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Here’s just a quick add on to our post of the other day where we outlined our position that investors should sell bonds in which they probably have pretty healthy profits and let the proceeds sit in cash for a bit. In addition to there now being not much opportunity cost associated with making that trade, there could be, for taxable accounts, a reasonable tax advantage as well. Let me explain.
Current long term capital gains tax rates are at 15%. Taxes on interest income are at your ordinary income tax rate. So, here’s how the math goes. If you owned a bond that matures in 2012 with a 6.75% coupon on it that you bought in late 2008 around 100, it’s probably worth at least 112 today. If you sold it, you would record a long term capital gain of 12 points; that gain would be taxed at 15% which means you would owe tax of $1.80. If, on the other hand you held the bond until maturity, you would earn 6.75% in interest income 2011 and 6.75% in interest income in 2012. Now, we don’t know for sure what Congress will do with the Bush tax cuts, but you can bet if you pay a marginal tax rate of 25% in 2010, you probably won’t pay much lower in 2011. So, let’s assume Congress extends the Bush tax cuts into 2011. You would pay $1.69 in taxes on your 6.75% interest income in 2011 and another $1.69 in taxes in 2012, for a total of $3.38—substantially higher than the $1.80 you’d pay by selling the bond now.
Low opportunity cost; lower tax liability. Two reasons to sell those bonds in taxable accounts.
Mike Timm
Tight spreads between corporate bonds and US Treasuries; unabated demand for bonds by retail investors despite the lowest rates in history; corporate issuance of 100-year maturity debt; and, importantly, for the first time since 1962, the dividend yield on the Dow Industrial Average exceeds the 10-year US Treasury yield. These indicators tell us that, if history is any indication, we may well be witnessing the beginning of a bottom in interest rates. This does NOT mean rates will actually rise significantly anytime soon.
What it does mean is that we are not interested in owning longer maturity bonds; we find much more interesting the equity of companies who can actually issue those bonds during such uncertain times. We confirm our call from last month: “Attractive valuations; respectable dividend yields; solid balance sheets; international exposure; growth potential: all good reasons to consider large cap multinational company stocks over low yielding bonds in the current environment.” Additionally, we now intend to selectively sell some of our high premium corporate bonds and temporarily park those proceeds in cash.
Rick Morgan, Ryan Comstock, Mike Timm
Thinking about the absolute level of bonds generally, I for one am amazed at what we have been witnessing over the past 3-4 months. We know that individuals have been piling into fixed income ad nauseum since March of 2009. Lately a new player has entered the game –namely the hedge fund guys. In the last several months they increasingly have become a much bigger factor in the government market and also the new issue corporate market. Whether rates go up or down from here you have to agree this trade is getting very one sided. I don’t know what changes this momentum but given the number of commentators espousing bonds, risk is being forgotten in this market.
Things to watch for as signals to suggest an inflection point; a plethora of 50-100 year maturities being issued by corporations, investment grade corporates tightening to yields fractionally less than govts. (15 or so), bb high yield coming into the 75 basis point spread to governments in the 5 year maturity. Also watch for when bad economic news is announced and bonds DON’T rally. One thing we can agree on the distance we have come from 15% to the current level and the unanimity of the bond trade.
Conclusion: We are very close to an inflection point or there is truly something nasty lurking out there.
Rick Morgan
Principal
When U.S. Secretary of Treasury Tim Geithner traveled to the G20 summit in Toronto a few weeks ago the agenda in his briefcase was one for growth, even if it meant extending government aid a while longer to ensure that the world collectively has escaped the grips of recession. Not all foreign governments at the G20 saw eye to eye on this matter. Others facing larger budget deficits in Europe were focused much more on austerity measures to get their balance sheets in order opting for some short term pain to ensure longer term health. Much of this has been publicized and is common knowledge but it surprised me how many parallels can be drawn between this and the U.S. savings rate.
As recently as 2005 American’s were saving only 1.1% of their personal disposable income. This would turn out to be a trough in the savings rate after a long and gradual decline from roughly 10% in the early 1980’s. Going into the recession, market pundits complained Americans were spending too much and saving too little as no one was prepared to handle the layoffs that ensued. In the courses required to become a financial planner I had it drilled into me class after class to always have an emergency fund to fall back on. This is found by taking your total liquid assets and dividing them by your total monthly non-discretionary expenses; an answer of 6 to 9 months is generally considered a safe and desirable level to have on hand. This made certain that you could support yourself for at least 6 to 9 months while searching for employment. This is effectively what many European countries with debt troubles are trying to do right now. They are cutting back expenses in order to build up that emergency fund so they will be better equipped to handle future economic cycles. Our banks are doing this right now as well. Unfortunately, that means higher restrictions and fewer loans to small businesses at the moment.
Coming out of the recession, now that the savings rate has climbed almost fourfold to 4% in the U.S., many are now worried that Americans are saving too much and need to start spending more in order to prop up GDP. As we have written in previous letters, consumer spending makes up roughly 70% of our GDP. This is similar to the argument Tim Geithner brought to the G20 meeting that looks like it fell on deaf ears.
Could we get all the way back to a 10% savings rate? Maybe. What is more likely to happen is that we will fall some place in between the current 4% rate and the 10% rate of the early 1980’s. State pensions and what is left of pensions in the corporate world are beginning to retool requirements and calculations. One of the ways they are doing this is by requiring new entrants to pay a higher % of their pay into the pension. Effective July 1st, a state workers union in Mississippi covering over 3,300 workers will now be requiring employees to contribute 9% of monthly earned compensation into their pension up from 7.25%. This in itself raises the savings rate. Those future retirement hopefuls not in pensions have also realized what a recession can do to their nest egg and could potentially start saving/investing increased amounts in order to make sure they avoid outliving their retirement assets. Total U.S. consumer credit is down over 5.5% since reaching a peak in mid-2008 and for the month of May the drop in consumer credit was $9.1 billion versus a much smaller expectation of $2.3 billion. U.S. consumers are getting their houses in order just like the US banks and just like many European countries.
What could pick up the slack in consumer spending for the US GDP? We can think of one possible answer. In China the last two months have been filled with strikes by workers fed up with their salaries. It seems like once a week a story is published about a Chinese manufacturer raising their salaries by 30%. This is evidence of a growing middle class. Match this with the recent announcement that China is going to slowly let its currency start to appreciate and even more buying power is created. This increase in Chinese demand could eventually filter through to U.S. products and replace some of the gap created by the increase in U.S. savings rate.
U.S. Savings Rate as a % of Disposable Income
~Ryan Comstock, CFP®
With all of the negative news spilling out of the Gulf of Mexico recently, including failed “junk-shots”, wildlife soiled with oil, closed fishing grounds, and pictures of tar-balls starting to hit the Florida coast, we thought it would be a good idea to consider how the future of offshore oil production in the Gulf of Mexico might change going forward.
Why would we want to drill for oil in the Gulf of Mexico anyway? Can’t we just buy more oil from foreign countries?
For the last ten years 40% of the world’s oil discoveries outside of the U.S. have occurred in deepwater drilling. During 2009, oil production from the federal waters of the Gulf of Mexico totaled about 1.6 million barrels/day, and accounted for 31% of U.S. oil production. The U.S. Energy Department forecasts that by the year 2035 offshore oil production from the lower 48 states will increase by over 80% and account for approximately 38% of U.S. oil production. Additionally, production from the federal Gulf of Mexico accounted for 11% of total domestic marketed natural gas production.
Yes, we could just prohibit drilling for oil in the Gulf of Mexico going forward; this would eliminate the environmental risk of blown-out deepwater wells spilling oil into the Gulf waters. But the cost in terms of our trade deficit would be huge. Assuming a $75/barrel oil price that results from a permanent drilling moratorium and which would eventually cause U.S. oil production from the Gulf to cease, and that we would need to replace the lost domestic oil production with imported crude oil, the increase to our trade deficit would total nearly $44B annually. Every barrel of oil that we do not produce in the U.S. is a barrel that we need to import.
In terms of employment, we could say goodbye to the jobs of the 100+ people who work on each drilling rig. Add to that the oil services supply chain, which includes helicopters, supply boats, caterers, equipment manufacturers, etc., etc. The Minerals Management Service estimates that offshore operations provide direct employment of 150,000 jobs. No doubt countries that already have ongoing offshore drilling activity would benefit from a permanent ban on deepwater drilling in the Gulf of Mexico. If such a ban were to occur, you could expect an exodus of floating drilling rigs (and jobs) out of the Gulf of Mexico and towards offshore West Africa, the North Sea, and offshore Brazil.
The deepwater Gulf of Mexico is one of the few oil-rich basins in the world that is open to investment by the major oil companies and smaller independents, that is near existing infrastructure, and that offers a stable tax regime. In fact, Apache Energy recently agreed to acquire Mariner Energy, one of the leading independent oil and gas exploration and production companies in the Gulf of Mexico, precisely because of Mariner’s exploration prospects in the deepwater Gulf of Mexico. Apache believes that the Gulf of Mexico offers significant growth potential in a world class basin. Advanced seismic technology has significantly increased success potential and growth in deepwater infrastructure has reduced development costs.
Given that the environmental and economic costs of this oil spill already exceed those of the Exxon Valdez, we can expect more federal government regulation of offshore drilling in those areas outlined above. Additionally, it is increasingly likely that it will be at least a year before the government permits deepwater drilling of any kind to resume. Because the oil and gas from the Gulf are an integral part of our nation’s energy supplies, the interruption in its operation will put additional pressure—and create additional opportunities—in on shore reserves. As you know, we have written extensively about the opportunity we see in natural gas, and this unfortunate disaster in the Gulf will no doubt elevate the prospects of these gas reserves so that they become more central to any future U.S. energy policy.
James G. Tatakis
Assistant VP, Research
The recent market activity has been dominated by volatility. We had 11 out of 14 days where we have had more than a 150 point move in the Dow Jones Industrial average. In spite of all of this volatility, and the wild day we saw last Thursday, we have stayed within the technical ranges of the market. On the downside we bounced off the 200 day moving average and on the upside we bounced off the previous 52 week high. As stomach churning as this has been we do not yet see a significant change in the domestic economic situation. What we do see is a fundamental currency relationship that has been adding to the volatility. The euro has been moving steadily downward as the European Union reacts to the Greek debt crisis. The weakness in the euro causes relative strength in the dollar. A strong dollar leads to lower oil and commodity prices and that has been moving the market lower. Even though the EU has put in a very large backstop to the pan European debt problems it will likely continue to weaken the European currency. Longer term we feel that US economic recovery will drive earnings and that is still a positive trend. In the meantime we expect this currency/commodity volatility to prevail.
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The Search for Returns
Tired of earning next to nothing on your money market accounts? Wondering where those 4-5% CD rates went? Concerned that bond yields might stay low for a long period of time? If you are like us, you probably answered each of these questions with a frustrated “yes.”
Clearly the market is not rewarding you for being a saver. Fixed income investments, to quote Jeremy Grantham, are “desperately unappealing”. Nominal yields are currently close to all time lows. And importantly, for investors who need income from their portfolios, this rate environment has made generating that income increasingly difficult.
Where do you turn? Since the spring of 2009, we have advocated that investors consider buying large capitalization multinational companies with dominant market share and stable, predictable businesses. We believe these types of stocks are cheap compared to their historical valuations; these companies have solid balance sheets and large cash hordes; most sell their products internationally, generating at least 50% of their revenues outside the US; and a good number of them pay stockholders over 2% dividend yields. This is one area of the stock market that presents a compelling opportunity.
What’s an investor to do? First, we continue to think one of the answers is to buy investment grade, large cap US multinational companies many of which pay dividends in excess of 2%. These companies are about as cheap as they’ve been since the late 1980s. S&P 500 Price/Earnings ratios are close to thirty year lows, and at 13.4X, well below their long term average of 15.3X.
Second, many of these companies have strong balance sheets. Analysts estimate that net debt/market cap ratios of the non-financial large cap companies in the S&P 500 are at only 12.9% compared to a 46 year average of 20.6%; and, cash now represents close to 10% of assets on the balance sheets of companies in the S&P 500.
Third, dividends on many of these equities yield 2 ½% plus—often more than US Treasury or high grade corporate bonds. Additionally, those dividends are growing between 4% and 10% per year. The long term annualized dividend growth rate of the S&P 500 is over 5.5%.
What does this mean for the average investor? Well, let’s be conservative and assume that dividends only grow at 4% per year for the next ten years. And let’s further assume that the price on the average stock in the S&P 500 does not change over the next ten years. How would the return on the stock compare to owning a ten year US Treasury bond that yields 3% to maturity? The math is pretty compelling.
The dividend income alone on the stock would exceed the interest earned on the US Treasury bond by some 60%. What’s the catch? Obviously, in ten years the stock could be worth less than the $1000 you initially paid for it—but, it could also be worth more than you originally paid for it too. Remember, we are talking about buying companies whose businesses are stable, staple parts of the worldwide economy. What about the Treasury bond? At maturity your bond will pay you back exactly what you paid for it ten years before—there is no potential for growth in principal. Additionally, you don’t know where interest rates will be in ten years from now so you have no idea what you will be able to re-invest that principal at when the bond matures.
The final reason these large cap multinational companies look cheap to us is that you have a reasonably priced call on global growth. Remember that S&P 500 companies generate over 45% of their revenues from sales outside the US—with many of them posting sales as high as 75% from foreign locations, which means they take advantage of fast growing emerging markets. If the US economy does grow at below average rates for the next few years, sales to those economies whose prospects are brighter than the US’s should help these quality multinational companies maintain solid profitability.
Attractive valuations; respectable dividend yields; pristine balance sheets; international exposure; growth potential: all good reasons to consider large cap multinational company stocks over low yielding bonds in the current environment.
Richard B. Morgan
Principal
Michael L. Timm
Vice President