This is almost getting silly: Muni Bond Yields

In a normal world, muni bonds yield slightly less than taxable bonds, such as treasuries. If a 10-year treasury bond was yielding 2.6% (like it is right now), we would expect a muni bond to yield somewhere between 2% and maybe 3%. The low end would be for ultra-safe state general obligation (ie, "unlimited taxing authority") bonds and the higher end might be a lower-rated local government entity.

We bought some 11-year muni bonds this morning yielding 7.625%. That is not a typo. An after-tax yield that is about three times what we can earn on a treasury bond -- and over 4x if we consider taxes. You might wisely ask -- what's the catch? Surely this must be some kind of junk bond...? Nope -- I'd put my grandmother's life savings in this bond.

The muni bond world breaks down into three big buckets. The first bucket (that I put no money into) is bonds sold for private non-profit things like hospitals, universities and other charitable enterprises. We also include here such things as pollution control bonds and airport terminals. These are essentially corporate credits, and I don't invest in them.

The rest of the muni world is bonds sold to fund what we think of as essential public facilities: Roads, schools, libraries, water systems, etc. There are two types of these bonds: Those supported by a direct revenue stream and those supported by the "general fund" of the agency or city. If you've been reading the paper, you know that local and state agencies are under extreme financial stress right now. Elected officials will have to make the tough decisions about how to allocate a fixed revenue stream. There is risk in this process for bondholders -- if the agency's fixed obligations (pensions, public safety, basic teacher head-count, etc.) exceed its revenues, there is some risk for interest payments. That type of bond does, perhaps, deserve to sell at higher yields.

The other type of local government bond is not affected by these other demands. Some muni bonds are paid from property taxes or other revenues that do not first pass through the general operating fund of the agency. Those revenues are captured, sequestered and used to pay the bondholders. Property owner pays taxes; county captures taxes; taxes go to bank to pay our bonds. I like that arrangement. The Governator can't get his hands on my money!

That is the type of bond we've been buying. For technical reasons, bond mutual funds are being forced to dump bonds on the market -- bonds with a very high degree of security that in many cases were not rated by S&P or Moody's when the bonds were issued. The bond we bought today is secured by special property taxes on over 4,500 housing units in Irvine, CA. I have worked on projects like this as an investment banker, tax administrator and disclosure consultant for over 20 years. Getting paid 4x over treasury yields to take this little risk is as good an investment as I have ever seen.

To the point that it's almost silly. I keep pinching myself.

Meeting with your advisor soon? What to ask.

A friend asked me a perfectly reasonable question last night: I'm going to meet with my advisor soon. What should I ask about?

Here's the single most important thing to ask your advisor: If I had all of my portfolio 100% in cash right now, what would you do with it? That is the place from which we should always start when reviewing our portfolios. If we, even for one moment, consider our portfolio from the perspective of what we already own, we are engaging in the well-documented behavioral biases of commitment and loss-avoidance. Rather than view the investment landscape by considering today's conditions and tomorrow's potential -- we try to drive forward by looking backwards.

I will guarantee you that 90% of advisors are giving all-cash clients different advice than they are clients with various mixes of stocks and bonds. And this is completely and utterly irrational. Let's imagine that an advisor is telling new, all-cash clients to allocate only about 20% into stocks right now and to maybe do some dollar-cost averaging back into the market. Be cautious; take our time and see how the recession plays out. Perfectly reasonable advice, in my view.

Now, let's think about what the advisor is telling a longtime client with identical goals and life position; a client who's had 70% of her money in stocks for several years. I'll bet you a box of donuts that the advisor is telling the longtime client a different story. The advisor is talking to that client about "holding on" and waiting for a recovery. After all, the poor client's stock portfolio is down by almost half and the only way the advisor is going to recover the client's confidence is if most of that is won back, and quickly.

So that client is told to hang on. See the irrationality of it all? Under identical market conditions, what is good for one investor is 20% stocks and what is good for his twin is 70% stocks. This type of advice borders on malpractice, but it will happen in tens of thousands of year-end meetings over the next month or so.

Ask your advisor what he'd do with all cash. If that differs significantly from how you are invested, either ask the advisor to explain himself, or find a new advisor. If your advisor really thinks that you should be invested differently than a "twin you" who's starting with cash, then you have some hard decisions to make.

Acting Quickly in Troubled Times

All investment decisions have to be made after a sober and diligent consideration of all relevent information. We study, we ponder, we stare at the ceiling. Eventually, it all comes down to a judgment call and we decide -- buy or not buy.

We think the bond market offers the best investment opportunities right now, when considering both the return and the risk. The fracturing of the credit markets has caused large numbers of investors to flat-out dump perfectly good bonds onto a market wholly unable to digest them all. Those that can pick the wheat from the chaff will profit from this forced selling.

Last Thursday, I received an email from a bond broker that we like (and that I used to work for) with a few bonds out on offer. I scanned the list and immediately replied that I'd take a block of one particular bond.

Let's see -- how long did I spend researching that bond? It didn't have an underlying credit rating, and the AMBAC insurance is nearly worthless. I spent about 5 seconds considering the bond. Did I do my homework?

You bet. I had worked with this particular school district in my past life as a municipal bond investment banker. I knew the deal; I knew the community. The bond is secured by over 9,000 single-family homes. The assessed valuation of the property is nearly 80 times the amount of the debt. I know that the tax collector in that county has a policy of advancing delinquent tax payments from bond districts of this type. Standard & Poors and Moody's might have their points of view, but mine was simple: This is a money-good bond. As secure as any muni bond we can get, including those issued by the state of California.

Alas -- I wasn't the only one who jumped quickly. This bond maturing in 6 years, yielding 6.25% tax free, traded before I could even get back to the broker.

We will see more opportunities like this, and we will jump quickly on the ones I can understand at a glance. The muni bond market is as cheap, relative to other alternatives, as I have ever seen it in my career. But, we have to seize opportunities when they arise.

Why are banks cancelling the good loans?

I've heard a few personal tales of perfectly good borrowers with perfectly good leased-up commercial properties finding that their formerly perfectly cooperative bank is declining to renew a mortgage. It seems strange that banks would decline to make safe and profitable loans during a time when they must be desperate for safe and profitable loans. But, we need to imagine ourselves in the mind of that banker...

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Sure, my bank has fifty billion of assets that we have no clue how to value, or how secure they are. They're just sitting there and we're going to have to figure that one out with Paulson and Bernanke. But, I do have this other twenty billion over here and I most definitely understand the quality of this batch. These are good loans to good borrowers, but the accounting rules require me to carry them at 70 cents on the dollar, since that's what they're trading for on the open market. Heck, I'll make at least a 40 percent return on these assets if I simply hold them to maturity.

But -- the regulators are going to make me sell them if I can't raise some capital or reduce my total loan portfolio! What am I going to do? My kids need new shoes and I need new golf clubs. Hmmm...the capital we raised came from the Feds and is tied up supporting that fifty billion in assets that we (and they) don't understand. I'll need to reduce my total assets in some way...hey, here's a loan that's coming due for one of my longtime clients. I can only get away with charging this guy 7 or 8 percent, but he's a good borrower with a great property.

What to do? I can make 40 percent by keeping these oddball assets that the regulators don't like, or I can make 7 percent by renewing that commercial loan to my longtime client and golfing buddy.
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We see where this is going, don't we? Banks are being perfectly rational by calling in low-risk loans because they are also low-yielding loans. There is more money to be made investing in oddball assets that are also low-risk.

This is pretty much the same thing we're doing by not buying Treasury bonds or California GO bonds -- they're safe, but they don't yield diddly. We can make more money by buying very high-quality bonds that the market simply happens to hate at the moment -- GNMAs and local goverment revenue bonds among them. Capitalism is not a perfect system -- its flaws run deep and are well understood. But in this instance, the market forces that push us toward the best combinations of risk and return will serve their purpose in the fullness of time.

The Wisdom of "Why?"

I am an unrepentant skeptic. If you want to get my attention, make a claim about a factual matter without providing any proof or data to back up your claim. Even worse, provide bad or incomplete data. The practice of skepticism has a long and shining history, starting with the Greek philosophers and running through such modern luminaries as Albert Einstein and Michael Shermer.

At its core, skepticism is the art of asking, “Why?” Someone makes a claim or observation. You ask, “Why?” They give a first answer, to which you again ask, “Why?” The process of drilling down into the issue – of peeling back the layers of the onion – can eventually lead to truth. Or, equally often, it will uncover the lack of truth.

I’d like to illustrate the concept with reference to a magazine article I read a couple of years ago. A national news weekly gave the advice that, in order to beat inflation, you should buy stocks. They used three periods of time to illustrate their point: 1926 to 2004; 1987 to 1990; and 1979 to 1981. During those selected periods, stocks paid significantly more than the rate of inflation. The investment skeptic will ask, “Why,” and look more deeply at the question.

First, we should notice the odd selection of time periods. A 78-year period, a 3-year period and a 2-year period. Hmm. What about 5, 10, or 20 year periods? I don’t have 78 years to wait, and 2-3 year periods are too short a horizon for stocks. On a hunch, I looked through the data myself. It wasn’t hard to find a few periods where stocks did not keep up with inflation. In fact, they all but leap out of the database.

For the 5 years from January 1973 to January 1978, stocks paid a total annual return of minus 4.5%, while the annual inflation rate averaged 8.0%. Stocks trailed inflation by a compounded 46%, over only 5 years! The spending power of stock portfolios was cut almost in half.
What about periods in which stocks made good money, but inflation was high enough to wipe out returns? Since you asked, the 5 years following January 1945 saw annualized stock returns of 5.2%, with annual inflation of 7.4%. I could go on and on.

The point here is that, with a sloppy or careless examination of the data, one can find select periods of time that support almost any conclusion. The question, “Why?” doesn’t lead to an answer about why stocks beat inflation, but rather to the question about why the magazine chose these time periods.

As we continue to ask, “Why,” we begin to find that stocks tend to do well not merely when inflation is high or low, but rather when inflation is moving from high to low. Paul McCulley of PIMCO has written about the difference between the journey and the destination. It is the journey of inflation from one level to another higher or lower level that triggers stock movements. Stocks move higher more often when inflation has drifted lower than when inflation is stable.

Since 1900, whenever inflation in one 5-year period changes a small amount from the previous 5-year period – what I call stable inflation – stocks beat inflation two-thirds of the time. This is true whether inflation is high or low. In times when the rate of inflation declines significantly across those sequential 5-year periods, stocks beat inflation an astounding 98% of the time.
Finally, if the rate of inflation increases significantly, stocks fail to keep up with inflation 55% of the time. In 5-year periods during which inflation rose, stocks trailed inflation by an average of 1.5% per year.

These figures provide some evidence that it is the change in the rate of inflation that matters most to stock investors, not so much the actual rate of inflation itself. The national magazine article looked only at the average rate of inflation, not the change in direction of inflation. This article also highlights the fact that even well-meaning, independent investment advice can lead us astray.

While the magazine implored investors to move into stocks as inflation moves higher, the evidence from the 20th century provides advice to the contrary. If you believe that inflation is moving higher, you need to make a decision about stocks.

Investors must be skeptical, and continually ask, “Why?” If someone advises you to buy an investment, you must ask, “Why?” If the answer is, “Well, it has paid 11% annually for the last 25 years,” you need to ask, “Why did it pay 11%?” What were the facts and circumstances that led to that 11%? Are those circumstances likely to repeat themselves? What about other time periods?

This last example should be asked of index fund promoters, who are fond of merely citing the historic average return, while giving no thought whatsoever to whether those historic returns have any hope of being repeated. Investment returns don’t just happen. They happen for reasons. An argument over index funds versus active funds misses the point. What are the reasons and conditions that led to past investment returns? Are those conditions present today? Should we rationally expect the past to repeat, or should we actually pick up our heads and look around at the real world?

The skeptic has a reputation for being a curmudgeonly naysayer that questions everything and everyone. While this behavior might not be the best way to approach all areas of your life, it is the best way to approach your investing.

Up and Down and Up and...

The Roller Coaster Continues...

I sit to write this missive and start typing the same thing I typed last time. What more is there to say? The economy is most clearly going backwards; the bond market is behaving entirely irrationally; stocks keep getting cheaper. What's an investment manager to do? I'll take the easy route and just answer the two questions that we get from clients, friends and the Friday morning Rotary meeting...

1. Where is the bottom? You already know my answer: I don't know. But what I do know is to look at past cycles and examine what was going on and how the market bottomed. In my analytical world, the "price" of stocks isn't the number you see on the front page of Yahoo -- it's an inflation-adjusted price-earnings ratio that looks at the last 10 years of earnings. My PE ratio tells me how much I am paying -- the price -- for the expected earnings of stocks over some reasonably long future period. That, and that alone, is the price that we care about when parsing historic tables and making judgments about stocks.

Using our methodology, stocks have bottomed with a PE of 7-8 several times in the past 75 years. They closed today at a PE of about 13. That means that the S&P 500 *could* fall another 45%. Yikes. That would be a 70% decline from its peak in summer 2007. A huge fall, to be sure, but not unprecedented.

However, as my friend and friendly competitor Eric Hull pointed out to me recently, those single-digit PE bottoms have generally occurred in a period of accelerating, double-digit inflation. The market bottoms in periods of declining and low inflation have been in the 11 to 13 range. When we came to work this morning, the PE was at 12.5 and we bought some stocks. Not a lot -- just 2-5% in most accounts.

I will not make any prediction about a possible market bottom, but I can tell you this with all candor: History shows that investors who buy stocks at prices like we see today are amply rewarded over 5-7 year periods. Patience is the key -- if you have the stomach for some volatility, the odds are very high that the total return on stocks over the next 5-7 years will be higher than the returns to bonds or cash, especially after adjusting for inflation.

2. What Kind of Stocks Should I Buy? For the first time in 50 years, the dividend yield on a basket of blue-chip stocks is significantly higher than the yield on long-term treasurys. The 10-year treasury closed today yielding 3.17%, and the yield on our favorite bundle of dividend stocks is over 5.5%. Even better, yields on stocks rise with inflation over time, while yields on bonds are fixed.

This situation might not strike you as all that earth-shattering, but I assure you it is. This is a major milestone that I never thought I would see in my lifetime. For my entire career, the choice about stocks came down to something like this: I can buy stocks and earn a nothing yield of 2% and hope stocks go up. Or, I can put money in cash and bonds and earn 5-6%. But I will miss out on any stock upside.

Today, we can own stocks and earn much higher income than on cash and bonds, and we still have all the upside of stocks. Keep in mind that, if we buy $100k of stocks and receive a $5k annual dividend, we keep getting that $5k even if the stocks go down. That $5k is higher than the $1k to $3k we would have gotten from cash or bonds. From an income perspective, we are no worse off by owning stocks -- even if they go down in the near term. If you have the willpower to stay with that decision for 5-7 years, I am highly confident you will be happy you did.

Our recommendation, should you choose to buy stocks right now, is to look at dividend-oriented stock mutual funds and ETFs. The usual search tools at Morningstar and Schwab can point you in the right direction.

Have a wonderful Thanksgiving week!

Cheers,
Rick Ashburn

Back to Business...

With the election behind us, we should now consider what the near-term holds for our portfolios. To tackle the first question on everyone's mind: Is Barack Obama going to be good for our portfolios? My view has long been that the President has far less effect on economic outcomes than folks would like to believe. Mostly, people believe that if something good happened on "their guy's" watch, then he deserves credit for it. If something bad happens, it's not his fault. Conversely, if something bad happens on the "other guy's" watch, it's clearly that guy's fault. Phooey. Mostly, stuff just happens. I don't need to be shy about the fact that I'm no fan of G. W. Bush, but I'm not about to lay this financial crisis and economic downturn at his feet alone. Lay it at Greenspan's feet? You bet, but that's a blog for another day...

President-Elect Obama has shown all the signs of preparing to deal with our economic problem in a thoughtful and rational way without resorting to populist salves. He has, to date, surrounded himself with experienced and thoughtful advisors with a decidedly centrist economic bent. We remain optimistic that, to the degree an Administration can do much at all, the pending Obama administration will do a good job. The real cures for our economic turmoil are out here on main street and time needs to pass for things to turn right again.

I like to think about our current predicament as a family that has built a third story on its house, and then moved everything up to the third floor. The view from the third floor is grand and we have all the worldly comforts we can imagine. But then one day we realize that we can't afford the third floor that we built and begin to move back down to the second floor.

Once we are back on the second floor and a little time passes, we will realize that the view from here is darn near the same. We have pretty much the same stuff, even if it's not as new as we would like. Frankly, life is hardly distinguishable from that third floor we used to think was so essential.

The US Consumer is in the process of moving down to the second floor. The painful disruption is not in the eventual destination -- it is in the moving down process itself. The longer it takes to get the move over with and to board up and forget about the third floor, the longer the recession will last and the longer the bear market will last. As I write this, the move down seems to be picking up speed. While I do not gloss over the pain of that move down -- job losses, bankruptcies, depleted portfolios -- it's better to get the move over with sooner rather than later.

Our investment themes for the time that the movers are still carrying boxes:

- Remain underweight to stocks. Look for opportunties to buy small amounts when the S&P500 index is below about 925. Accelerate a move back to full allocations if the S&P500 moves sharply down into the <800 range.
- Stay short on the bond maturity spectrum. 3-5 years at the longest.
- Stay in high-quality bonds. Treasuries, mortgages and high-grade corporates.
- Buy muni bonds. Again, stay short (3-5 years). Munis are a screaming good deal right now. Stick with high-quality GO (ie, voter-approved) and utility revenue bonds and you won't need to worry about looming budget problems in the municipal sector.

Congrats to those whose candidates/initiatives won and condolences to the not so fortunate. We're all still one big happy family and we now look to the road ahead.