Monday, December 22, 2008
Monetary and fiscal favors showered Wall Street last week, even though they should have been on the naughty list. In completely unprecedented action, the Federal Reserve dropped their target interest rate to 0%, announced they would force longer-term interest rates down through “quantitative easing,” and they would continue this activity for a prolonged and indefinite period of time. This is a very aggressive, inflation-be-damned policy gesture that immediately weakened the dollar and strengthened gold.
Nevertheless, this activity meets the measure of the current economic condition and while we may not like the taste, I suggest we take the medicine. 30 year fixed mortgage offers fell below 5%, as intended. On the fiscal side, Detroit received a Christmas bonus of $17 billion from Santa Bush. The loan provision contained several directives and checkpoints that must be met, but then completely left the interpretation, oversight and enforcement of these provisions to the Obama administration. The structure outlined hints at the quasi-bankruptcy that makes the most commercial and political sense for all parties. The accountability of the automakers through the process will be a function of how strongly the Obama administration is convinced that Detroit needs to be made fully competitive. Huge sacrifices and concessions will be called for from all stakeholders. The drama will be intense. Put it on your watch list for 2009.
The selection of beginning and ending points drives the calculation of performance. If you look at the S&P 500 from 1/1/08 through Thursday, the index has fallen 39.4%. From the October 10th low, the S&P 500 has advanced 6% and from the November 20th low, %. Each of those time periods contains different conditions, different winners and losers and countless investment decisions. For the purpose of the following analysis, let’s examine the most recent rally from November 20th. This time period of 21 trading days contained less volatility and more rationality than we have witnessed for months. Therefore, the developing themes may be more trustworthy than those that appeared and disappeared so rapidly while the market was on spin cycle. Here are category returns using Exchange Traded Funds:
Name Category Month Return
Gold Miners (GDX) Precious Metals 52.54%
Long Treasury Bond (EDV) Government Bond 47.22%
Building and Construction (PKB) Infrastructure 33.88%
North American NAREIT (IFNA) Real Estate 32.31%
Home Construction (ITB) Infrastructure 28.06%
China (FXI) Asia/Pacific 25.54%
The obvious strategy? Front-run the government! Gold advances when weak dollar concerns increase. Gold miners use a lot of oil when they mine for gold, so a weakening dollar and weakening oil prices are the perfect ingredients for gold miner returns. The Fed’s quantitative easing measures (i.e., purchasing longer dated maturity bonds) have driven the yield on the 30 year Treasury bond down from 4% to 2.6%. Bond prices rise when yields fall, and yields fell by 35%! The Obama administration has been openly considering a trillion dollar infrastructure spending plan. Buy asphalt! That has lit a fire under building and construction names in anticipation of huge spending on the horizon. With interest rates being forced down by the Fed, the prospects for real estate and home builders improve as seen in the share price appreciation across REIT and home construction names. Finally, China simply has the most committed government, most robust balance sheet and the world’s highest growth rate. Any recovery in investor confidence will lead to outsized recovery in Chinese equities. W&A equity model portfolios have exposure to these themes which has driven our recent relative outperformance.
While the rest of the market demonstrates tentative reaction to daily news flow, those segments that directly link to the government’s intentions stand to benefit. Notice that for the course of this rally, the financial services’ names do not appear. While the government has clearly taken up residence in this segment, the benefit is not as clear. So the takeaway for this research report is, whether you approve of the government’s participation or not, you can and will profit from it.
The Corporate Bond Market
The Federal Reserve has taken interest rates to zero in an effort to push investors to take investment risks, since there are no returns in the risk free Treasury market. By abandoning other forms of fixed income, investors have left behind some remarkable values. Right now, the corporate bond market valuations imply a default rate of over 30% of all credits. During the Great Depression, 21% of credits defaulted. By this measure, the economic environment we are entering should be 1.43 times worse than the Great Depression. If you are not buying that, then consider corporate bonds. The corporate bond index yields 6% more than Treasuries and the high yield index yields 16% more.
Since we find this environment irresistible, 80% of our bond model targets non-Treasury bond opportunities. Consistent with the recovery in the equities market, our most opportunistic corporate bond fund has appreciated 3.8% in the last month and has a current yield-to-maturity of 13.44%, or 11.4% more than Treasuries. If you expect the current economic environment to be 1.43 times as bad as the Great Depression, stay in Treasuries. If you don’t, then we strongly suggest considering the historic opportunities in corporate bonds.
I will say as I close this one out that Government Claus has delivered a Santa Claus rally to remind us all that markets, just like the seasons, are cyclical. We are all so fortunate in so many ways, so take the opportunity the holidays provide to re-allocate your perspectives. We will be spending a little less this year at the Waddell house on gifts and a little more on gratitude.
Fewer gifts and more appreciation = higher returns per gift. OK, I’ll stop now.
David S. Waddell
Senior Investment Strategist
David S. Waddell commentary, USA Today, December 17, 2008.
Click here for more information on Waddell and Associates.
**This blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.