Hi everybody,
This is usually a very quiet week in the markets, and while I originally planned to just take the week off or run something from the archives, I thought that a quick piece from the heart might be more appropriate.
I hope that our enthusiasm about this newsletter has been evident thus far – I’m thrilled at how The Draconian has taken flight. It has been a pleasure to work on, and it has taken each of us here to challenging new places, both professionally and personally.
And we’re just getting started, too. We have a bunch of surprises in store for you all over the coming months and even more planned for the coming years. As with our business and our funds, we are very focused on the long term with The Draconian. Even still, when we published the first issue five months ago, I would never have guessed where we’d be today, both in terms of content and readership. So I’m sure there will be plenty of surprises for me as well in the coming years.
We launched The Draconian back around the 4th of July, my favorite holiday of the year. But Thanksgiving runs an extremely close second. Perhaps it just suits my personality best – a time to gather friends and family around the hearth or dinner table, a time where we are all reminded and convinced of the things that really matter in life, even if the feeling only lasts for a day (before the nation hits the malls for “Black Friday” deals). Consumption of all sorts aside, this is a time of authenticity in addition to giving thanks.
And so I’d like to extend my authentic thanks to all of you.
Today we live in a world that is ripe with stimulus, a world of perpetual bombardment where every morning we don thick jackets to shield us from the flak of advertisements, emails, phone calls, solicitations, text messages, junk mail, and streaming multimedia. In this era of information overload, there is no greater gift that one can receive than the genuine attention of another human being. I am honored beyond words that you have given me a slice of your time.
With each new reader I am reminded of my end of the bargain, to give you something worthy of your time. I know that as long as I hold that notion above all others I’ll never go astray.
Thanks for reading.
Fat. Juicy. Robust. Sexy. Firm. Tantalizing.
No, we haven’t turned into food critics here at The Draconian, nor have we devolved into the realm of the risqué.
We’re talking about dividends. Strangely enough, those are some of the adjectives I most frequently hear being used to describe stock dividends. I suppose we economists are an observant bunch, though perhaps a little bit desperate. Or maybe we just have too few outlets for our creativity.
Today we’re going to break down the world of dividend investing. There was a little more talk of dividend stocks earlier in the year when investors everywhere were looking for alternatives to traditional growth, which had burned them so badly in the crash. But today the risk trade is back on in full force and some of these dividend stocks are starting to go unloved once again.
Remember that when you purchase a share of common stock, you’re purchasing an ownership interest in the company. Typically, owners of businesses demand some sort of compensation for their investment and the dividend has long been a popular way of rewarding those who make the investment.
But first…
Welcome, UNR!
Welcome to all the UNR students and members of the Financial Management Association! Thanks again for letting me come and speak to your club and for being such an intelligent audience. As I mentioned in the lecture, reading and learning about the industry is mandatory if you’re serious about a career in finance or want to be successful as an investor. Don’t forget to read opinions that are different from your own – it’s important to understand multiple viewpoints and avoid the dangerous feedback loop of only exposing yourself to that with which you already agree.
We try and add a local perspective to our commentary on here, and while Reno might not be a major financial hub, there’s more happening in local finance than you might think. Newsletters like ours are a good way to stay plugged in. Don’t forget to join us over at Facebook.com/DracoCapital where you can interact with us and others in the community.
On with our scheduled programming:
1. Dividends come from stocks.
With equity dividends, you’re buying shares of a company’s stock. This means that if something bad happens to the company, the value of your stock will suffer. If market goes down, there’s a very good chance that your stock will go down too. Of course, the converse is also true. If good things happen to the company or the market goes up, odds are your stock will increase in value.
Just remember that dividend stocks are not fixed income. Equity holders are the absolute bottom rung of the capital structure, which means that should the proverbial you-know-what hit the fan, the value of your stock is the first thing to get wiped out. Bondholders, as creditors, have a little better spot in the corporate food chain. The principal value of bonds can certainly fluctuate, but it’s usually much less volatile than a company’s common stock. Even in bankruptcies, bondholders can recover some or all of their original principal.
Because this is equity investing, it’s a good idea to buy at least a few stocks in different sectors to help diversify away both idiosyncratic and sector risk. Just remember that you won’t be able to diversify way systemic risk by simply grabbing a basket of stocks. Typically, companies that pay steady and reliable dividends exhibit lower volatility than the market, but you will have to resort to other measures if you want to get rid of market risk completely. Look at the rest of your portfolio and if you feel you’re overweight equities, do a little rebalancing in conjunction with adding dividend stocks or use some options to hedge away some of your risk. Maybe write some covered calls and pick up some protection puts with the proceeds. (Don’t worry if that sounded a little technical — in the coming weeks our own Kyle Ferguson will be launching a fun series, “Draco Trade School”, that will break down some rather sophisticated trading strategies that are surprisingly simple to employ.)
Take appropriate steps to protect yourself.
2. Dividends are always subject to the board’s discretion.
Stated dividends are anything but guaranteed. Ultimately, they are subject to the discretion of a company’s board of directors. If a company falls on hard times, a very common reaction is to reduce or eliminate any dividends. When a company slashes its dividend the stock often goes down and hurts your future cash flow as an investor.
Keep that in mind, especially with the economic bogeymen that lurk in front of us.
3. Don’t just chase yield.
This is the single biggest rookie mistake when it comes to dividend investing. Stocks with really high dividends have really high dividends for a reason. And the reason is usually lousy fundamentals.
If you find some company that’s yielding a 15% dividend, there’s probably a reason for that. The market might think that the company will either cut or eliminate its dividend. Investors typically demand a chance for higher compensation when taking more risk, and the dividend yield is another way that the risk/reward balance can express itself.
Keep in mind that as the stock price goes down, the yield on the stock goes up. The way dividends work is that X dollars are paid out per share of stock. The yield is calculated by dividing that payout by the price of one share. So if the price of a share goes down, the yield goes up and vice versa. If the company raises its dividend from X dollars per share to (X + Y) dollars per share, that also will increase the yield. Dividend yield can actually be a interesting little indicator on its own.
Long story short: don’t be fooled by super high yields. If it looks too good to be true, it probably is.
4. Look for companies with good cash flow and good balance sheets.
The best dividend stocks are the companies that are boring. There’s a reason that utilities are often associated with reliable dividends. Demand for their service is very inelastic; to most people it’s not really a choice for them whether or not they pay their phone bill or their gas bill. This means that these companies have stable cash flow that they can rely on to pay their equity dividends.
5. Dividends are taxable!
Like so many wonderful things in life, they are made substantially less wonderful when Uncle Sam demands his cut. You’ll get a 1099-DIV from your brokerage at the end of the year detailing the income you earned from all your dividends and a breakdown of how they are to be taxed.
Today, if you hold a stock for more than 60-days, your dividend will be taxed as long-term capital gains (0% or 15% depending on your tax bracket) or at the ordinary income marginal rate. But that’s most likely set to change in 2011 as the Bush tax cuts expire. All dividends will be then be taxed at the ordinary income marginal rate.
Incidentally, when you hear broad political rhetoric about “tax cuts/hikes for the wealthy” without any sort of qualification, it often refers to dividends or capital gains. Politicians refer to this type of tax and income as “tax/income for the wealthy” because those individuals that own stocks typically have above average income and net worth. Voters get really excited by generic “tax the rich!” rhetoric while their eyes tend to glaze over when their congressman talks about marginal increases in the dividend tax rate or capital gains rate.
Be sure and factor all this in to your broad portfolio strategy, and consult your financial or tax advisor before getting too crazy acquiring some dividend stocks.
6. Don’t get lazy with your dividend stocks.
Investing is work, people! It doesn’t need to be a second job for you, but laziness in investing will punish you the same way laziness will in other areas of life. Do some work and stay on top of it.
Now, allow me to do some work for you!
Some sample screens
I like things that are cheap – not “cheap” in the sense that they are inexpensive in absolute terms, but “cheap” relative to the benefits they provide. In other words, things that are a good value. My wife and I love to eat out at local favorite La Famiglia, which costs quite a bit more than Taco Bell. The former always leaves us with a smile on our faces and a sense of enjoyment for our money spent, while the latter typically involves a bloated sense of regret. Taco Bell might be less expensive, but to me, La Famiglia is the better value.
So my first screen was a rather strict value screen, companies that are cheap on a variety of quantitative valuation metrics. All of these companies have a:
-Market cap greater than $2 billion
-PE Ratio of less than 15 for this year’s earnings and next
-Price/Sales of under 2x
-Price/Cash Flow of under 10x
-Positive revenue growth over this year and next
| Company |
Ticker |
Yield |
P/E |
| Aspen Insurance Holdings |
AHL |
2.26% |
6.0 |
| Raytheon Company |
RTN |
2.55% |
10.5 |
| Biovail Corp. |
BVF |
2.63% |
9.7 |
| Allegheny Energy |
AYE |
2.67% |
12.7 |
| Endurance Specialty |
ENH |
2.76% |
5.7 |
| Wisconsin Energy |
WEC |
3.04% |
14.4 |
| Public Service Enterprise Group |
PEG |
4.28% |
10.7 |
| Tele Norte |
TNE |
5.15% |
11.9 |
| Consolidated Edison |
ED |
5.80% |
14.0 |
| Westar Energy |
WR |
6.07% |
14.2 |
| Progress Energy |
PGN |
6.53% |
12.8 |
| Linn Energy |
LINE |
10.30% |
4.2 |
| MFA Mortgage Investments |
MFA |
13.60% |
6.3 |
(data as of 11/13/2009)
This is really interesting, because it’s important to remember that even with a fairly stringent quantitative screen like this, there are names that will emerge that you will want no part of. Always apply a subjective and fundamental filter before making any kind of investment decisions. Talk to your financial advisor about it, too.
In this example MFA Mortgage Investments stands out. There’s a reason why it’s yielding 13.6%. That large dividend is either not long for the world, or the stock is depressed for a very good reason. I don’t know for sure what it is this company does, but I really don’t want to be involved with anything that has “Mortgage Investments” in the company’s name.
A few other names stand out:
Consolidated Edison has long been a favorite of mine and always seems to make its way onto every dividend screen I do. A 5.8% yield is very nice. Their dividend has always been very stable, and with good reason – they sell a product with very inelastic demand. Folks in New York are always going to need their electricity, which makes ED a very boring company. They have slowly grown revenues each year, but are currently trading at 14x ttm earnings, which is at the richer end for a company like ED. But it’s trading a less than 1x sales, and is current priced essentially right at book value. Their balance sheet looks pretty clean without a lot of debt. And to top it all off, the stock has a beta coefficient of 0.28 with the market, which means that when the market moves, it usually doesn’t move much or even in the same direction.
Have a look for yourself:
Raytheon is another name that stands out, another old favorite of mine. I really like the Aerospace & Defense sector, especially in a post-9/11 world, and even more so when I look to the future. Raytheon makes all sorts of awesome stuff from integrated defense and missile systems to intelligence and network control systems. Check it out!
The stock is reasonably cheap at present at just over 10x earnings and 0.8x sales. They have hardly any debt for a company of their size, and on top of that, their long-term debt has trended down every year for the last five. They too have slowly grown their revenues over the years and are expected to slowly grow revenue in the future. Boring and stable.
You can see that they had a pretty rough year in 1999 as the stock collapsed amidst a recall of some faulty missiles and also an accounting scandal with PricewaterhouseCoopers that hid a bunch of cost overruns. But to their credit, they managed through it and are today a very relevant company, the 5th largest U.S. government contractor. That’s a good spot to be in, especially with the current administration at the helm.
One of their chief competitors, Honeywell, failed to make the screen because the stock is expensive relative to book value and earnings are expected to drop in the next two years, but that’s also a name I like. That dividend is yielding about 3.1%
Another screen
For my second screen I used a smaller universe but a broader filter. I started with the S&P 500, mostly large- and mega-cap companies, and filtered out ones that were generally a little cheaper than their industry peers on a valuation basis. I then applied a much stricter subjective filter:
| Company |
Ticker |
Yield |
P/E |
Beta |
Mkt. Cap. |
| Wal-Mart |
WMT |
2.05% |
15.4 |
0.2 |
205 b |
| Baxter International |
BAX |
2.12% |
15.4 |
0.4 |
33 b |
| MetLife |
MET |
2.15% |
– |
1.9 |
28 b |
| General Dynamics |
GD |
2.28% |
10.9 |
1.2 |
26 b |
| Exxon Mobil |
XOM |
2.34% |
16.9 |
0.4 |
341 b |
| Yum! Brands |
YUM |
2.38% |
16.1 |
1.1 |
17 b |
| Procter & Gamble |
PG |
2.87% |
17.4 |
0.6 |
180 b |
| PepsiCo |
PEP |
2.94% |
18.6 |
0.5 |
97 b |
| Northrop Grumman |
NOC |
3.15% |
– |
1.0 |
17 b |
| Clorox |
CLX |
3.35% |
14.9 |
0.4 |
8 b |
| Lockheed Martin |
LMT |
3.40% |
9.9 |
1.0 |
29 b |
| Valero |
VLO |
3.53% |
– |
1.2 |
10 b |
| SYSCO Corporation |
SYY |
3.58% |
14.5 |
0.7 |
16 b |
| Conagra Foods |
CAG |
3.60% |
14.2 |
0.8 |
10 b |
| Waste Management |
WM |
3.63% |
17.8 |
0.5 |
16 b |
| ConocoPhillips |
COP |
3.83% |
– |
1.1 |
79 b |
| PG&E |
PCG |
4.04% |
12.1 |
0.3 |
16 b |
| Kraft Foods |
KFT |
4.32% |
16.7 |
0.6 |
40 b |
| Sunoco |
SUN |
4.41% |
– |
0.6 |
3 b |
| NYSE Euronext |
NYX |
4.45% |
– |
1.7 |
7 b |
| Bristol Myers Squibb |
BMY |
5.36% |
12.3 |
0.7 |
46 b |
| AT&T |
T |
6.24% |
13.1 |
0.7 |
156 b |
| Verizon |
VZ |
6.30% |
15.5 |
0.6 |
86 b |
(data as of 11/13/09)
As you can see, there’s nothing really flashy on that list. These are my kinds of companies.
There are a lot of companies out there that pay dividends and things can get overwhelming in a hurry. Screens and filters like this are a good place from which to start and there are lots of website out there to help you do this. Any brokerage will have the tools you need to conduct a search like this.
There are also a few lazy ways to play dividends. You can pick up an exchange traded fund like SDY, the S&P Dividend ETF. You can also buy shares of a mutual fund geared towards investing in stocks with good dividends. There are plenty of funds like this out there, and it can get complicated and overwhelming in a hurry. The good news with funds like this is that they are an inexpensive way to diversify idiosyncratic risk. If one company blows up, it won’t drastically affect the value of your investment. The bad news, however, is that these funds tend to track the market very closely.
Back when I was in school dividends were somewhat out of fashion, and the argument was that companies could put that capital to better use reinvesting in themselves for growth. But the 80’s and 90’s were a very growth-obsessed era, and today dividends are coming back into fashion. Savvy investors around the world are looking for ways to steadily compound their way to riches instead of trying to aggressively grow (or greedily gamble) their way there.
The choice of how to do it is totally up to you. My goal here is simply to lay down a foundation whereby you can evaluate these individual names on their own.
The final caveat
As I bring this to a close, I do so with a sense of awkwardness.
I feel like my timing for something like this is bad. Dividends are a long-term strategy and I believe we’re getting close to the top end of a bear market rally which could come under serious pressure next year. Don’t get me wrong, there still could be another 10-20% to run in the market, and possibly more than that if the dollar keeps deteriorating and investors keep exhibiting an increased appetite for risk. Neither of those trends will last forever, though, and when those types of trends reverse they often do so with great ferocity and zero mercy.
So do your homework and take an honest inventory of your personality and willingness to accept the associated risks.
See you all next Thursday!
We’ve received a lot of feedback so far on The Draconian, and for the most part it’s been pretty positive. Your comments and suggestions have helped shape the design of the site and also directed its content. I’m thrilled to hear that you’ve found it interesting.
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The Draconian brings the goods
One of the ways that we can really bring our readers value is by leveraging the unique information that comes across our desk. We’ve been at this for quite a while, and over the years we’ve established a fairly robust network of unique information channels. We have a lot of contacts deep in the industry. These are perspectives and information that a lot of investors don’t have and never see through mainstream sources.
As you know, we manage a few different funds, a proprietary trading fund and also a fund of hedge funds. I recently had a conference call with one of our traders. They manage some very large funds. In today’s letter, I will pass along some tidbits from their ground zero perspective in the credit markets. Obviously, I have to leave out a lot of specific information that is subject to confidentiality arrangements, but I am free to discuss general themes and ideas, most of which are shared by us anyway.
Of course, if you are one of our current investors and do want to discuss these topics with a little greater specificity, feel free to give me a call or send me an email through Feedback@TheDraconian.com.
On with the show…
The “Undead” Recovery
In the past few months, we’ve talked a lot about the recovery on here and what shape it will take. I even wrote a detailed piece on what the recovery will look and feel like. For all you new readers, our view is essentially one where the U.S. experiences technical growth i.e. positive GDP, but where its inhabitants just feel kind of “blah” about things. We think it will be a recovery in name only, one that feels like a great big hockey stick, even if the technical shape of GDP growth resembles a U or W.
I actually think the market so far has confirmed that story. You can see the crisis in the chart and also the resolution. But now we’re back in line with the longer-term bear trend that was established well before the crisis:
For the record, I think the market could keep chugging right along even though it’s now in an area where I dislike it for both technical and fundamental reasons. That being said, there is still a little juice on the buy side of this market, but it will need to be squeezed out tactically, not strategically. Go right ahead and buy on the dips, especially when it feels scary to buy or it feels like the market might be rolling over. Days where it feels the most difficult to buy are frequently the best days to do it – that should make perfect sense to your rational brain, though I guarantee your emotional brain won’t like it one bit.
I don’t think the market is a very exciting long-term or medium-term buy right here. Welcome to The Great Range, people. I think five years of up-and-down starts right about now. It’s The “Undead” Recovery¹. I’m sure you zombie aficionados will appreciate that metaphor.
Is the stimulus working?
This is a very tricky question to answer. Really, it’s a question that can only be answered at the top level and by fast-forwarding decades into the future and looking back. I expect to have a definitive answer somewhere around 2050.
In the meantime we can take inventory of many of the government programs and see how they’ve done to date. Before we get into some insider perspectives, you can go have some fun with CNNMoney’s Bailout Tracker and see for yourself where all this money has gone.
Unquestionably, the biggest efforts in terms of both dollar amounts and publicity have centered on bailing out the banking system and keeping these large, technically insolvent entities solvent. All that has really done is further consolidate the banking system, essentially boiling it down into four major firms (Citigroup, Bank of America, Wells Fargo, and JPMorgan Chase). We’ve actually exacerbated the problem that existed pre-crash – that of financial institutions that were so big they posed significant systemic risk to the rest of the world. Today these firms are even bigger and their failure would be even more catastrophic. We are moving in the wrong direction here, though arguably, we’re still in the “stabilization” phase of the crisis resolution.
Perhaps more important is the other major pre-crash problem: there are still mountains of stinky MBS and CDO assets that are rotting on these banks’ balance sheets. Banks are incredibly difficult to analyze and value right now, but if there’s one thing I’m sure of, it’s that their balance sheets are nowhere near as good-looking as they are currently reporting. Add to that the fact that we’re entering a new wave of mortgage resets and a new wave of foreclosures, and the rotten core of this mess hasn’t yet been taken out with the trash.
There are still hundreds and hundreds of regional banks that will fail, ultimately succumbing to the poison within all this toxic debt. This will stress the FDIC further and thus the taxpayer, shareholders, and the labor market. The bottom for real estate might be in sight, but the future continues to look dark and stormy.
Raise your hand if foreclosure relief has worked for you or anyone you know. Anybody? Anybody?
So far the AIG bailout hasn’t worked, nor has the GMAC bailout worked. In fact, just the other day the Fed quietly announced a re-(re?)-bailout of GMAC. Wow.
Halloween has come and gone, but I wonder if the ghost of Friedrich von Hayek haunts the halls of the Federal Reserve. I don’t know for sure, but I certainly wouldn’t want to be there after dark. That has got to be one angry spirit. Spooky stuff…
What should scare you even more than all of this is that the market appears to have completely forgotten all the problems of yore. The high-yield debt market is now gladly accepting new issuances of extremely high-risk CCC grade bonds, the junkiest of the junk! That’s paper that will dissolve and default at the first whiff of difficulty or distress.
Even Christina Romer has been more realistic in her discussion of the stimulus’ effects of late, and she recently admitted that there would have been basically no growth in the economy were it not for all the stimulus. The only thing real about this recovery is the name.
So why on earth is everything in the markets going up?
Simply, we are still in the middle of the biggest buy program in the history of the world. In the last 9 months, the Fed has purchased $1.2 trillion of cash securities, about two thirds of which went towards mortgage backed securities. Most of the rest was straight-up quantitative easing. In essence, people around the world have been selling their MBSs to the Fed and now have to do something with their proceeds. There’s no doubt in my mind that a lot of that money has trickled into the stock market, fueled by the powerful combination of frustratingly low yields and increasing appetite for risk.
These trends can certainly continue and the market could certainly move higher, but man, I would not want to be long the market when this policy stance reverses. At some point it will. It has too. The consequence is the destruction of the U.S. Dollar, the ultimate probability of which I believe is very low. Bernanke knows dollar destruction is wrong, and the rest of the world will not tolerate the continued devaluation of the global reserve currency.
Let’s now look at what could put the kibosh on this asset recovery.
Possible catalysts
1. The real catalyst could be a simple reversal of policy from Bernanke. When he starts tightening rates again, this will trigger tidal waves of activity across the planet. All those major trends – a lower dollar, a rising stock market, inflating commodities, bonds that continue to rally against all odds, rising gold – will come under pressure. If too many people see the writing on the wall, there could be a rush for the exits of those trades. Those are seldom pretty and it’s much better to watch those from the sidelines than be a part of them.
Even slightly tighter fiscal policy could spark a gigantic rally in the Dollar, or at the very least could put in a firm bottom for the Dollar. You will not enjoy owning gold, stocks, real estate, or bonds when this Fed purchase program is scaled back and interest rates start rising. Even the talk of doing so could trigger moves in the market.
So pay careful attention to Bernanke’s language now and in the future. Right now, Obama has admitted that he will nominate Bernanke for another term. But Bernanke will need to be confirmed by the Senate sometime before January 31st of next year, and in order to do that, he’s going to have to swear before them that he’ll continue this accommodative policy stance. These senators want to get re-elected after all, and more of their re-election is in the hands of Fed & Treasury than they might be comfortable with. Bernanke and other Fed governors have recently been campaigning for this big event, and for the most part they have all toed the party line. They’ve sounded awfully dovish.
2. The second catalyst – one we’ve talked about on several occasions here – would be the market just waking up to the realization that this recovery will be boorr-rring. Eventually, it could figure out that the economy is at risk for a double dip recession, the materialization of which would almost certainly send the stock market trending lower. At that point, look for a possible ultimate retest of some of the lows we saw last year. The market will open up a new channel to the downside.
3. And the final major catalyst could be a geopolitical destabilization of sorts. This is a little tougher to predict. It could be the breakout of a new war. It could be Iran acting tough instead of just talking tough with possible nuclear weapons. It could be a deterioration of relations with Russia. It seems like everybody in this country wants China to loosen its currency peg with the Dollar, but that too could send very destructive ripples through the markets.
We are a very sensitive, defensive, and angry country right now. We’re back from the financial abyss, but we are more concerned with the future of our way of life in America than we have been in a long, long time. I have little doubt that we will react swiftly and severely to any legitimate geopolitical threats or direct actions against us.
American psychology is very touchy and reactionary at present, and periods like these are when world wars – total wars – have historically been waged. The classic example is the sinking of the Lusitania (or to a certain extent, even 9/11) versus the bombing of Pearl Harbor. These were all incredibly significant events: explicit, direct attacks on the U.S. and its way of life. But the national atmosphere was very different and our reaction to them was equally different.
In the case of the Lusitania, there was plenty of fallout and outrage, but it took another 2 years for the U.S. to gradually enter the war. (After 9/11, the personal reaction was equally passionate, but involved a similarly awkward implementation of policy.) When Pearl Harbor was bombed, Congress declared war the next day almost unanimously not just against Japan but also Germany. The years between 1900 and 1930 were not ones of crisis. Nor were the halcyon years of 1985 to 2005. The Great Depression and 1940s was an era of American crisis. So, I think, is today.
I certainly hope we can avoid a major war and I honestly think the odds of doing so are probably good. But the collective psychology right now should not be discounted. The nature of any exogenous shock will be much tougher to predict than our reaction to it. These reactions will be quick, decisive, and severe. In this country there is a staggering reservoir of fear buried under a thin crust of caution.
It’s a time to reflect on the words of the Jedi Master:
Fear is the path to the dark side. Fear leads to anger. Anger leads to hate. Hate leads to suffering.
I want to believe in a future free of suffering, but the American psyche is in a darker place today than it would like to admit.
Market recap
It’s been up, up, and away in the stock market!
Like I mentioned above, this is still a market that can be tactically traded with great success.
On the strategy side, if you got crushed in the stock market last year and didn’t get out, the market is giving you an opportunity to atone for the sins of your past. Use this opportunity to rebalance your total portfolio across a wide range of assets and strategies. Use it to pick up a little gold, build up a pile of cash, acquire some high grade or government bonds, lighten up on your real estate, bring down your leverage, and get access to some alternative strategies.
Alternative strategies are our passion and we’ve been studying them and practicing them for 25 years. If you have any questions about this sort of thing, send them to Feedback@TheDraconian.com. I’m always looking for ideas on future content that you all will find interesting and/or useful.
It seems like I talk about TIPS (Treasury Inflation Protected Securities) every week, but they’ve been a good place to be and demand is heating up. Check ‘em out.
I frequently look at Bloomberg’s yield quotes to get a read on the bond market. Right now, the TIPS market is pricing in an average inflation rate of about 2.15% per year for the next 10 years. If you think that’s too low, you should probably own some TIPS. Grab some straight Treasuries if you think 2.15%/year is too high. In my opinion this is one of the lowest risk, most sophisticated trades that the novice investor can take a look at right now. It’s a very accessible trade because everyone’s got an opinion about inflation. Give it a thought if you’re risk averse like me but want to get a little more than the 0.05% your money market fund is yielding.
Keep in mind, though, that inflation is still very much like the Chupacabra – I’ll believe it when I see it. I think we will continue to face some significant deflationary or at the very least, disinflationary, pressures. That being said, I haven’t stopped building some low-risk defenses against the Inflation Chupacabra.
Just in case.
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¹Fun sidenote: I just noticed that according to Bing, we are apparently the first website in the world to use the terms “Inflation Chupacabra” and “The Undead Recovery”!
Before we get rolling with our recap of the markets, we have a special announcement.
Many of us have had our lives touched either directly or indirectly by cancer. One of our firm’s founders and my uncle, Bruce Jones, lost his long battle with lymphoma many years ago. Those of you who are investors have no doubt met Kelsey Joyce, our spectacular admin whiz. She’s also the one who handles the e-mailout of The Draconian. Her mother was recently diagnosed with Multiple Myeloma, a rare type of cancer that attacks the white blood cells. It’s treatable through chemotherapy, but at present is inoperable and incurable.
In response, Kelsey has organized a 5k Walk/Run event. It’s scheduled for this Sunday, November 8th, at Idlewild Park. Sign in begins at 10am and the race starts at 11am. Here’s a link in case you’re unsure where it is. Kelsey’s informed me that she’s got about 80 people signed up so far and that anybody is welcome to just show up and walk or run. There are extra T-shirts!
The sign up fee is $25, but additional donations are appreciated whether you plan to attend or not. All proceeds will benefit the Multiple Myeloma Research Foundation and their search for a cure. This is an investment newsletter after all, so it bears mention that your donation is completely tax deductable.
For information on how to help and make a donation, you can contact Kelsey via email at Kelsey@JonesFunds.com.
On with our recap of the markets…
Is the Recession Over?
With GDP growth in the third quarter of +3.5%, it appears the end of the recession could be here – that wouldn’t surprise us, we called the recession end back in July. But as I’ve talked about, this is hardly anything to celebrate. About 2.4% of that was from increases in consumer spending, and most of that was directly attributable to cash-for-clunkers. This is still an economy on very shaky footing.
On the one hand you have reactions like Joseph Stiglitz’s, which sound straight from the “New Normal” forecast that we’ve discussed at length here at The Draconian. And on the other hand there are still plenty of voices like Ken Fisher’s, who sound a little tipsy on the talk of a sustained bull run and V-recovery. You’ll get a different response altogether from David Tice and the folks at Prudent Bear (hint: they’re pretty bearish).
I never take any one forecast too seriously, but I mention these today to remind everybody that the environment is still very much fugue-like with so many different opinions that are so different from one another. The market’s personality is all over the map, and investor reactions to it are equally varied and chaotic.
As for where I come down on the matter and how it will affect the markets, take a look at this chart which I grabbed from a post over at The Big Picture:
For what it’s worth, I think the market will vaguely resemble that sketch above in the coming 5-10 years. We saw a heck of a bear market, followed by a quick, powerful rally. I don’t think we’re quite at the top of that rebound rally yet, but we’re close enough to it that if I’m a long-term investor, I’m using this rally to rebalance and diversify elsewhere.
The coming years will be up and down. And up and down.
Stocks
We sure had a spooky Halloween to close out October and open November.
Stocks sold off:
And volatility spiked:
This has been the normal pattern during the rebound. With volatility still generally low compared to prior years and credit spreads substantially lower than they’ve been since before the crisis began in 2007, I think the odds of a crash are highly unlikely. That’s assuming there aren’t any exogenous shocks. In the meantime, selloffs and volatility spikes should be utilized tactically. It can be scary to buy during times like that, but I still don’t see any of the major danger indicators flashing at present.
If you’re a trader, buying on dips and lightening up on rallies continues to be the right strategy for good returns and managed risk. That won’t last forever, but it will probably take a catalyst of sorts to reverse that trend.
We’ll look at possible catalysts in coming weeks. I think there are three huge ones lurking to watch for.
Gold
Gold continues to make new highs, even touching $1,100/oz on the futures.
The big news of the week, however, was India buying 200 tons of gold for $6.7 billion from the International Monetary Fund (IMF) to boost their reserves. This is a very big story. Gold watchers have been expecting a large purchase like this to come from China, who needs a lot of gold right now for industrial reasons but also to hold in their reserves, which are very low relative to countries of similar global importance. The IMF still has about another 200 tons for sale so expect another big purchase like this to follow eventually.
As I mentioned a few weeks ago, I do not think this is a speculative bubble in the gold market. It could mark the beginning of a speculation bubble, but as long as the dollar is weak and getting weaker, gold will be a difficult beast to contain. Owning gold is going to be a lot of fun until the Dollar rallies, in which case a big time pullback should be expected.
The Dollar
On the subject of the dollar, the trend is still very clearly down.
When it comes down to it, pretty much everything is still keying off the U.S. Dollar. Lots of assets are showing strong correlation with the Dollar. For the most part, when the Dollar goes down, stocks go up, commodities go up, gold goes up, and bonds go up.
Yes, I do think the trend in the Dollar will continue to be lower, but you see now why cash is such an important diversifier. Should the Dollar strengthen for some crazy reason, make sure you actually own some dollars and not just things that are denominated in them. You don’t want to have your whole portfolio go down together.
In the meantime, I think the 50 day moving average (the blue line in the chart above) will continue provide resistance for the Dollar. Traders can also use the Dollar as a conjunctive signal for when to buy risk assets.
The Recovery Strategy (Redux)
Back in July we also outlined a strategy for how to invest through this recovery which I think will look a little different than prior economic recoveries. Whether or not the NBER comes out and officially declares the recession over in 3Q 2009, we think the strategy we discussed is still relevant.
To repeat:
- Get as diversified as you can. Build some fixed income into your portfolio and look at high quality corporate debt. Keep your cash reserves up to guard against deflation. Add things like gold and TIPs which behave differently and can protect you against dollar weakness and inflation.
- Get some exposure to alternative strategies or hedge funds if you qualify for them. The next decade will be dominated by alpha-generating investments, not ones with beta-driven returns. Without getting too technical, alpha returns come from skill while beta returns come from systemic factors i.e. broad market moves.
- Don’t take outsized, “all-in” risks to try and recover past losses. The worst thing investors do when responding to big losses is doubling down, trying to win it all back as quickly as possible. That road ultimately leads to only one destination: the land financial ruin. Instead, reflect on the investment mistakes you’ve made in the past and learn from them. Now is a chance to re-position yourself in a manner better equipped to deal with the world ahead.
I simply cannot stress the importance of those three factors enough.
When it comes to stocks:
- Allocate to sectors where the government will be focusing its stimulus. Don’t forget that there are a lot of government stimulus programs that still haven’t taken effect yet. There’s a lot of Gov’t Cheese waiting to be spent.
- Buy companies that are increasing top line revenues and not just improving their earnings. Stocks that have rallied on earnings improvements that have come through efficiency measures and cost-cutting won’t be able to sustain any momentum they’ve built up.
- Dividends are sexy again. In a world where investors get increasingly desperate for yield, don’t forget about solid companies that pay reliable dividends. AT&T (T) and Verizon (VZ) are each yielding about 6.5% and while they may not be exciting growth companies, they will remain relevant businesses in the New Normal. Maybe next week I’ll do a big screen of stocks that pay fat dividends and sort out the good ones from the bad. If that sounds helpful, let me know at Feedback@TheDraconian.com.
The Long Road Ahead
I can’t help but always fall back on large macro themes and big picture ideas. As an analyst and investor, this is simply who I am. My vision of the future is one that is dominated by uncertainty of all types. The last few decades have revolved primarily around deregulation and decreasing the power of institutional bodies. It’s been a predictable environment where corporate profitability, personal consumption, credit expansion, and government accommodation could all be counted on. And it’s been the major wind current beneath the wings of the long-boom.
But I think those days are over. At least for a while – longer perhaps, than many might think (or hope). The next few decades will revolve around reregulation and the rebirth of government power. Individuals will become more willing to exchange freedom and choice for security and certainty. I think that trend is now well underway.
My view of whether these trends are the right trends or wrong trends is irrelevant. Judgmental investors who can’t divorce themselves from personal views of rightness and wrongness will be frustrated. Successful investing will depend instead on accurate assessments of which events are likely to transpire and which are unlikely to transpire, and the individual’s ability to flexibly anticipate and react to these events.
I think we are in for times that will call for public sacrifice and cooperation. Rational individuals understand that the unsustainable path cannot continue indefinitely.
Incomes will go down, taxes will go up. We’re in for waves of epic legislation. Individuals will consume less, and less conspicuously. By 2015 I think my (then) 10-year old paid-in-full Toyota 4Runner might even be a status symbol of sorts. I think individuals with strong, steady cash flow and minimal debt obligations will be admired and emulated, particularly by young entrants to the workforce.
By 2020, Gordon Gekko will appear a strange relic from an intriguing era. Future generations may even have a hard time believing individuals like Gekko (or Angelo Mozilo) ever existed, much less were idolized by an an entire industry. Capitalism won’t go away, but listen to all the rhetoric about it today. Social responsibility has become a major buzzword.
All this will have investment implications. What worked from 1982 through 2007 will not work as well in the decades to come. Blind buying and holding U.S. stocks worked very well for pretty much every investor who practiced that thinkless strategy. But that’s not going to work in cycles of uncertainty. The time for alternative strategies and an alternative psychology is now. What got you through the decades pre-crash won’t get you through the decades post-crash.
Death of an Individualist
As an old-school (and card-carrying) Libertarian, I feel distinctly out of place today, especially when it comes to politics and finance. The world is turning. These trends are much too large for me to fight and so instead I must find ways to go along with them. I need to forge new expectations lest I suffer the pain that follows a reality that refuses to match them. I need to focus on the world that is and not the one that I wish there was.
One way or another the seeds of a new economy and new infrastructure will be sown. A new order will emerge. As humans, there is nothing we value more highly than the reproduction of our species, and as Americans there is nothing more important than ensuring the survival of our country.
The other night I was watching the 1946 Hitchcock classic, Notorious, with one of those timeless pairings – Cary Grant opposite Ingrid Bergman – that seem to be missing in so many films today. Their cool, subtle chemistry in steamy Rio de Janeiro make it one of Hitchcock’s best. However, I was struck dumb not by that historic kiss, but a throwaway line from the Claude Rains character. True, Rains’ Alexander Sebastian is a Nazi and technically the film’s villain. But his is the most honest character in the movie by a long shot. As he attempts to console Bergman’s Alicia Huberman about the loss of her father (her grief is faked), he says:
Many things have died for all of us. We mustn’t let our spirit die with them.
He says it with such a casual, honest nonchalance that it comes across as a statement of simple fact. It’s understood that the viewer then would take that notion of “sacrifice for the greater good” for granted; it sounds a little stranger to a viewer today. Think of movies made in the last 20-30 years. Lines like that have invariably capped passionate speeches, inspiring masses of troops to keep fighting or Americans to keep persevering. It’s the kind of thing the President says after Michael Bay has blown up the entire planet in any one of his films, not the sort of thing a man matter-of-factly says to a woman over dinner.
As fun as this movie talk is, the real key here is the date: 1946. Notorious was released shortly after the conclusion of WWII, and was written while the war was still going on. V-J Day marked the end of almost two decades of crisis, ones where public sacrifice were the unfortunate norm. G.I.s sacrificed themselves in battle, families made sacrifices at home through the Depression, and policy makers forced sacrifices upon everyone through actions like higher taxes and inflationary policy measures.
Since the cultural revolution of the 1960s, the power and the importance of the individual have grown stronger while institutions have generally weakened. I think what we are seeing today in this post-crash period is the beginning of the reversal of that cycle. I understand that might be difficult to imagine, but I think that the housing crash and the finance bubble are just a few of the crises to come that our society will react to in increasingly similar ways.
Buckle up for higher taxes, compromised entitlement benefits, lower incomes, more volatile asset prices, and weakening purchasing power.
Public sacrifice will again become the order the of the day as we work our way through the most difficult and uncertain two decades since the 30s and 40s. Bluntly, this is the only way to reverse the unsustainable course our nation has charted for itself and repair all the wrongs we have wrought. It’s uncomfortable to imagine, but we will rise to any challenge and any threat, regardless of the public or personal cost. We must.
The consequences of not doing so are catastrophic.
