Jun 30, 2010

Grandpa Always Said...

Commentary from the 2010 Morningstar Investment Conference
“We are on the brink of losing a generation of young investors who don’t understand this volatility.” Bill McNabb, the CEO of Vanguard, addressed an audience of nearly 1500 financial advisors at the Morningstar Investment Conference in Chicago last week. I thought his comment was a bit of an understatement as both young and seasoned investors alike have been understandably concerned with the past few years of market volatility.

We hear these concerns every week from folks in all walks of life. We have witnessed solid AAA rated firms promising healthy financials on Friday and collapsing on Monday morning; we have seen a “Flash Crash” in the market and we have watched as institutional investors paid the government for safety while treasuries had a negative yield. These events are anything but normal. The loose promises of stock brokers suggesting an easy 8% + on investments are gone. Investors have lost trust in the markets.

According to Morningstar, $356 BILLION flowed into bond funds in 2009 and the trend hasn’t stopped in 2010. Year to date nearly $120 billion more has moved into bond funds. Folks are concerned! They are worried about losing any more principal, about losing another decade, they are concerned about a bond bubble. The government debt here and abroad is top of mind, and inflation, now on the back burner, may boil over soon.

What can we do? As top minds gathered in the “Windy City,” I had a chance to engage in discussions on strategies to help us protect clients’ assets and look ahead to opportunities. Many fund managers were available for questions. Morningstar analysts were also at the conference sharing their opinions and asking pointed questions of portfolio managers.

Spending and deficits will haunt us if we don’t prepare.

Pat Dorsey, director of equity research at Morningstar, opened the conference with discussion on the economy and debt and deficits. This theme persisted throughout the conference. Dorsey pointed out that the U.S. financial system was stretched before the crisis and without some sort of intervention our country is in for some major trouble. Spending on defense and entitlements including Social Security, unemployment, Medicare and Medicaid make up 75% of our budget and until law makers begin addressing these issues seriously things will not improve.

Rudolph-Riad Younes, a fund manager for Artio Global investors, joked of prior bubbles in a later session that, “we had dot-com, we had dot-home and now we have dot-gov.” He suggests that the economy is so hyped up on drugs from unprecedented global stimulus and from the bursting mortgage bubble that it is extremely difficult to tell what the global economy is really doing. “Tylenol will cure an infant’s fever for a minute,” he says, suggesting that the stimulus has helped to cover up problems, “but homeowners going through foreclosure are vacationing in Hawaii.” This spending makes no sense and analyzing markets in this environment can be difficult.

Across the globe, spending on all levels is rampant. Many federal governments are in debt, municipalities in many cases are up to their ears, state pensions and the Social Security program are over their head, and many individuals are under water. No matter who was speaking, this theme was echoed throughout the conference.

Michael Hasenstab, the manager of Templeton Global Bond, further addressed these concerns. “There are many countries around the globe with very little debt.” He is looking around the globe for countries who have managed their finances better than we have. Because of his global perspective, the fund is able to hedge against the poor financial situation in the U.S. by investing in foreign debt using the U.S. Dollar or other currencies.

As a country we have a few more resources to deal with debt than Greece did. When faced with massive deficits a country can grow and increase GDP, they can lower interest rates, default, accept a bailout, (termed Government Transfer payment, much like in Greece) they can print more money, cut spending, or raise taxes. Of those options many are not possible. GDP growth will not fix our problem, interest rates cannot go below 0 and no one country could afford to bailout the U.S.

Our options are limited. The U.S. has already begun printing money. Generally this leads to inflation, but Pat Dorsey from Morningstar pointed out that increased regulation for banks has required more deposits. He suggests that “the Fed hasn’t printed money but it has created deposits.” This, along with a continued slump in demand, has offset deflation somewhat, but it is coming.

After November we may see the government begin to cut spending, but as Dorsey and many others at the conference mentioned, until they work on substantially cutting defense and entitlements, cutbacks will make little impact.

What’s left? You’ve got it, taxes are increasing. We have been harping on this for months. Bush’s tax cuts will expire at the end of this year and that is only the beginning. There are already talks of a 1₵ per trade tax on the markets, capital gains will increase, health care reform will eat away at marginal income. Now is the time to plan for higher taxes.

Municipal bonds will help many investors to reduce taxes, and at the conference they were generally smiled upon by analysts. Christine McConnell, a portfolio manager for Fidelity, stated that “duration risk is at a maximum. It begs the question is credit risk a better bet?” Analyzing the credit risk of municipal bonds can be challenging, but rewarding. Some bonds are rated AAA and deserve a much lower rating, while others are rated very poorly and can be bought at a discount but have good cash flow or consistent revenues.

Stocks that yield dividends were a key focus as well. Healthy solid companies didn’t tend to rally like the troubled companies in 2009. Many of the portfolio managers are looking to mega-cap consumer-staples companies to provide consistent income. Hersh Cohen, a portfolio manager for a dividend strategy fund, mentioned that it has been literally 60 years “since you could get more up front return on good solid companies than on bonds.” This was a recurring theme at the conference as well.

This gave some support to our recommendations for companies who pay steady, consistent, rising dividends last year. The investments did not see gains like we expected in 2009 but have been plugging away paying investors each month. I was glad to hear that we were not alone in this thinking and appreciated the reassurance.

Inflation is coming, but when?

Pat Dorsey, when asked about gold said, “all I know is that it is shiny.” The metal has been looked at in the past as a hedge against a weak dollar and inflation, but Dorsey suggests that with the emergence of ETFs that track the price of Gold, the yellow currency may be over inflated because of the ease of entry.

Dorsey also had this to say in regards to when inflation will occur, “We have never been here before and we just don’t know if we will see inflation or deflation short term.” When advisors were asked if they expected inflation in the next 12 months, none of them raised their hands, but when they were asked if inflation would be an issue in the next 20 years they all agreed that it is unavoidable.

Because inflation is looming, but not expected right away, inflation protection is relatively cheap. The challenge will be to take advantage of the price without being negatively impacted by deflation or rising interest rates.

There is a bond bubble, but it may not pop quite how we expect.

Curtis Arledge is Blackrock’s Chief Investment Officer of fixed income. “The bubble is real,” he said, “but it is made up of very safe and short term investments.” Earlier I mentioned that nearly one half of a trillion dollars has flowed into bond funds in the past 18 months. Curtis and a few other bond fund panelists agreed that the majority of this money has moved into ultra-safe investments, thus setting this bubble apart from the dot-com bubble and the housing bubble.

Curtis re-emphasized the bond panelists concerns, “consumers are missing an opportunity to lend while demand for credit is high and banks are not lending.”

This money will flow out of bond funds eventually, but investors will miss out on opportunities while they wait. We have been trying to put money to work in accounts, looking to alternative strategies and de-valued bond funds. We have never been in a place where interest rates were so low for so long and government spending so high. We are working to find opportunities for conservative allocations but are concerned about principle preservation as well.

The next decade in your portfolio does not have to resemble the last.

The last ten years has been labeled by investors as, “The Lost Decade.” Rob Arnott, a fund manager for PIMCO All Asset suggests that, “the past decade was only a lost decade to investors who were 100% in equity and weighted by market capitalization.” In plain English, if you were invested in the S&P 500 you would be flat for the decade. The S&P 500 is market weighted. This means that if you own the index, the majority of your holdings are focused on the largest and MOST EXPENSIVE companies. In the same way, if you owned a bond index you probably owned the MOST INDEBTED countries and companies.

Well, grandpa always said to buy low and sell high. Arnott suggests that folks who did not blindly purchase indexes should have performed better over the same time period. Arnott says to, “Use your risk dial. If I am not getting paid to take risk, I don’t want to take risk.”

For a decade that saw the emergence of the ETF, this flies in the face of many new beliefs. We believe Arnott has a strong point. Although we have done our due diligence for investors regarding passive investing and ETFs, it seems that so far, good managers who understand risk have been able to add value throughout a lost decade.

This was a good trip and a great chance to sit with many of the managers that we work with. Our goal is to make sure that they are adding value, picking good holdings and avoiding bad ones. These managers cannot see into the future, they don’t know where the markets are headed exactly, but overall they are looking for themes, just like we are. We are always happy to entertain questions or have discussions on these topics.
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