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Bob's Journal 
What's this?______________________________________________ NOTE FOR MEMBERS: An expanded and more frequent version of Bob's Journal now appears on the members' site at www.RetirementWatch.com. Check in there for more commentary and insights on all the financial aspects of retirement.
July 30,
2007 12:20 p.m. Here are a few thoughts and bits of information regarding last week’s big decline in the markets. ? Markets always can be affected by outside factors, known as exogenous factors. Last week, stocks were affected by a change of sentiment or outlook among bond and mortgage investors. With investors unwilling to lend without higher interest rates and better terms, stock prices were revalued. The easy availability of debt to buyout firms kept a floor under stock prices, and a change in credit availability means a lower floor for stock prices. ? Market cycles are caused by a shift in investor sentiment from extreme pessimism to extreme optimism and back. Investors in the credit markets were extremely optimistic until recently. That is why they did not demand significantly higher yields from riskier bonds; they believed that recent low default rates would continue. Now, investors are less optimistic. The change started in the mortgage markets and has moved to the corporate debt market. The issue is whether investors will become extremely pessimistic before the markets recover. If so, they have a long way to fall. Yields and yield spreads are around long-term average levels. If the economy remains healthy, that should make many investors comfortable. ? One of the most extreme revaluations of assets has been in real estate securities. Cohen & Steers Realty Shares now is about 25% below its peak of a few months ago. Before the correction, private real estate buyers believed publicly-traded real estate was undervalued by 10% of more. A number of major REITs were taken private at premium prices, and other REITs sold portions of their portfolios of buildings. Now, barring a sharp downturn in the economy, REITs are attractively valued and nearing bargain territory. ? After the credit markets settle down, investors will focus on the stock markets. Two factors will be particularly important. One factor will be the extent to which the borrowing ability of private equity firms either is limited or more expensive. A reduced ability to borrow or significantly higher borrowing costs should mean the buyout firms will be willing to pay lower prices for companies. The other factor will be corporate profit margins. Data and reports that received less attention because of the focus on the credit markets indicated that businesses might find it more difficult to maintain their profit margins. Costs are rising, but it is difficult for many to raise prices. We’ll discuss this in more detail in the future.
July 27,
2007 10:20 a.m. One hundred points on the Dow aren’t what they used to be. In 1987, when the Dow declined by over 500 points in one day, the move caused about 25% of the average’s value to evaporate. Thursday’s 311 point decline was only a 2.26% loss. The S&P 500 lost a little more at 2.33%. Despite all the nasty headlines and the fear that seems to pervade the markets, the Dow is only 4.59% below its record high of 14121.04, set only the previous Thursday. For some time now, major themes of Retirement Watch have been that investors are not being paid enough to take many of the risks in the markets and too few investments have reasonable margins of safety. Most investors did not perceive much risk in the markets and were chasing marginally higher gains and yields. We were more wary. One never knows when the market will readjust or what will cause a readjustment, but extreme market valuations do not last forever. The main mis-valuation was in the bond markets. As I repeatedly pointed out, the yield differences between treasury securities and other bonds was too narrow. In the last few weeks, especially the last few days, investors finally agreed. While investors flocked to treasuries and drove down their yields, they sold other securities and their yields rose. In fact, many types of non-treasury bonds could not be sold to anyone the last few days. That is why the banks lending money for the Chrysler and a few other buyouts decided not to bring the bonds to market soon. You have heard and read the details in other media. The question now is: Where will this lead? A sharp market decline, even a crash, does not have to lead to a bear market or an economic crisis. Even an economic crisis does not have to have a lasting impact. We saw this in 1987 and 1997-1998. While there was a great deal to be concerned about each time, the problems were solved or at least deferred. On the other hand, there were more serious consequences after the technology bubble burst and was coupled with the terrorist attacks of 2001. I suspect the consequences this time won’t be disastrous, but it is not a sure thing. On the negative side, the stock market looks poor technically. Yesterday’s point decline was on record trading volume, always a bad sign. The number of declining stocks far outnumbered those gaining in value (3050 to 319). A large number of stocks hit 52-week lows while relatively few hit 52-week highs (809 to 31). I also have been concerned that after 2000 investors never hit that extreme level of pessimism that marks the bottom of a bear market. That point could still be ahead of us. Yet, this decline could turn around soon as the other declines have done since this bull rally started in March 2003. The economy is doing well, and inflation is contained. I have some concerns about corporate profit margins, which I will share in the future, but earnings growth remains healthy. Even more to the positive side is that the decline was in response to a readjustment occurring in the credit markets. Investors are repricing riskier investments such as high yield bonds. This is only a repricing. There is no sign of a credit crunch. There is plenty of credit and liquidity available. Investors simply decided that they were lending on too generous terms in the recent past and that investments in risky industries such as automobiles should receive higher yields. The important point is that we don’t have to forecast the next path of the economy and stock market, and then bet our portfolios on that forecast. Instead, we invest where there is a margin of safety, keep some diversification in our portfolios, and have sell signals on key investments. That is why we have maintained a hedged, diversified portfolio for a couple of years and will continue to do so for a while. Let’s take a look at how the Sector Managed Portfolio performed recently. Since July 1, ProFunds Ultra Bull has declined 5.20%; Oakmark Select declined 6.32%; and Longleaf Partners International declined 2.38%. These funds were balanced by our positions in Hussman Strategic Growth, which appreciated 1.45%. The result is that our total portfolio declined only 1.09% during a period when the S&P 500 declined 2.32%. What about in the more volatile last week? Since July 18, the portfolio lost a value of 1.63%, with ProFunds Ultra Bull leading the way with an 8.26% loss. The Vanguard Index 500 fund, on the other hand, lost 4.1% over that time. That’s an impressive showing by the portfolio, especially considering that the portfolio was earning solid returns before the market headed south. These numbers reveal several things you won’t see in the headlines. One is that the overall market has not declined as much as all the media hype would have you believe. The market has been quite volatile, but the days of gains do not get as much attention as the days of losses. Of course, these numbers also reveal the benefits of our portfolio construction. We participate in most of the market gains but lose much less when the market declines. In addition, the sell signal on ProFunds Ultra Bull will further reduce losses if the market continues to decline. This shows the wisdom of always having a margin of safety in your portfolio. It will ensure that we earn solid returns in good markets and preserve our capital in bear markets.
July 25,
2007 11:20 a.m. Stocks are grabbing all the headlines, while the real action is in the bond market. The bond market action is causing a lot of the volatility in stocks. We’ve touched on these factors before, but now it appears that we are at a real turning point. For some time, I have said that income investors are not being paid enough to take risks greater than those in money market funds or short-term bonds. Other types of bonds offered only marginally higher yields than treasury bonds, and longer-term bonds paid roughly the same yields as short-term bonds. Investors on the whole simply did not perceive there to be much risk, so they were willing to accept marginally higher yields from investments that historically have more risk than short-term treasury bonds. Now, investors are starting to retreat from that risk. For example, until mid-February 2007 the spread between treasuries and investment grade corporate bonds was about 0.70%. Now, it is 1% and climbing. For high yield bonds, the spread was close to 2%. Now it is almost 5%. Those are big changes in a short time and have hurt the yield hogs who took extra risk to grab those slightly higher yields. The question is what this means for these bonds and other investments. Bill Gross of PIMCO triggered a large portion of yesterday’s sell off when he pointed out these yield changes and said stocks still have not dealt with them. Here are some points to consider: ? While the yield spreads surged recently, they are around their long-term averages. ? Rates in general still are low compared to the last few decades. ? Corporate cash still is at high levels and balance sheets in general are in good shape. Bill Gross’s points were that stocks probably are priced for the easy credit, low risk, low volatility environment of the last few years. That environment is changing, and stock prices need to readjust. In addition, we probably have not sent he worst effects of easy mortgage lending. Also, some of the debt issued to finance buyouts over the next few years will default when the companies stumble and are not able to meet their obligations. Adding to the worries is that some of the buyout deals are having trouble with their financing. In some cases, the buyout firms cannot get debt to make the purchases. In other cases they cannot get the terms they want. They have to either reprice their deals or have them fall through. Those arguments do not mean we should bail out of the stock market today. Some of these factors already are priced into stocks. That is why stock appreciation has not kept pace with earnings growth since 2002. International economic growth is stronger than U.S. growth and has been helping many U.S. companies, and liquidity still is high in the global economy. While there is the potential for the debt build up of the last few years to lead to some kind of financial disaster, that does not appear to be imminent. Absent a major shock to the system, it likely will take a year or more for things to begin unwinding in a serious way. Most likely there has to be a credit contraction, significantly higher rates than today, and larger yield spreads. There is risk in the markets, and much of that risk is not reflected in today’s prices. That is why we have hedged and conservative positions in our portfolios. But there still is a lot of potential in stocks in both the U.S. and overseas. It is not time yet to exit the equity markets.
July 19,
2007 01:00 p.m. Stocks captured a lot of attention when the Dow surged past 14000 last week. There were some points that were not addressed in much of the coverage. New highs often spur many investors to finally buy equities or add to their holdings. They reason that the momentum will continue. Here are some reasons to be cautious about the recent momentum continuing in the short term. ? The rally that began in March 2003 now is the second longest bull market without a 10% or greater correction. Even long-term, healthy bull markets have corrections. On the positive side, this rally has been less robust that the average bull market. It is able to last so long without a correction because investors are not as exuberant. ? The technical factors of the market are not great, including the ratio of advancing stocks to declining stocks and the number of stocks reaching new highs compared to those hitting new lows each day. ? A good part of this rally likely is due to corporations buying back their own stock. These purchases have been at record levels the last couple of years. The trend is worrisome for several reasons. Corporations boost their earnings per share by decreasing the number of shares rather than increasing earnings. Some corporations are borrowing to buy back the stock, while others use the large amount of cash on their balance sheets. In either case, it is not a positive factor that the best use corporations can find for their credit and cash is to buy stock rather than investing in their current or new businesses. The influence of stock buy backs makes one wonder how long the stock rally can last and how strong corporate earnings really are. ? There is a lot of private equity financing coming to market. The paperwork and details for the big deals announced the last few months are ready to actually sell the bonds that will be used to finance the purchases. In several recent deals investors proved to be more reluctant than they were a few months ago. The large amount of bond offerings set to come to market will be a real test of the buyout boom. ? The Fed apparently wants inflation to be 2% or less, and it is stubbornly clinging to a level just above 2%. Will the Fed patiently wait for the rate to fall, accept this moderately higher rate, or increase interest rates to bring inflation lower? ? Bonds are in a bear market. Yields seem to have hit their lows for this cycle. The issue is how high yields will rise, and will that level reduce economic growth? ? The dollar continues to slide against the Euro. A weak currency usually is not a good thing for a country’s capital markets. Yet, the dollar is doing well against the yen, so it is not universally weak. ? What does the bull market in gold and commodities mean? Traditionally rising commodity prices is a sign of rising inflation. That does not have to be the case. Strong economic growth around the globe is outstripping the ability to increase the supply of key commodities. I suspect the commodity bull market is more due to a good global economy than to rising inflation. If I’m wrong or the Fed disagrees, watch out for interest rates to rise. ? Geopolitics always held the potential for a negative surprise for the markets. The risks generally are priced into the markets. Pakistan, however, is not receiving the attention I think it deserves. A forced change in leadership in Pakistan, which could happen this fall, might seriously disrupt the war on terrorists and efforts to contain nuclear proliferation. Much attention is focused on Iran, Iraq, North Korea, and other places, but Pakistan has the potential to surprise investors. These are not reasons to exit the stock markets now. They are part of the wall of worry stocks are climbing and reasons to maintain a margin of safety in your portfolio despite the record highs and strong media enthusiasm.
July 10,
2007 02:00 p.m. Many analysts have forecast that various events would lead to steep declines in the economy and the markets, yet both have been quite resilient. There were a few pauses since March 2003, but the economy and markets have been upstoppable. Just a few of the upheavals that turned out to be mere speed bumps were: $80 per barrel oil; a $6 billion loss in the Amaranth hedge fund; problems in Iraq; a change in control of Congress; and rising interest rates. The latest disaster was supposed to be the peak of the housing market coupled with defaults in subprime mortgages. Several hedge funds have reported steep losses and either closed down or been bailed out. The major credit rating agencies are downgrading the credit quality of many pools of mortgages. Yet, the stock markets are surging, and the economy appears to be bouncing back from its pause early this year. Several factors are causing this resilience. The economy and markets truly are global now. Problems in a sector of the U.S. economy do not automatically pull down the rest of it, because economic growth around the globe is pulling stronger in the other direction. The U.S. economy primarily is service-based. Service industries are more stable than manufacturing. Recessions have been less frequent and shallower as the economy transitioned from manufacturing to services. Financial engineering gets a bad rap from many people who do not understand it, but it likely has been helpful. Investors and businesses are able to hedge risks because of all the new options, futures, and other contracts. They also are better able to identify risks and potential risks and take preventive measures. This is a big change from 1998 when bad bets and excess debt by the Long-Term Capital Management hedge fund almost brought down the world financial system. Central bankers around the world have learned over the years. They are less likely to cause credit crunches that bring down their economies. There still are risks in the world. The most serious risks right now are what the economists call exogenous risks. These are risks outside the markets, such as geopolitical events. That is why our portfolios retain some hedges and caution even as we benefit from the new highs in the stock markets. As always we invest with a margin of safety and seek to avoid large losses.
July 3,
2007 10:00 a.m. Not too many weeks ago, investors and analysts looked around and couldn’t see anything that would stop the rise in stocks or the buyout boom. Now, the market indexes are stuck in a trading range below their record highs, and reasons to be less optimistic are drawing notice. Here are a few reasons to retain some caution and be sure there is a margin of safety. ? It is summer, traditionally a time of weakness in the stock markets. ? The private equity boom has had a few rough patches. Several deals have fallen through. Also, for months investors have scoured the markets for potential buyout targets, driving up their stock prices and making buyouts of those companies less likely. Heads of buyout funds have said that their investors should anticipate lower returns in the next few years. ? Credit might be tightening. The subprime mortgage meltdown caused many lenders to increase credit standards and regulators to tighten their rules. In addition, potential buyers of bonds used to finance buyout deals have objected to the terms in some recent deals. Analysts for some time have pointed out that bond holders do not have much protection from default in the deals of the last few years. Now, investors are more concerned about risk and are demanding some protection. Yet, while the terms are a bit stiffer than a few weeks ago, there still seems to be a lot of capital available. ? A potential trade war is brewing. Congress let the President’s trade negotiating authority expire, and there is no rush to reinstate it. In addition, those who object to trade with China are finding new ways to reduce trade. Safety concerns have curbed the import of some items, and Congress might hold hearings on the issue. ? Last week I addressed the potential tax increases advocated for the wealthy, corporations, hedge funds, and private equity firms. Congress also is scheduled to allow the 15% tax rates for long-term capital gains and qualified dividends to expire after 2010. ? Geopolitical events always are a concern. The series of incidents and arrests in Britain are leading to a concern that more events are planned around the globe this summer. None of these factors are sure signs of an imminent collapse in the markets. The economy remains strong; interest rates are low; inflation still is under control; and most stocks are reasonably valued. But the items listed above are reasons to be cautious. Investor perceptions, rather than financial fundamentals, influence the market’s direction over periods other than the long-term. That is why in our managed portfolios we have our stock positions hedged against a potential decline.
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E-mail: BCarlson@ Bob's Journal Archives January 2007
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