most believe.

Though we frequently cite his administration for political comparison, the current state of financial markets is not unlike the 1970s under Jimmy Carter. The market actually made a peak in 1966 under Nixon, and despite making a marginal high under Ford around ’73, the market didn’t really go anywhere until 1982, right after Carter left office.

What this amounted to was essentially a lost decade for stocks, much like the one we have just emerged from. In 2000 the stocks set new highs, after which the market basically trended sideways until setting a new all-time high, though marginally, in 2007.

Our contention is that, thanks in part to changes in technology that permit information to be disseminated more quickly, the market has accomplished in ten years what previously took fourteen: The market has undergone a prolonged and substantial correction in stock prices, in real terms, and is now poised to resume the trend of a long-term bull.

For our outlook we look once again to the past: After the bull market closed with the Carter years, Reagan took office and oversaw drastic policy changes that ushered in a new era of prosperity for companies and escalating stock prices that last for approximately twenty years.

The same shift is, in our opinion, developing in the market, and will likely take place at the end of Obama’s first (and probably only) term. Lately the economy has begun showing signs of life, from housing inventory dropping to manufacturing beginning to shift to the US, to the financial crisis abating.

Please don’t misunderstand, investors can’t simply throw caution to the wind and begin buying indiscriminately. There is still a possibility that we are in store for a slight double dip, although more so in stock prices – it has already started – than in the economy. However, this is mostly because the economy has shown improvement, but not nearly enough to justify the stock market’s recent high prices.

Nevertheless, we maintain that this correction is likely the start of a shake-out that will cause many investors to shift to traditionally “safer” investments (Treasury bonds and the like). These investors will certainly grow to regret their impatience, as we’ve written before. With bond yields at long-term lows, bondholders are going to take major losses when interest rates start creeping back up. Getting back on point, once the shake-out in equities draws to a close, which will happen much sooner than most probably think, look out for the bull coming through!

Wednesday, June 2, 2010

Riding Out the Storm

After months of inexplicable sluggishness in the markets, things have finally started to move in recent weeks. While this is not in the form of a bull market run, which many would like, things are developing in the market, and they are doing so very quickly.

Even though we are currently undergoing a serious correction, we are thankful that the market seems to be behaving much more rationally. Many will recall that we’ve been calling for a healthy correction for months now, and we are thankful that it has finally arrived.

It is regrettable, though, that it will likely be more violent than necessary, because of how unreasonably long the market rally extended (nearly 14th months with very little break). However, after such a substantial rally, both in duration and in magnitude, prices had simply reached levels that were unjustified by the little economic recovery that has so far occurred, and therefore unsustainable.

Now in our 5th or 6th week of this downturn, it is possible, if not likely, that this correction is not quite over yet. However, it is our firm belief that this correction – which we have been waiting for – is going to create some fantastic buying opportunities in the market, but only in select sectors.

Because of this correction, many investors will undoubtedly flock from the world’s equity markets to more traditionally ‘safe’ investments, simply out of fear. This reaction with likely prove to be both careless and expensive.

Consider the current alternatives to equity investments:

Bonds, the typical choice for fixed income, have yields still near generational lows. Those investors who buy now for safety will see their principal deteriorate severely once interest rates begin to rise. More importantly, many government bonds – long-thought safest of the safe investments – currently face a real risk of default.

As we wrote nine weeks ago in “Defending Dividends,” investors who are seeking safer investments and relatively stable income are strongly urged to look at high-dividend paying stocks rather than debt instruments.

Instead of bonds, a good deal of investors will likely turn to insurance as another haven of safety. Many are lured in by those ads that claim investors have never lost money. In response, we would challenge those investors to try to get their hands on their money. Then they’ll really see how much they’ve lost thanks to penalties and fees.

It is our opinion, although not entirely unbiased, that most investors who purchase insurance products really don’t understand what it is they’re buying, or the potential implications of getting into life insurance or annuity products.

The vast majority of these ‘investments’ – they are insurance products, not securities – have extensive find print outlining lock-ups, as well as fees or penalties associated with early withdrawals. In most cases, it can cost clients a significant amount of their invested assets to get their money out ahead of schedule.

Therein lies the rub: While the stock market might look fairly grim right now, and many investors may be discouraged and thinking about shifting out of equities, the question they need to ask themselves is whether they honestly think that they want to take their money off the table for an extended period of time, perhaps even the rest of their life.

Unless someone can say with certainty that they don’t ever want to invest in equities again, insurance probably isn’t a good option, certainly not for an entire portfolio. Investors under 50 don’t even need to ask themselves this question. They simply shouldn’t lock their money up in insurance products. The market will come back – roaring back; in fact, we think some of the market’s brightest days are ahead in the not-too-distant future – and it’s important not to apply a long-term solution to a short-term problem.