Risk, Risk, Everywhere

We try to avoid sending our readers to anything that smacks as an advertisement to sell newsletters, but sometimes the questions are relevant enough to justify addressing them head on, even if there is a sales pitch in there. Fortunately John Mauldin not only has a good pulse on the global investment community, but any sales pitch in his material is minimal compared to the content.

So with that, we point out some serious questions and concerns he addressed in a recent email which we happen to agree with. One might ask, how can you not agree with observations from the real world? Right, well, some do, so we just want to point that out.

From John's survey of readers, he concludes:

When everything is manipulated... you don't know the TRUE value of anything, right?

The Fed-driven fixed interest rates are breaking the backs of retirees (or near retirees), who find their nest eggs dwindling unless they take larger investment risks.

And the growing federal debt and the resulting "true" inflation is eating away at investors' capital.

They see interest rate risk, inflation risk, central bank and currency debasement risk, confiscatory tax rates... and bonds on life support, running out of air.

src: How to Find REAL in a World Full of FAKE

Stocks, Bonds, and Currencies doesn't agree with everything said or implied by John Mauldin or Grant Williams, but they have a long-standing reputation that justifies considering some of what they say. If you take a look at the video, come on back and tell us what you think.

Investing on The Edge of a Precipice

Today we highly recommend the March 8th weekly comment by John Hussman, The Rubber Hits the Road. Hussman makes some good points about history, comparing post-war economies with financial-crisis economies, relates that to this present period we face, and describes the human psychological factors that come to bear on security prices. The discussion of pending mortgage resets and how that may play out is particularly relevant.

It is interesting to see someone actually point out how and when we may rely on the irrational exuberance of speculators to make informed decisions of our own:

As we move through the coming months, resolving the "two data sets" issue will help us to determine which set of historical precedents is relevant. If the current economic environment produces fresh credit strains similar to previous periods of credit difficulty in the U.S., Japan and elsewhere, valuations and margin of safety will remain the most important consideration in determining investment positions. If the economic situation reveals itself to be more like typical post-war cycles, valuations will still be an important consideration, but we'll be better able to assume that speculation (provided sufficient evidence from market internals) will be reliable even in the absence of clear fundamental support from valuations.

If you are a Graham-Dodd fan, you'll particularly like how Hussman builds upon their foundation in presenting the expectations of investors in the current environment. Our conclusions is that with the infatuation Americans have with entertainment and personal emotions and opinions over facts and substance, we are unlikely to see any sound behavior by the general public with regard to investments.

The one thing he didn't mention in March 8th were the fundamental factors pointed out in a previous weekly comment, which contribute a third influence on the confluence of forces affecting the markets: the Fed quantitative easing policy coming coming to an end, just about the time we may begin to receive some clarity on his "two data sets". Add to that the potential for more debt issues out of Europe in the next few months, and the security markets may very well be resting on a weak precipice.

Sector Analysis and Business Cycles

Faheem Gill has a nice analysis of the business cycle and equity sectors that do well in each. He focuses on energy, but the charts would be good for one to copy and mark with one's own preferred investments at each stage.

The only thing lacking is a note to shift out of equities into bonds at the peak of the interest rate cycle.

Insider's view of the business cycle

What does the business cycle look like after a bust when you're the one on the inside looking out at the investment horizon? According to Bloomberg, it looks like half a trillion dollars.

"Buyout funds sitting on half a trillion dollars committed by investors may need more than a decade to put the money to work if mergers and acquisitions continue at the current pace."
(source: Bloomberg)

As readers should be well aware, nothing stays the same. The rate of M&A spending of the last year or so won't be the rate of spending in the future. As the business recovery solidifies the evidence of a "good buy" will change for the better and this money will start flowing. But notice this key point from the same article:

"“Investors only give the fund a particular investment period, typically three to six years, to invest the capital,” said Michael Harrell, co-chair of Debevoise & Plimpton LLC’s private-equity funds group in New York. “If you don’t use it, you lose it.”"

So there are two strong human factors at play there. First, those entrusted with the money don't want their clients to take it back. They will find a way to put that to work, and they have only two or three years to do so. What a coincidence this lull in M&A just happens to coincide with the first signs of recovery. (NOT!)

Second, if they don't put that capital to work, the clients who take the money back are going to have a lot of pent up demand as they seek out someone who will put the money to work for them.

No matter how you slice it, the business cycle is alive and well with capital left over from the recession looking for something to buy. 'Buy' is the operative word there. The only unanswered question is what will be in demand, and you can be sure it won't be cash and cash equivalents. After all, we're not talking about a world of Warren Buffett money managers. These are sharks looking for a kill.

But lest one gets too excited, temper the emotions with an interesting chart from the Bespoke Group. Looking at that 2009 March low, which was the bottom of that bust of the last business cycle, one should expect the 68% number will stick. Not only is the potential from here much less than the potential from 'there', but we still have a wave of news about to arrive regarding the mortgage reset wave of 2010.

We don't personally expect the news to crash the market or the economy, and don't expect a double-dip recession, but we do expect a wobbly stock market too jittery to make a firm run in either direction, albeit with a bias trend upward as happens with any business cycle boom phase.

As an aside, the astute reader should be careful to differentiate a boom from a bubble. Bubble talk won't be appropriate until about two or three years from now.

The S&P 500 According to the U.S. Treasury

Let's do a little common sense extrapolation. From the minutes of the August 4th Treasury Borrowing Advisory Committee meeting, we have this little factoid about American corporate income taxes.

Director Ramanathan discussed the components of federal revenues in the current fiscal year versus last year, noting that corporate income taxes (which generally account for about 10% of total receipts) were lower by over 50% year to date...
(source: Treasury Borrowing Advisory Committee)

Ok, so if tax revenues are down by 50% and there are no significant changes in tax rates, one can extrapolate that corporate profits are down 50% from a year ago.

A stock price is claim on long-term future cash flows from the company. Therefore, equity prices should be about half of what they were last year all things being equal.

But all things are not equal. Credit is different, money is different, business prospects are different, and perceptions of risks are different. Credit will not be as readily extended, the currencies across the globe are being diluted as fast as possible, businesses don't know when or where growth will come from, and everyone is on edge about credit defaults.

The SPY 52-week high is roughly 130 and today's trading is around 102. Valuations on stocks a year ago were at historic norms according to much of the research at Hussman Funds.

It sure seems to us that S&P 500 prices today are not at sustainable levels unless one presumes valuations last year were reasonable (i.e. the current year profits are a glitch on a much longer time frame) or currency debasement has been so deep current equity prices are normal when adjusted for real purchasing power. Neither of those seem to make sense, though, unless somehow the world is at a stage to repeat the growth of the 90s. How that might happen given the financial system's recent changes is a mystery.

When Premiums Make Sense

In the car industry there are rare events where certain cars sell at a premiums to MSRP when the product is rare and not likely to ever be available again.

While it's useful to know fact from fiction, especially in something that's easy to mathematically quantify, it's also good to know free market prices that are out of line with traditional pricing models don't necessarily indicate irrational behavior. Context is always the most important thing. While "bubble" is one of the most popular words in the investment community today, not everything you see that you don't value highly is a bubble. Context is everything.

When context lines up with analysis, you have strong forces at play. Such was the case in the dot.com bubble and the more recent real-estate bubble. On the other side of such crisis, when context no longer lines up with analysis, you have to put aside computer models and add human insight. In the case of PHK, the context is a rare bond market dynamic unavailable to retail investors. So it's not irrational for buyers to pay a premium to get a piece of something that won't be available shortly, specifically because it has very, very strong fundamental market forces behind the assets, and many of those assets are still priced to account for the end of the American economy within thier lifetime.

If $1.3 trillion of newly created money weren't chasing the bond market; if the Federal Reserve wasn't the primary market maker in commercial paper; if MBS and CDO bonds were trading in a free market; then PHK would probably be the worst product on earth. But this is not a free market. The dynamics of a deep pocket buyer chasing what no one else wants is unlikely to ever occur in my lifetime. Owning anything that has that kind of demand behind it can't be evaluated by traditional methods.

When the Delorean sold over MSRP, it wasn't foolish for those who paid the premium to get it while they could, because those who knew the auto market knew the prices would never be that cheap again, and the opportunity was limited. Now in hindsight we can see Delorean motors collapsed. So if you think the bond market and Federal Reserve buying program is going to collapse, you should not be participating in these bonds. But if you think the market is normalizing like it did in the other crisis, then a little investigation of fundamental forces is in order.

For months I would read John Mualdin describe the valuation of collateralized debt and the out of proportion pricing relative to real risk during the worst of the credit crisis. Every time I would salivate over the chance to buy those out-of-favor bonds as the irrational fear that the world as we know it was going to end tomorrow drove prices of even well-structured bonds into the ground. Not having a Bloomberg terminal or a bond trader's account, there was a fundamental opportunity of a lifetime that I had no way on earth to participate in. Then I discovered PIMCO was chasing that market for the same reason and in the same way I wanted, and had a vehicle available for me to jump on.

I paid a premium to get a piece of it because a) there was no other way for a common citizen to sell junk to the Federal Government at top dollar, and b) there were no option contracts I could buy to lock in the inevitable rise in price for this class of bonds, and c) Ben Bernanke's actions made it undeniably clear there was nothing on earth in the financial market that he wasn't willing to buy - nothing, not even the worst junk imaginable.

Like an option, there's no guarantee the market moves in your favor. One has to know the deeper fundamentals behind the cash flows and demands for the assets of the entity in question. You can't just look at the balance sheet values of the Real Estate assets of Sears Holdings Corporation (SHLD) and know what it's really worth. You have to know the actual location of that real estate and whether the real estate market itself will sustain, threaten, or increase that value. If the market for those R/E assets is drying up, SHLD may be overpriced. If they have a large government revitalization program behind them, SHLD may be under-priced. The issue boils down to whether the retail market has realized those values yet, or not. Price to book value may grow far more quickly than book value, primarily because book value is constrained while human intellect is not, even if abstractions and market forces not quantifiable by GAAP make it clear where future book values are most likely to move.

If we revisit this CEF when the credit crisis of 2008 is a distant memory, after bond spreads have normalized, and it still trades at a high premium, then I will join the short-seller's camp. Until then, Uncle Ben and Tim are ensuring the bonds I own through PHK have a strong, liquid, demand-driven market. I don't know any other product on earth that has an avid open buyer standing in the wings with an unlimited supply of blank checks to buy product.

When that buyer departs, things will change. But at this point their interest is strong and reliable.

Security Analysis

Are all equity investments created equal? Is a common stock, CEF, and ETF all fundamentally the same because they are bought and sold on the stock market exchanges? How about securities in the same class? Is it reasonable and necessary to presume all types should match their peers' fundamental metrics?

Today PHK went ex-dividend for the month and in typical fashion took a beating in price. This time it was compounded with a recent set of negative reviews at Seeking Alpha.

PIMCO High Income Fund: Substantially Overvalued?
CEF Funds Review: Worst to First

In the first, we've commented on the analyst's perspective asking some of these questions. If you have some insights to add, we hope you'll speak up and add your analysis to the mix, either here at SBC or at Seeking Alpha.