July 31, 2016 Exit

Risk/Reward Vol. 316

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

Having reached my goal for the year on the portfolio that I manage, I decided to sell on Tuesday. As described back in March and April (Vols. 300 and 302 www.riskrewardblog.blogspot.com ) that portfolio was constructed based upon two premises: 1) the rate on the US Ten Year Bond staying below 2% and 2) the price of oil staying above $40/bbl. The events of the past few months have permitted this portfolio to produce a capital return much better than I had expected with oil touching $50 in May and June and the 10 Year Yield hitting all time lows in the wake of Brexit. That said, the price of oil has slipped below $42/bbl. and over the next few months, the yield on the 10Year is more likely to rise than to fall. (Remember a rise in yield means a drop in value). Accordingly, I reaped my profits and headed to the sidelines. Below is a further discussion of my rationale.

As I expected on Wednesday, the Federal Reserve Open Market Committee voted to keep short term interest rates at their current 1/4 to 1/2%. I read the press release following the FOMC meeting to be more upbeat on the economy. This attitude normally prompts the Fed futures market to increase the odds of a rate increase, and this time was no exception. The odds of a September rate hike rose that afternoon from 25% to 30%. Do I believe that rates will be increased at the next FOMC meeting in September? No. We will be in the thick of the election cycle, and the Fed will avoid anything that would disrupt the markets to the detriment of the establishment candidate, HRC. Doubt me? Read the article on Fed Governor Lael Brainard in last week's NYTimes, and you too will conclude that she aspires to a top policy position in the Clinton administration. A further reason to hold steady on rates was the disappointing gross domestic product report issued on Friday. The US economy year to date has only grown at an annualized rate of 1%, well below the 2-2.5% expected. Thus, the current rate on the 10Year remained in the 1.5% zone through the week. Frankly, my desire to exit interest rate sensitive securities was not as pronounced as my desire to exit oil, but I saw no compelling reason to stay. So I sold. As I have said repeatedly, selling on a high note is good for the soul. Or as Bernard Baruch remarked "I made my money selling too soon."

As to the price of oil, several factors have contributed to its retrenchment. First, recent articles have brought into question the accuracy of reports tallying the quantity of stored oil worldwide. Several countries, most notably Russia, do not report stored oil figures to the markets, nor do those private entities that own oil tankers currently moored off shore. Second, the disruption in the flow from Canada incident to the fires in Alberta has been all but eliminated. Third, I am concerned by the steady increase in the number of rigs operating domestically. Fourth, the supply of gasoline in the US continues to build even in the midst of the summer driving season. None of these factors bodes well for oil or oil related stocks. Accordingly, I chose not to risk losing the gains that I have achieved. The decision to sell on Tuesday appeared prescient on Friday as Exxon and Chevron reported disappointed earnings.

Some may wonder whether my buying and selling creates a tax nightmare. The answer is no---for the most part. I use a 401k and some IRA's as trading accounts. Trading there does not generate any capital gains tax. I try to keep the personal assets that I manage in cash. The only exceptions are master limited partnerships which are not suitable for tax deferred accounts. Remember that for the past year or so, I have rarely invested more than 40% of available capital. In disinflationary (nay deflationary) times, cash remains king. Furthermore, when opportunities arise (e.g. buying GM in the wake of Brexit or OKE when it carried a sustainable 13+% dividend), I have plenty of dry powder.

Don't take my actions as a sign that the asset bubble about which I often write is about to burst. I believe that the central banks of the world will continue to subsidize financial assets even in the face of declining economic growth. Europe and the US are the new Japan where secular stagnation persists. But please note that as of last month the cumulative wealth of the US (e.g. the total value of stocks, bonds, houses, etc.) is now 5 times the gross national income. This bloated ratio has only been achieved two other times in our history: 1999-2000 and 2004-2005. In other words, just before the two most recent stock market crashes. At some time even cheap money cannot keep the bubble from bursting. Undoubtedly, I will dart in and out of the market several more times before that occurs, but I am ever watchful for signs of it approaching

July 24, 2016 Observations

Risk/Reward Vol. 315

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

Another week and more record highs on both the major stock indices. This, despite another quarter of fewer earnings--albeit better than expected. Of the money I manage personally, I am 30% invested. I am contemplating taking profits and heading to the sideline.

Here are some observations:

1) The S&P 500 (SPY) is trading at 21 times trailing 12 months earnings. This is above the long term average of 16 times earnings, but no where near the multiples that pervaded the NASDAQ back in the dot com days. Is it a bubble? Maybe. But I am less concerned by the S&P multiple than I am by the S&P's possible interplay with that which is clearly a bubble: the world's bond market. If and when rates start to rise there will be a stampede to sell the trillions of dollars worth of bonds that are currently yielding at or below 0%. As the once and current bond kings, Bill Gross and Jeff Gundlach, have warned, in the wake of Obama's Dodd-Frank legislation, money center banks, once the dominant player in providing bond liquidity, can no longer make a market in bonds. No institutions have taken their place. In short there is insufficient liquidity in the bond market. If and when the stampede starts there will be few if any buyers, and the value of bonds will plummet. To meet obligations, investors may need to sell other assets at bargain prices including stocks. We could see 2008-2009 again. And you wonder why the Federal Reserve refuses to raise rates even as unemployment falls below 5%?

2) The domestic oil rig count rose for the fourth consecutive week and now numbers 371. This is a far cry from the 1600 that operated domestically in 2014, but the increase did contribute to the price of oil falling to $45/bbl. For students of Joseph Schumpeter, the collapse in the price of oil presents a classic case of "creative destruction." Until recently, domestic producers could not profit from oil prices below $60/bbl. Innovation forced upon producers by declining prices has resulted in some being able now to operate profitably at $40/bbl. This is the beauty of capitalism.

3) Two of the largest public pension funds, CALPERS and CALSTERS, announced their June, 2016 fiscal year results. One earned 0.6%, the other earned 1.4%. They pay benefits based upon an actuarial assumption of earning 7% on their assets, an average return they have not seen in years. The pension funds of 20 states are below 70% funded despite increasing contributions more than 75% since 2007. This unfunded liability is one of the greatest financial threats facing America. O K, maybe we owe long term public employees their pensions, but why promise these goodies to new hires? .

4) No one expects the Federal Reserve to raise rates at its meeting next week, but look for any hint of a September increase in the press release following the meeting.

5) For those of you chasing yield by purchasing emerging market securities or junk bond funds, I highly recommend reading Jason Zweig's article in Saturday's Wall Street Journal. Zweig is the editor of the most recent edition of Benjamin Graham's classic "The Intelligent Investor."

July 17, 2016 Henry Ford

Risk/Reward Vol. 314

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

Both the S&P 500 and the Dow Jones Industrial Average hit all time highs this week even as the bond market held strong. The conditions underlying this new, new normal of which I wrote last week are still in place. (
http://www.riskrewardblog.blogspot.com/ ) US investors keep pouring into equities as foreign buyers lap up US debt. What choice does either group have? Each is picking the tallest pygmy in a game of pygmy basketball. Take the bond market. In early 2008, the average yield on a 10 year government bond (US and foreign) was 4.3%. Today that average is 0.5%. No wonder the US Ten Year at 1.5 is so attractive to foreign buyers. Domestically, I pity the poor asset managers at pension funds, insurance companies and similar institutions. For years they have assumed that they will see, on average, a 7-8% return by mixing a healthy dose of conservative US Treasury securities with a sprinkling of more speculative, yield-boosting equities and alternative investments. But how can they possibly expect to approach that average when the yield on a 30 Year US Treasury Bond is a paltry 2.25%? The answer is that they cannot. Thus they are forced to invest far into the risk curve, doubling down on an unhealthy percentage of stocks. Consequently, stock prices continue to climb despite five straight quarters of declining profitability across the S&P 500, a factoid that is emblematic of the disconnect between the financial markets and the general economy. Like the witches in Macbeth, asset managers ply their trade while lamenting: "Double, double toil and trouble/ Fire burn, and caldron (read, equity markets ) bubble".

I caught some flack from readers last week for suggesting that secular stagnation will prevail unless and until wealth is redistributed. Believe me, I do not "Feel the Bern", but clearly a lot of folks do. That said, wealth redistribution does not have to be government mandated, and to my thinking is better when not done so. Back in 1914, Henry Ford came to realize that laborers in his employ could not afford a Ford, an automobile designed to be everyman's vehicle. Thus in the matter of 24 hours, he doubled the wages of his assembly workers to $5/day. Editorials across the land excoriated Ford for sewing the seeds of capitalist destruction. But destruction did not ensue and for the next several years America saw wages climb and the economy grow. Today's Henry Ford is Jamie Dimon, the CEO of JPMorganChase. He announced this week that over the next few years he will be raising the wages at the bottom of his workforce. Tellers, who make on average $10.15/hour, can expect to see wages of $12-16/hour. Hardly as dramatic as Henry Ford's move, but significant nevertheless Similar actions are under consideration at Starbucks. Apparently, Mssrs. Dimon and Schultz see things as I do. A consumer based society simply cannot grow when 42% of its workforce makes $15/hour or less.

I for one am enjoying the recent stock run up. Both the major indices are up over 5.5% since the results of the Brexit vote were announced on June 23rd. The S&P is up 18% since sliding into a trough in February. I have comfortably exceeded my annual goal of 6%, and am contemplating exiting the market for a while. That said, I do not see any serious threat to my portfolio in the near term. And, I like it's average dividend yield of 7+%. My big winner recently is GM which I ought on June 28. It's up over 11%. The big winner year to date is OKE. My recent re-entry is up 30% since April 28. Had I held it continuously since when I first bought on February 26th, I would have seen a 102% profit. I can't complain since I captured a majority of that gain during my two holding periods.

The Promenade des Anglais in Nice is one of our favorite places. We will return there one day.

July 10, 2016 New New Normal

Risk/Reward Vol. 313

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

The jobs report issued on Friday was pure Goldilocks: large enough to indicate a strengthening economy yet not so large as to threaten an interest rate increase. 287,000 new jobs was just right. As a consequence, both the bond market and the stock market reached new intraday records, an anomaly during normal times because they are usually inversely correlated. But what is "normal" these days? Indeed, this "double counterintuitive" may signal a new "new normal" at least in the United States. The old "new normal", a phrase coined by Mohamed El Erian several years ago, described his prescient prediction that we were in for a prolonged period of low interest rates. This new, new normal arises from domestic investors eschewing U S Treasury securities in favor of higher returning risk assets (equities) at the same time that foreign investors buy those very same US Treasuries. To the latter point, the yield on the US Ten Year Bond fell to 1.36% on Friday but still attracted a surfeit of foreign bond buyers who are facing the harsh reality that one third of all government bonds worldwide are trading at negative interest rates.

The sad news from Baton Rouge, Minneapolis and Dallas paints an ugly picture of race relations in this country. I do not offer any opinions on this subject, but any investor who ignores this fact does so at his/her peril. Lost in the news was a recently released study from the respected Pew Research Center showing that white households have 13 times the wealth of black households and almost that much more than Hispanic households. Combine this fact with another Pew study reporting that the modal age of whites is 55 while that of blacks is 24 and that of Hispanics is 8 and one comes to the following obvious conclusion. Wealth in this country is concentrated in aging white households, and that concentration will become more intense absent a redistribution of wealth. Until that occurs, our consumer driven economy will remain moribund. Why? Because old people simply do not consume. Doubt me? Look at Japan. To reiterate, our economy faces a demographic headwind of historic proportion. I leave to others whether and how to redistribute wealth, but absent that occurring secular stagnation will be the order of the day.

So how does an investor prosper in these times? Here is one strategy. I believe that secular stagnation will persist, that interest rates will stay at historic lows, that Mr. Market has not fully embraced this and that thus there are still pockets of mispriced assets. Top on the list of mispriced assets are preferred stocks. As described in Vol. 207 ( www.riskrewardblog.blogspot.com ) most income securities trade in relation to the yield on the US Ten Year Treasury Bond. Since the 2008 financial crisis, the spread between the yield on the 10Year and the yield on an index of preferred stocks (as measured by the exchange traded fund, PGX) has been 360 basis points. In the wake of the post-Brexit drop in interest rates, that spread has widened to over 430 basis points (yield on PGX 5.7%- yield on US Ten Year 1.4%= 4.3% or 430 basis points). History indicates that if the yield on the 10Year remains low, over time this spread will revert to the norm by the price of PGX increasing to the level that its yield is 5%. (Remember the higher the price the lower the yield). If that occurs one will see capital appreciation as well as receiving a nice monthly dividend. I bought PGX this week. I also added to my collection of preferred stock closed end funds (HPF, HPS, HPI, DFP, JPC, JPS). As a note of caution, due to their use of leverage and the fact that they now trade above net asset value, one must be careful in one's selection of closed end funds.

Enjoy the new, new normal!

July 3, 2016 Busch's Postulate Redux

Risk/Reward Vol. 312

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

As I predicted last week, Brexit nothwithstanding, the stock markets recovered. And it is no mystery why. Where else but equities can an investor get a return, and where other than US equities would any rational person invest?

With $11 trillion worth of bonds world wide trading at below zero interest rates, only speculators would enter the bond market. Between our Federal Reserve's failure to raise rates and the rate vacuum elsewhere in the world, it is small wonder that the yield on the US Ten Year Treasury Bond reached an all time low of 1.385% intraday on Friday . Now I want all of you to stop reading for a moment and to grasp how historic this is. The United States began issuing 10 Year Treasury Bonds in 1790 during the tenure of Alexander Hamilton, our first Treasury Secretary serving in President Washington's cabinet. In all of the time since, the US Ten Year has never yielded as little as it did on Friday. Can anyone say "central bank manipulation'?

But why are we experiencing such sluggish economic growth after 9 years of artificially low interest rates? Maybe, just maybe, the wonks at the Federal Reserve have had it all wrong. But like weathermen, they are incapable of admitting to a mistake. Indeed, the closest to an admission that I have seen or read occurred 10 days ago during Janet Yellen's testimony before Congress, an admission that was lost in the furor arising from Brexit. Read that testimony, and you will find buried there an admission that perhaps we are in for a much longer period of sluggish growth---one where productivity laggers. Laggering productivity is a euphemism for secular stagnation which in turn is a fancy word for unfavorable demographics. The fact is that the baby boomers (those born between 1946 and1961) have driven economic prosperity in the US since the 1960's. They are getting older and less productive. In addition, they don't buy as many cars or boats or playpens or houses as those who are young, and there simply are not as many young adults as there are boomers Those of advanced age, like boomers today, tend to be savers not consumers. And not shockingly, when boomers can't get a decent return on conservative investments like a cd or a savings account or a bond, they are forced to save more. Logic would say that given this, the Federal Reserve should adopt policies that INCREASE the rate of return on conservative investments so that boomers would have more disposable income to spend. But have they? No they have doubled down on what is proving to be an ever spiraling race to zero interest and below.

What does this mean to me? I continue to subscribe to Busch's Postulate described more than two years ago in Vol. 218 Riskrewardblog and repeated below.

"You may be right/I may be crazy
But it just may be a lunatic/You're looking for."---lyrics from "You May Be Right" sung by Billy Joel

"People who need people
Are the luckiest people in the world
Children needing other children"---lyrics from "People" sung by Barbra Streisand

"A room is still a room
Even when there's nothing there but gloom
But a room is not a house
And a house is not a home."---lyrics from "A House Is Not a Home" sung by Dionne Warwick

Busch's Postulate: Interest rates will not increase in the foreseeable future.

In so postulating, I posit two premises: 1) economies in countries with aging and shrinking populations do not grow; and 2) the above notwithstanding, central bankers and the economists that they employ believe they can spur economic growth by maintaining low interest rates. I lit on these two premises while reading Harry Dent Jr.'s new book "The Demographic Cliff". If you google Mr. Dent, you may conclude that he is a crackpot. "You may be right/He may be crazy/But it just may be a lunatic (as opposed to an economist) that we are looking for." And before dismissing premise number one, take a gander at Japan's experience over the past 15 years and keep an eye on present day Europe. One has long suffered from economic stagnation, even deflation and the other is on the verge. (Indeed , my concern is such that I am currently spending several days on the French Riviera helping its economy.) The US is not far behind. All three have aging/shrinking populations. Dent is not alone in his thinking. Read the musings of Stephen Conwill who as president of Milliman of Japan has witnessed deflation first hand and who has issued the following challenge: "Find in history an example of an economy that has combined solid growth with a declining population."

It is Mr. Dent's further contention that a person's peak age of consumption is 46--- a larger abode, college tuition, a second home, a nicer car, etc. With the post World War II Baby Boom ending in 1961, simple math led Dent to conclude that Baby Boomer consumption crested in 2007. The offspring of the Boomers have heretofore reproduced at less than the population replacement rate (1.84 births per woman vs. 2.1 needed to simply replace a population) and even that rate is trending down. Apparently, they do not believe that "People who need people/Are the luckiest people in the world." Or that "children need other children." As Harry puts it, in the US the dyers are outnumbering the buyers. (N.B. In 2012 deaths outnumbered births in the US non-Hispanic white population for the first time in history.) The birth rate in Europe and Japan is even lower, and if you think that China will help spur demand, think of the impact of the "one child rule". Hence, Dent sees years of lessening demand world wide and slow to no growth.

So how does this impact my investing? As noted in premise two above, central bankers have unlimited hubris, but limited tools to combat slow growth. They can keep short term interest rates low by fiat (e.g. via the Fed fund rate) and longer term ones low by quantitative easing (e.g. buying bonds and mortgages). Both may have a short term positive impact on the stock market but neither has proven to spur economic growth. As reported this week, despite spending hundreds of billions of dollars to suppress mortgage rates (QE3), new home sales for March were at an annualized rate of 384,000 down from February and downright puny when compared to the 1,400,000 new homes sold in 2005. Last week, the number of existing home sales was reported at an annualized rate of 4.6million compared to 7.25million in 2005. Talk about "nothing there but gloom." I guess Dionne is right, "a room is not a house/And a house is not a home"--- if no one buys it, that is. Yet, despite demonstrated ineffectiveness, we can expect the Fed to keep interest rates low. And as long as interest rates stay low (especially on the 10Year US Treasury Bond) my high yielding, income securities remain a good investment. Holding pat with preferred stocks, utilities, real estate investment trusts and leveraged close end funds seems the right thing to do.

The mediocre performance of the stock market year to date (as of Friday the Dow Jones Industrial Average is down 1% and the S&P is up less than 1%) reflects mounting concern over the prospects for solid economic growth despite low interest rates. Some, like Dent, believe that slow growth could become no growth or even deflation. I'm not saying that any day soon you, like Ms. Warwick, will be able to "put $100 down and buy a car", but the deflationary impact of an aging/shrinking population is disconcerting. And as for Janet Yellen, like all central bankers,

"The moment she wakes up
Before she puts on her make up
She says a little prayer"

that low interest rates will spur growth. Bonne chance, Janet!

Au revoir from Nice.

June 26, 2016 Brexit

Risk/Reward Vol. 311

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

My summer schedule is such that publishing Risk/Reward may be sporadic. In other words, I am having too much fun on Friday and Saturday to bother with composing it. That said, what happened this week is too important to go without comment.

As I wrote in the last edition (http://www.riskrewardblog.blogspot.com/ ), until very recently Europe's elites had underestimated the likelihood and the impact of Brexit. Going into Thursday's referendum the vote was slated to be close, but markets across the globe were convinced that Britain would remain in the European Union. I continued to monitor the situation but saw no reason to sell given that stocks continued to perform well. Indeed with the early returns showing that Brexit would be defeated, Thursday proved to be a major up day. After the close of the United States stock markets that day however the vote began to turn. By Friday morning Brexit was a reality. Predictably the markets tumbled as uncertainty reigned. And as we all know Mr. Market abhors uncertainty. By Friday's close both the Dow Jones Industrial Average and the S&P 500 had fallen 3.5 %. That fact notwithstanding both were down only 1.6% for the week.

As for my portfolio, I too took a hit on Friday but remained positive for the week. As stated I monitored the situation closely throughout the week and do not second-guess myself in staying put except in one respect. I should have sold Shell and BP before the close on Thursday. Had I done so I would have mitigated half the loss that I experienced on Friday. Holding those Eurocentric stocks was not worth the risk of Brexit no matter what the odds.

I believe that Friday was the worst of it and that we should see a positive return next week