Sunday, November 29, 2009

Dubai debt concerns

On Wednesday, November 25th there was an announcement by Nakheel, the Dubai World property development arm, of a planned default on a $3.5 billion payment due on December 14, 2009.  Nakheel proposed a 6-month extension of the payment.  Stock and bond markets around the world declined in response to this, led down by shares in banks.

To put this in some perspective, the entire public debt of Dubai is estimated to be $80 billion (about the same size as their GDP), with about $60 billion of that issued by Nakheel and other Dubai World affiliates (much of it for property development).  For comparison, the US government has over $100 billion invested in Citibank alone. 

Everyone knows property development in Dubai has been hugely overdone (they are presently working to finish world's tallest skyscraper) and they made questionable investments near the peak of the bubble in other worldwide real estate investments (i.e. ill fated CityCenter in Las Vegas http://tiny.cc/HnAdc ).

The size of this upcoming $3.5 billion default and even the size of all of Dubai's debt itself is not material.  Instead this is important only as a reminder that there are still problems out there.  Banks worldwide are thought to still be short of needed capital, and any possible losses such as Dubai just brings this back to mind.
 
Sometimes it is good to be reminded that investments offer both risk and return.  Maybe that way we can avoid immediately going back to the bubbles that helped to cause the economic crisis in the first place.

Monday, November 23, 2009

Alternative assets

Alternative assets have an important role to play in achieving portfolio diversification.  To start, Wikipedia.org defines alternative assets by examples including real estate, commodities, collectibles and private equity.  We would expand that definition to be non-traditional holdings (i.e. not stocks, bonds or cash) that over time perform in a fashion differently than traditional portfolio assets.

It is this lack of performance correlation with stocks, bonds and cash that makes alternative assets attractive to portfolio construction.  The extreme market volatility of 2008 and early 2009 provides a good opportunity to view which alternative assets in fact did perform substantially different than stocks and bonds.  In such market duress some of the so called alternative assets, including many hedge funds, turned out just to be traditional assets with high levels of leverage, thereby increasing the risk of portfolios where they were used. 

Frequently, but not always, alternative assets also are less liquid than traditional assets (for example, it is easier to sell a stock than an apartment building).  However, there are some alternative assets that are also liquid and are can be purchased in an open-end mutual fund format.

Informed investors may well begin to use alternative assets, particularly those that offer liquidity, to reduce overall portfolio fluctuations in some of the future volatility that many market experts expect to see.

Monday, November 16, 2009

October 2009 Market Update (Posted to our blog two weeks after sending to our clients.)

The four most dangerous words in investing are “This time it’s different.”
Sir John Templeton, founder Templeton Mutual Funds


As we approach the end of October (this is authored on Thursday, October 29th) we continue to examine the events of the past 18 months (to gain perspective on those dramatic events) and to consider what can be reasonably expected for the future. First, the returns on the S&P 500 are 1% month-to-date for October and 20% year-to-date for 2009. These returns indicate a US stock market that has bounced back dramatically from the March 9, 2009 lows (when the S&P 500 was down 24.6% YTD), but where the bounce back gains would seem to have largely occurred. Now the market would seem to be trying to determine where the economy and stock prices are headed over the next year or more.


Last week saw a new book released by author (and NY Times business reporter) Andrew Ross Sorkin with the title “Too Big to Fail”. About 600 pages in length, this is a fascinating, behind the scenes look at how government and Wall Street dealt with last year’s events. We are left with a number of impressions from this read:


1. Until the September 14, 2008 Lehman Bros. bankruptcy filing few of the players realized the severity of what was happening.

2. The quality of information on asset values at some of the biggest financial companies in the world was extremely poor, particularly at Lehman and AIG.

3. The primary component that holds the world’s financial system together is trust, and when that is removed there is systemic failure.

4. The road from riches to rags can be a very short one once trust is lost, or in street parlance once others will “no longer take your name”. The 580 million of Lehman Brothers shares outstanding (of which ¼ was owned by their 28,000 employees) traded at $65/sh starting 2008 ($38 billion total market value), $20/sh in August 2008 ($12 billion total market value) and was virtually worthless by September 15, 2008.


Turning to the economy and stock market in the future, we generally see two schools of thought: (1) “New normal” economy of reduced consumer spending, high levels of unemployment, increased government involvement, lower household and corporate borrowing, and reduced company revenue and earnings leading to low stock returns. The “new normal” theory has be put forward by the highly respected people at PIMCO (who manage the largest bond mutual fund in the world). (2) “Traditional economic recovery” (our term) with inventories being rebuilt as consumers start to spend again leading to increasing corporate profits. The “traditional economic recovery” approach has a number of proponents, including Dr. David Kelly, who is chief market strategist at JP Morgan funds.

Referring to the quote at the beginning of this, the “new normal” would fall into the category of “This time it is different” thinking and should be closely examined in comparison to the “traditional economic recovery” arguments of Dr. Kelly and others. We present each below and then give our conclusions. As a preview, at Payne Wealth Partners we really do think this time it is different, at least over the long-term.

Dr. Kelly provides the following to support his belief in “traditional economic recovery” with GDP growing at an annual rate of at least 4%:

• Credit spreads (level of corporate interest rates as compared to US Treasury instruments) have returned to normal levels

• GDP logged solid 3.5% growth in the 3rd quarter after four quarters of decline

• Over past 50 years there have been 7 recessions and GDP growth for first full year after these recessions has averaged 5%

• Bigger recessions result in bigger recovery; 1st year after two biggest recessions of past 50 years saw GDP grow average of 7%

• Four areas of the economy that are severely depressed could be expected to provide over ½ of economic growth in a traditional expansion (even though they only account for 17% of long-term GDP growth): Autos, housing starts, inventory rebuilds, business equipment spending

• Unemployment can be expected to grow into mid-2010, but then come down at a rate of about 1%/yr over the next five years thereby adding a full 1% to each of those years GDP growth

Bill Gross and Mohamed El-Erian of PIMCO support their case of the “new normal” with:

• The US entered last year with Federal debt to GDP at 45%, but is presently adding to this at a rate of 10%/year. This trend must eventually result in higher interest rates which will slow the economy. At some point the US government credit rating can be expected to be lowered from AAA if the deficits continue at these high levels.
• Consumer indebtedness in US and UK is still too high relative to income expectations and will reduce future consumer spending.
• Banks are holding more reserves at requirements of both regulators and their management, and will not provide the necessary credit needed for recovery in areas such as residential and commercial real estate
• Unemployment has risen beyond expectations, and is expected to remain high for years and eventually settle back at a higher “natural” rate than experienced in the past
• The high levels of public debt will inhibit future fiscal stimulus and will greatly complicate how governments eventually exit their private sector support

At Payne Wealth Partners, we must choose a set of future expectations against which to make our portfolio decisions. As to those future expectations, we see a likely short-term to intermediate-term environment much like that expressed by Dr. Kelly, but with the positives of such an environment already largely reflected in today’s pricing of equities and in levels of corporate interest rate spreads over Treasuries. When we look out longer term we lean to the “new normal” arguments and the lower returns for stocks (and certain bonds) such an environment would bring. For this reason we have our portfolios generally targeted to stock allocations at the low end of our allowable ranges. Specific steps we are taking now in client portfolios:

1. Slightly reducing our allocations to high-yield bonds which have experienced year-to-date returns in excess of 35% as markets normalized. Although we still feel this category has additional future return potential, now is time to eliminate some risk and lock in profits.
2. Slightly increasing our allocations to emerging market equities (with a reduction in developed market international equities) to reflect our plan to continue to increase the exposure of portfolios to the high levels of economic growth we believe emerging economies will experience.

3. Establishing a position in alternative investments that will bring to portfolios return that is somewhat uncorrelated to the stock and bond markets. We are funding this with the reduction in high-yield bonds and a reduction in investment grade bonds (that are again at normalized spreads to Treasuries). Specifically we will have positions in a managed futures mutual fund (Rydex/SGI Managed Futures Strategy) and an option-collared stock fund (Gateway).

Longer term, we can see continuing increases in allocations to the emerging markets, although we would note that it is now commonplace to see emerging markets investments recommended by many, so we would not be surprised to see some short-term struggles for an area that today seems somewhat overdone. Further, we likely will continue to build investments in alternative types of investments that will provide some absolute levels of returns and with correlations designed to offset some of the ups and downs of traditional stocks and bonds.

Friday, November 13, 2009

China

Investors and policymakers worldwide recognize that China continues to increase in importance to all. With a centralized government and a strong balance sheet, China was able to quickly provide stimulus last year. An important part of the stimulus was huge increases in lending (from government controlled banks) starting 4th quarter 2008. At its peak in the 2nd quarter of 2009, Chinese credit growth for a 3 month moving average (annualized) was about 60%. This has since been brought back to about 20% as the Chinese authorities worked to avoid bubbles in their real estate and stock markets.

Even though the Chinese “manage” their economic releases through central government filters, there is certainly significant growth in their economy. This week they released data showing property development and investment for January to October increased by 18.9%. This doesn’t appear to be too speculative as the number for same period of 2008 was 24.6%. The World Bank believes Chinese household incomes are rising faster than prices and therefore affordability is increasing.

Chinese authorities have not raised interest rates, and observers think they will not until first half of 2010 at the earliest. In the meantime it will pay all investors worldwide to give close attention to economic and market news from China to make sure this key growth engine continues to power everyone’s returns.

Saturday, November 7, 2009

U.S. unemployment now over 10% for first time in 26 years

In October U.S. unemployment rose over 10% (to 10.2%) for the first time in 26 years, and only the 2nd time since the 1948 employment record keeping began.  Behind this headline number we examine additional concerning details:
  • the rate of unemployment rises to 17.5% when including those who have stopped looking or are working part-time since they can't find full time work
  • although unemployment in management and professional occupations is only 5%, the rate in production is about 15% and the rate in construction is about 20%
Although the 3rd quarter U.S. GDP was recently announced at a preliminary estimate of growing at an annual rate of 3.5%, the jobs report shows this growth has yet to reach Main Street America.  Further, some now estimate additional increases in unemployment such as Moody's Economy.com who sees the rate peaking at 11% in mid-2010.

In the meantime, Congress and the White House have been focused solely on healthcare legislation.  Expect this to change in the near future as voters this week sent a signal of dissatisfaction with election of Republican governors in New Jersey and Virginia.  Although the White House claims to have saved or created 640,000 jobs with fiscal stimulus, the math by observers reveals the cost-to-date of each such job to be $92,000.  A jobs credit bill is now being discussed, but the already record-high U.S. budget deficits make any such action challenging for lawmakers.

The big question for the economy and investment markets seems "Will U.S. consumers continue to spend as concerns about unemployment grow amid a diminishing ability of government to do anything about it?"  We shall see.