Regular readers know that I am or have become a bigger proponent of income investing lately and if you don’t know what I am talking about you should be reading my material more. However, there seems to be preconceived disconnect with my philosophy and what you believe to be true about interest rates moving forward. Some people see my bullishness on bonds in the face of rising interest rates as purely insane, especially given what treasuries are doing, but I can assure you it is not.
Keep in mind I am talking about investment grade corporate bonds and high yield bonds, my favorites are ‘BB’ and ‘BBB’ rate paper in an ETF format, I do not like mutual funds because of the once a day pricing. As an aside I do like selective sovereign debt as well, but don’t go out and buy Eastern European government debt or anything, be selective as the risk return is there, but supply is going to be an issue moving forward so it will pay to be extremely selective in 2010. Anyhow, back to corporate debt and why I like it.
Treasuries are entering a bear market for the first time in my memory and I expect there to be a bear market until the next crisis hits, so for only a few months. The reason there is a bear market is simple, supply, end of story. You cannot issue an endless amount of paper and expect the market to eagerly accept it without paying more for it because people, foreign central banks in this case, know they will never fully be repaid for the US debt they buy now, it is mathematically impossible for the US to repay its debt so don’t shoot the messenger hate the calculator. Because of that mathematical probability interest rates on treasuries are going higher and, according to those wonderfully bullish, and misguided, government data figures investors are pricing in interest rate hikes which kill treasuries and other high grade corporate debt, high grade being the operative word, so remember that please.
High grade corporate debt is technically, and in my opinion, anything rated higher than ‘A’ and issues interest rates slightly above treasury yields. We are talking about your really safe corporate paper issued by IBM and similar firms. Essentially, those are a riskless investment which is why your yield is so close to treasuries and why those bonds will get crushed when/if interest rates go higher. For those who do not understand how bonds work think of bonds and interest rates like a teeter-totter with interest rates on one side and bond prices on the other side, when one goes up the other side goes down. Therefore rising interest rates are bad for bonds because new bond issues will have higher yields so your existing bond will have less appeal in the marketplace and if rates go down new issue bonds will have lower rates which means your existing bond will be more attractive because it has a higher interest rate. Make sense, good.
All of that is important because we are at zero interest, technically we are in the negative interest rate area because of quantitative easing and deflation which is bond friendly. However, this red hot economy we are in, sarcasm is my trademark, many people are expecting an interest rate hike to happen at some time this year and they are right. The Fed will raise interest rates in 2010 from 0-.25% to .25-.50%, wow. There is an outside chance that rates may go to 1% by the end of the year, but that is pure speculation right now because the economic data or ‘recovery’ is spotty at best. Even if rates go up it is relatively meaningless to lower grade corporate bonds because it does not hurt the spread as badly as it does for higher grade corporate bonds.
What I mean is newer higher grade corporate debt and treasury debt will have higher yields than current issues so existing paper will get slammed. However, existing lower quality corporate paper will do OK as we would need rates to go up substantially in order to really hurt the spread. I am not saying that there is no risk in lower quality corporate debt, defaults will be a huge issue moving forward, but I am also betting that the Fed’s liquidity programs end up not going away either. In fact, I would speculate that the Fed’s balance sheet will continue to expand over the next 12 months, perhaps double again if the FASB gets its way and the SIV’s have to be added to banks balance sheets right away, but again that is speculation right now.
If the Fed does actually raise interest rates this would be a bullish signal to the markets because it means we have real growth in the economy as well. This means lower grade paper would perform better, even if that growth is only at lower levels. However, higher interest rates will not be good for stocks, in my opinion, which is why I shifted focus to lower quality corporate bonds and to companies like Alteria. I would not expect, even if the economy is cruising, to see rates go much higher than 1-1.5% though because the Fed is stuck and it cannot move rates higher or to a meaningful level ever again. Regardless, corporate bonds of ‘BBB’ or ‘BB’ and selective ‘junk’ should do OK moving forward in the face of higher interest rates because of what I said previously. We will not see huge returns like that of 2009, but I think they will do better than stocks moving forward, plus you are first in line when the company folds, something to think about.
Why the Fed is stuck
What do I mean by that, a meaningful level? You see, the US is in a debt trap that we cannot escape from, it is simple mathematics. The Fed will not be raising rates to protect the dollar, they want a weak dollar that is for another post, they do not really care about inflation as they really want massive inflation but we cannot create it. The Fed will raise interest rates to keep politicians off of its back and that is about it, but raising rates higher than 1.5% presents problems that the US cannot handle.
Congress just had to raise the debt ceiling by a few hundred billion to fund the government for the next 6-8 weeks, unbelievable, and a more ‘permanent’ fix of raising the debt ceiling to about $14T will be coming soon.
I know this is no big deal to liberal democrats because, after all, under Bush we had to raise the debt ceiling 7 times and to them 8 or 9 wrongs make a right, but this is a major, major problem. Considering that raising the debt ceiling to $14T moves the total US debt to just about 100% of GDP marks a new low for the US and is the greatest amount of debt any country has ever attempted. What I am saying is that our current debt servicing costs with the Fed holding rates at 0% and using QE is about $500B+ a year and our average maturity of our debt is less than 10 years, again this is a first in all of the world’s history.
If the Fed moves rates up past 1.5% then that debt servicing cost will go up, dramatically, and there will be major consequences that the American people are not ready to face. Forget the debt ceiling, we will repeal that silly little rule, especially since we have to raise it almost every year anyhow. Within 7 years out debt servicing costs will begin to take its toll on the national budget squeezing out typically paid for items, like earmarks. Defense spending will have to decline immensely which is why the US remains a superpower even though we have a relatively small manned military compared to say a China, India or North Korea. The dollar will decline much further, it will anyhow as the latest rally, which I anticipated, is a head fake and was driven by Dubai, Greece, Fear, short covering and the selling will comeback harder and faster than you could ever imagine.
All of the senseless spending is coming home to roost, now. China is telling us where to stick it as there is not enough dollars to buy our debt, which is kind of funny in a sick way, and they said no to strengthening their Yuan which makes sense for them and smells of protectionism to me. When we demand a foreign country make their products more expensive in the US just so we can shrink out trade deficit thereby boosting our GDP and sell more products to them that is protectionism, straight up. I do not like to be so grime, but many of the things I foresaw and have been keeping to myself are coming out in the open. Things are not good, but hey as long as the market keeps going up, who cares right? Well, you will when it comes crashing down around you. Fixed income never looked so attractive right now.
One of my accounts has the Royce Special Equity Fund, it is a small blend portfolio, that has a pretty stellar track record. I do not like mutual funds, I prefer ETF’s as I have stated numerous times, but this one account I had left behind in a former 401k plan so it has funds in it. It has OK funds and it is a small account, so I never did anything with it and left it alone, I am lazy.
Regardless, this portfolio has done very well over the long-term. Last year it was done some 19% vs. the Russell which was down 33% and even in 1999 this fund moved to value when it wasn’t popular. Sure, in 1999 it had negative returns, big deal because look at the 2000-2003 returns, the PDF is below. However, the bulls say everything is great and the markets will shoot up another 20 or 30%, but here is this fund, which has killed the market over the long-term, and look at its cash position, it is currently holding 20% cash or cash equivalent.
Now, call me crazy, but that seems odd for a fund that is a long only fund and that has performed extremely well over the long-term. In fact, this flies in the face of “the everything is great” argument the bulls give us now. Based on the track record of the fund manager I am guessing they are a lot smarter than I and know the market pretty well. Considering they are holding so much cash seems a bit odd and bearish from my view point. I think we should pay attention to these guys considering they returned 16%, 30%, and 15% in 2001, 2002, and 2003, respectively, when most fund managers got crushed.
You must think I got killed today with my short positions? Yes, but not really. Most of my puts were bought at much higher levels and I have a lot of time on my side. I did, however, get clobbered on an intraday bet on a turn around. I know, it was a 3.5% GDP print, am I nuts? Nope, because I looked at the numbers and did not like what I saw, did you look at the report or wait for Steve Leisman to read the selected items for you?
Yes, it is a very boring read, most important documents are, but that means you should really read it. The vast majority of the “growth” was government spending or incentive that is not good. Consider this, Cash for clunkers, the $4,500 credit, costs us $23,000 by the time we actually pay for it, nice. How about the $8,000 tax credit? That costs us $40,000 by the time we pay for it. By the way, when I say “we” pay for it I mean the taxpayer, you and I, because the government is broke and issuing debt to pay for all of this junk. Better yet, most of the mortgages written are FHA so it is a double whammy when those mortgages default, fantastic!
I know, don’t let the facts get in the way of a great story. How about that initial jobless claims report this AM? Wait, you did not hear about that because of the 3.5% GDP print? Funny, because the number was another 530K, that is not the sign of a healthy economy and the whole employment is a lagging indicator is a bunch of bull. Let me ask you this, what got us here, mortgage defaults right? They defaulted because they couldn’t afford the payments on the house, regardless of why, but now that problem is worse because folks are unemployed. This was a credit collapse, not an inventory recession, that is a huge difference, I know Michelle on CNBC doesn’t get it, I expect that from her, but not from you, you know better.
Dig deeper in the report, near the bottom and you will see data that is not friendly to the bull’s case. Did you here this at any point today:
“Disposable personal income decreased $20.4 billion (0.7 percent)in the third quarter, in contrast to an increase of $138.2 billion (5.2 percent)in the second. Real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent.”
I did not think so, but that is bad, bad news. If disposable income is declining how will people buy their iPods and iPhones let alone buy those expensive Christmas gifts. Disposable income means excess spending which drives growth and if that is gone then the companies that will do well are those that sell toothpaste and toilet paper. The economy is turning to a needs based economy instead of a wants based economy, which is fine and where we should have been 8 years ago.
Then we have things like this that are in the final parts of the report:
“Current-dollar personal income decreased $15.5 billion (0.5 percent) in the third quarter, in contrast to an increase of $19.1 billion (0.6 percent) in the second.
Personal current taxes increased $4.8 billion in the third quarter, in contrast to a decrease of $119.1 billion in the second. The quarterly pattern of taxes reflected a much smaller decrease in federal
withheld income taxes in the third quarter, based on the quarterly pattern of wages and salaries and a leveling off of the effects on withholding rates from the Making Work Pay Credit provision of the American Recovery and Reinvestment Act of 2009.”
Personally, I do not see much of anything good here, do you? Income decreased which shows layoffs and people making less money, that’s great, I guess because stocks went up 200 points today. As a sign of a strong labor market, which will surely show monthly job losses of 200+ next Thursday, taxes increased a tiny little bit. This is the bulls signal for a recovery, right here, a $4.5B tax withholding increase in the 3Q09 preliminary GDP report. Let us not forget that GM and Chrysler brought back tons of workers, just in time for cash for clunkers, which probably is why this number went up.
Now, I also hear a lot about software and things of that nature were all positive and that had nothing to do with stimulus, wanna bet? My daughter, in 4th grade, has 6, count them, 6 new laptops in her class, in every class in her school. My kindergartner has 4 computers in her class, 4. All brand new IBM’s, sorry, Lenovo’s and all complements of President Obama. So, do you really want to tell me that all those numbers were not government induced because I am pretty sure they were.
I will not even comment on the Goldman last minute revision of their GDP estimate yesterday, but wow, I would love to see their long positions at the close yesterday. We also need to remember a couple of things. First, this is a preliminary number and will be revised, probably down. Second, the 4Q09 number will not be as good as you think because all the Beige Books so far look pretty bad, but the ISM on Monday, I think its Monday at least, will confirm this. Finally, valuation, the market is in the nose bleed section and it doesn’t matter if you believe me or not, but for the love of Pete do your homework before committing money to this thing.
This stunning statement came across the close of CNBC from Tyler Methison who apparently quickly polled strategists after the close today for confirmation. How this is not the beginning of a correction is beyond me as this week’s trading has been nothing but negative, unless you are short the market of course, however this is the stance CNBC is taking. I am afraid much like 2007 and early 2008 it will take much more for the bulls to believe that the market is overheated and ready to come back to reality.
What is causing the pullback? Pick your poison. The technical’s, today the S&P smashed through its 50 day moving average, compliments of Mark, and the transports have been signaling trouble for about a week now. There is the weak consumer confidence which suddenly sank yesterday and, frankly, should have sent the market far into the red. Then there is the weak top line earnings which I have been warning about since the second quarter as the consumer is dead broke and credit is contracting at a 15% annual rate, you cannot have an economic expansion without credit creation. Finally, there is the dollar, my personal favorite indicator lately, which has gained some strength lately which is drawing money out of equities.
Goldman Sachs was also no help today as they announced they are trimming their 3Q09 GDP estimates from 3% to 2.7%, which is really not surprising given a weak consumer. This may have been the ultimate trigger considering stocks have priced in a V shaped recovery with a strong GDP number built in. As a matter of fact, not only did the market price in a +3% GDP for the third quarter, but I have a feeling it priced in a much stronger 4Q09 and 1Q10 GDP figure as well, which is kind of crazy since may retailers are starting to warn about weaker holiday sales. Wal-Mart now has some 100 toys priced at $10 or less compared to last year at only 10 or so toys prices at $10 or less, that is Wal-Mart entering a price war, but with who exactly, The Dollar Store?
Under Armour also, in a roundabout way, warned its 4Q numbers were going to be weaker than expected. This is the shopping season and these are popular products warning that sales are going to be weak during the holidays. If this doesn’t tip you off that the recession is not over I don’t know what will. I realize that employed economists who do not leave their ivory towers much and place way too much emphasis on government transfers think the recession is over, but if they talk to real people perhaps they would realize that data points are more than just data points, they are people and they are hurting.
Some 500K a week initial jobless claims is not good news, it is horrible news and bad for the economy. Cost cutting means nothing if you are firing the very people who you depend on to buy the products you sell. That is exactly what is going on and why unemployment is a leading indicator of our problems. As long as economists are unwilling to listen to that basic fact and try to get you to believe in a jobless recovery, which is a myth I might add, then nothing will get solved.
The markets could get much, much worse in the near future, especially if unemployment or GDP numbers are slightly worse than expected. If the numbers are better than expected we will have a bounce, but I would not expect it to last very long. Traders are getting tougher to please as they are expecting more because they were told everything is better and as they see things progress in the opposite direction they will take the market lower. Yes, I am a bear and I am short, but you already knew that or should have known that as I made no secret about it and I tried to give everyone fair warning.
Disclaimer: I currently hold SPY Jan 2010 100 puts, SPY March 2010 90 puts, SPY June 2010 89 puts, SDS, SKF
Perhaps the most absurd statement anyone can make is that if you are not always bullish on US equities you are not patriotic. That type of talk is eerily similar to that of the Soviet Union or some other regime that discourages freedom of speech or thought. Unfortunately, that is what I get a lot from some readers and media personalities.
Tonight Dennis Kneale said, in his Blog You!, segment that because I am negative on US equities I am not a patriot. He seems to think that blind patriotism and belief that things will always get better because we are America is the way to go. He seems to think that things improved so much over the past 12 months that nothing can go wrong. That cannot be further from the truth and let us not forget that it was about 12 months ago that this guy had no idea what the VIX was and said Citi was a screaming buy at 25 a share or so.
Forgetting his past indiscretions let’s just take a look at the facts which determines why I am bearish on US equities. Real estate, both commercial and residential are in serious trouble and since most mortgages were securitized and sold to banks, later used as collateral, then it is safe to assume that banks have billions more in bad debt on their books. That fact alone should scare any normal person about the banking system by itself, not to mention that the Fed and the FDIC are both very concerned over commercial real estate as you read this post. A banking system that holds this much bad debt is not good and our actions will either postpone the inevitable or, in the best case scenario, create zombie banks.
Equities got way ahead of themselves and are currently trading about 130x their current earnings, 26x future earnings. The current pricing of the S&P 500 means that GDP has to have 4% growth in order to maintain these prices, I do not see that as a possibility no matter how they use hedonics to play with the numbers. I think a rational person would say 2% GDP growth is what we should expect which places the S&P 500’s fair valuation at about 850 or so. Earnings are down some 26% year-over-year and very few firms beat on revenue which means they are firing people to make their numbers, is that patriotic?
Monetary policy is a mess and I do not see how anyone could think differently. The Fed has monetized debt, propped up who knows how many banks, printed tons, literally, of money, have interest rates at zero, refuse to let us know exactly how bad the banking system really is and the list just goes on and on. While inflation is clearly not a problem, deflation is here for some time to come, it is highly unlikely that the Fed will be able to rein in this extremely accommodative monetary policy in a timely fashion and inflation will be a major problem in the future. Also, when foreign banks question the value of your currency and have voiced very public concerns over your currency that is a major problem, especially as we depend on them to fund our deficit spending.
Unemployment is a catastrophic problem because consumption is 70% of our GDP and anyone who thinks that the consumer is coming back, you might want to reevaluate that thought. Considering unemployment is going up it is highly unlikely that the consumer will spend on anything other than the basics. There is no sign of unemployment declining in the near future which will remain a problem for economic growth until we either get used to the new normal or change the structure of our GDP, guess which will happen.
Government subsidized growth is not growth as we must pay for it through our taxes sometime in the future. The programs that have been successful cash for clunkers and the first time homebuyer tax credit is the cause of all the demand that we have seen and will more than likely skew the GDP to positive for 3Q09. However, this artificial demand is not sustainable and eventually we will have to pay for it through taxes. Essentially the government is in the banking business, financial services business and the mortgage business all of which is bad for the free markets.
Based on that information how in the world can you be bullish? Long-term I am sure we will be fine, but if we look around the world I am sure we can find better investment opportunities than in the US at the moment. Until things get back to a new normal or until we are fully aware of the risks banks have n their books I think it is incredibly dangerous to just blindly invest on patriotism. After all America is about opportunity to better yourself and if that means you invest in China or India to make more money than that is as patriotic as you can get.
It is unbelievable that a media personality would go to the, if you don’t invest in America then you’re a traitor’ level. I think that is childish and it looks desperate, kind of like picking a fight with bloggers I might add, for ratings. I am in fine company with my bearish call with the likes of Doug Cass, at the moment at least, Paul Tudor Jones, the folks at Horseman Capital, Peter Schiff and a whole host of others. Of course there is the possibility that I am wrong, but based on the evidence I see I really don’t think that is the case, but in the event that I am wrong I will admit it.
Frankly, I consider myself more patriotic than most as I voice my dissent to the status quo and calling out things in the media that I see as blatantly false or spinning. Anyone voicing their opposition to what they see as wrong is a patriot no matter if it is on healthcare or the way our politicians blatantly vote against their constituents. In the days of old it was the media who was inquisitive about the government and tried to get the real facts, but somewhere along the way the media thought that the latest Britney Spears news was more important than reporting on what our government is up to. I guess they forgot why the Constitution gave them such wide power.
Be the First to Comment 
Subscribe to Annuity IQ's Feed
