Category Archives: Shaping a portfolio for 2011

Shaping a Portfolio for 2011 (l): a macro view

January 6, 2011 By in Constructing a Portfolio, Current Market Thoughts, economics, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

I’m envisioning writing four posts on how I’m shaping my portfolio for 2011.  They are:  a macro view; what’s discounted in today’s markets; what I think about different sectors + overall trends; and, finally, my conclusions.  I can’t guarantee that I won’t deviate somewhat from this plan as I go along, since I tend to use the act of writing stuff down as a way of refining my thoughts.

Today is the macroeconomic view, or at least as much of it as I think an equity investor needs to know.  Actually, better make that as much of it as I’m aware of.

The most basic fact, I think, is that the world is in recovery.  That is to say, global economies are generally starting to grow again in a healthier way than they have been over the past four years or so.  I don’t mean that the world is healthy yet, just that it is in the process of repairing itself.  “Repair” means substantially different things in different parts of the world.

the US

The epicenter of the problem.  In early 2007, what proved to be a massive speculative real estate bubble began to unwind.  Two consequences:

1.  At the depths of the ensuing crisis, the entire world banking system froze up, as financial institutions stopped lending to anyone, even overnight, for fear the counterparty was insolvent and wouldn’t repay.  This problem, which caused the world economy to lurch to a halt, has long since been fixed.

There has been one lasting effect, however.  Industry responded with a rapid contraction of production, including deep layoffs.   Companies have learned that they could operate with far fewer employees than they had imagined.  Therefore, they have been slow to rehire.

2.  Crazy bank lending meant that when the bubble burst and house prices began to decline:

–Lots of people ended up with houses whose value was less than the mortgage and with too much credit card debt

–The country ended up with, to pluck a number out of the air, 10% more houses than anyone wanted/could afford.  The same for commercial–especially retail-oriented–real estate.

This is an enduring issue that is affecting the speed and scope of economic recovery, in the following ways:

a.  Unlike food or out-of-fashion clothing, excess houses and strip malls don’t wear out and can’t be moved.  So until the excess inventories are used up, there won’t be much new construction.

b.  People, especially soon-to-retire Baby Boomers, are trying to get their debt under control and will consume less.  Demand for luxury goods is already back above its pre-crisis peak.  But less buoyant middle- and low-end consumption will be with use for some time to come, I think.

c.  The housing bubble retarded for almost a decade the adjustment of US workers in labor-intensive jobs to the fact of competition from China, India or other low labor-cost countries.  This is likely to be a chronic social problem, and a reason why the unemployment rate won’t improve very quickly.

The federal government response to the crisis has been to flood the country with liquidity by stimulus spending and reducing short-term interest rates to effectively zero.  The idea has been to, as it were, take extraordinary measures to restore a sick person to health, even if doing so may create problems in the future.

From September 2010 onward, signs are that this strategy is beginning to work.  Hiring is happening at a faster rate.  Consumer confidence is rising.  The rate of economic growth is picking up.

My guess is that this trend will continue, and modestly accelerate, through 2011.  I think the recovery will continue to have a 90/10 aspect to it, however.  For the 90% of the workforce who are employed, life is returning to normal.  For the other 10%, however, it seems to me that their situation hasn’t changed for the better so far.

The net of all this is that I think 2011 will be at least as good economically as the consensus expects.  I expect that the aggregate numbers, by ignoring the 90/10 split, will underestimate the strength of high-end consumption and be too optimistic about ordinary Americans.

Two other points:

1.  Not all the liquidity flood has remained in the US.  A lot has flowed through currency pegs maintained by developing countries into the emerging world.

2.  I think there’s still one more economic shoe to drop in the US–state and local budget deficits.  My general picture is that during the boom times, governments of every stripe spent every penny that came in.  Now they are facing retrenchment.  This will mean layoffs of government workers, rather than tax increases.

At the same time, a potential crisis is brewing over the generous medical and pension benefits retired government workers typically have.  Part of this may be envy, part may be partisan politics, part may be dismay that the full cost of government workers has been hidden from the voters–but no matter what the cause, this could become a big issue later in the year.  To what effect?–renegotiation of benefits would result in less spending by government employees.

Europe

The UK is like the US, writ somewhat smaller and with one exception, noted below.  Also, most of the toxic transactions made by US financial institutions flowed through London, even though they may have involved US assets and US parties.  Why?  –UK policy was “regulation lite,” in return for which it got lots of tax revenue.

True, the sub-prime mortgage crisis may have originated in the US, but the ultimate “dumb money” in the banking world is state-controlled banks in continental Europe.  And,sure enough, they have ended up holding tons of dubious debt securities and derivatives.

But that isn’t the only economic problem the EU has.  It’s an association of countries that has agreed to maintain a common money policy, but whose members have had very different growth rates–a slow-growing core (Germany and France) and a fast-growing periphery (most of the rest).  A money regimen that’s appropriate for the center has proved to be as overstimulative for Ireland, Spain and Portugal as anyone imagined–and then some.  All that “extra” money sloshing round in the peripheral countries has not been soaked up by the countries in question through restrictive fiscal policy–as it should have been–but allowed to flow into speculative real estate deals.

What’s worse, Greece has been falsifying its national accounts for years.  And Irish banks somehow passed the European stress tests despite being thoroughly bankrupt.

The EU response to the banking crisis has been waffling.  It knows what has to be done–closer fiscal integration–but can’t bring itself to pull the trigger.

Unlike the US, the EU and UK response to government deficits has been austerity.  That is, higher value-added taxes and severe government budget cuts.  The idea has been to fix the problem no matter what the cost in near-term economic progress or pain to the EU citizen.

Not a place to look for domestic growth in during 2011.

BRICs

International investors have traditionally described emerging economies as acting like options on developed world economic growth, meaning that they move in the same direction as the developing world but with higher highs and lower lows.

That hasn’t been the case this time around.  The financial crisis has been almost completely a developed markets problem, leaving emerging economies relatively untouched.  To the degree that they provide raw materials or industrial/consumer products to each other or to the rest of the world, they have prospered.  And by the World Bank’s purchasing power parity measure, emerging economies in the aggregate product almost half the world’s output–scarcely an option any more.

To the extent that they peg their currencies to the US dollar, emerging economies are in somewhat the same position relative to the US as the peripheral countries in Europe have been to the core.  That is, hugely accommodative money policy in the US is communicated to the local economies, where it’s exactly the wrong thing, though the peg.  In addition, developed world investors have been shifting immense amounts of portfolio capital to the developing world as they search for better returns.  This increases the money stimulus.

The big question for many emerging countries is how to cool themselves down.

Australia/Canada

These commodity-producing countries have by and large escaped the financial crisis.

Japan

In the early Nineties, Japan decided that it would forgo economic progress if that were the price it had to pay to preserve its traditional way of life.  To a Westerner, that continues to be a horrible bargain.  An obsolete industrial base, an aged population and no economic growth in sight.  I haven’t looked for statistics, but I’d be willing to bet Japan is experiencing a huge brain drain as skilled young people move elsewhere.

municipal bond defaults (ll): implications

December 28, 2010 By in Constructing a Portfolio, Current Market Thoughts, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , , , Leave a comment

size of the market

Outstanding municipal debt amounts to something over $3 trillion.

I can’t find good figures for the breakout of the state vs. the local government portions of the debt (feel free to comment if you know).  The state portion, however, appears to be $2 trillion+ and the local government part $1 trillion-.

Over the past 15 years, the dollar volume of issuance has been roughly split into 1/3 GO, 2/3 project (revenue bonds).

State and local governments report unfunded deficits of around $1 trillion in the pension plans they offer to employees.  Independent observers suggest that if more conservative (and realistic) assumptions about the growth of assets are used, the underfunding may top $3 trillion.

Annual state revenue amounts to around $1.2 trillion.  Local government intake is about $900 billion.

hair-splitting, or maybe something a little more serious than that

Yes, there are unrated bonds.  Small local governments may find it too expensive to pay for a rating, for example.  Let’s ignore that market and ask:

How likely is it that fifty to one hundred cities or towns, involving hundreds of billions of dollars, default on their debts in 2011, as Meredith Whitney claims?

Eliminate GOs from consideration, since

–tax revenues are rising again,

–governments have lots of money relative to their outstanding debt,

–governments can be legally forced to reallocate funds to repay GOs, and

–GO defaults have been almost non-existent.

That leaves project bonds.

By far, the largest number of the 51 project loan defaults over the past forty years have been in health-care (21 instances) and housing (also 21).  The two currently comprise 6.6% and 10.6% of all rated municipal loans.

As I pointed out in yesterday’s post on municipal bonds, about .5% of the outstanding municipal project bonds have defaulted over the past forty years.  33 of those defaults occurred during the past decade, giving a ten-year default rate of .3%.

So,

–to get $200 billion of defaults from the roughly $2 billion total outstanding of state and local project loans, it would be necessary for 10% of the loans to default, assuming defaulters were of average size.  That would be 333x the average number of yearly defaults over the past ten years.   Is this likely?  Unless municipalities want to default, probably not.

Others have commented that if we’re talking about bankruptcy rather than just default, the pool of possible dud loans shrinks to $600-$700 million.  If so, you can only get to $200 billion of defaults if a third of the outstanding loan amount goes bad.  This, in turn, can only happen if several of the biggest cities in the US, like New York City, or Los Angeles, go under.

My conclusion about the Whitney assertions?  I don’t know enough about the muni market to have an opinion.  My hunch, though, is that she has no case.

there is a problem, though

It’s possible that Ms. Whitney simply said what she thought she needed to say so that she would be endorsed as an expert on municipal bonds by Sixty Minutes–and thereby jump-start her new business. Arguably, she knew, or should have known, that what she was saying had little factual support.  But that doesn’t mean there’s clear sailing for state and local governments.  What got her on Sixty Minutes is the growing awareness of problems in municipal finance.

Two related problems actually.

The first is the size–personally, I believe the $3 trillion figure–of the unfunded pension liability for state and local government workers.

The second is the issue of state and local government budget deficits.  My thumbnail description is that governments are sized for the boom times of 2005-2006, and now are being forced by today’s lower revenues to downsize.

These are not problems of the magnitude of the financial crisis, when world commerce froze and corporations made massive layoffs. But they are significant.  And they’re gradually building, as companies and retiring Baby Boomers increasingly migrate away from high taxes and cold weather in the northeast and the midwest to warmer–and lower-cost–areas elsewhere.

Unattended, the pension problem will grow worse.  Balanced-budget requirements are forcing the second to be addressed.

effect on the stock market

…which is mostly what I’m concerned about.

I think the major effect will be to slow improvement in the unemployment rate, as state and local government layoffs offset private sector hiring to some degree.

I think it’s also possible that some municipalities will take the occasion of dealing with a budget deficit as an opportunity to address the pension issue by entering Chapter 9 and hoping to renegotiate contracts with employees.  That would doubtless make headlines and depress stock prices.  The process of change would also be long and arduous.  My guess, though, is that such events will be small enough that they’d represent buying opportunities rather than causing permanent damage to the market.

That leaves the states.  I think it’s telling that high-tax dysfunctional states like California, New Jersey and New York have recently elected governors who have run on platforms of fiscal responsibility.  As an equity investor, I find it impossible to handicap the chances of a material negative change in the financial situation of places like this.  I think Wall Street’s default option in such a case is to assume that the entities will muddle through.  Therefore, a sudden change in sentiment that had bond investors denying a state access to new financing could easily clip 5% off the S&P’s market cap.

 

 

 

 

municipal bond defaults (l): general

December 27, 2010 By in Current Market Thoughts, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , Leave a comment

I’m finally trying seriously to formulate a detailed strategy statement for 2011.  As usual, I’ve waited to the absolute last minute.  In thinking about what might go wrong on a macro level, two issues stand out:

–possible EU sovereign debt problems and

–potential municipal financing difficulties in the US.

So I started doing research on municipal bankruptcies.

the slapstick

I learned there’s been a media firestorm over this topic during the past week, with real slapstick comedy overtones.  Putative municipal credit rater Meredith Whitney appeared on Sixty Minutes last week to predict that 50-100 cities in the US will declare bankruptcy next year, defaulting on “hundreds of billions of dollars” in debt.  This compares with the current record default year of 2008, during which cities stopped paying on about $8 billion of their obligations.  Muni experts were not amused.  They point out that the figure mentioned would imply just about every large city in the US going belly up.

Ms. Whitney is probably best known for being the spouse of former professional wrestling “champion,” John Layfield,  who performed under the nommes de guerre of “Hawk”  (a member of the Undertaker’s “Ministry of Darkness”), “Bradshaw,”  and “JBL.”  He is now a seller of herbal potions, as well as a financial commentator for Fox.  Whitney, also a financial commentator for Fox, gained fame while a bank analyst at Oppenheimer for her well-publicized (and correct) opinion that the financial crisis would be far worse than the consensus expected.

Though widely criticized for her non-consensus views on municipal finance, Whitney has found defenders, including Henry Blodget, a former Oppenheimer analyst himself, who is now barred from the securities industry as part of his agreement to settle securities fraud charges brought against him by the SEC.

the rationale

It’s not clear that Ms. Whitney has any deep knowledge of the municipal markets.  She does “get” the value of publicity, however.  And she has already been a big winner from understanding and exploiting two aspects of the traditional for-sale information business on Wall Street:

1.  Industry analysts depend for their livelihood on the viability and importance of the industry they cover.  As a result, they tend to gradually become like home-town sports announcers, that is, industry apologists.  They screen out any negative information.  That allows someone like Ms. Whitney to play the role of the boy who shouted out that the emperor wasn’t wearing any clothes.

2.  Sell-side analysts get noticed by staking out positions that are unusual and controversial, not by clinging to the consensus.  If radical positions prove wrong, customers quickly forget.  If the ideas are right, they’re the ticket to fame and fortune.  So a junior analyst has nothing to lose by getting as far away from the consensus as possible.

So not only is there a good chance that long-time observers of a section of the capital markets like municipals will ignore seemly obvious problems, but trying to point them out is a no-lose proposition.  So Ms. Whitney’s strategy of going out on a limb makes a lot of business sense.

the facts about municipals

two types of bonds

Municipal bonds are generally classified either as:

—general obligation bonds, which means that the full faith and credit of the issuing government stands behind the issue, or

—project bonds, or revenue bonds, which is basically everything else.  These bonds are backed by the revenue-generating power of some specific government-related endeavor.  They can range from a power plant or a road, to a nursing home or some more dubious private enterprise that uses municipal finance as a “conduit” or wrapper.

default rates are extremely low

According to data complied by Moody’s about issues rated by the agency, defaults on municipal bonds have been relatively rare.  Moody’s latest study covers the forty years from 1970-2009.  Of the 18,400 issues considered, 47% were GO issues, 53% project bonds.

Over that time period, 54 issues, or .3% of the total, defaulted.  Three of them were GOs, implying a default rate of .03% for GOs.  The project bond default rate was about .5%.

There has been some acceleration in the default rate, though.  36 issues, including all three GOs, have defaulted since the turn of the century.

In the defaults, investors’ recoveries have averaged 67% of principal.  The median recovery has been 85%.  The difference is caused by a few real clunkers of project financings where investors lost 95% of their money.

municipal bankruptcy isn’t easy to do

States can’t go into bankruptcy, period.

Cities and towns can go into Chapter 9 of the bankruptcy code, but require the permission of their states to file.  In a little fewer than half the states municipalities are simply prohibited from doing so.  In others, the process may be a lot more complicated–and time-consuming–than simply throwing a switch.

Chapter 9

Chapter 9 differs from the corporate Chapter 7 (liquidation) or Chapter 11 (reorganization), in that:

–the municipality must elect to enter Chapter 9.  Creditors can’t compel them to, as they can with corporate debtors

–Chapter 9 provides only for renegotiation of debt terms, not for liquidation

–the municipality continues to be in charge of operations, not a bankruptcy judge

–the municipality can’t enter Chapter 9 in anticipation of running out of money or even if it has decided to default on loans by simply not paying.  It has to be actually unable to pay.

In the case of a GO, if a municipality stops paying creditors can get a court order telling the municipality to raise taxes or do whatever else is necessary to raise the money need to cure the default.

Some commentators have observed that in the case of states, even those in the worst financial conditions, raising taxes by 2% would wipe out the budget deficits.  I don’t know if this is true or not.  I do think that matters are not that simple.  Higher taxes may increase non-compliance.  They may also hasten migration to areas (in the South or West) that don’t have income taxes.  As a practical matter, it’s entirely possible that raising taxes may result in a government getting in less revenue than before.

I’ve read, but been unable to confirm from the agency website, that the federal Government Accountability Office has recommended that municipalities use Chapter 9 as a vehicle for renegotiating employee pension obligations that they have previously agreed to but now find they aren’t able to afford.  In the few cases where this has been tried, however, the process is–as you might imagine–protracted and very contentious.

(In all this, remember that I’m an investor, not a lawyer.  My main point is that this area is much, much more complicated than it might seem at first.)

That’s it for today.  Tomorrow:  the scope of the problem and what effect it might have on the stock market.

2011 S&P profits

December 26, 2010 By in Current Market Thoughts, Portfolio management, Shaping a portfolio for 2011, Stock ideas, Strategy, Uncategorized Tags: , , , , , Leave a comment

I usually don’t read Barron’s. Early in my career–and that was a long time ago–I combed through it carefully every weekend.  But I found that any time I relied on an idea that appeared in the magazine I lost money.  Of course, I was much less experienced then, and I had done what I considered careful research in every case.  But I concluded that, although I didn’t know why reading Barron’s did me no good, I knew that for me its ideas were toxic.  So I stopped.

Yesterday morning, I found complimentary copies of the Wall Street Journal and Barron’s on my front lawn.  So I brought both inside and paged through Barron’s for the first time in years.

It seems a lot more superficial than I remember it.  The Market Week section still has a ton of statistics, but the rest of the magazine struck me as a mere shadow of its former self.  It could just be me, but it may also be the effect of the change of ownership of the magazine that put it in the Rupert Murdoch empire.  After all, that same move clearly resulted in a sharp decline in the quality of the business information in the Journal.

Still, one column in the main section, Profit Growth:  From Great to Good, caught my eye (it also appeared online as: Yearning for Earnings in 2011).  It contained advice that didn’t exactly square with the evidence advanced for it, but the interesting part was a table from ThomsonReuters that aggregated the consensus earnings estimates of Wall Street brokerage firms for the S&P in 2010 and 2011.

In my earliest posts (I began writing this blog just before the market bottom in 2009), I’ve written extensively about what happens in the early days of a market rebound from recession. But we’re now 5 quarters from the low point in S&P profits, 6 quarters since the official end of recession and 7 quarters from the bottom in the stock market.  In other words, we’re no longer in the early days of recovery.  In a typical up cycle, lasting maybe three years, investor emphasis gradually shifts from value stocks that benefit from the overall economic rebound to growth stocks that are capable of generating their own earnings momentum internally, with only a mild tailwind from the economy aiding them.

The table illustrates the point or maturing recovery pretty sharply.  It shows that S&P earnings will likely have grown by 32% year on year in the fourth quarter.  That will cap off four quarters in which S&P profits will have expanded by 38% vs. the prior year.

Prospects for 2011?  A 13% advance, or only about a third of the rate of 2010.  A glance at value- and growth-oriented market indices suggests the corresponding shift from value to growth began to take place in early September.

The chart also breaks out growth prospects by industry, as follows:

–on the low-growth side of ledger:  utilities, health care, technology and staples

–on the high-growth side:  materials, financials, industrials, consumer discretionary and energy.

I’m not sure these figures are enough to base an investment strategy on.  On second thought, they may be useful in delineating the underperforming industries, the ones like health care and utilities that have persistently slow earnings growth.  So they show you the areas to avoid.

But this part of the market cycle typically also favors smaller capitalization names, so in an industry undergoing rapid structural change, like technology, the sub-par overall growth rate may mostly reflect the fact that newer, smaller companies are eating the lunch of older-generation giants.

Overall, the chart has two messages:  2011 offers the possibility of being another 10%+ year for stock prices, but it will be harder to achieve outperformance than 2010 has been.