A Great Article on Asset Allocation

In today’s Barron’s magazine there is an interview with Dennis Stattman of BlackRock Global Allocation called “Mixing It Up in an Uncertain World”. In this article he discusses his world view and his views on asset allocation. It is a great article and highly recommended.

Dennis starts by explaining that our current situation is odd.

The first thing you have to realize… is that it is an artificial environment because of extraordinary government measures, both on the fiscal and monetary side… but our portfolio strategy has to take into account with what is going on with our unit of account, the US dollar.

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It Is All Market Timing

When I first started in investing one of the cardinal rules (for the general public) was “don’t try to time the market”. From a practical perspective this meant that you were supposed to continue putting money in the market whether it went up or down and then hold for the long term.

Everyone knew that the market does move in cycles, such as the giant bust at the time of the great depression in the 20’s and the 30’s when stocks crashed, wiping out many investors. Another classic example is the Japanese stock market which peaked in 1989 at around 39,000 before falling to a low of 7000 in 2009, over 80% below its high (today it is around 10,000). Even the most cursory review of the chart shows that if you sold at the peak and / or bought at the trough (this hasn’t worked yet in Japan because the market hasn’t moved back up yet) you’d make a tremendous amount of money; but the popular wisdom is that it was “too hard” for an individual investor to determine when to enter and exit the market so don’t try at all.

To some extent “re-balancing” is a form of market timing, because as stocks rise in value if you practice the model you are supposed to sell off some stocks and buy bonds (or whatever else is in your portfolio, could be commodities or real estate) which accomplishes much of what market timing is supposed to do. Re-balancing is more complex because it involves multiple asset classes which each have their own valuations but you could say that re-balancing is at least a “cousin” of market timing.

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Mispricing Risk on Bonds

Interest rates are at an all-time low.  Companies are able to borrow money and pay almost no interest under the most favorable of terms.  This one caught my eye:

SAN JOSE, Calif.–(BUSINESS WIRE)–eBay Inc. (NASDAQ:EBAY) today announced the pricing of a $1.5 billion underwritten public offering of its senior Notes, consisting of $400 million of 0.875% Notes due 2013 (the “2013 Notes”), $600 million of 1.625% Notes due 2015 (the “2015 Notes”) and $500 million of 3.250% Notes due 2020 (the “2020 Notes”). The public offering price of the 2013 Notes was 99.793% of the principal amount, the public offering price of the 2015 Notes was 99.630% of the principal amount, and the public offering price of the 2020 Notes was 99.420% of the principal amount, in each case plus accrued interest, if any. The offering is expected to close on October 28, 2010.  eBay intends to use the net proceeds from the offering for general corporate purposes, which may include working capital, acquisitions and capital expenditures.

It is completely astounding that a company with a business model like eBay is able to borrow for:
– 2-3 years at under 1%
– 5 years at under 2%
– 20 years at a bit over 3%

These are not secured debt items; they are notes – and per the description above, eBay can use the money for anything they want, including working capital, which means that they can use the money for ANYTHING.  THIS IS LESS THAN 1% ABOVE THE RISK FREE RATE (i.e. what you can get for Treasuries).  This is absolutely unprecedented.

This article in today’s Wall Street Journal essentially tells the same story with Wal-Mart.  Wal-Mart was also recently able to sell debt at an absurdly low premium over the risk free rate.  Per the article:

Wal-Mart sold $750 million worth of three-year bonds paying 0.75% a year. It sold $1.25 billion of five-year bonds paying 1.5%, $1.75 billion of 10-year bonds paying 3.25% and $1.25 billion of 30-year bonds paying 5%.

The difference between Wal-Mart and eBay is that WMT also has an instrument that delivers yield as well as some potential for appreciation; a stock paying a dividend.  The dividend on the shares of WMT yield a bit over 2% a year and receive preferential tax treatment (due to the dividends received deduction) to boot.  Per the article:

Wal-Mart has raised dividends by an average of 16% a year over the past decade. If it merely raises them by 10% a year in the future, the yield on the stock will surpass that on the 10-year bonds within about five years. It will surpass that on the 30-year bonds within 10 years.

I have no idea why someone would buy debt, which has many risks (the risk of inflation in the economy, as well as a company specific risk) with this sort of minuscule premium, especially when taxation is so unfavorable (it is taxed as ordinary income today and highly likely tomorrow).

This is the equivalent of a “bubble market” for bonds.

Cross posted at LITGM and Trust Funds for Kids

Lack of New IPOs and Impact on Performance

If you read typical finance articles out in popular media you commonly see facts and figures about how US stocks outperform other investment classes over “the long term”.  As I do my own research I tend to see threads leading back to the premise that US stocks are entering a new environment going forward and past results are going to be less and less relevant in predicting future performance.  One of the reasons for this is the fact that the United States has ceased to be a dominant player in launching new public companies, and in fact is now mostly an also-ran when compared to Chinese markets or even Brazil as of late.

The Agricultural Bank of China is about to come out as an Initial Public Offering next week that will be one of the largest IPOs of all time.  Per this article:

Hong Kong and China have dominated the global IPO market. That dominance will only increase when Agricultural Bank of China starts publicly trading next week.  In 2009, Hong Kong was the world’s largest IPO market, with companies raising a combined $32 billion in capital, according to Dealogic, a data-tracking firm. This year, China is on track to assume the mantle, with $31.7 billion raised by early July.

The Wall Street Journal had a recent article titled “How to Fix the IPO Market” by Jason Zweig.  I didn’t agree with their analysis or recommendations but the article did have a lot of useful facts and figures that illuminate the changes in the public markets in the United States, such as the following:

Ten years ago, around 9,100 companies filed annual proxy statements with the Securities and Exchange Commission. Last year, roughly 6,450 did; so far in 2010, only about 4,100 have, estimates Wharton Research Data Services.  In two-thirds of the years from 1960 through 1996, the number of initial public offerings exceeded the number of stocks that dropped out. Since then, however, there have been more deaths than births among stocks every year: 7,725 stocks have disappeared over that period, while just 4,299 new ones have arisen to replace them, according to Wharton.

What is happening is that existing companies are swallowing up smaller companies and other ones went bust during the market tumult.  New companies, however, haven’t joined them.  Recently there was a bit of a hoopla about an IPO for Tesla Motors, which raised $266M.  However, prospects for the car maker are cloudy and the stock has declined below its offering price since then.  If Tesla, a loss making niche enterprise, is the future of our growth companies, we are in trouble.

The reason that this matters is that the entire “stocks outperform over the long run” is based on data from a few markets that haven’t suffered major disruptions (war, occupation) which pretty much brings you down to US and UK market data, mostly US data.  And this data was based on a continuous growth in companies launched through IPOs with a growing market for companies; today the market for US based companies is small and much of the new and larger IPOs are happening overseas.

There is nothing wrong with overseas markets growing; it is just that the US markets seemed to have stopped, and investor money (both US and foreign based) is going where the IPOs are.  While we do not see the “full” effect of this trend, because many large multinationals are still US based and doing well, we will see it in the future as the newer companies don’t fill in the gaps and come through the ranks at some point in the future.

This doesn’t mean that I am saying that US markets will go up or go down as a result of this; I am just saying that the long term data was based on a premise that new companies would grow to replace the old (“creative destruction”) but in fact the new companies aren’t coming up in the footsteps. Perhaps stocks are best in the “long run” in aggregate across all markets but it may not be US based stocks if we just have aging companies and the young, growth companies are nurtured elsewhere.

Cross Posted at LITGM and Trust Funds for Kids

Bond Bubble?

A recent Wall Street Journal article titled “Bond Fund Managers See Signs of A Bubble” discusses the state of the bond market and large inflows into bond mutual funds by investors seeking returns and attempting the avoid the risk that they see in the stock market.

A key element to understanding this or any other analysis on bonds is the difference between holding an individual bond to maturity vs. buying a fund that invests in bonds. They behave very differently. If you buy an individual bond and hold it for its life, unless that company goes bankrupt or has some sort of liquidity event, you will receive back your principal at some point in the future and interest payments along the way. Unless you are unlucky and it goes into default, it is a predictable stream of payments. Bond funds, on the other hand, invest in a whole range of individual bonds and do not necessarily hold them to maturity. Bond funds are significantly impacted by interest rates; when interest rates RISE, the value of their bond holdings immediately falls and investors receive losses. If interest rates FALL, investors in bond mutual funds receive gains. Thus holding individual bonds, once purchased, is mostly about default risk for that particular issue, while investing in bond mutual funds is primarily about the direction of interest rates and also overall default risks across all issues.

This situation is summarized as such in the article:

Interest rates will likely rise in coming years from a base of almost zero today. But investors mostly only know what they have seen in the past 25 years, which for the most part has been period of steadily declining interest rates and rising bond prices.

There isn’t any “up side” to bond mutual funds right now, from an interest rate perspective, because rates are almost at zero. If rates are going to change they are going up. In addition, low interest rates means less pressure on entities that require debt financing, and rising interest rates will not only slam bond fund values but they will increase the default risk on bonds in the fund as those entities must pay a higher price to refinance future needs.

Compounding the problem is that many investors don’t remember when bond funds did lose money for a prolonged period.

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