Posted on Friday, October 23, 2009 - by Henry Walter
October 2009 Roundup
Please note – The views and opinions expressed in this article are those of the writer and do not necessarily reflect the views and opinions of High Falls Advisors, LLC. The information provided is not specific financial advice or a recommendation to buy or sell. We must review your profile, needs and accounts specifically to determine what is right for you.

OUTLOOK

Secretary of the Treasury Tim Geithner says the signs of recovery are “stronger” than expected. If this was truly the case, why are the White House and Congress falling over themselves to introduce new and expand existing stimuli to spend taxpayer’s money and further bankrupt the nation? We don’t know, but maybe it has something to do with the upcoming election in 2010.

The automobile “cash for clunkers” program did boost sales while it was in effect, but as soon as it expired sales dropped like a lead balloon-- indicating to some the higher sales were simply borrowed from the future. In November, the housing purchase tax credit will expire and we will see what happens, although it looks like Congress is ready to extend it and even make it more generous. On the business side, most of the programs simply prevented healthy change by supporting zombie banks and corporations.

Currently, investors are enjoying the ride but are becoming concerned that the ongoing rally has run too far, too fast, and may be due for a correction. What is driving the rally? Possibly the tidal wave of excess liquidity washing into stock markets as central banks around the world are flooding their economies with money. Or it could be that we have seen the bottom and economic growth is expanding. Or it could be both, or some other forces. Second quarter earnings reports were better than expected, principally due to cost cutting. But now most companies are down to the bone and will have to find other ways to improve results, like increasing revenue. So the next few weeks of earnings reports will be key. If we can get through the third quarter reports without major upsets, we may enjoy the usual seasonal strength towards the end of the year. Don’t count on it; that’s a big if.

Investment performance depends to a large extent on investors’ entry and exit points. Tactically, the rally provides an opportunity for investors to reduce risk in their portfolio by taking some chips off the table, and/or shifting from risky assets to less risky assets. What ever you do, don’t become complacent. Short-term the environment for investors may seem to be improving, but longer-term the U.S. faces major problems and the experts tell us most of the growth going forward will be in Asia.


STABLE VALUE FUNDS

Kodak employees and retirees have large stakes in the Fixed Income Fund, on average approximately 70% of their SIP balances, compared to only 20% for the average participant in a 401(k) plan with the stable value option. As a result, SIP participants are extremely interested in the safety of the fund and we have written on this subject frequently (see bulletins on Oct. 22, 2008, April 3, 2009, and May 5 and 27, 2009).

Michael Markov, head of Markov Processes International LLC, which offers quantitative investment tools and technologies, principally to institutional investors, has written some interesting pieces on stable value funds on his blog ( March 5th, 2009). http://5minforecast.agorafinancial.com/:

“In all recent cases of alleged fraud including Madoff, Stanford and WG Trading, investors were looking for stable positive returns and were willing to take risks and invest in investment products with no protection and no transparency. Stable Value funds, while providing very similar smooth positive returns, are legitimate registered products but investors have to understand that they carry certain risks. Unlike money market funds, SVF invest in longer-term high grade bonds and, therefore, are exposed to interest rate and credit risk. At the same time, these risks are not visible to investors because SVF are priced at book value rather than market value which allow them to report such stable positive returns. Principal and accrued interest is guaranteed by a number of insurance-wrapper contracts with multiple insurers, AIG included. As of today, almost 20% of all DC assets (defined contributions) or over $400 billion is invested in SVF."

To read more on this topic Google “MPI Blog Stable Value a free lunch?”


INDEX or ACTIVELY-MANAGED FUNDS

It is well known that most actively managed funds lag their comparable index funds over time. A new study by Morningstar further twists the knife. Active management funds suffer even more by comparison on a risk-adjusted basis.

Over the past three years, about half of actively-managed funds outperform their respective Morningstar style indexes, but only 37% did on a risk-, size-, and style-adjusted basis. The number is similar for five- and 10-year returns.

To read more, check out the Morningstar web site or Google “Active Managers Fail on Performance, Risk”.


CHINA

According to the IMF’s World Economic Outlook, China could be the world’s second biggest economy as soon as 2010, and the world’s largest in as little as twenty years. China is growing at around 8-9% a year as Japan, currently the world’s second largest economy, will be lucky to grow much faster than 1.7%.

Researchers at the Nomura Institute of Capital Market Research estimate that China will pass the U.S. sometime between 2026-2039, depending on the Yuan appreciation.

You may recall that 20 years ago every broker was convinced that Japan would be the world’s economic powerhouse, so it pays to be skeptical. In 1988, eight of the world’s ten biggest companies were Japanese, today there are none. The biggest, Toyota, is 22nd.


DIVIDENDS

While dividend cuts are becoming less common, increases are hard to come by. According to Jim Nelson's blog ( on Agora Financial), "active income investors should look to where the least number of cuts are occurring. And more importantly, which sectors are the few increases coming from?"

His conclusion, based on his own research, is that consumer staples, industrials and utilities are the three sectors still increasing their dividends consistently. Financials is a sector to stay away from.


OUT OF FAVOR

In the July 2009 Roundup we covered the opportunitis in natural gas stocks with some additional comments in the August 2009 Roundup. In a nutshell, industrial demand, which usually represents 35-40% of total demand, fell precipitously as the recession took hold, and supply increased at a rate much higher than in the past, due to new discoveries and improved technology. The combination caused the price of natural gas and natural gas stocks to crater. Already, with winter approaching and industry recovering, albeit slowly, the price of natural gas is up approximately 40%, and all the stocks we mentioned in July have recovered nicely. Industrial energy users are swapping out of relatively high priced oil to relatively low priced natural gas. We still believe there is much more to go on the upside, provided the economy cooperates.


OUR THREE BOMBS

Thomas L. Friedman, in an OpEd in the October 7 New York Times notes that as a 56-year-old baby boomer, "We grew up in the shadow of just one bomb--the nuclear bomb." He continues, "Today's youth are growing up in the shadow of three bombs--any one of which could go off at any time and set in motion a truly nonlinear, radical change in the trajectory of their lives."

The nuclear threat is still with us but can now be delivered by all kinds of states or terrorists, including suicidal jihadists. At least in the cold war the threat was from one seemingly rational enemy, the Soviet Union.

"But there are now two other bombs our children have hanging over them: the debt bomb and the climate bomb." To read the complete article, Google "Our Three Bombs."


GOLD

We commented on gold in the last Roundup, but buying it over $1,000 makes us nervous. So we will take the easy way out and quote an expert. Sean Brodrick of Uncommon Wisdom gives four reasons to buy gold now:

1. Investor demand is strengthening as central banks have cranked up the printing presses and produced a mountain of paper currencies destined to steadily lose value. Gold is one form of money that can't be printed and is universally viewed as an alternative to paper currencies.


2. Central banks are buying. For a decade they have been sellers, but have now turned into net buyers.


3. A big gap is developing in production as exploration budgets dropped by 40%, according to Canada's Metals economic Group.


4. Gold is still cheap. Adjusted for inflation it has a long way to go to match 1980 prices.

• FDIC – Its reserve fund will soon be depleted.


• FHA – It is on the same path as Freddie Mac and Sallie Mae.


• GM and Chrysler – will need additional funds to make it.

For questions or additional information on this blog entry, please contact us.

Posted on Thursday, September 10, 2009 - by Henry Walter
September 2009 Roundup
Please note – The views and opinions expressed in this article are those of the writer and do not necessarily reflect the views and opinions of High Falls Advisors, LLC. The information provided is not specific financial advice or a recommendation to buy or sell. We must review your profile, needs and accounts specifically to determine what is right for you.


OUTLOOK

If you are an optimist there is a lot of good news out there to support your views. First and foremost, the market has been on a tear since the low of March 9 and extrapolation is so easy. Second, the government and many gurus are telling us the worst is over and it’s back to normal. Third, investors have $3.5 trillion sitting in money market accounts and are just waiting to buy stocks. And there are probably another 20 or so reasons to be bullish.

We think it better to be a realist. But rather than give you our views, we are going to highlight some comments Bill Gross of PIMCO made in his September manager commentary. We think this is an important article for anyone serious about developing an investment strategy, regardless of whether you agree with him or not.

Gross begins by relating that he heard Barton Biggs on Bloomberg Radio in early 2009 say that he (Biggs) was a “child of the bull market”. Barton Biggs is a well-known figure on Wall Street and currently a hedge fund manager and author. Biggs went on to say that for as long as he has been in business – and that’s a long time - it has paid to buy the dips, because markets, economies, profits, and assets always rebounded and went to higher levels.

Gross thought “child of the bull market” was a brilliant phrase and continues, “This is not only the way he learned it, but that is the way, basically, that capitalism is supposed to work. Economies grow, profits grow, just like children do. I think that’s why he said he was a child of the bull market, not just because he had experienced it for so long, but also because economic growth and higher asset prices are almost invariably a natural evolution, much like the maturation of a person. That’s how people grow, and so I think Barton was saying that capitalism just grows that way too.”

And then Gross introduces his concept of a New Normal, “Well, the surprise is that there’s been a significant break in that growth pattern, because of deleveraging, de-globalization, and reregulation.

All of those three in combination, to us at PIMCO, means that if you are a child of the bull market, it’s time to grow up and become a chastened adult; it’s time to recognize that things have changed and that they will continue to change for the next – yes, the next 10 years and maybe even the next 20 years. We are headed into what we call the New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which the government plays a significant role in terms of deficits and reregulation and control of the economy; in which the consumer stops shopping until he drops and begins, as they do in Japan (to be a little ghoulish), starts saving to the grave.”

The focus on what Gross calls the DDRs – deleveraging, deglobalization, and reregulation is a little hard to get one’s arms around. Why would they necessarily lead to a new, slower growth normal?

“A little easier to grasp might be the following approach, which feeds off the same concept, but which extends it a little further by suggesting that DD and R lead to a number of broken business or economic models that may forever change the world we once knew and make even Barton a chastened adult.”

And he goes on to describe four examples:

1. “American-style capitalism and the making of paper instead of things. Inherent in the ‘great moderation’ of the past 25 years was the acceptance of a sort of reverse mercantilism. America would consume, then print paper assets and debt in order to pay for it. Developing (and many developed) countries would make things, and accept America’s securities in return. This game is over.


2. Private vs. public-driven growth. The invisible hand of free enterprise is being replaced by the visible fist of government, a temporarily necessity, but (if permanent) damnable condition itself in terms of future growth and profits.


3. Global economic leadership. It’s premature to award the 21st century to the Chinese as opposed to the United States, but if the last six months have been any example, China is sort of lookin’ like Muhammad Ali standing over Sonny Liston in 1964 yelling, ‘get up, you big ugly bear!’


4. United States housing and employment. Old normal housing models in the U.S. encouraged home ownership, eventually peaking at 69% of households. The model has been broken if only because home ownership is declining, not rising, sinking to perhaps a New Normal level of 65%."
   

1. Global policy rates will remain low for extended periods of time.


2. The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.


3. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.


4. Asia and Asia-connected economies (Australia, Brazil) will dominate future global growth.


5. The dollar is vulnerable on a long-term basis.”
   

• “If they (the Fed) keep printing money to buy bonds, it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our (Chinese) foreign reserves are in U.S. bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies.”


• “Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets.”


• “The U.S. spends tomorrow’s money today. We Chinese spend today’s money tomorrow. That’s why we have a financial crisis.”
  

For questions or additional information on this blog entry, please contact us.

Posted on Tuesday, August 25, 2009 - by Henry Walter
August 2009 Roundup
Please note – The views and opinions expressed in this article are those of the writer and do not necessarily reflect the views and opinions of High Falls Advisors, LLC. The information provided is not specific financial advice or a recommendation to buy or sell. We must review your profile, needs and accounts specifically to determine what is right for you.


OUTLOOK

According to Bridgewater Associates, a large money-management firm in Westport, Connecticut, the optimists see signs that the recession is ending, and they forecast the normal next step: a stronger stock market. In other words, they believe the economic and stock market recoveries will continue to look like a V. The pessimists believe the most important development isn’t the end of the recession, it is the long process of debt reduction by families and businesses, and they fear that any recovery will be more like a W or a series of W’s. (As reported in the Wall Street Journal, Aug. 10th. 2009). And the process of debt reduction could take 6-8 years according to Harvard economist Ken Rogoff, which in turn will slow retail sales and overall economic activity. There is about $20 trillion in excess private sector debt to be eliminated. Regarding the V and W, David Kotak, president of Cumberland Advisors, points out the up leg of a V and the first up of a W look the same when you are in them.

But let’s see what policy makers and other influential commentators have to say.

“We just had a meeting with Sheila Bair head of the Federal Deposit Insurance Corporation (FDIC),” Senator Jim Bunning (R., Ky.) remarked at a July 16 hearing of the Senate Banking Committee. “She is a pretty honest lady and tells it like it is. She told us that unless something dramatic happens that we could lose up to 500 more banks.” As we write, 77 banks have gone belly up so far this year including Colonial Bank with 346 branches across Florida, Alabama, Georgia, Nevada and Texas, and the 6th largest bank failure in history. There are now 305 banks on the FDIC’s “troubled” watch list.

“I don’t think the worst is over. It’s very likely that more jobs will be lost. It would not be surprising if GDP has not yet reached its low.” Larry Summers, former Treasury Secretary and president of Harvard, currently head of the National Economic Council, and a candidate to be the next chairman of the Federal Reserve if Ben Bernanke is not reappointed.

“To be honest, a new bubble now would help us out a lot even if we paid for it later. This is a really good time for a bubble . . . There was a headline in a satirical newspaper in the U.S. last summer that said: ‘The nation demands a new bubble to invest in.’ And that’s pretty much right.” Paul Krugman, Nobel Laureate, Princeton professor and Op-Ed editor for the New York Times.

“Our comfort level with the “unloved” bull remains firm. But even though the S&P 500 is up 49.7% since the March 9 lows, now is not the time to become complacent with such a healthy gain. In fact, we’ve started to look ahead 12-18 months down the road and ask ourselves . . . what could go wrong to cut this bull market short?” Jim Stack, InvesTech Research, frequently interviewed on PBS and other financial programs and usually right based on rigorous research.


NATURAL GAS

Last month in a piece titled ‘Out-of-Favor: An Opportunity’ we suggested looking at natural gas. Here are a couple of additional notes on the natural gas market for those interested. Exports of natural gas are limited because most terminals, if not all, were built to receive liquefied natural gas (LNG) from foreign sources, but lacked the capability to export natural gas to markets in Europe and Asia desperate for it. Europe is in particular need of alternative sources as Russia cuts off supplies each winter. Kitimat LNG Inc., a Canadian company, is building a LNG export terminal in Kitimat, British Columbia, and Apache (APA) and EOG Resources (EOG), two large U.S. producers, have signed on to the project. Others will follow. Originally, the Canadian project was conceived as an import terminal. But a year ago the company realized that new North American supplies made the facility unnecessary, so in September, Kitimat announced it would build an export terminal instead. Other export terminals are being planned.

Oil and natural gas are increasingly interchangeable in a growing number of industrial applications. The ratio of the price of oil to natural gas is historically around 6:1, reflecting the thermal content of each. Currently with oil at $70 per barrel and natural gas at $3.50 per Mcf, the ratio is more like 20. As a result, current natural gas prices correspond to oil at $21. As the recession ends and industry starts to use more energy, this ratio is likely to drop as users switch to the lowest cost source of energy. Coal is not an option because of pollution. The smart money is betting that the ratio will drop because the price of natural gas will rise. It is possible it will drop because the price of oil drops. Most believe the latter is unlikely because developing countries have an enormous appetite for oil.

In the original article we did mention the United States Natural Gas Fund (UNG). We would avoid it as regulators are cracking down on position sizes, and this is a huge fund. This crackdown has no effect on the fundamental story, but it might add a little volatility to NG prices in the near future, which we would welcome as it would give us the opportunity to buy high quality stocks at lower prices. Sooner or later, LNG exports, falling production and rebounding U.S. industrial demand will push North American natural gas prices higher along with the prices of natural gas stocks.


CHINA

Even if you believe, as we do, that the economies of Asia, and in particular China, will grow much faster that those in Europe, North America and other developed countries, caution is advised. But first, to illustrate why investors are bullish on China and emerging markets in general, here is some data from Birinyi Associates. From 1970 to 2008 (38 years!) Birinyi found that emerging markets, which included China for part of the measured span, had a 16.12% annual compound return, compared with 10% for the S&P 500 Index. During the same period, EAFE returned 10.23%, modern art 9.64%, high grade corporate bonds 8.74% and New York City taxi medallions 8.15%.

Why the caution? Because as a result of the huge injection of liquidity into world economies, it is beginning to look like a massive bubble is forming in the Chinese stock market as hot money from around the world, eager to get a piece of the action, pours into one of the few economies reporting strong growth. The Shanghai Composite is already up 103% since its low in late November, 2008. Could it go further? Absolutely, from 2005 to 2007 the composite rose six-fold before crashing 70% in 2008. But trees don’t grow to the sky and analysts are increasingly questioning the economic data coming out of China.

Without getting into too much detail, China’s economic statistics are based on recorded production according to John Makin, an economist at the American Enterprise Institute, rather than being a measure of expenditure growth as U.S. data are. This permits the government to consider funds from the stimulus as part of production before they’re actually spent. (For more details see Barron’s, August 17, 2009, page 6.)

But long-term, China is where the growth potential lies. As an example, there are 10 cars per 1000 people in China compared with 760 cars per 1000 in the U.S. Add in India and the other Asian tigers and you can see why there is so much interest in Asia as investors keep their eyes on where the growth is.


BRIEFLY

• The 2009 Fortune 500 includes 140 American companies, the lowest number on record. China has 37, its largest presence ever. Seven of the top 10 are oil companies.


• The case of Jones v. Harris, now pending before the U.S. Supreme Court, could create new standards for setting mutual-fund fees. Three investors in Oakmark funds sued Harris Associates alleging that the fund’s fees were excessive, and that the board of directors was not sufficiently independent. One legal loop-hole permits former executives of investment managers to become “independent” board members once they have been out of the firm for two years.


• Vanguard is launching some new low-cost bond index funds and ETFs later this year. Three will track broad benchmarks for government bonds, three for corporate bonds, and one mortgaged-backed securities. The main attraction, besides dealing with a reputable firm, are the low expense ratios of 0.15% for each fund.


• Dollar-cost averaging was a viable strategy even in 2008. We just saw an analysis of a theoretical investor who purchased $1000 of the SPY at the start of each month beginning when the S&P 500 was at 1400. At the start of August with the S&P 500 about 1000, $15,000 had been invested and the value was almost $16,000. The reason that returns are positive is that shares were purchased at very low prices early this year, especially in February and March assuming the investor had the guts to follow-through. Unfortunately human nature is such we doubt if many investors would have had the guts to buy at the start of February and March when the market was in free-fall.


• In a report called “Demographics and Capital Markets Returns,” Robert Arnott and Anne Casscells argue that the crisis is not in Social Security, but in demographics. “When an entire society ages,” suggest Arnott and Casscells,” . . . the thing that matters most is the ratio between the workers to retirees. Unfortunately, the aging of the baby boom generation, which is a significant bulge in population, will cause a dramatic increase in the ratio between workers to retirees, one that will put enormous strain on society and cause friction between generations.”

For questions or additional information on this blog entry, please contact us.