2010 Invest­ment Strate­gies: Six Areas To Buy, 11 Areas To Sell

(excerpted from the Jan­u­ary 2010 edi­tion of A. Gary Shilling’s INSIGHT)

Our invest­ment strate­gies for 2010 fol­low from our fore­cast of con­tin­ued eco­nomic weak­ness and defla­tion, as dis­cussed ear­lier in this report and in pre­vi­ous Insights, espe­cially our Dec. 2009 edi­tion. We see the 2010 invest­ment cli­mate dom­i­nated by weak eco­nomic growth here and abroad, led by U.S. con­sumer retrench­ment. More gov­ern­ment fis­cal stim­u­lus and con­tin­u­ing Fed pol­icy ease are likely in this set­ting. So is low infla­tion or deflation.

INVESTMENTS TO BUY

1. Buy Trea­sury Bonds. Long-term Insight read­ers know we started rec­om­mend­ing long Trea­sury bonds back in 1981 when we fore­cast sec­u­lar and huge declines in infla­tion and inter­est rates. So we declared back then that “we’re enter­ing the bond rally of a life­time.” The yield on 30-year Trea­surys was 14.7% and our even­tual tar­get was 3%. Last year, yields blew through 3% to reach 2.6% at year’s end, so in our Jan. 2009 Insight we declared “mis­sion accom­plished” and removed Trea­sury bonds from our rec­om­mended list.

But then Trea­surys sold off, push­ing the yield on the 30-year bond to 4.7% at the end of 2009. So we’ve reac­ti­vated the strat­egy with our fore­cast of a return in yields to 3.0% or lower. Trea­surys will con­tinue to be a safe haven in a trou­bled world and ben­e­fit from defla­tion as well as their three ster­ling fea­tures. They are the best cred­its in the world. They are highly liq­uid. And they gen­er­ally can’t be called by the Trea­sury, and calls limit price appre­ci­a­tion when inter­est rates fall.

A decline in yields from 4.7% at present to 3.0% may not sound like much, but the bond price would appre­ci­ate over 34%. If it occurs over two years, then two years’ worth of inter­est is col­lected, and the total return on the 30-year Trea­sury would be 44%. On a 30-year zero-coupon Trea­sury, which pays no inter­est but is issued at a dis­count, the total return would be about 64% — most attrac­tive! Recall that in 2008 when 30-year Trea­surys ral­lied from 4.5% to 2.7%, their total return for the year was 42%..

Trea­sury bonds way out­per­formed equi­ties in the 1980s and 1990s in what was the longest and strongest stock bull mar­ket on record. The supe­ri­or­ity of Trea­surys has been even more so since then. Chart 1, our all-time favorite graph, shows the results from invest­ing $100 in a 25-year zero-coupon Trea­sury bond at its yield high (and price low) in Octo­ber 1981, and rolling it into another 25-year Trea­sury annu­ally to main­tain that 25year matu­rity. In Novem­ber 2009, that $100 was worth $16,972 with a com­pound annual return of 20.1%. In con­trast, $100 invested in the S&P 500 at its low in July 1982 was worth $2,099 in Novem­ber for an 11.8% annual return includ­ing div­i­dend rein­vest­ment. So Trea­surys out­per­formed stocks by 8.1 times!

Doubters

Many believe Trea­sury yields are headed up, not down. They think that all the bank reserves cre­ated by the Fed that have not gen­er­ated bank loans will do so, flood­ing the econ­omy with money and then cre­ate excess demand and infla­tion. They also think the con­tin­ual heavy issuance of Trea­surys to fund the non­stop fed­eral deficits will push up yields. In con­trast, we don’t fore­see the rapid eco­nomic growth needed to induce chas­tened banks to lend and cau­tious cred­it­wor­thy bor­row­ers to bor­row. And if we’re wrong, it will take at least sev­eral years to eat up global excess capac­ity dur­ing which the ever-inflation-wary Fed will no doubt remove the excess bank reserves, as Fed offi­cials have already indicated.

We do expect large fed­eral deficits for many years, in part because of pres­sure on gov­ern­ment to cre­ate jobs and restrain unem­ploy­ment in a slow growth econ­omy. But those deficits will increas­ingly be funded by U.S. con­sumers as their sav­ing spree con­tin­ues. Although stock mar­ket bulls sali­vate over the prospect that increased sav­ing will mean more equity pur­chases, we believe most of the money will con­tinue to reduce the immense debt con­sumers have accu­mu­lated in recent decades.

Repay­ing debt will be attrac­tive to many Amer­i­cans in 2010 and beyond as they shun many invest­ments after their huge losses in stocks through­out this decade and their shock­ing set­backs in real estate. A num­ber will want to be less lever­aged as slower eco­nomic growth makes employ­ment less sta­ble and unem­ploy­ment more likely. Chas­tened lenders, pressed by reg­u­la­tors, will be push­ing indi­vid­u­als to lower their lever­age by repay­ing debt.

Another con­cern for Trea­sury bonds is that con­tin­ued huge fed­eral deficits and the required Trea­sury financ­ing will erode con­fi­dence in these issues by Amer­i­cans and for­eign­ers, as noted ear­lier. This seems unlikely, espe­cially before the end of this year. Also, as U.S. con­sumers save more and curb spend­ing on domes­tic prod­ucts and imports, the trade and cur­rent account deficits will con­tinue to shrink. Ear­lier fed­eral deficits were financed by for­eign­ers as they recy­cled back to the U.S. the dol­lars gained from their trade and cur­rent account sur­pluses. The grow­ing U.S. cur­rent account deficit mea­sured the increas­ing gap between domes­tic sav­ing and invest­ment, or, in effect, and the need for for­eign­ers to not only finance gov­ern­ment deficits but also make up for declin­ing U.S. con­sumer saving.

But now, the cur­rent account and trade deficits are shrink­ing, and fur­ther declines will accrue in future years if, as we fore­cast, exports grow faster than imports. So for­eign­ers will have smaller Amer­i­can cur­rent account deficits to finance. At the same time, much more of fed­eral deficits will be financed by ris­ing U.S. con­sumer saving.

With 3-month trea­sury bills yield­ing 0.046%, we’ve moved out on the yield curve for what is essen­tially cash posi­tions in some cases. Sure, 5-year oblig­a­tions are much more volatile than 3-month bills and do have risk of loss if inter­est rates rise. But we think the direc­tion is down in that part of the inter­est rate curve, and 2.6% returns vs. 0.046% seem enough to off­set the risks.

2. Buy Income-Producing Secu­ri­ties. This includes high-quality cor­po­rate and munic­i­pal bonds as well as stocks of util­i­ties, con­sumer prod­uct com­pa­nies, health care firms and oth­ers that pay mean­ing­ful div­i­dends that are likely to rise. Mas­ter Lim­ited Part­ner­ships are also pos­si­bil­i­ties, but only if their under­ly­ing busi­nesses are secure enough to con­tinue sig­nif­i­cant income flows to lim­ited part­ners and stock­hold­ers. Banks used to pay sig­nif­i­cant div­i­dends but slashed them when their earn­ings col­lapsed. Nev­er­the­less, their delever­ag­ing and rever­sion to safer but less growth-oriented busi­nesses will prob­a­bly pres­sure them to again pay attrac­tive dividends.

Util­i­ties lagged behind the stock mar­ket last year, but at the end of Novem­ber, the div­i­dend yield on util­i­ties aver­aged 4.5% com­pared to 2% for the S&P 500 index. That low return com­pares with 3%, which used to be the floor (Chart 2). Pay­out ratios recently have been essen­tially mean­ing­less with the col­lapse in cor­po­rate earn­ings, but low, 31% in the third quar­ter of 2009. Under pres­sure from stock­hold­ers, div­i­dend yields are likely to return to 3% or more. The cur­rent high level of cor­po­rate cash will also encour­age div­i­dend pay­ing.. Also, the S&P util­ity sec­tor has returned 53%, includ­ing div­i­dends, since 2000 while the total return on the S&P 500 index has been a minus 11%.

With stocks likely to be weak this year, div­i­dend yields may con­sti­tute 100% or more of total returns. Note, how­ever, that although the prices of util­ity and other defen­sive stocks some­times rise in bear mar­kets asso­ci­ated with reces­sions, that’s not always the case. That was clearly true in 2008 when vir­tu­ally every stock sec­tor went down. Util­ity and other dividend-paying stocks and ETFs based on them, how­ever, can be hedged against gen­eral stock mar­ket declines.

3. Buy Con­sumer Sta­ples and Foods. Items like laun­dry deter­gent, bread and tooth­paste are basic essen­tials of life that are pur­chased in good times and bad. In fact, as we’ve seen lately, con­sumers are buy­ing more of their calo­ries in super­mar­kets and they econ­o­mize by eat­ing at home rather than in restau­rants. Note, how­ever, that they are down­grad­ing from national brands to cheaper house brands, and likely will con­tinue to do so as a weak econ­omy and high unem­ploy­ment per­sist. Among retail­ers, the win­ners may con­tinue to be dis­coun­ters. Pro­duc­ers of national brands will need to con­tinue to adapt to con­sumer down­grad­ing by empha­siz­ing cheaper “value” products.

4. Buy Small Lux­u­ries. This is an invest­ment con­cept we devel­oped years ago. Con­sumers, espe­cially when they’re hard pressed, tend to buy the very best of what they can afford, even if it’s within a low-priced cat­e­gory. We first noticed this ten­dency years ago, before apartheid ended in South Africa. We read that urban blacks there often car­ried the ele­gant, slim and expen­sive umbrel­las typ­i­cal of invest­ment bankers in Lon­don. They couldn’t afford cars or maybe even taxi fares, but did achieve sta­tus and sat­is­fac­tion with fine umbrel­las. We also learned of a cur­rently unem­ployed man who enjoyed the sta­tus of morn­ing cof­fee at 7-Eleven six days a week. By reusing his cup and the one he takes home to his wife, he gets a 32-cent dis­count per $1.37 serv­ing and saves $655 a year on this small luxury.

Com­pa­nies are adapt­ing to small lux­ury modes in var­i­ous ways. Some are offer­ing the same prod­ucts with lower cost and sell­ing prices. Coach is cut­ting ladies hand­bag prices and work­ing with sup­pli­ers to reduce costs. Neiman Mar­cus is press­ing sup­pli­ers for lower-cost ver­sions of designer styles.

Oth­ers are putting their pres­ti­gious names on dif­fer­ent prod­ucts. C.F. Mar­tin rein­tro­duced its stripped down 1930s gui­tar for under $1,000. Aver­age prices were in the $2,000 to $3,000 range and its top of the line gui­tar sells for $100,000. Cal­i­for­nia wine­mak­ers are empha­siz­ing cheaper wines as sales of those over $25 per bot­tle slump. Con­sumers are retrench­ing and din­ing out less at upscale restau­rants where fine wines are sold. Tiffany sales of prod­ucts over $50,000 are weak, but high-quality small items con­tinue to sell well–always in its trade­mark blue box. Proc­ter & Gam­ble has not cut prices on its top of the line prod­ucts that sell at pre­mi­ums but carry high-quality images. Con­sumers still splurge on such small lux­u­ries as Gillette’s five-blade Fusion razor and Olay’s Pro-X mois­tur­izer. But P&G has intro­duced cheaper “value” ver­sions of Tide and other prod­ucts to com­pete with the grow­ing con­sumer inter­est in lower-cost national and house brands.

5. Buy The Dol­lar. Dump­ing on the dol­lar was the favorite sport of investors and the finan­cial media until very recently. The finan­cial melt­down in 2008 drove investors to the dol­lar as the global safe haven, but in early 2009 that sta­tus faded as fears of finan­cial col­lapse melted. Buck-busters cited the record low short-term inter­est rates, with the fed funds tar­get rate at 0–0.25%, even lower than in Japan. This made the green­back the pre­ferred fund­ing cur­rency for the carry trade in which it is bor­rowed and then sold for other higher yield­ing cur­ren­cies with ris­ing inter­est rates. The falling dol­lar against those cur­ren­cies enhances the prof­itabil­ity of those trades. Buck dumpers also empha­sized the tremen­dous amount of dol­lars being pumped out by the Fed and the Trea­sury 70 in their attempt to revi­tal­ize the econ­omy 68 and the Fed’s clearly-stated com­mit­ment to keep short-term inter­est rates low for an extended period.

Despite all its draw­backs, how­ever, the dol­lar remains the world’s reserve cur­rency and safe haven, regard­less of sug­ges­tions by the Chi­nese and oth­ers that the dol­lar should even­tu­ally be replaced by a global cur­rency. This sta­tus for the buck appears to be reemerg­ing and will grow if we’re right and hopes for a rapid eco­nomic recov­ery are dashed. Fur­ther­more, almost every­one was on the dump-the-dollar side of the boat, a sit­u­a­tion sim­i­lar to early in 2008 that pre­ceded the dollar’s jump start­ing in mid-year (Chart 3). His­tory sug­gests that when that hap­pens, the winds often shift and all those folks will get tossed into the water as the boat sails in the reverse direction.

We favor sell­ing British ster­ling since the U.K. econ­omy remains in deep trou­ble, with even higher exter­nal debt than in the U.S.– a ratio to GDP of 404% in 2008 com­pared to 95% in this coun­try, which has caused bond rat­ing agen­cies to threaten a down­grade of U.K. gov­ern­ment debt. Also, the trou­bled British finan­cial sec­tor accounts for 21% of total jobs com­pared with 14% in the U.S. The U.K. was almost alone among advanced coun­tries in suf­fer­ing a falling econ­omy in the third quar­ter of last year.

The euro is vul­ner­a­ble, in our view, because the euro­zone has a one-size-fits-all mon­e­tary pol­icy but its economies vary in strength from Ger­many and the Low Coun­tries at the top to Por­tu­gal, Italy, Spain, Greece and Ire­land at the bot­tom. Those lands can’t use inde­pen­dent mon­e­tary poli­cies to stim­u­late their economies since that’s the prov­i­dence of the Euro­pean Cen­tral Bank. So they need to resort to fis­cal stim­uli and increas­ing gov­ern­ment bor­row­ing to finance the result­ing deficits. A num­ber have suf­fered sov­er­eign debt rat­ing down­grades, which increase their bor­row­ing costs, and more are likely. This could spark renewed threats that one or more coun­tries will with­draw from the euro­zone and go back to using drach­mas, drac­u­las or what­ever as their cur­ren­cies. That prob­a­bly won’t hap­pen as the ECB will do all it can to pre­vent dis­so­lu­tion, but seri­ous dis­cus­sion of the like­li­hood could depress the euro con­sid­er­ably against the dollar.

These con­cerns are not new for us. Just as the euro was being launched 10 years ago, we wrote in our Dec. 1998 Insight that with a com­mon cur­rency, indi­vid­ual coun­tries would be forced to rely on fis­cal pol­icy to deal with local busi­ness con­di­tions and “the limit on fis­cal stim­u­lus will be default risks. Gov­ern­ment bond investors and rat­ing agen­cies will become the police­men and will blow the whis­tle…. It’s even pos­si­ble that eco­nomic dif­fer­en­tials among coun­tries may be so great that the com­mon cur­rency doesn’t hold together, espe­cially in the next Euro­pean reces­sion when unem­ploy­ment leaps….”

Commodity-driven cur­ren­cies like the Cana­dian, Aus­tralian and New Zealand dol­lars are also likely to weaken against the green­back as com­mod­ity prices fall. The Japan­ese econ­omy remains weak and back in defla­tion, but the yen’s involve­ment I the carry trade makes it a tricky cur­rency for investment.

6. Buy Eurodol­lar Futures. In most mar­kets, traders want to be where the action is, where liq­uid­ity is the great­est even though that’s where com­pe­ti­tion is the strongest. Years ago, a jew­eler in New York City com­plained to us about how fierce the com­pe­ti­tion was in his loca­tion. His shop was on 47th Street between Fifth and Sixth Avenues, the heart of the jew­elry dis­trict. We asked why he didn’t move to a less com­pet­i­tive area. He shrugged and said, “This is where the action is.” In the case of short-term credit instru­ments used in futures trad­ing, eurodol­lars are where the action is.

Our inter­est is in eurodol­lar futures con­tracts. Eurodol­lar futures are a way for com­pa­nies and banks to lock in an inter­est rate today, for money it intends to bor­row or lend in the future, and for investors to bet on the future direc­tion of short-term inter­est rates. Each Eurodol­lar futures con­tract has a notional or “face value” of $1 mil­lion, though the lever­age used in futures allows one con­tract to be traded with a mar­gin of about $1,000. Trad­ing in Eurodol­lar futures is exten­sive, and the mar­ket for them tends to be very liq­uid. The prices of Eurodol­lars are quite respon­sive to Fed pol­icy, infla­tion, and eco­nomic indi­ca­tors. It’s ironic that eurodol­lar futures mar­kets dom­i­nate trad­ing, not those for Trea­sury bills or fed­eral funds on which eurodol­lars are essen­tially based.

Eurodol­lar futures prices are deter­mined by the market’s fore­cast of the 3-month US$ LIBOR inter­est rate expected to pre­vail on the set­tle­ment date. Eurodol­lar futures con­tracts extend out for 40 quar­ters or 10 years, so they can be used to bet on inter­est rate move­ments many quar­ters ahead.

Long posi­tions in eurodol­lar futures have been one of our most suc­cess­ful invest­ments in recent years. Ear­lier, the futures mar­ket did not price in the full extent of the Fed-engineered decline in short-term inter­est rates. With our fore­cast of the finan­cial cri­sis and the worst reces­sion since the 1930s, how­ever, we believed that the Fed would ease dra­mat­i­cally. So we rea­soned that eurodol­lar futures prices would rise as they reflected the Fed’s action. So far, they have.

Now the futures mar­ket assumes that the Fed will raise its tar­get rate in the course of this year, so the LIBOR rate on which eurodol­lar futures set­tle will increase by 1.22 per­cent­age points between Jan­u­ary and Decem­ber. We, how­ever, believe that a weak econ­omy will keep the Fed on hold through­out this year, so the inter­est rate implied by the Decem­ber 2010 con­tract will fall by 1.22 per­cent­age points. That would result in a $3,050 profit on a $1 mil­lion futures con­tract. That’s a mere 0.3% gain. This is hardly worth the invest­ment with­out lever­age. But with only a $1,000 mar­gin require­ment on the futures con­tract, well, you do the math.

INVESTMENTS TO SELL OR AVOID We hope these six invest­ment strate­gies for 2010 that involve buy­ing or being long secu­ri­ties are use­ful. But given our fore­cast that, at best, the U.S. and global economies will be slug­gish this year, it won’t be a sur­prise that we have a longer list of strate­gies that involve sell­ing or avoid­ing var­i­ous sec­tors. In fact, there are 11, or nearly twice as many. 7. Sell U.S. Stocks in Gen­eral. The S&P 500 index in late Decem­ber was sell­ing at 19 times top-down Wall Street strate­gists’ oper­at­ing earn­ings esti­mate of $60.59 per share for this year, as noted ear­lier. That’s an his­tor­i­cally high P/E to start with that makes stocks vul­ner­a­ble going into the year. Even more so because it assumes a steep eco­nomic recov­ery in 2010. And even more so if our fore­cast of con­tin­u­ing reces­sion or slug­gish recov­ery at best proves out. Our $50 esti­mate of oper­at­ing earn­ings, down 11% from esti­mates for 2009, puts the S&P 500 index P/E at a nose­bleed 22.5 level, as noted ear­lier. Sell­ing stock indices short, either through futures con­tracts or ETFs, strikes us as a pru­dent idea. Index shorts can also hedge long posi­tions in util­i­ties or other long strate­gies we dis­cussed ear­lier. Be well aware that our fore­cast of a declin­ing U.S. stock mar­ket is crit­i­cal to many other strate­gies we’ll dis­cuss later that involve sell­ing or avoid­ing equity sec­tors here and abroad. We believe they all will per­form worse than the stock mar­ket over­all, but if we’re wrong and the stock mar­ket leaps this year, we’ll prob­a­bly also be wrong on many of these other strate­gies. 8. Sell Home­builder and Selected Related Stocks. Home­builder stocks rebounded sharply from their March 2009 lows, along with stocks in gen­eral, but peaked in Sep­tem­ber with a slight down­ward trend since then. This may be begin­ning to reflect our fore­cast of another 10% decline in house prices (Chart 4). Excess inven­to­ries of houses for sale, the mor­tal enemy of prices, remain huge. And inven­to­ries may rise, even with hous­ing starts at very low lev­els, as peo­ple fore­closed out of their houses dou­ble up with fam­ily and friends. Also, a quar­ter of home­own­ers with mort­gages are under water, 40% of those who took out mort­gages in 2006. Increas­ing num­bers of these peo­ple are con­vinced that they’ll never regain pos­i­tive home equity and are aban­don­ing their abodes in favor of rent­ing other houses at lower monthly costs. Still, the sub­se­quent fore­clo­sures on their mort­gages will keep them from qual­i­fy­ing for a government-guaranteed mort­gage for three to five years and will stay on their credit records for seven years. Despite leap­ing mort­gage delin­quen­cies, federally-mandated but mostly unsuc­cess­ful mort­gage mod­i­fi­ca­tion pro­grams are keep­ing many houses, espe­cially mid­dle– and higher-priced homes, from being fore­closed and sold–temporarily. Fur­ther­more, the invest­ment tax credit for new and some exist­ing home buy­ers, which was extended beyond Novem­ber 2009, is sched­uled to expire in April. The over­hang of aging new single-family homes avail­able for sale is huge (Chart 5 ). Also note that new res­i­den­tial mort­gages are almost entirely depen­dent on guar­an­tees from gov­ern­ment enti­ties such as Fan­nie Mae, Fred­die Mac and the FHA, and they are tight­en­ing their credit stan­dards. Low mort­gage rates are a plus, but are only mean­ing­ful to those who qual­ify for loans as lend­ing stan­dards tighten. Most now need to meet the old con­ser­v­a­tive stan­dards of 20% down, good credit, full doc­u­men­ta­tion of income and assets, etc. And lower bor­row­ing rates don’t help under­wa­ter home­own­ers either refi­nance or buy other houses. Fur­ther­more, rates on large “jumbo” mort­gages remain high. Finally, lower house prices don’t induce buy­ers who expect the down­ward trend to con­tinue and hold out for even-lower prices. 9. Sell Selected Big-Ticket Con­sumer Dis­cre­tionary Equities–for two pow­er­ful rea­sons. First, as con­sumers per­sist in their sav­ing spree they’ll con­tinue to cur­tail spend­ing on expen­sive post­pone­able items. Sec­ond, as wide­spread price declines per­sist, they will be antic­i­pated. Prospec­tive buy­ers will wait for lower prices. As a result, excess inven­to­ries and unused capac­ity will mount, forc­ing prices lower. That will con­firm prospec­tive buy­ers’ sus­pi­cions so they’ll wait for still-lower prices in a self-feeding down­ward spi­ral. Defla­tion­ary expec­ta­tions are clearly at work in the vehi­cle mar­ket. The cash-for-clunkers pro­gram gen­er­ated one-time sales as buy­ers viewed it as just one more rebate induce­ment in a never-ending stream. But who would dare announce to a friend that he paid the full sticker price for any car? Of course, defla­tion­ary expec­ta­tions don’t work for small, inex­pen­sive items. Sup­pose you know for sure that tooth­paste will be cheaper next month. If you run out, you won’t brush your teeth with Ajax while wait­ing for lower prices before buy­ing a tube. Even the rich, nor­mally immune to reces­sions, are cut­ting back and down­grad­ing. Note the weak sales at Tiffanys, Nord­strom and Saks Fifth Avenue and the poor auc­tion results for Sotheby’s and Christie’s. A Mer­rill Lynch study found that the num­ber of peo­ple in the world with $1 mil­lion or more in investable assets fell from 10.1 mil­lion in 2007 to 8.6 mil­lion in 2008. Those assets dropped from $40.7 tril­lion to $32.8 tril­lion. Their equity hold­ings fell in step with the S&P 500, about 40%, and their real estate also dropped in value. Ever since the data series began in 1967, the share of income of the top 20% has trended up while all other shares fell. Note that these are shares, not income levels–which have grown on bal­ance for all quin­tiles. Stud­ies have found con­sid­er­able rota­tion in and out of the var­i­ous quin­tiles, with many of those in the top bracket in a given year absent from it in ear­lier and later years. Still, the drop in pur­chas­ing power for many middle-income peo­ple in the last year in addi­tion to the col­lapse in their homes’ val­ues has cre­ated con­sid­er­able anger at those at the top. The equi­ties of most pro­duc­ers of big-ticket con­sumer dis­cre­tionary goods and ser­vices col­lapsed in the 2007–2009 bear mar­ket, reflect­ing con­sumers’ buy­ing strike, but have recov­ered some­what since March. With our con­vic­tion that Amer­i­can con­sumers have reached a water­shed and switched from a quar­ter cen­tury borrowing-and-spending binge to a decade or longer sav­ing spree, we are very sus­pi­cious of the sus­tain­abil­ity of any rebound in stocks of pro­duc­ers of major con­sumer dis­cre­tionary prod­ucts such as cruise lines and air­lines. 10. Sell Banks and Other Finan­cial Insti­tu­tions. Dur­ing the finan­cial free-for-all days, large banks moved well beyond tra­di­tional spread lending–taking deposits and then lend­ing them with inter­est rate spreads to cover their costs, loan risks and rea­son­able prof­its. They hyped their leverage–and their risk–as they set up off-balance sheet vehi­cles, engaged in pro­pri­etary trad­ing and in the orig­i­na­tion of and invest­ment in deriv­a­tives. Reg­u­la­tors stood by under the the­ory that free mar­kets would dis­ci­pline exces­sive risk-taking. Both the big banks and the reg­u­la­tors, how­ever, knew or should have known that those insti­tu­tions were too big to fail and could take the finan­cial sys­tem down with them. So those finan­cial insti­tu­tions were really play­ing a game of, heads we win, tails we get bailed out. And fail they did, and bailed out they have been. Many investors seem to believe that’s the end of the unpleas­ant­ness and now it’s back to busi­ness as usual. The recent big trad­ing prof­its by some finan­cial insti­tu­tions cer­tainly point in that direc­tion as did the stock rebounds until recently. We doubt it, though. The finan­cial sec­tor expanded its lever­age over about three decades and its delever­ag­ing will prob­a­bly con­sume most or all of the next decade. Big risk-taking CEOs like Ken Lewis at Bank of Amer­ica are being forced out, send­ing a clear mes­sage to the senior offi­cers who remain. Strin­gent, prob­a­bly exces­sive reg­u­la­tion is replac­ing the lais­sez faire model. Higher cap­i­tal require­ments and other lim­its on risk-taking will curb bank prof­itabil­ity. So will the lim­its on exec­u­tive pay aimed at reduc­ing the incen­tive to take big risks. Weak Loan Demand Fur­ther­more, with slow eco­nomic growth, con­sumer zeal to save and repay debts, and weak cap­i­tal spend­ing this year, loan demand will likely be weak. In addi­tion, the present steep yield curve makes bor­row­ing cheap deposits and lend­ing long-term at higher inter­est rates very prof­itable. But it will prob­a­bly flat­ten as the year pro­gresses and long rates fall. Banks, of course, can increase fees on check­ing and other accounts, but are lim­ited by com­pe­ti­tion from money mar­ket funds and other alter­na­tives. Also, banks’ costs of bor­row­ing in the bond mar­ket is well off its highs rel­a­tive to Trea­surys, but still ele­vated com­pared to pre-crisis years. The spread now runs over three per­cent­age points com­pared to about one in pre-crisis days. Much of the cheap debt banks acquired from pri­vate mar­kets in ear­lier years and the gov­ern­ment more recently will mature in the next sev­eral years and need to be replaced at much higher costs. The matu­ri­ties for U.S. banks have dropped from 7.8 to 3.2 years in the past five years. Regional and com­mu­nity banks are also likely to be unat­trac­tive invest­ments this year. Iron­i­cally, in the go-go days, many of them were unwill­ing to vir­tu­ally aban­don their under­writ­ing stan­dards to com­pete with non­blank res­i­den­tial mort­gage lenders. So they lent to the com­mer­cial real estate mar­ket instead. That’s prov­ing to be a jump from the fry­ing pan into the fire, as dis­cussed ear­lier, and is shown by weak demand, falling prices and ris­ing delin­quen­cies. Regional banks have more than their share of the $1.7 tril­lion in out­stand­ing com­mer­cial real estate owned by all banks. These loans con­sti­tute 35% of regional banks; total loans, up from 25% in 2000. Due to bad com­mer­cial as well as res­i­den­tial real estate loans, smaller banks are drop­ping like flies, 140 so far this year (Chart 6 ). Indi­vid­u­ally, they aren’t too big to fail, but col­lec­tively they are since they are the pri­mary financers of smaller busi­nesses. Those busi­nesses don’t have access to com­mer­cial paper and other credit mar­ket vehi­cles and must rely on their local banks for loans–or on the per­sonal credit cards of their own­ers. 11. Sell Con­sumer Lenders’ Stocks. Con­sumer lenders’ stocks have also rebounded sharply from their March 2009 lows. We were wrong on our strat­egy of sell­ing them last year, but believe it will work in 2010. Con­sumer lenders had their hey day dur­ing the long con­sumer borrowing-and-spending spree. Con­sumers were trained–and we use that word deliberately–to believe they deserved instant mate­r­ial grat­i­fi­ca­tion. Buy now, put it on the plas­tic card and pay later– much later–became the norm. And cred­it­wor­thi­ness was no prob­lem for credit card issuers and other con­sumer lenders. They sliced and diced con­sumers’ finan­cial sta­tuses, used sophis­ti­cated mod­els to deter­mine pay­ment risks and charged fees and inter­est rates to fit any risk cat­e­gory. But their mod­els and analy­ses inher­ently assumed that the borrowing-and-spending binge, as well as the abil­ity to repay, would last indef­i­nitely. But then con­sumers sud­denly switched to a sav­ing spree and started to pay down credit card and other debts. Also, heavy lay­offs, leap­ing unem­ploy­ment and col­laps­ing house prices and inad­e­quate con­sumer incomes spiked credit card delin­quen­cies. Con­gress last year restricted credit card fees and inter­est charges. Also, con­sumers went on a buy­ers strike a year ago and cut back on their use of credit, debit and charge cards. Recent devel­op­ments are vir­tu­ally all neg­a­tive for the credit card busi­ness now and for years to come. The cot­tage indus­try to help these peo­ple deal with their huge credit card debts is explod­ing in size. As noted ear­lier, charge cards and debit cards are replac­ing credit cards as con­sumers real­ize they can’t trust them­selves to restrain debt and need to pay off monthly or accu­mu­late the money in a bank account before spend­ing it. Lay­away plans are replac­ing the buy now-pay later approach. With the switch from a quar­ter cen­tury con­sumer borrowing-and-spending binge to a long run sav­ing spree, the credit card busi­ness has moved from a growth indus­try to a laggard.

12. Sell Many Low and Old Tech Cap­i­tal Equip­ment Pro­duc­ers. Low and old tech pro­duc­ers will remain depressed in a world of chronic excess capac­ity. When oper­at­ing rates are low, pro­duc­ers don’t need more capac­ity and worry that rev­enues, prices and prof­its won’t be ade­quate to jus­tify even exist­ing capac­ity. And note that the volatil­ity of the pro­duc­ers of equip­ment is much greater than that of the users. Auto sales declined by over 47% from their peak in July 2005, but orders for machine tools, auto­matic trans­fer lines and other equip­ment fell much more as auto assem­blers and parts mak­ers almost froze orders. Recall as well how the recession-sired excess capac­ity in air­lines has caused mas­sive can­cel­la­tions and post­pone­ments of orders for Boeing’s Dreamliner.

Ear­lier, we dis­cussed our sta­tis­ti­cal mod­els that explained cap­i­tal spend­ing. They show that in account­ing for the year-over-year change in the equip­ment and soft­ware or in equip­ment and soft­ware plus non­res­i­den­tial struc­tures com­po­nents of GDP, thelevel of oper­at­ing rates is far and away the most impor­tant explana­tory vari­able, even more so for the year-over-year change in oper­at­ing rates. This indi­cates that even if capac­ity uti­liza­tion is grow­ing rapidly, if it remains at low lev­els as at present, the growth in cap­i­tal spend­ing will be subdued.

Other vari­ables, such as the year-over-year changes in cash flow, prof­its and inter­est costs, were sta­tis­ti­cally sig­nif­i­cant in our mod­els, but much less effec­tive in explain­ing the change in cap­i­tal spend­ing. These find­ings are impor­tant because many believe that the neg­a­tive gap between cap­i­tal expen­di­tures and inter­nal funds is sure to gen­er­ate a cap­i­tal spend­ing surge. But our mod­els, based on his­tory, say that with huge excess capac­ity, that cash flow won’t burn holes in cor­po­rate pock­ets. And our mod­els don’t quan­tify and add in the extra cor­po­rate cau­tion spawned by today’s reces­sion­ary cli­mate and finan­cial crises.

Besides the depress­ing effects of excess capac­ity, low and old tech com­pa­nies suf­fer from ongo­ing prob­lems. For­eign com­pe­ti­tion con­tin­ues to grow as their tech­nol­ogy is trans­ferred to China and other cheap pro­duc­tion locales. Some suf­fer ris­ing cost pres­sures due to lack of pro­duc­tiv­ity gains. High-cost union­ized labor forces are some­times a prob­lem. And many sell into sat­u­rated, slow growth markets.

13. If You Plan to Sell Your House, Sec­ond Home or Invest­ment Houses Any Time Soon, Do So Yes­ter­day. This strat­egy has worked for the last two years and will con­tinue to do so if we’re cor­rect and house prices nation­wide fall another 10%. Sure, prices have been weak­est in states like Florida, Ari­zona, Nevada and Cal­i­for­nia where the biggest bub­bles pre­ceded the col­lapses. But almost every area of the coun­try has expe­ri­enced price declines (Chart 7 ).

Many own­ers have tried to wait out the bear mar­ket in hous­ing, a tech­nique that worked in ear­lier years when any price declines were small and short-lived. But huge excess inven­to­ries, a flood of dis­tressed sales after mort­gage mod­i­fi­ca­tion attempts are over, depressed incomes and ris­ing unem­ploy­ment will prob­a­bly keep sell­ers plen­ti­ful, buy­ers reluc­tant and prices falling through­out 2010 and per­haps beyond. In past regional house price col­lapses, it’s taken home­own­ers a year-and-a-half to give up and throw their houses on the mar­ket for what­ever they will bring. After the final bot­tom is reached, house prices will likely mir­ror infla­tion, or in future years, defla­tion as they have historically.

14. Sell Junk Bonds. Dur­ing the dark days of the finan­cial cri­sis, the yields on junk bonds leaped to 19.3 per­cent­age points over Trea­surys as investors wor­ried about com­plete finan­cial col­lapse and wide­spread defaults among low-grade issues. Triple-C rated bonds, the low­est junk tier, sold at 42.6 cents on the dol­lar at the begin­ning of last year.

But the bailout of the big banks and eas­ing of the finan­cial cri­sis allayed investor fears and junk spreads nar­rowed. Insti­tu­tional investors piled in, fol­lowed by indi­vid­ual investors, many of whom sought alter­na­tives to low returns on bank deposits and money mar­ket funds. So the spread has dropped to 4.6 per­cent­age points, much closer to where it was before the cri­sis began. Last year, junk bonds returned over 50%, much more than the 25% gain on the S&P 500 index.

Nev­er­the­less, we believe this rally is way over­done. Default rates on junk bonds nor­mally peak late in reces­sions or in the year after it ends. Also, the default rate may reach or exceed the pre­vi­ous peak in 2002 if the econ­omy remains weak, sug­gest­ing major declines in junk bond prices. Fur­ther­more, the value of bonds after default is likely to go lower if the reces­sion drags on, as we fore­cast. Slow rev­enue and cash flow growth will make it dif­fi­cult if not impos­si­ble for a num­ber of finan­cially weak and weak­en­ing firms to ser­vice their bonds and other debts.

15. Sell Com­mer­cial Real Estate. As dis­cussed ear­lier, excess capac­ity and big refi­nanc­ing require­ments in com­ing years will con­tinue to plague hotels, malls, ware­houses and office build­ings. Moody’s/REAL Com­mer­cial Prop­erty Price Index was down 44% last Octo­ber from its Octo­ber 2007 peak. Retail­ers closed 8,300 stores last year, more than the pre­vi­ous peak of 6,900 in 2001. Busi­nesses will con­tinue to cut costs this year, not only by hold­ing down employ­ment and there­fore the need for office space, but also by mov­ing in the par­ti­tions to fit the remain­ing peo­ple in less space, as men­tioned earlier.

Increas­ing use of telecom­mut­ing will also reduce need for office build­ings. And more tele­con­fer­enc­ing will cut hotel-utilizing busi­ness trips, espe­cially after inten­si­fied air­port secu­rity in reac­tion to the recent ter­ror­ist inci­dent in Detroit on Christ­mas Day. At the same time, fru­gal con­sumers will restrain dis­cre­tionary travel and the hotel and motel use involved. Weak con­sumer spend­ing will keep mall and ware­house space under pressure.

Some believe that com­mer­cial real estate woes may exceed the res­i­den­tial col­lapse, and they may be right. Com­mer­cial tends to be less lever­aged but if refi­nanc­ing isn’t avail­able, it may note make much dif­fer­ence how lever­aged it is. Also, dis­tressed com­mer­cial real estate own­ers def­i­nitely don’t have the polit­i­cal sym­pa­thy and bailout prospects enjoyed by trou­bled home­own­ers. The Fed has set high stan­dards for bailout loans on com­mer­cial real estate. Com­mer­cial real estate REITs rebounded last year along with the over­all stock mar­ket (Chart 8 ), but strike us as vul­ner­a­ble. These leaps com­bined with plum­met­ing real estate prices have pushed REIT prices to a 25% pre­mium over their net asset values.

16. Sell Most Com­modi­ties. Com­mod­ity prices rebounded last year and ben­e­fited from cheap and avail­able money. Some live in their own worlds. Petro­leum is not only influ­enced by fun­da­men­tal supply-demand con­di­tions, but also by OPEC deci­sions. Nat­ural gas prices in the U.S. weak­ened last year with the reces­sion, but also because of new pro­duc­tion tech­nol­ogy that unlocked abun­dant shale gas. The prices of agri­cul­ture com­modi­ties, includ­ing honey, are highly depen­dent on weather.

In any event, we believe that eco­nomic sup­ply and demand will rule most indus­trial com­mod­ity prices this year and result in weak­ness due to slug­gish global busi­ness con­di­tions. Also, investors put a record $50 bil­lion into com­modi­ties in 2008 but then retreated last year after prices nose­dived. They learned the hard way that com­modi­ties aren’t an asset class but spec­u­la­tions, and may be cau­tious this year. And the strength­en­ing dol­lar should depress the prices of the many com­modi­ties traded world­wide in dol­lar terms. We look for falling com­mod­ity prices this year. Also, we believe that many commodity-producing com­pa­nies and their sup­pli­ers of equip­ment and sup­plies will be unat­trac­tive invest­ments as weak demand, excess capac­ity and soft prices per­sist. The same is true for economies such as Per­sian Gulf sheik­doms that depend heav­ily on petro­leum, as wit­nessed by the finan­cial col­lapse of Dubai.

17. Sell Devel­op­ing Coun­try Stocks and Bonds. As late as the end of 2007, most fore­cast­ers believed in decou­pling. Even if the U.S. econ­omy suf­fers a set­back, they said, the rest of the world, espe­cially devel­op­ing coun­tries like China and India, would con­tinue to flour­ish. Indeed, the strength of those economies could even aid the U.S. as they bought more Amer­i­can exports.

We dis­agreed. We did a study two years ago that found that China was not yet devel­oped suf­fi­ciently to have enough peo­ple with dis­cre­tionary spend­ing to sup­port the econ­omy domes­ti­cally. She remained export-led, with most of those exports going directly or indi­rectly to U.S. con­sumers. So, with our fore­cast of a major retrench­ment by U.S. con­sumers, we pre­dicted big trou­ble for China. Our analy­sis revealed that in China, it takes about $5,000 per capita to have mean­ing­ful dis­cre­tionary spend­ing power. About 110 mil­lion Chi­nese had that much or more, but they con­sti­tuted only 8% of the pop­u­la­tion. In India, that class was a mere 5% of the pop­u­la­tion. In con­trast, it takes $26,000 per capita in the U.S. to have dis­cre­tionary spend­ing power and 80% of Amer­i­cans have at least that much.

Well, as they say, the rest is his­tory. The Chi­nese and most other devel­op­ing Asian coun­tries nose­dived as U.S. con­sumers retrenched. But in the wake of China’s huge $585 bil­lion stim­u­lus pro­gram last year, mas­sive imports of indus­trial mate­ri­als like iron ore and cop­per, jumps in con­struc­tion of cement, steel and power plants and other indus­trial capac­ity, and a pick up in eco­nomic growth, many fore­cast­ers again believe in decoupling.

We con­tinue to dis­agree. Sure, some coun­tries such as Brazil were not hurt too severely by the global reces­sion, at least so far. Still, most devel­op­ing economies depend on exports for growth, and the U.S. con­sumer has been the biggest buyer of those exports and far and away the globe’s biggest spenders. As the Amer­i­can con­sumer sav­ing spree con­tin­ues to shrink the U.S. trade and cur­rent account deficits (Chart 9), those devel­op­ing economies will be subdued.

China’s econ­omy looks like a house of cards. Her most recent fis­cal stim­u­lus not only went into indus­trial capacity-building but also bank lending-spawned stock mar­ket and real estate spec­u­la­tion. But what will uti­lize that capac­ity and jus­tify those spec­u­la­tions? The usual out­let, exports, is cur­tailed by retrench­ing U.S. con­sumers. And, as noted, China is not far enough down the road to indus­tri­al­iza­tion for local con­sumers to fill the gap.

We doubt that the rebounds in emerg­ing mar­ket stocks and bonds cor­rectly fore­cast robust, decou­pled eco­nomic growth that is sus­tain­able. While the S&P 500 now trades at 20 times earn­ings over the last 12 months, nor­mally cheaper emerg­ing mar­kets are more expen­sive. Recently, the Shang­hai Com­pos­ite Index sported a 32 P/E while South Korea’s was at 35 and Indonesia’s was at 29. And note that the 65% jump in emerg­ing mar­ket stocks in 2009 only off­set two-thirds of the 54% drop in 2008.

Fur­ther­more, as was made clear by the uni­ver­sal weak­ness in secu­rity mar­kets in 2008, bond and stock mar­kets around the world are highly cor­re­lated. With glob­al­iza­tion, the days are gone when a globe-trotting sleuth can dis­cover gems in the remote reaches of Asia or Latin Amer­ica. The sim­i­lar­ity of bond and stock per­for­mance is even greater when adjusted for risk. Emerg­ing mar­ket stocks and bonds may climb more in bull mar­kets, but have greater falls when the bear arrives, as we believe he is about to. There’s no such thing as free lunch.

John Mauldin is pres­i­dent of Mil­len­nium Wave Advi­sors, LLC, a reg­is­tered invest­ment advi­sor. All mate­r­ial pre­sented herein is believed to be reli­able but we can­not attest to its accu­racy. Invest­ment rec­om­men­da­tions may change and read­ers are urged to check with their invest­ment coun­selors before mak­ing any invest­ment decisions.

Read more from the author/contributor here.

Comments

Comments are closed.