March 2009 - Posts

Partial Profits and Toxic Debt
24 March 09 04:06 PM | Brian Dightman

Markets made the most of the details released Monday on how the government plans to deal with toxic debt at banks.  The new information helped continue the rally started March 9th.  The action overall, however, is suspect.  Consider the following:

  • The rally was touched off with partial quarter reports by Citigroup, JP Morgan and BofA saying they were profitable in the first two months of the year. Gee, we only have to wait another month to find out what happens to their profit after they factor in write-downs and other costs over a full quarter.
  • This was followed by The Fed announcing a huge quantitative easing program which may offer some short term benefits but has very negative long term costs.  The same day the dollar took a dive and prices for several inflation sensitive asset rose.
  • Monday morning Treasury Secretary Geithner announced his private-public toxic debt plan.  Let me see if I get this right.  The government wants investors to buy bonds that a judge can modify (Home Affordability Act - an unintended consequence?) using cheap financing and 6 to 1 leverage (characteristics of what got us in this mess).  The market was thrilled to at least have a Plan A and perhaps it will help banks clean up their balance sheets.
  • There was little stock leadership in the rally, mostly very depressed stocks (many big financials) coming up from very low prices.  This does not bode well for sustainability.
  • The bond market does not seem to be as euphoric.  Interest rate spreads on bonds issued by financial companies tracked by Merrill Lynch have only narrowed slightly from the high they hit on March 11th.  The bond market seems to be reserving judgment on partial quarter profits and toxic debt recovery plans.

In my opinion, these along with many other characteristics, call this market advance into question. 

In terms of economic news, we have received the first signs that the U.S. economic contraction may be stabilizing.  ECRI reported some improvements in the housing market, among other developments, contributed to a stabilizing of their leading U.S. economic growth indictor.  This is a potentially positive development but will require confirmation in the weeks that follow.

Regarding how we could solve the toxic debt problem in other ways.  One idea that has been suggested is to nationalize insolvent banks and transfer their operations to regional banks that are in better fiscal shape.  This action would severely impact the capital structure of the insolvent banks and may send massive ripples through the global financial system.  It would probably require coordination with monetary authorities in other countries.  It is entirely possible that a Plan B of this sort is in the works.  Congress is already considering non-bank takeover power of financial companies.  What is surprising to me is how long it is taking the government to address the severity of the problem and a willingness to come clean about what it is going to take to fix it.

The risk in Geithner's plan is that asset sellers (banks) and buyers (institutional investors) will not be able to agree on price, even with the incentives offered to buyers and the government arm twisting sellers, so few transactions will actually result.  Banks will continue to hoard their capital and the much needed stimulus to constructive lending will be non-existent.  I am also surprised by the degree to which our government has rewarded the management of institutions that managed risk so poorly.  Since when is failure not an option?  In cases like this we want failure to be orderly, but at some point we have to recognize the losses (unless we can continue to defer it).

With Medicare, Social Security, deficits and national debt, it is difficult not to be disturbed by the path our government has taken.  I don't even want to think about what the future will hold if the plans being unveiled, and there is little room for error, fail and they don't have a Plan B.

Stock Stimulus & Bond Bailout
02 March 09 11:59 AM | Brian Dightman

The Obama presidency is off and running and since taking office I believe the administration has provided enough details to help me position my near-term strategy.

By most accounts, the United States has systemic problems in its economy that have been building for decades.  There's not been a day that has gone by in the past year with a news report or a commentary reminding us that American's individual spending habits are beyond their means, or government spending policies are flawed. Understanding how our current economic problems are going to be addressed near term, as well as the list of priorities the new administration is committed to, has led me to formulated the following investment themes.

I believe the likelihood we are going to see declines in stock prices from these already low levels is high for two simple reasons.  The first is consumer spending, which represents approximately 70% of our economy.  It has declined and is likely to continue doing so as unemployment trends higher and those still working focus on paying off debt and saving.  The stimulus spending the government has initiated will fill some of the void left by consumers but overall it represents about 5% of our GDP and will be spent over more than one year.  (Stimulus Spending = $787 Billion/ U.S.  GDP = $14.6 Trillion)  The second reason involves residential real estate which is forecasted to experience a high foreclosure rate for the foreseeable future which will continue to put pressure on credit markets, even if real estate prices stabilize.  The plan to help distressed homeowners may bring some relief to the residential real estate market, but I expect it will have limited utility.

Some industries may be able to produce positive results in 2009 but so far those that seem well positioned because of the administration's priorities, such as a push to alternative wind, solar and other clean energy sources, as well as environmental services and infrastructure groups, have not yet been able to separate themselves from the broader market selloff.  As a matter of fact, most of these groups have lost significantly more than the S&P 500 during the last six months.  Some of these groups may lead the next rally, but at present they are not doing so.  Other industry groups I am watching closely include those tied to commodities, especially those in energy markets and materials.  On the international front, some emerging market countries may be able to recover more quickly.  Those countries with abundant natural resources as well as a strong fiscal position may become good candidates for portfolios in the future, but I believe it is too early to take positions.

In terms of our government's effort to prop up our banking system, it is an incredibly complicated situation.  I am in support of letting some fail, which has happened and will likely continue, but a wholesale collapse of the system should be avoided.  What has become clear is this; all of the bailout programs along with stimulus spending are going to cause our deficit to shoot up by an estimated $1.8 Trillion in 2009 followed by many more years of potentially huge deficit spending.  This will require our Treasury to issue bonds at an alarming rate.  It will be worth watching the Treasury to see if they are able to continue issuing debt at low interest rates.  The Fed has shown a willingness to expand its balance sheet, so we know they can help support a low interest rate policy but I feel like this may hamstring the Fed's ability to continue with their quantitative easing policy.

At present my strategies are very defensively positioned and I expect they will remain that way most of this year.  However, if there are limited opportunities to have a positive effect on strategy returns, I believe they should be considered.

This brings me to my first investment theme.  Near term, one of the few debt markets where you can receive a reasonable interest rate is corporate bonds.  By example, 10 year Treasury bonds are currently paying less than 3%.  Even with a much shorter maturity of 1-3 years, which should reduce interest rate risk, the corporate bond index fund I am looking at is paying closer to 4.5%.  Corporate bonds, however, do carry default risk.  A highly diversified pool of bonds can help protect against default but a deteriorating stock market can have a negative effect on the prices of corporate bonds.  Tight credit markets can also make refinancing debt difficult, which many corporations will need to do.  Longer maturities and high-yield bonds also look attractive in this environment based on their spread over 10 year treasury yields.

Another investment theme I have developed involves energy markets and at some point possibly other commodities like metals.  I believe we are going to remain dependent on huge amounts of foreign oil for years to come.  The alternative energy programs proposed, while important, are a long way from significantly reducing our need for oil.  Since we have chosen in the near term to remain dependent on oil supplied by unstable countries that have strained relations with the United States, many different factors can lead to a supply constraint sending prices higher.  Demand has waned in the economic contraction which has kept prices low.  However, I believe the supply demand function will eventually drive energy prices higher and I will be looking to expand portfolio exposure to energy markets.  Currently I am focused on an investment with exposure to master limited partnerships and the attractive income payout they generate.  I expect to expand holdings in this area through direct exposure to price changes for raw materials and to industry groups positioned to benefit from higher demand for raw materials.

Finally, the strength of the dollar relative to other currencies will be an interesting development to watch.  There are a lot of moving parts to contend with in currency markets, making them a complicated investment decision.  For this reason I am inclined to defer most of my currency exposure to my managed futures position.  It has performed exactly as expected and is based on an index that goes back to 1985.

In summary, corporate bonds are likely to play a role in my strategies by generating income and maintain a defensive posture.  I do expect some investment opportunities in select industries may materialize.  On the international front, those countries rich in natural resources and/or exhibiting strong fiscal conditions may become attractive.  An increase in my managed futures position is also under consideration.   In general, I expect 2009 will be a difficult year for most stock investments but I do think some positive returns may be generated through investments in specific debt markets, exposure to energy and possibly other commodities, potentially select industries and foreign countries, and managed futures.

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