A Long Winters Nap

Although the street will be thinly staffed for the next week, markets often go nuts this time of the year. The cause is the reduced number of market participants. While many individual investors are scurrying to make year end trades, most market makers are snug in their beds while visions of sugar plums dance in their heads. Notable exceptions are hedge funds. The Ebenezer Scrooges among them will not permit them to enjoy the season. They are all business. This can be a very dangerous time for small investors. It is true that volatility brings opportunity, but it also brings danger. This is alright fro traders who have large pools of capital with which to play and the ability to hedge bets, but such market environments can spell trouble for investors. There is a vast difference between a trader and an investors.

Market conditions prevalent during the past 25 years has turned many investors into traders. Market conditions have made trading relatively easy. One need only buy a portfolio of high-quality stocks and wait. If one waited long enough one experienced a profit of varying amounts. Why was this so? Because the preceding 25 years were terrible for the markets. Tax and economic policy changes, along with lower interest rates and (I hate this term) financial innovation, sparked the longest period of economic growth in U.S. history. What we witnessed was a prolonged recovery from a prolonged slump. The recovery matured in 2000. Efforts to rekindle growth created a bubble which could not be sustained. As with mature economies, mature markets are more stable, Growth and corrections will be more subdued. This had caused many investors to allocate assets outside their stated risk tolerance levels. Some may not realize they have done so.

Emerging markets have been an attractive destination for investor capital. Thus far the bet has been a good one, but it has coincided with the recovery in U.S. equity markets. This is merely a rebound from last years' crisis. The truth is that there is no decoupling. Economies around the globe are more intertwined than ever. Another problem facing investors in emerging markets is that they may be sowing the seeds of their own demise.

The influx of capital from the U.S. has begun to hurt export driven economies by strengthening their home currencies. Stronger currencies versus the U.S. dollar mean that goods produced cost more in terms of dollars. The results are higher prices, reduced profits or both. Countries such as Brazil are considering tax penalties to discourage foreign investment to keep the real week. Several other nations have acknowledged they are also considering similar moves. Then there is China.

China, being a command economy,. can add and remove stimulus at will thereby managing internal consumer demand. Banking on Chinese consumers to lift the global economy to new heights is a pipe dream at this time. China will only permit consumers to spend to meet its specific goals. If the government believes that the economy is overheating and inflation is becoming a problem it will engage in polices limiting consumer spending. The Chinese economy is likely to exhibit strong growth for the foreseeable future as the country is so far behind the West it will take many years of strong growth just to build the necessary infrastructure to make China a truly developed nation. Also, Chinese economic data are difficult to verify. The government controls the release of all data, including corporate earnings data. If China reports 8% growth one must take it at its word.

Domestically-focused investors have been placing bets on inflation. Their thinking is that low interest rates, the printing of dollars and record U.S. debt issuance will result in inflation pressures. The effect may be far less than many investors believe. Interest rates and debt issuance are just two factors influencing inflation pressure. One must also consider consumer demand, foreign exchange rates and corporations willing to erode profit margins to maintain their share of a smaller U.S. market. Allusions to the stagflation days of the late 1970s disregard the changes within the U.S. economy which have occurred since then. The U.S. economy is less insular and is no longer manufacturing-based. Back in the days of polyester leisure suits job growth (or losses) and inflation sprang forth from places such as Detroit, Pittsburgh, Cleveland and Bethlehem, PA. Now job production is scattered around the country in service industries such as technology, retailing, healthcare and financial serviced. The production of goods is primarily done overseas and these exporters would rather erode their significantly-wide profit margins than raise prices and lose valuable market share. This, combined with reduced spending as consumers live closer to their means, promise to keep inflation relatively low.

Subdued inflation make TIPs bad bets as trading vehicles. All are at premiums and have inflation indices over 1.00, some significantly so. Short-term TIPs (inside five years) could result in net losses for investors should inflation be tame. TIPs should be used as a hedging vehicles rather than speculations. The best TIP is the 1.375% due 7/15/18 as it is priced near par and has an inflation index near 1.00. Corporate inflation-protected notes are (how should I say this?) garbage. They adjust versus a year-over-year calculation of inflation. Even if inflation ran a steady 3.00% year after year there is now upward adjustment if the coupon as the rate was unchanged. If inflation declined from 3.00% to 2.50% coupons fall even though inflation was positive. This is a simplified but accurate explanation of how such bonds work.

I don't think there will be a double dip recession, but growth charts could more resemble a Nike "swoosh" as consumers rely more on income and less on borrowed fund. Also, much of the growth we have seen this year has been due to government stimulus plans. This was to be expected. However unlike in the recent past, such stimulus may not prime the economic pump, but rather give a temporary boost resulting in the economy settling back to a fundamental growth rate lower than to what we have all become accustomed during the past two decades. Recent home sales data illustrate the effect government stimulus is having. Existing home sales were surprisingly positive due to home buying benefits, but new home sales fell as the data reflects contracts to build new homes not closings. These home buyers would not be able to take advantage of government programs unless extended. Since it takes upwards of a year to bring a home from plans to completion, counting on government programs still being in effect when it is time to close is a risky proposition.

Less volatile markets present a problem to those investing via fee-based accounts. Growth rates and lack of volatility will make it difficult to justify paying management fees of two or three percent. Why pay annual fees to sit and watch a portfolio. This is especially true of fixed income accounts. The best plan is to construct a portfolio which meets your current needs consisting of appropriate securities and adjusting it only when your needs change or when an unforeseen event affecting an investment requires reallocating capital.

Enough of this talk of business. It is Christmas Eve, a time for those who observe the holiday to be with friends and family. Tonight as I sit by the fire with those I love, I will raise a glass of Old Fezziwig ( a great ale brewed by Samuel Adams) and wish a happy holiday season to all my readers and health and prosperity in the New Year. I shall be back the first week of January.

Slacker

I am of the opinion that the peak Fed Funds rate during the coming cycle will be somewhere around 4.00%. My thinking is that with consumers forced to live closer to their means, growth and inflation will lag recent past cycles. To make sure I wasn't being too pessimistic, I asked a very respected fixed income strategist (one who has been somewhat more optimistic than I) his opinion regarding where he thinks Fed Funds will peak before the Fed begins to ease again. Imagine my surprise when he tells me that he believes Fed Funds will peak around 3.00% during the coming cycle. This is bad news for investors determined to stay in cash or who think they can eliminate interest rate risk by purchasing LIBOR-floater longer-term bonds and preferreds.

Please understand that the Fed SHOULD remain extraordinarily accommodative for an extended period of time. I am a cruel sot. I believe in responsible borrowing and investing. Corporations and individuals should be permitted to suffer the consequences of their actions. Keeping rates too low for too long could create new bubbles. Fed policy is certainly at least partially responsible for higher gold and oil prices.

So what is a fixed income investor to do? Diversify. Ladder, barbell and use different products, CDs on the short end, agencies on the belly of the curve and bank and finance bonds seven to ten years out. Also, please understand what makes a bond tick. Features such as calls, floats and steps are structured to benefit the issuer, not the investor.

A TARP Christmas

"I'm dreaming of a TARP Christmas."

That is the Christmas carol ringing in my head. First we had Bank of America repay its TARP funds, then Citi will pay back a portion of its TARP funds. Well Fargo is the latest to announce its TARP repayment. Well will sell approximately $10.4 billion of stock and will repay all $25 billion of government aid. This is in contrast to Citi which will pay back only $20 billion of the $45 billion of aid money it received from the government. The Treasury will also sell up to $5 billion of Citi shares. That would still leave another $20 billion of aid money Citi would have to repay. It also means that the government will continue to have a major ownership stake in the most troubled large bank in the U.S. Baby steps Vikram, baby steps.



Today, JP Morgan came with a sweetheart of a preferred deal. A sweetheart deal for JPM that is. The new preferred will have an initial coupon in the 7.25% to 7.375% areas. That is a fairly low coupon for long term debt. However, it gets better for JPM. After five years the coupon will float off of three-month LIBOR. Typically these deals float 400 or more basis points over three-month LIBOR and have no floor or ceiling. However since Three-month LIBOR cannot go below 0.00%, the effective floor is the spread. Investors and financial advisers became all giddy at the prospect of rising coupons. However, if the coupon rises above where JPM can issue long-term securities, JPM will simply call it away at 25. A flat or inverted yield curve is usually required for such a situation. If the yield curve remains steep and the coupon remains below the trading yield, the preferred will trade at a discount, regardless of how high "rates" rise. Although as long as rates rise one is at least compensated with higher rates while one suffers with a $22 trading price.

The truly negative outcome is for the yield curve to be steep and short-term rates to remain low. That is probably the most likely scenario for 2014. Why do I believe this? Let's look at typical Fed policy cycles. The economy slows, the Fed eases, rates fall, but short-term rates fall more significantly than long-term rates. The economy shows signs of recovery. Inflation expectations cause long-term rates to rise, thereby further steepening the curve. The economic cycle matures and to combat inflation the Fed tightens by raising the Fed Funds rate, moderating inflation pressures casing the curve to flatten. It is often the case that the Fed overshoots resulting in a flat or inverted yield curve. It usually takes a number of years to go through this cycles, often three to five years. This would be perfect timing for this JPM preferred to experience a coupon decline when it begins to float. Floaters DO NOT eliminated interest rate risk for investors. If they did issuers would be exposed to such risk. Floaters are like Las Vegas. Investors can win, but the deals are structured to favor the house (the issuer).

Happy Chanukah and Merry Christmas.

In The Year 2010

2009 is winding down, but the year will not go quietly. First their was the Dubai default. Then there were the Greece and Spain credit ratings downgrades. Even the U.S. and UK received stern warnings about their respective credit ratings coming under pressure in the near future. The grass isn't greener in the neighbors back yard. In fact even China, that vaunted engine of growth, is not is nearly as strong as its economic data and its cheerleaders would have us believe. Nearly all of its growth has been driven by huge amounts if government stimulus, which is sustainable. What the Chinese government is hoping for is that it can keep its economy expanding (and its people happy) until demand increases from (drum roll please) the U.S.!!! The good ole USA is still the world's main source of economic activity.

There is a mistaken belief that U.S. banks are the worst on the planet. Although U.S. banks (even healthy banks) remain impaired when compared to their typical condition, European banks (along with others in various parts of the world) have their fair share of impairment and foreign governments are feeling the pain of propping them up. It may be fair to say that the worst of the financial crisis is over, but it may be a long time (if ever) before we return to conditions common during the past 25 years. Why if ever? Let's answer a question with a question. Why do many people assume that the economic conditions of the past 25 years are "normal" After all, those conditions never existed prior to that time period. The truth is that there is no "normal" The economy is evolving and ever-changing. One thing is for sure. Consumers cannot spend more than they make ad infinitum. Eventually one becomes over leveraged and can no longer spend like a drunken sailor. When that happens, demand falls and prices follow. All of the government spending or shovel-ready jobs the government can conjure up can create sustainable economic expansion similar to what we saw during the days of ever-cheaper and ever-easier credit.

So what does this mean for the markets? As it becomes apparent that the U.S. remains the best of a fermenting (I won't say rotten) bunch, the dollar will strengthen. Equity markets will begin to trade sideways (possibly correcting mildly), non-industrial commodities will fall (see gold) and the dollar will strengthen. At some point the Fed tightens further strengthening the dollar. Tighter money takes away the bank carry trade and makes leverage more expensive which in turn makes borrowing to play the markets more expensive. The result will be credit spreads stop compressing and corporate bond yields begin to follow movements of treasury yields. The reason is that bank profits will moderate from levels seen in 2009. Most other sectors of the markets will see spreads remain constant or widen slightly. Junk bonds could see a significant correction in a year or two as weaker firms struggle to refinance debt at affordable levels (if at all). I think Fed Chairman Ben Bernanke has it right when he says that the economy will grow, but will face significant headwinds. Investors will have to accept that they are in fact investors and not traders because trading opportunities will be fewer and farther between than to what they have become accustomed. Ladders and barbells anyone?