Plan for next week

It has been a terribly busy week, so I apologize for the lack of posts. Depending on my schedule over the next few days expect to see some new posts on new topics. As always readers are invited to comment, and I'll do my best to respond.

• Continuing my series on fixed income investments, by talking about TIPS and then moving on to more exotic fixed income securities. I see TIPS as one of the best investments contra recession, especially a stagflationry recession.
  
• Just to recap: part 1 of the series was on why bonds are important, and Part 2 was on Bond ETFs. So far we have concluded that the Lehman Aggregate ETF (AGG) is the quickest, easiest way to add bond exposure to a portfolio.
  
• The great Douglas Emmett (DEI) IPO of 2006. This IPO raised 1.4 billion dollars, about $300 million more than expected. The underwriters increased the offering to 66 million shares and priced at upper range of $21 a share. DEI opened trading at $23.75. I have several opinions about this IPO, but mainly I think it is yet another a sign of a potential top in the BIGREIT sector (ICF). Large equity REITs have had a huge run up in value. The Douglas Emmett IPO is in the opposite direction of recent private equity takedowns of publicly traded REITS.
  
• Some thoughts on developing high performance socially responsible indexes. A way must be found to counteract the persistent large growth and glamour biases that sap Socially responsible investment SRI returns.
  

Like an old pair of jeans that you won't give up

Richard DeKaser, senior vice president and chief economist for National City Corp (NCC), predicts 40 percent of the nation's housing is at risk of losing value, but the areas are definitely in low employment, over-built regions. He said consumers who are in the market for a home should forget about stretching as far as they can for a bigger and better home and be more realistic about what they can afford.

"There's a large group of people who are really stretched out," DeKaser said. "They should be in a home that's half as expensive as the one the have. They are finding themselves with a reset mortgage where all of their spendable income is going to the house and they can't afford to go out to dinner."

Value can still be found in real estate, Tim Kelly: The (Everett, Wash) Herald, October 28, 2006

This ties into Roubini's call for a recession sounds more real now by Nick Godt, over at Market Watch.

On SLX the Market Vectors Steel ETF

On October 16th 2006, Van Eck Global launched the Market Vectors Steel ETF (SLX) based on the AMEX Steel Index. This follows the IPO of the Market Vectors Gold Miners ETF (GDX) on June 22 2006. Since then the gold miners ETF has gathered $282.4 million in assets. As I predicated, Van Eck would catch the ETF bug and start more hard asset ETFs.

The core motivation for investing in steel is capturing the global macro infrastructure theme. Currently there is huge global investment in new infrastructure and industrialization. All of that growth needs steel. If this is your motivation for investing in steel, then it makes sense to think about certain factors related to industrial metals investing.

• The base metals sector is very cyclical. The fact that we are several years into several different bull markets masks that. If economic growth or public investment were to slow down, steel makers would feel it.
• The biggest foreign markets for steel (think BRIC), also have the most state involvement in the sector.
• Basic steel is a commodity industry and very competitive. This increases volatility.
• If people need steel, then they need other base metals as well. Unlike precious metals (GDX), steel is not consumed all by itself.

It is in that last point where I don't see the steel ETF (SLX) being better than the SPDR Metal and Mining (XME) for most investors. If people need steel, they will need other base metals as well. Most goods that require steel also need copper wiring and other performance metals/alloys. Owning the full base metals complex gives XME internal diversification that SLX lacks. XME has a slightly lower expense ratio as well.

Unless you have a specific reason for investing in steel rather than base metals; XME is probably a better way to capture any steel related market action.

The Case for Bonds: Part II In the Aggregate

The current bond ETFs can be split into two groups. The treasury yield curve group and the asset class groups. iShares Lehman 1-3 Year (SHY), iShares Lehman 7-10 Year (IEF), and iShares Lehman 20+ Year (TLT) cover the short, intermediate and long portions of the treasury yield curve. Unlike bonds themselves, ETFs are perpetual instruments, and so you can't ignore market price risk. Because of the ability to dynamically position themselves and hedge exposure active bond funds may be less volatile than the benchmark.

The longer treasury ETFs are mostly good for speculating on the treasury yield curve. In the current inverted yield curve environment, SHY is hopelessly dominated by money market funds with zero duration.

The asset class bond ETFs (AGG,LQD,TIP) each represent the exposure to an entire area of the investment grade universe. (LQD) to liquid corporate bonds and the (TIP) to TIPS universe.

The Lehman Aggregate (AGG) is the benchmark for most investment grade bond funds. Based on the total investment grade market, it is heavily weighted towards short term US treasury and government agency securities. AGG sits in the sweetspot of very low credit risk, reasonably short duration and attractive yield. The aggregate is the underlying index for the popular Vanguard Total Bond Market Index Fund (VBMFX). If you don't want to fuss with active management, AGG is probably your best choice for an ETF bond allocation.

The Case for Bonds: Part I - Only the boring survive

2006 has seen the introduction of many toys for the "Global Macro Hedge Fund in my E*Trade Account" crowd. ETF sponsors have wrapped all sorts of exotic assets such as foreign currency, precious metals, emerging markets, commodities, and short positions into ETFs. The previous obscurity of these asset classes kept them safely out of the hands of retail investors.

The main asset class that the fast money crowd ignores is bonds. This is only to their loss. I don't think I can say it better than PIMCO, on the role of bonds in an asset allocation strategy:

Bonds can play an essential role in asset allocation by diversifying risk, generating income, and preserving wealth across a range of economic and financial market conditions that can cause wide fluctuations in stocks and other asset classes.

Bonds act as ballast for portfolio. They give your ship stability in rough waters and prevent it from becoming top heavy and unstable.
The Benjamin Graham recommended that investors should always have at least 25% allocated to high quality bonds. For most investors he felt the target allocation should be even higher.

Now (mid October 2006) the stock market is making new highs, it is a good idea to rebalance and make sure that you are invested in harmony with your risk tolerance. Investing in bonds as an asset class is too complex to do by yourself. Hence the need for a cheap and well managed bond fund.

The problem with the passive bond ETFs is that they can not pick up obvious alpha via duration management (i.e. they don't adapt to an inverted yield curve) and they can't exploit spreads between equivalent risk bonds. Without the ability to dynamically reposition the portfolio or hedge interest rate risk, bond ETFs tend to get quite bouncy. Maybe too bouncy for most investors.

Thought by many as the best fixed income manager of the past 25 years, PIMCO's Bill Gross manages the PIMCO Total Return Fund (PTTDX), with $93 Billion in assets. PTTDX is core bond fund with an intermediate duration and average AAA credit rating. This fund is suitable for all investors.

PIMCO is also the leading subadvisors for bond mutual funds rn by other companies. Bill Gross's team also manages the Managers Investment Group's Fremont Bond Fund (MBDFX) and Harbor Bond Fund (HABDX). The Fremont Bond Fund is on the no transaction fee list at most online stockbrokers including Scottrade. Both of these funds have the same strategy as the name brand PIMCO Total Return fund (charging 0.75%) but charge 0.60%.

Look at XME !!

A mere one day after I mention that XME at 39.96 could be cheap on October 4th. Today, October 5th, the entire metals sector goes wild and rockets up 5.23% in a single day.

Big drivers for the sudden jump metal stocks include bullish comments about US Steel (X) and talk of a takeover of British Steel (CGA) by Tata Steel. Excitement about steel spread to Nucor (NUE), AK Steel (AKS) which may successfully deunionise once of its plants, and Reliance Steel & Aluminum (RS) all going up about 5.5% each. Bullish comments about copper demand (staying high) and future prices (not getting cheaper) from Morgan Stanley pushed Phelps Dodge (PD) and other copper miners up.

The rally wasn't just limited to the big famous names either. Fairly obscure names such as Carpenter Technology (CRS) as well as Platinum/Palladium miner Stillwater Mining (SWC) were also up strongly. Pretty much every single name in the SPDR Metals and Mining ETF (XME) was up 5% today. The metals rally even spread to the gold miners with the Market Vectors Gold Miners ETF (GDX) up only 2.19% for the day.

As this chart of five days trading of the Goldman Sachs Natural Resource ETF (IGE), SPDR Oil Gas Exploration & Production (XOP), Gold Miners (GDX) and Metals and Mining ETF (XME) demonstrate: all natural resources are not alike and energy is not the entire story.

The Second wind of SPDR Metals and Mining XME

Recently I have been looking at the SPDR Metals and Mining (XME). This ETF represents an equal weighted index of stocks involved in metals and mining. The fund is mostly base metals miners, together with a few steel makers, coal miners and gold miners.

This nifty chart, shows the performance of XME over the past three months. XME has followed the path of iShares Goldman Sachs Natural Resources ETF (IGE) even though IGE has very little exposure to metals and mining. 60% of IGE is Oil Stocks and 18% Oil & Gas Services, with only a 13.41% weighting to base metals and mining. Gold/Silver Miners (GDX) are only a small percent of XME, and so XME is not very sensitive to the price of gold and precious metals.

The main question about investing in XME is the relationship between energy prices and demand for metals. Fundamentally lower energy prices make it cheaper to refine metals while freeing up income to be spent on metal and metal objects. It seems that this point has been forgotten during the current Natural Resources relaxation. If core energy prices go down, mining and refining metals is more profitable.

The core arguments for a secular bull market in natural resources remain in place because the faster growing parts of the world (EEB) are slowly converting from export to consumption driven economies. Over time consumers throughout the developing world will demand more metal intensive consumer goods (think of cars, refrigerators, air conditioners etc). Natural resources have been a hot investment theme for the past few years. But all natural resources are not alike.

Douglas Emmett DEI and the 1.1 Billion Dollars

All systems go at Douglas Emmett (DEI), as the REIT plans an IPO of 55 million shares at between $19.00 and $21.00 per share. This pricing implies an IPO takedown of $1.1 Billion dollars for a portfolio of trophy office/residential properties located in Los Angeles and Honolulu. See more background about DEI here.

DEI plans to pay a dividend of $0.70/share, equivalent to 3.5% yield on a $20 offering price. Assuming a post IPO book value of $16.91/share, Douglas Emmett will trade at an 18.2% premium to book value.

That dividend would high by the standards of the few "trophy" REITs such as SL Green (SLG) and Boston Properties (BXP) which have sub 3.0% dividends. The trophy REITs specialize in owning Class-A/Trophy real estate in supply-constrained markets. These companies own skyscrapers in downtown central business districts. Only a few REITs have such properties and they trade at premium valuations.

At this point it is clear that principals of DEI will do very well in the IPO, but for current and future investors it is not so clear. DEI does have some built in growth, from rent rollups and fully leasing a few properties that are slightly vacant. All in, I would expect yearly FFO growth of around 4%. For various reasons the major equity REITs are trading at incredibly high valuations.

As Benjamin Graham observed: "the Margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, non-existent at some still higher price." I think these valuations, including the out of the gate valuation of DEI, give investors a negative margin of safety.

While Douglas Emmet is a very nice REIT; real estate and even very nice real estate, has risks and should trade a yield premium to risk free assets. If online savings accounts are paying 5.0% or more, is 3.0% with no safety of principal compelling?