June 2007

June 25, 2007 12:00 p.m.

Will Congress Stop This Market?

Last week I asked what can stop this bull market. There are only a few things that derail a stock market rally. The current bull run has been in place since March 2003 without a correction approaching 10%. The small correction in 2006 bottomed about a year ago, and the major indexes have climbed about 24% since with hardly a pause. Many investors forecast various forces would cause either a correction or bear market, but the market has kept surging.

Yet, things might be changing. The indexes have been in a trading range within about 3.5% of its record high for about seven weeks. Interest rates are higher. Crude oil approaches $70 per barrel. Last week, the Dow lost 2.1%, for its second worst week this year. Leadership in the market is very narrow, with a decline in the number of new highs each week.

Only a few things cause sustained declines in stocks. One is a credit or monetary contraction, which we don’t have now. Others are grouped under government policy mistakes that include trade restrictions and regulations or taxes that constrict economic growth.

Is it a coincidence that the Dow declined 184 points the day congressional leaders announced their plans to increase taxes on private equity and hedge fund managers? Other plans for higher taxes on “the rich” have been steadily leaked or announced the last few weeks. It indicates to me that investors are worried about the potential that Congress will increase taxes on investors or businesses. That would be bad for stocks. My expectation is that higher taxes might pass Congress but will not survive a presidential veto, at least until 2009. But passage of higher tax bills will cause some turbulent in the markets for the rest of this year.

June 25, 2007 12:15 p.m. Subprime Mortgage Update

Many homebuyers who took out subprime mortgages in the last few years are hurting. More important, though, is how defaults on these mortgages made to those with less than pristine credit records will affect the economy and investment vehicles. A key is determining how long the shakeout in the subprime mortgages will last.

Last week I heard a presentation from a major player and well-respected authority in the mortgage market. He expected a crash in subprime mortgages several years ago and was a bit surprised at how long it took for problems to service. Now, he believes the shakeout has begun. He is planning to begin buying select subprime mortgages at a fraction of their face value. But he won’t buy in a lump sum. Unless the slide accelerates, he expects there to be a one to three year investment window. Then, investors will have to hold the mortgages for another one to three years before the panic is over and prices recover. In all, he is expecting to spend three to six years easing into this opportunity and profiting from it.

To give an idea of how poor the underwriting was on some of these mortgages and how careful investors must be about the mortgages they buy, he said that of the sample of subprime mortgages his staff thoroughly investigated about 8% never had a single payment made on them. Of those, about half were issued to people who cannot be located. That is quite a bit of outright fraud.

The markets will punish all subprime mortgages, driving the prices of many below their intrinsic value. In a few years the value of many of the mortgages will recover. But investors need a lot of resources and knowledge to be able to profit from this opportunity.

June 22, 2007 10:45 a.m. Patience and Research

The Longleaf Partners Quarterly Report of March 31, 2007, gives a good example of how patience combined with solid research produces solid gains. The example also shows the importance of ignoring headlines and short-term news.

The Longleaf funds have owned Dell Computer for a while. Investors have not been attracted to the stock, because the company’s financial performance the couple of years has not been robust. The stock fell from a high just above $40 in August 2005 to around $20 in the summer of 2006. (Ironically, it was just before that when the major news stories were about how Hewlett-Packard was in decline and Dell had become the clear winner in the PC business.) In each quarterly letter for the last couple of years, the Longleaf managers explained that they had thoroughly examined Dell and believed it was undervalued. They thought investors were ignoring the strength of Dell’s international business and the competitive advantages of Dell’s established business model and distribution network. They saw the potential for Dell to resume strong growth and also believed that Dell’s strong margins and cash flow would increase.

The managers obviously were receiving a lot of negative feedback from their shareholders, yet they believed their analysis was correct and stood fast to their position despite negative headlines and complaints from shareholders.

Finally, the stock hit what seems to be a bottom of around $20 in the fall of 2006 and it approaching $30. The Longleaf funds are not selling the stock. They believe it still is significantly undervalued and has a lot of room to rise. That is why in the Partners fund Dell is over 8% of the portfolio and the fund’s largest holding. Not all investors are suited for such concentrated investing or have the patience to stand firm when the markets and headlines are telling a different story. But the Longleaf funds have been doing this for a long time very successfully and serve as excellent examples of how patient, margin of safety investing pays off.

June 22, 2007 10:40 a.m. Capital Ideas Evolving

An important book for most investors to ready is Capital Ideas by Peter Bernstein. It describes the history of how investment theory has developed since the late 1950s. Most investors are unaware of the ideas and how they are used by those who give them investment advice.

When the book was published in 1992, it essentially advocated that investors select a diversified portfolio of index funds and hold that portfolio allocation indefinitely. I was an opponent of this investment approach. Index funds have numerous disadvantages. The most important disadvantage occurs during bear markets. Those extended periods of negative or below-average returns are when index funds do the worst and alternatives do better. The goals of most investors cannot withstand an extended period of negative returns.

Since the bull market peaked in 2000, Bernstein and others have recognized the flaws in the theory in Capital Ideas. Now, Bernstein has published a new book, Capital Ideas Evolving that updates investment theory since 1992. In the new book, Bernstein discusses the flaws of traditional investment theory. He also describes how some advocates of the traditional theory have changed their views. A great quote from the book is when William Sharpe says, “It’s dangerous, at least in general, to think of risk as a number.” This is a criticism many of us have directed at Sharpe’s investment theories for years.

Bernstein also discusses behavioral finance, a school of thought that exposes the many flaws in traditional investment theory. An interesting observation from Bernstein is that as behavioral finance studies point out ways investors lose or make money, investors learn from this and change their behavior. This changes how markets behave and also makes it more difficult for investors to find ways to beat the averages.

June 19, 2007 09:30 a.m. What Can Stop This Market?

Only 10 days ago, investors and the media seemed to be in a panic. A brief comment from PIMCO’s Bill Gross that the firm’s five-year interest rate forecast had increased caused a major sell off in stocks and bonds. Bonds have recovered only slightly from the decline, but stocks rebounded quickly. The rebound raises the question of what might bring this extended rally to an end. Here are the most likely possibilities.

• Higher interest rates. The trade deficits the U.S. has with many emerging countries keep a ceiling on interest rates, because those countries buy our bonds with their surpluses. This will be discussed in more detail in the July issue of Retirement Watch. Some countries are setting up sovereign wealth funds to invest their surpluses. The funds will invest in other investments. That reduction of the flow of money into bonds could raise the ceiling on interest rates. Rates have been artificially low for several years because of the surplus investments. They could return to a more normal level as those countries diversify their portfolios. The recent rise of the 10-year yield from 4.5% to 5.2% could be only the first phase. Higher interest rates will make stocks less attractive and perhaps cause investors to look at other investments.
• Higher taxes. The new majority in Congress seemed determined to raise income taxes. The recent budget plans for the 2003 tax cuts to expire after 2010. There now are proposals to raise taxes on the wealthy in order to pay for a change in the alternative minimum tax, to increase taxes on hedge fund firms, and to repeal tax breaks of oil companies. Higher taxes are likely to reduce economic growth and cause investors to sell stocks.
• Falling profits. Higher interest rates can reduce the profit margins of companies. Their borrowing costs increase, which reduces their margins. Rising costs of labor and raw materials also could cut profits. The labor market is strong, which puts upward pressure on wages. In the past, companies have made up for higher wages by increasing productivity. There are signs that productivity is slowing, reducing the ability of companies to absorb higher wages. The same holds for rising materials costs. The incentives for ethanol production increased the demand for corn and triggered a chain of price increases through the economy. Businesses are not able to pass through to consumers all the time. In some industries, such as oil, passing on higher costs is fairly easy. In others it is difficult. Falling profit margins, of course, makes stocks less attractive.
• These factors are in addition to the usual threats of higher oil prices, geopolitical events, rising inflation, and a reduction in international economic growth.

In this environment, it is best to avoid assets that do not pay investors to take on their risks. These include corporate and high yield bonds, real estate, and many commodities. Stocks and international stocks remain good investments, but they should be offset with some hedges and sell signals should be used for the most volatile stocks.

June 12, 2007 11:10 a.m. The Big Reversal

Bill Gross of PIMCO is regarded as one of the most successful bond investors, and his views on interest rates grab a lot of attention. For some time Gross has been anticipating a sharp economic decline. He believed the housing problems in the U.S. would lead to a general economic decline and bring long-term interest rates lower. Yields on the 10-year treasury bond were expected to fall below 4%, perhaps much lower.

Last Thursday, Gross changed his forecast rather dramatically. Instead of lower economic growth and lower inflation bringing lower yields, he said the 10-year yield should rise above 6% in the next few years. The forecast is said to have rocked the bond and stock markets. Yields shot up that day, and the Dow declined over 200 points. Curiously, the same morning I was in a conference at which Paul McCulley, a managing director at PIMCO, spoke. McCulley was not nearly as dramatic as Gross and did not give a hint that a major announcement from Gross was coming. My notes record that McCulley forecast over the next five years inflation and interest rates will be “a little higher.” He emphasized that he did not foresee an Armageddon or a disaster. He also said the change would be gradual.

The episode demonstrates the importance of not investing based on forecasts. From time to time, doing so can generate some high returns. But it is tough to get both ends of a forecast correctly: when to buy and when to sell. Instead, portfolio management should be an exercise in risk management. Determine the investments with high risks and low margins of safety. Eliminate or reduce those assets from your portfolio. Search for assets selling at discounts or with reasonable margins of safety. Emphasize these in your portfolio. That is how we construct portfolios for Retirement Watch, and we avoid sudden swings in forecasts.

June 12, 2007 11:00 a.m. Corn and Unintended Consequences

I didn’t think I would write about corn in this journal, but the time has come. The law of unintended consequences is in full effect.

Inflation has been stubbornly high around the world, especially food inflation. As a result interest rates are rising around the globe. This development can be traced to a progression of events.

To reduce the use of fossil fuels such as oil, the U.S. government created incentives for oil refiners and retailers to increase the use of ethanol. Ethanol currently is made primarily for corn. The incentives were significant enough to increase demand in corn. That demand has increased the price of corn. The increase is significant enough to generate complaints from traditional users of corn: livestock farmers, food manufacturers, and restaurants among them. The cost of meats and dairy products are rising because of rising corn prices. Also, farmers have shifted production of other crops to corn. The increased supply is not enough to bring down the price of corn, but the change is enough to decrease the supply of other crops and boost their prices.

That is how the law of unintended consequences works. The government changes a policy to change a certain behavior. The policy change also encourages other behavioral changes that were not anticipated. That is what happens when policymakers do not understand economics.

June 6, 2007 1:30 p.m. Bulls vs. Bears

Why is the10-year bond yield now near or above 5%? Is it good or bad? That is the debate in the markets, and the belief of most investors will determine what happens to the world’s stock markets the next few months.

Recently, I pointed out that over the last few years the stock markets sold off each time the 10-year yield popped above 5% for a sustained period. On those occasions, the rise was due to inflation worries. Investors believed that inflation was not under control and that the Fed would have to raise rates and slow the economy to bring it under control. The rationale caused selling of both stocks and bonds. The inflation fears quickly subsided each time, and stocks resumed their rally begun in early 2003.

This time, economic growth seems to be the reason for rising rates, at least in the U.S. Investors now believe the economy is about to reach the low point of the current slow down and economic growth will increase soon. If true, that would eliminate the possibility of a Fed interest rate cut any time soon, which seems to worry stock investors. The more pessimistic believe that economic strength will result in rate hikes. The European Central Bank increased its rate today.

One of the rationales behind the bull market is that stocks are cheap relative to bonds and many other investments. If bond yields rise, at some point stocks are not relatively attractive. In addition, corporations and private equity funds have profited by borrowing at low rates to buy stocks. If rates rise, borrowing to buy stocks is not a wise move. My guess is that stocks would start to look unattractive if the 10-year yield rises to between 5.25% and 5.50%.

What is an investor to do? My advice always is not to try to pin down an economic forecast and adjust the portfolio accordingly. Instead, decide which risks you want to avoid and which you are willing to take. In our portfolios, we are well-hedged. We do not want to bet on an unending continuation of the stock market rise. It is far longer than the average rally and by historic standards due for a meaningful correction. That is why we own Hussman Strategic Growth, which hedges its portfolio against a broad market decline.

We also do not want to join the bears and bet on a steep correction. Global economies are healthy; it is not clear that rates will remain meaningfully above 5%; and there still is a lot of liquidity in the markets. That is why the rest of the portfolio is invested to profit from rising stock prices in the U.S. and overseas. We have sell signals on some of these funds in case of a meaningful bear market.

In times such as these, a diversified, hedged portfolio is the investor’s best friend.

June 6, 2007 10:35 p.m. The Margin of Safety

One good way to receive an investment education is to read the shareholder letters of some of the quality mutual fund managers. Most funds do not have shareholder letters or have dry, institutional letters that try to avoid saying anything. The best fund managers tend to use the letters as an opportunity to educate shareholders on their approach to investing. A good example is the March 31, 2007 edition from the Oakmark Fund.

The fund managers explain how using a margin of safety approach saved shareholders from a loss despite an investment mistake by the managers. The fund purchased Gannett in 2000 at about 8 times cash flow. The stock was selling for less than other newspapers and seemed attractive. Unfortunately, the newspaper business has been in decline since then. Other newspaper companies recently sold for about half what they were purchased for 10 or more years ago. Oakmark decided to sell Gannett in view of the difficulties of the newspaper business. Because it initially purchased the stock at a low valuation-at a margin of safety-Oakmark shareholders did not suffer the serious losses incurred by investors who purchased other newspaper companies.

That example showed how Oakmark’s margin of safety discipline when purchasing a stock avoids large losses. The letter also has an example of how to sell to preserve a margin of safety. The fund had winners in both Comcast and Mattel. Other investors continue to recommend the stocks and believe their prices can rise further. But Oakmark estimates a company’s business value. It buys stocks only when they sell at substantial discounts to the value. It also sells a stock when it rises to the fund’s estimated value. Even if the stock might rise further because of market momentum or other reasons, Oakmark will sell when there no longer is a margin of safety between the share price and the estimated value of the company. The practice undoubtedly kept the fund from squeezing extra dollars of gains out of its winning investments over the years. But it is more important to avoid big losses, and that is what the fund tries to do.