Equity Risk Premium

[This week] Stock prices are being driven by one simple factor: a drop in risk adverseness. Over the past several weeks, investors have become more concerned with beating benchmarks than with wealth preservation.

Charles Rotblut, posting on the Zacks blog, September 28, 2006

Fearless predictions

My fearless predictions about the housing markets and other things.

Soft to bumpy landing for housing market

1. Mild national housing recession with regional hard landings in overbuilt areas.
   
2. Reserve army of unsold housing depresses housing prices for longer than generally expected.
   
3. Waves of opportunistic refinancing as people switch out of ARMs and lock in fixed rates.
   
4. Widening of spreads between credit and non-credit ARM portfolios.
   

Macro US

1. Growth slows to below long term trend with some self-fulfilling slowdown as a result of lost consumer/business confidence.
   
2. Higher oil prices seep into core inflation moderated by less economic activity reducing total demand for oil.
   
3. Core inflation will stay above Fed's 2.0% target, but rates will not be raised more than once if at all.
   
4. Fed holds rates steady till early-mid 2007
   

Investment strategy

1. Increase in required equity risk premium holds down US stock prices.
   
2. Greater investor interest in safer investments: (SDY)/(SPY) continue to diverge.
   
3. Investor boredom with natural resources/commodities may create buying opportunities (IGE)(XME).
   
4. Continued divergence between equity and bond markets over economic outlook.
   
5. Continued underpricing of inflation in treasury bond market suggests TIPS are undervalued relative to normal bonds.
   
6. Yield curve inversion continues until there is a "relaxation of tension" among market participants. Fixed income strategy should be focused on short end and especially liquid end of yield curve.
   
7. Risk for BRIC countries is underpriced because the export-fueled growth means that the fate of these economies is very linked to consumer countries. (EEB)(VWO)
   

Claymore Zacks Yield Hog CVY

The Claymore/Zacks Yield Hog ETF (CVY) has accumulated $5 million in assets in its first week of trading, since September 21, 2006.

This the underlying Zacks Yield Hog Index replicates the strategy of an aggressive equity income investor. 50% or more of the the portfolio is made up of classical dividend stocks. While the remaining 50% is allocated between various other high yielding equities such as Master Limited Partnerships [MLPs], REITs, preferred stock and closed end funds. The funds benchmark index is the Dow Jones Select Dividend index which underlies the iShares (DVY) etf. Based on Zacks comissioned backtesting, the Yeild Hog index has the same risk profile as (DVY) but with a higher return. Claymore has prepared a small briefing book and the index components are available from the AMEX.

I think the best way to think about CVY is to imagine it as an equity income strategy wrapped up in single share. Its not so much useful for asset allocation as it is for strategy allocation. Now that the sector and index ETF space is fully populated, I expect that we will see more "strategic" ETFs that embody different strategies that can be used in isolation or mixed to create optimal portfolios.

What makes Chindia run?

According to Morgan Stanley's Andy Xie, participant in the "The Nature of Growth in China and India: Challenges Ahead and Implications for the Rest of the World," panel at the 2006 IMF/World Bank Annual Meeting in Singapore: The secret is fearless liquidity.

This [positive] sentiment bubble will likely burst along with the end of the growth cycle, in my view. The current global cycle is all about liquidity and risk appetite. I believe it will come down either with an inflation problem that forces central banks to withdraw liquidity or with a collapse of risk appetite due to an accident. Judging from the crowd size in our session, the bubble is quite alive.

Andy Xie, Morgan Stanley Global Economic Forum September 22, 2006.

David W. Tice: Quote of the day

We just papered over the problem, creating more debt to keep the party going. It's like a group of partygoers who are drunk at 11 p.m. You can give them more tequila, and they'll be really drunk at 4 a.m., but that doesn't mean they weren't still drunk at 11.

From 10 Questions: Prudent Bear Fund Manager David Tice 05/06/2002.

TIP: never pay retail for Real Return Funds

With a free premium day pass from morningstar.com, I had chance to take a peek into Morningstar's mutual fund ratings. One fund that Morningstar brought to my attention was the Harbor Real Return Fund (HARRX). Harbor Fund farms out the management of its mutual funds to proven subadvisors while keeping costs down at the company and fund level.

This strategy really shows in Harbor Real Return Fund which is managed by PIMCO's John Brynjolfsson CFA, who also manages PIMCO Real Return (PRRDX). These have the same strategy of investing in Treasury Inflation Protected securities. Unlike a passive bond fund like (TIP), the manager has the flexibility to invest globally and hedge interest rate/duration exposure. The core difference between the funds being that PIMCO's fund charges 0.90% while Harbor's fund charges 0.57%. The Harbor Fund also has a smaller minimum investment ($1000 vs $5000), than PIMCO's fund.

Finding out about opportunities like this makes holding a monthly/yearly subscription to Morningstar a good value for anyone who is brave and smart enough to admit they need some help. I include myself in that category.

The Harbor Fund’s 0.57% expenses are not excessive when compared to the fully passive TIPS ETF (TIP) at %0.20. Because of dynamics of the TIPS market, active management can add value if you don’t over pay for it.

Emerging prudence about EEM Emerging Markets

Martin Hutchinson, who writes the "The Bear's Lair" column for PrudentBear.com his most recent (September 16 2006) column is The James Jesus Angleton economy. It is about Russia and dangers of an economy that runs for any purpose but enrichment.

Russia is said to be keen on inviting foreign capital into its electric power generators; an ambition that at first sight conflicts with its determination to keep control over its oil and gas sectors. However, this apparent confusion in economic doctrine is explained by the Russian government s overriding concern with security and power-political matters. What's not clear is whether an economy run in the interest of "National security" can work in the long run.

Mr. Hutchinson describes some of the motivations behind the Russian government’s meddling in the Russian economy. The Russian government seeks to operate the economy for the purpose of promoting Russian (i.e. Kremlin) influence, power and security. The Kremlin's interests are not always those of outside shareholders. Examples of intervention abound: the enforced liquidation/expropriation of the Yukos oil company, natural gas embargos on Ukraine, government attempts to cobble together a world class aluminum corporation. All this meddling and politics creates risk for investors who are not plugged into the Russian powerstructure. People tend to forget that.

Russia is not alone in having an economy susceptible to nationalist intervention. Each of the BRIC countries and many other emerging markets share this risk as well.

The non-democratic BRIC countries, (Russia and China) have a history of government intervention whenever the central government feels the economy is not operating "to spec". The democratic BRIC countries (India and Brazil) have left-nationalist political parties bouncing inside their democracies. Economic stress could lead to a Venezuela / Bolivia-style nationalist backlash in each the BRIC countries.

This economic paranoia driven political risk is unusual in developed markets. In developed countries political risk is predictable, constant, and not a factor in most investment decisions. It's easy for developing markets to have political blowups with substantial impact on share prices. Many people forget about that, because they aren't used to thinking about political risk.

ETFs make it simple to get exposure to emerging markets. The new BRIC40 ETF from Claymore/Bank of NY, will tap into investor interest in the prime emerging markets. The BRIC countries are expected to collectively overtake the US by mid 21st century. The extraordinary and unusual risks of emerging markets are an interaction of reflected US risk (given the tight linkage between export and import based economies) plus endogenous political/economic risk. This quote from Seth Klarman's 2005 Baupost Letter seems apt

When conditions are generally benign, with markets perhaps even shrugging off bad news, investors tend to forget just how much they can lose and are lulled into sleeping well when they should be tossing and turning. While the recent absence of calamity is not necessarily a sign of impending disaster, neither is it a reason to project only blue skies ahead. After all, financial disasters, like natural disasters, can strike without warning.

There is a diversification benefit from the unique risks of (EEM) investments. However what gets lost in the hustle is that the total risk of EEM investments is much higher than commonly thought. After adjusting for risk, are they still worth it? Probably not.

Seth Klarman Quote of the Day

No crystal ball is required for investment success. Smart investors stick to investments within their circle of competence, with which they are comfortable whose businesses they have the capability to understand. This does not require accurately divining the meaning of the markets pattern. You dont need an opinion on every security. And you dont need to know which way to lean, following every single news development. You simply need, to be meaningfully correct several times a year in order to earn a solid return on capital without excessive risk.

The challenge is to avoid the temptation to speculate, to have justifiable but not unreasonable confidence in your analytical judgements, to demand adequate return for the risks you incur,and to control risk through prudent, but not excessive, diversification and appropriate hedging while avoiding the usage of leverage.

-- Seth Klarman, Baupost Group manager

SPG, Simon Property Group: Very nice but you paid too much.

A breathless article from Reuters talks about renewed interest in Retail Mall REITs, especially Simon Property Group (SPG). Two different analysts: David AuBuchon of A.G. Edwards and Murat Sensoy of SSgA/Tuckerman contend that Simon Property (nifty chart) is not overvalued but secretly and unfairly undervalued.

Well maybe, but probably not. Compared to bubbly specimens such as SL Green (SLG) or Alexandria Real Estate Equities (ARE) yielding 2.10% and 2.90% respectively; SPG at 3.5% is undervalued. A long term perspective about the price and yield of REITs, gives us no comfort. We have no historical basis for talking about REIT investment at such frothy valuations.

It is a situation that Ben Graham observed and warned about in his books. Many times over the years: a very solid desirable company trading at an overbought speculative price. With such a high price, everything that is positive, and a little more, is already baked in. It would be very hard to have a positive surprise and very easy to have a negative surprise at these prices.

SHLD Geometrically unsound Sears

Recently Jim Cramer has been promoting Sears, claiming that Sears is wonderful. But Sears has a very deep problem, and no amount of share buy-backs can mask that. The problem is that Sears sucks.

There isn't a compelling reason to shop at Sears instead of somewhere else. Target (TGT) and Wal*mart (WMT) have roughly 90% of the merchandise that a typical Sears would carry, and they sell it for less. Specialty soft goods retailers like Linen N' Things, and Bed Bath and Beyond (BBBY) have the other 50%. While various discounters (TJX) and home improvement stores (HD) have the remaining 50% covered.

Monitor Groups's Bruce Chew has a really excellent article on the Geometry of Competition. The basic concept is that of a competitive frontier. At each price point, there is someone who offers the most quality at that price. This optimal line defines the "competitive frontier". Within its chosen price range, Sears is not the frontier. Someone else dominates Sears in every product line and at every price point.

The first three sentences of the first five pages

National City Bank's (NCC) Private Client Group serves a clientele of people who do not have to balance their checkbooks. The PCG publishes a weekly investment newsletter with the masthead "The A.R.T. of Investing". NCC defines ART as:

1. After Tax Returns
2. Risk Control
3. Time Horizon

These three concepts are the first three sentences of the
first five pages of investment success.

After Tax Returns

Investors often ignore the tax impact of their investments. Tax consciousness that some investments and activities are tax shielded while others are not. Unshielded investments should be kept in inside the protective bubble of IRA accounts. Some core concepts:

1. Investments with a high taxable dividends such as corporate bond funds, REITs and BDCs, are best kept in an IRA account.
2. Short term trading is best done, if at all, inside an IRA account
3. Qualified Dividends are partly tax-shielded which means the taxable equivalent yield of dividends is higher than the nominal yield. Roughly, 1% of Qualified Dividend Income is equal to 1.17% of fully taxable income.
4. Municipal money market funds often have a higher after tax yield than taxable cash investments.

Risk Control

The best way to keep life simple is to avoid making it complicated. A simple portfolio of 60% SDY and 40% LQD, rebalanced annually will outperform most active strategies with less risk.

Part of risk control is recognizing that we have a natural attraction for shiny objects and complex gadgetry. Wall Street, just like its clientele loves shiny objects and complex gadgetry.

Gadgets like narrow ETFs, stock options, commodity futures, precious metals and FOREX have very desirable properties. They are popular, fashionable, and generate lots of fees and trading commissions. These investments are "on message:" with plenty of grist for blogging and boasting at cocktail parties.

For these same reasons thoughtful investors avoid financial gadgets. The popular and fashionable tend to be overpriced and dangerous. Management fees and trading commissions don't enhance your wealth, but your broker likes them.

Time Horizon

Successful investors know their investment time horizon. Generally the longer the time horizon the more aggressive you can and should be. Having a short time horizon is not the same as having a short term focus. Fear and Greed work best on people who are focused on the short term and won’t give sound decisions time to wash through.