Are we there yet? Are we there yet? "There," in case you're wondering, is a genuine stock-market bottom, not a temporary low before the next tsunami of selling. It's the point (and price) at which it's safe to jump back in the market, with plans to stick around for a while. And no, we're not there yet, not by a long shot after the unprecedented events of the past year, say the wise men and women of Barron's 2009 Roundtable.
-- Yet, attractive investments -- and trading ideas -- surface even in grizzly bear markets, and our panelists have found quite a few. As usual, they were eager to share them, along with their typically trenchant views about the economy and financial markets, when the Roundtable convened Jan. 5. In this week's installment, the second of three, we're pleased to pass along the picks, pans and prophecies of Bill Gross, Archie MacAllaster, Felix Zulauf and Abby Cohen, along with observations from the rest of the crew.
Bill, founder and co-chief investment officer of Pimco, needs no introduction, but here goes: He is only one of the most influential guys in the bond market, give or take a Fed chairman or two. So, when he says something is the most "incredible" or "remarkable" thing he's seen in all his years in the business, as he does several times in the pages ahead, you'd best sit up and take notice. Bill hopes to exploit today's stranger-than-fiction anomalies by investing alongside Uncle Sam in bank preferred shares. He's also a fan of TIPS.
Archie, head of MacAllaster, Pitfield, McKay, should be classified as an endangered species. After all, the man says he's an optimist about stocks. Archie, who knows his way around financials like no one, and around bear markets, too, sees dirt-cheap bargains everywhere. He's especially keen on the prospects for Hartford Financial, Franklin Resources and Delta Air Lines.
When Felix talks, everything should sit up and listen. His 2008 Roundtable picks, showcased in last week's Barron's, made him and all who took his advice a bundle. For better or worse, his bearish macro forecast also came to pass. As founder and head of Zulauf Asset Management in Switzerland, Felix sees the forest and the trees. What he doesn't see is a quick resolution to the problems bedeviling the global economy and financial markets, which is why he's sticking with gold.
Abby changed hats about a year ago at Goldman Sachs, but it's what's under the hat that matters. No change there -- just the usual triple-A-rated mind (in this case, the rating means something), and an enviable eye for financial facts and figures. This year Abby's got a keen interest in interest, which leads her to a trio of high-yielding corporate bonds and a utility, among other stocks culled from the list of those recommended by Goldman's analysts.
So, buckle up, and read on.
Barron's: What grabs you in the bond market, Bill?
Gross: The government has issued hundreds of billions of dollars of Treasuries, but with yields of 2.5% on 10-year bonds and 0.8% on two-years, who wants to buy them? The market is beginning to address that question. Treasuries don't make sense at these levels. It will be at least 2010 before we see a hint of the Fed moving interest rates higher, simply because they are aware of the Japanese experience. They know the Japanese raised rates prematurely [after Japan's economy went into a tailspin in the 1990s].
Because of their low yields, government bonds are a trap. First the government lowers interest rates to the point where the investor receives a negative real return. That's where we are now. Second, the principal is depreciated through inflation. That's a hidden tax. The combination takes away any advantage Treasury bonds have, except under a deflationary scenario.
Q: This crowd seems a lot more worried about inflation.
Gross: There is a 10% possibility that government policy won't work and the U.S. will experience deflation a la the 1930s. That's not our prediction but it's more than a thin tail [low probability]. In that circumstance, long-term Treasuries yielding 3%-plus might make some sense.
Schafer: Doesn't a little inflation help us out of the current mess?
Gross: The entire capitalist system is based on a little inflation. A little, but not a lot.
Zulauf: How do German government bonds compare with Treasuries?
Gross: They are monitored by the ECB [European Central Bank], and inflation in Euro-land looks to be lower. If you had to buy government bonds, you'd want German bunds over U.S. Treasuries.
Q: The cost of insuring the U.S. Treasury against default has been rising. Is this just a hedge-fund game, or does it mean we're a worse credit than, say, Germany?
Gross: We're a worse credit than Germany, and at least a few other countries. That said, the CDS [credit-default-swap] market in Treasuries is relatively illiquid, and an anomaly. Countries default in a number of ways. They default by inflation. They default by devaluation, and, yes, sometimes they default and don't pay their coupons. But to go the third route through actual default would be a "black swan" [extremely rare and unpredictable]. It won't happen in my generation.
Faber: From whom would you buy such credit-default swaps? If the U.S. government goes bust, the sellers of such swaps would go bust, too.
Black: Bill, it's one thing when the Treasury prints money and issues bonds. It's another when the Federal Reserve expands its balance sheet from $750 billion to $2.2 trillion. Is this a ticking time bomb?
Gross: The Fed is expanding its balance sheet because the private sector is contracting its balance sheet. If it's one for one, it's not a problem. The Fed is trying to gauge how much is disappearing, versus how much should be put into the system, which is difficult.
Zulauf: How far can they go? Ireland has guaranteed its whole banking system, which is five times GDP [gross domestic product], and in a currency [the euro] over which it doesn't even have sovereignty.
Gross: Ireland and Iceland are examples of economies that have gone too far. The U.S. has had the benefit of being the world's reserve currency. How much longer can we abuse it? Probably not too much longer. If asset reflation works and the real U.S economy kicks back into gear, the dollar can hang on. If it doesn't work, it's a new ballgame. Perhaps the biggest question for the next few years is whether the dollar can hang onto its reserve-currency status.
Cohen: This is a function not just of the dollar but of the currencies that might be able to step in. One thing that has disappointed but not surprised many people is how long it has taken for the euro to assume a larger role as a reserve currency. Gross: In Asia the yen can't take the mantle because China eventually will be the dominant economy. But it's not ready financially.
Zulauf: The euro has problems. The eurozone is not a homogenous economic bloc. There are weak economies and structurally strong ones, and stress in the system. It is questionable whether the euro can survive in its current form long term. There may need to be a euro A and a euro B.
Cohen: We talked this morning about the state of the U.S. banking system. The European banking system by many measures started out in a much more levered state, and still is much more levered than the U.S.
Zulauf: European banks have approximately one-third less equity capital than U.S. banks. In general, the banking system in the industrialized world is still fragile, and not equipped to handle what's ahead in corporate defaults and loan write-offs.
MacAllaster: Bill, what is your view of the quality of the assets the Fed is taking on? A lot depends on whether the government will get anything back when it tries to sell these assets.
Gross: Up until this point the government has been buying primarily triple-A-rated paper. Its plan to start financing asset-backed securities such as student loans and credit-card receivables theoretically and technically will involve triple-A assets. I am skeptical that every triple-A-rated assets is in fact triple-A in quality. The Fed, though, is very careful and not likely to make mistakes in this area.
Zulauf: The Fed may go down the ladder and buy lower-quality assets.
Gross: [Federal Reserve Chairman Ben] Bernanke made that clear in 2002 with his helicopter speech, in which he said the Fed would be willing to buy almost anything in order to prevent deflation and support the economy.
Hickey: Has Pimco detected any reticence among governments in the Middle East and Asia about continuing to buy U.S. Treasury bonds at these low rates?
Gross: No. There is a reticence to take risks, including an unwillingness to buy even mortgages backed by U.S. government agencies like Fannie Mae and Freddie Mac. There is an anathema toward corporate bonds. Foreign central banks and others don't want any part of risk.
Hickey: Are they losing faith in the U.S.?
Gross: They recognize markets here are illiquid, and there is a possibility, be it 5% or 10%, that not just the U.S. but the global economy will enter a mini-depression. Isn't that what you see, Abby?
Cohen: Between January and October 2008, total foreign holdings of U.S. Treasury securities rose from $2.4 trillion to more than $3 trillion. The most significant change by country had to do with the U.K., where Treasury ownership rose to almost 12% of the total from 6.7%. The additional purchases came from two types of buyers: petroleum-producing nations whose investment offices are based in London, and global asset allocators who manage money for pension plans and others whose security of choice in recent months has been U.S. Treasuries. Zulauf: The $600 billion increase is just about equal to the U.S. external-account deficit for that period, so it means foreigners recycled those dollars into the U.S. Treasury market.
Q: Didn't risk-aversion peak in late November?
Gross: It did, as evidenced by stocks, credit spreads, oil and currencies. But that's not to say it peaked for foreign central banks and foreign investors. They continued to buy Treasuries and forced them to overvalued levels.
The bond strategy we have followed for the past 12 to 18 months is to go where the government goes in terms of its purchasing power. The government is going to buy $500 billion in the next six months of the $3 trillion in agency mortgages outstanding. We have been buying agency mortgages. Through the TARP [Troubled Assets Relief Program], the government has bought several hundred billion dollars of preferred stocks and attached equity warrants. The Treasury has accepted a 5% coupon on the preferred. Treasury Secretary Hank Paulson has decided 5% is a decent compensation for bank preferred, but the private market affords 11%, 12%, 13% yields on the same bank preferred stocks, which is remarkable. We are buying bank preferreds.
As for specific names, the best example of partnering with the government in the bond market is the case of AIG [ticker: AIG]. Some of us might agree it was a mistake for the government to bail them out, but it happened. The Treasury basically has taken $60 billion of troubled assets off AIG's books and extended it a $50 billion credit line. It has extended a commercial-paper program to one of its major subsidiaries, International Lease Finance, worth another $2.5 billion. The government has given or guaranteed AIG close to $200 billion. The outstanding debt of the United States is $10 trillion, so 2% of everything the U.S. government has issued has gone to AIG. But here's the most incredible thing.
Q: You mean, that wasn't it?
Gross: In the past three months, AIG bonds that are senior to the Treasury's $40 billion in preferred could be bought at 14%, 15%, 16% yields. You can buy them now at 11% and 12%, under the cover of nearly $200 billion of guarantees, or 2% of the outstanding debt of the U.S. Normally you can't have a bond yielding 14% without significant potential to default. It is the most incredible example of value I have ever seen in the bond market. AIG has a 10-year bond that can still be bought at 12.5%. Technically it's A-rated, but realistically it's close to triple-A. We own a lot of them.
My next pick is Treasury Inflation- Protected Securities, or TIPS. Here's an example of deleveraging at work. Theoretically TIPS should have performed like Treasury bonds. Instead they went down in price while Treasuries have been going up. TIPS now sport real yields of 2.5% in an economy that is growing nowhere close to that. And that's before you tack on the inflation kicker. [The principal of a TIPS increases with inflation and decreases with deflation, as defined by the consumer-price index. TIPS also pay interest twice a year, at a fixed rate applied to the adjusted principal.] When an economy deleverages, almost every asset goes down. As Abby discussed this morning, hedge funds, levered institutions, sold what they could when they had to raise funds. TIPS were the most liquid thing in many levered portfolios, and the hedge funds have been spitting them out billions of dollars at a time. Yet, the potential for inflation five to 10 years from now is high. You can buy TIPS via the iShares Barclays TIPS Bond ETF [exchange-traded fund].
Q: Maybe the problem with TIPS was marketing. They were sold as an inflation hedge. If inflation no longer is a problem, people feel they don't need them.
Gross: But they are getting the inflation insurance for free. That's the opportunity. Nothing is totally safe from the ravages of inflation or deflation. In a deflationary environment TIPS aren't going to work. Pimco will be a substantial buyer of TIPS in the next few months. There are few more attractive investment alternatives, except for municipal bonds. You can get a double-A-rated muni bond these days that yields almost twice as much as Treasuries.
Schafer: TIPS won't pay off for a number of years under your scenario.
Gross: That's not true. The big payoff comes in the next six months if this deleveraging cycle is halted and asset managers are reliquefied. TIPS bottomed in November. They are a risk asset without much risk. They can go up 10% or 20% in price simply on the basis of optimism that deflation has been averted.
Cohen: TIPS don't have the issuer risk associated with municipal securities. So, while municipals look appealing, there are concerns related to the budget problems of specific state and local governments.
Gross: Pimco is not a fan of the high-yield market. It is a little early to be buying high-yield bonds. Defaults are on the rise, but in recent months our closed-end funds, and others', have been subject to selling and to regulations that force such funds to delever. If assets fall by 20% or 30%, closed-end funds that typically are levered by 50% have to delever. Several Pimco funds, including Pimco High Income, were forced to suspend dividends for a month, which sent a confusing signal to the market that something was wrong. We had to reduce leverage somewhat by paying off adjustable-rate preferreds. The dividend suspension was a temporary regulatory fix.
Gabelli: You didn't need to build up capital. You had to reduce leverage.
Gross: Exactly. No one should have a favorite child, but this fund was my, and our high-yield desk's, focus every morning. It isn't a high-yield fund any more; 40% of its assets are high-yield, but 60% are investment-grade. Yet, while junk-bond funds in general yield 14%, the Pimco High Income Fund yields 23%.
Schafer: When it pays the dividend.
Gross: The fund sells for about net asset value. It has doubled in the past month, so somebody sees something. It has about $1 billion in assets. It's about as good a deal as any in the bond market today.
What is the status of Pimco's closed-end municipal-bond funds that ran afoul of regulations? Have dividend payments been restored?
Gross: We hope to restore them quickly. It's a matter of ensuring leverage is in line with the rules. The muni market is doing better since late November. Munis are another non-risky asset that investors sold because they had to. Given the fiscal problems state and local governments face, there may be a bailout for munis. When you see a single-A or double-A-rated California muni yielding 6% to 7%, you should anticipate Uncle Sam will bail out Dear Arnold [Schwarzenegger, governor of California]. We might not support bailouts philosophically, but as Bob Dylan said, you have to know which way the wind is blowing. We have been buying munis for several months.
As an aside, the size of government programs to date is staggering. The FDIC [Federal Deposit Insurance Corp.] will now insure bank deposits up to $250,000 [through Dec. 31], versus a previous $100,000. People assume that's where it stops, but it doesn't. The FDIC has guaranteed many more liabilities of the banking system through a program called TLGP, which extends the insurance temporarily, at least to checking accounts. In addition, there's the TARP, which guarantees a significant portion of the equity capital of banks. The banking system in effect has been nationalized. If you can buy a corporate bond issued by a bank at a 5% or 6% yield, as opposed to a Treasury bond that yields 1% or 2%, you've got a good deal. If you can buy bank preferred shares that yield 11%, 12%, 13%, you've got an even better deal. Hopefully, the government will have an exit strategy.
Q: Agreed, and thanks . . . . Archie, your turn.
MacAllaster: I am an optimist about the stock market. There aren't many of us. It's going to be slow going, but bargains are out there. If you can find them, you may do well. I have a few, starting with Franklin Resources, another California money manager. The stock is 66, about 50% below its high for the past year, 133. The low was 45.50. The company pays a dividend of 84 cents a share, and yields 1.3%. It has about $4 billion of net cash, equal to $15 to $17 a share. Total book value is $30 a share; cash is half of that, or more. Franklin, which manages mutual funds, bought up Templeton and Mutual Shares, and seems ready to buy other assets, which are cheap right now. Over the years the company has bought in a lot of stock. They have indicated they won't be buying in so many shares in the future, which tells me they are going to use their money to buy assets.
Templeton invests mostly in foreign equities. Mutual Shares invests in U.S. equities, and the original business was primarily tax-exempt investments in the U.S. In the fiscal year ended September, it earned $6.68 a share. Like other fund companies, it has had redemptions. It has $450 billion or $460 billion of assets under management, down $50 billion or $60 billion on the year. Therefore, earnings could be lower this year, at perhaps $4.75 to $5 a share.
Q: With people exiting mutual funds in droves, isn't this a bit like buying straw hats in winter?
MacAllaster: My view is long-term. Franklin's success goes back a long way. This year the company will earn less than last year, and it may earn less next year, too. But it is going to end up a much bigger company because it will use its cash to buy assets. In two years it will be making more money than ever before. And remember, the stock was as high as 133 last year.
Q: That doesn't mean anything. Everything was higher last year. The important thing is where it's going.
MacAllaster: It's going higher. My second stock is Supervalu. It closed Friday [Jan. 2] at 14.88. The 12-month range has been 35.91 to 8.59. The company runs both wholesale and retail grocery operations. They've got the third-largest grocery chain in the U.S., after Wal-Mart Stores [WMT] and Kroger [KR]. Supervalu pays a dividend of 69 cents and yields 4%-plus. Book value per share is $29, just about double the stock price. [The company wrote down goodwill and intangible assets when it reported earnings Jan. 7. Book value is now around $16 a share.] Sales are flat to down in retail and positive in wholesale. Earnings were $2.76 a share in fiscal 2008, ended February, and should be about $2.75 for fiscal '09. The stock sells for five times earnings. Debt is high due to the purchase of the Albertsons grocery chain in 2006, but the company has been paying down between $400 million and $500 million a year. [It announced Jan. 7 that it would pay down $600 million in fiscal 2010.] Sales are about $45 billion.
My third stock is Williams Cos., which produces and transports natural gas. The stock sells for 15.23. Once again, the range is 40.75 to 11.69. The dividend is 44 cents a year for a yield of 3%. They have raised the dividend in each of the past four or five years. Book value is about $15 a share, so the stock sells right around book. The company earned $1.40 a share in 2007. Last year's earnings haven't been announced yet but should be around $2.25 a share. This year they'll earn somewhat less -- $2 a share -- in view of the lower price of gas. But Williams has hedged a lot of its gas production, so its average selling price will be more than $7 per thousand cubic feet. Gas sells now for $5.50.
Q: Where is their natural gas?
MacAllaster: All through the West. Natural gas is the place to be in energy production. It's clean. It's domestic. It's cheaper than oil, and it looks like we'll use all the natural gas we can find in this country. Williams sells for about seven times earnings. The company raises its dividend every year. I suspect they'll raise it by a penny a share this year. In the past two or three years Williams has increased reserves by 20% to 22%. The balance sheet is strong, with debt down from $12 billion to about $7 billion, a 40% drop over five years. They have about $1.1 billion of cash and equivalents.
Next, Hartford Financial Services. It was trading for 17.09 Friday [Jan. 2]. The range has been 85.11 to 4.16. How about that? The yield is a little under 8%. Book value is $41 a share. Earnings in 2007 were $8.25 a share. Recently Hartford raised its 2008 earnings estimate to $4.70 to $4.90 from about $4.30 to $4.50. I think they'll make better than $5 and maybe $6 a share in 2009. The company has given itself all kinds of flexibility.
Q: How so?
MacAllaster: They raised a couple of billion dollars in Europe. They bought a savings bank in Florida. They got some money from the TARP. They won't have any financing problems. Hartford will be 200 years old in 2010. It has $350 billion of assets, and in five or 10 years will have a much bigger net worth than today. Meanwhile, you're buying it around four times earnings.
Delta Air Lines, my next pick, trades for 12.13. The range is 18.99 to 4. After merging with Northwest in 2008, it became the largest U.S. carrier. It is fresh out of bankruptcy court with a relatively clean balance sheet and about $35 billion of revenue. It is a speculation on continued low fuel prices. Delta should produce earnings of as much as $2-plus in 2009. Some energy hedges are working against it now, and in the last quarter of 2008, but that will end. In the next two or three years Delta could earn much more than $2 a share. Cash flow next year could be about $4 billion. The only thing is, if you're a long-term investor in airlines, you're bankrupt, so you have to buy this carefully.
Black: As Warren Buffett said, the Wright Brothers destroyed more capital than communism.
MacAllaster: Here are some one-liners: MetLife and Prudential Financial. MetLife is 36 a share; the range is 65 to 15. It yields a bit over 2%. Book value is $42 a share. The company raises the dividend every year. Any time you can buy MetLife under book value, you should.
Prudential is somewhat more speculative. It sells for 30.77. The range on the stock has been 92 to 13. Book is about $44 a share. Earnings for 2008 are estimated to be $3.50 a share. In '09 they could earn as much as $7. The dividend yield is 2%. In a few years this company, too, will be worth more.
Q: Thank you, Archie. Felix?
Zulauf: Last year saw the most severe bear-market decline since 1931. The instant reaction is to be bullish after such a decline, but the situation is more complex. The watershed events of 2007 and '08 lead to a different world in many ways. The household sector is traumatized by a 20% drop in net worth, as the worst year prior to this saw a loss of just 5%. The corporate sector is traumatized by a slump in earnings, and refinancing problems. Thus, everyone will turn more cautious, not just for 12 months but several years. Deleveraging is a structural process, not a short-term process.
Fiscal policy and other interventions may stabilize the economy later in the year and into 2010, but economic growth will be anemic and disappointingly low once things start to improve. Less leverage means lower growth, lower profit margins, a lower return on equity, lower valuations and such. But the market is slow at pricing that in. During the energy crisis of the 1970s, it took the market six years to stop extrapolating 6% annual growth and get in line with reality.
We are still in a secular bear market that started in 2000 in the industrialized economies. It has several more years to run. This is a transition year after the first slump, and we will see some corrections to the upside.
Q: We've just seen one.
Zulauf: The current rally will peter out sometime in the first quarter. It's the Obama hope rally. Obama is dangerous for the market in the sense that expectations that he can change the world are too high. He is a charismatic person, but a charismatic person with no track record. Eventually the market will grow disappointed that he can't change things as quickly and to the degree people hope.
The market will have a setback after this rally ends, with the next rally starting sometime in the second quarter. It will be more powerful and a bit more sustainable because some of the economic numbers will show positive momentum, and it will start from a new low. But you can't buy and hold equities for the long term. Investors will turn away from equities. They are fed up with negative returns over 10 years. In that period, as I said earlier today, risk was high and perceived risk was low. Now risk will be low, due in part to support from the world's central banks. But investors will perceive risk as high, and price financial assets accordingly.
Witmer: They already have.
Zulauf: In a few years' time there will be some fantastic long-term buying opportunities, but we aren't there yet. The Standard & Poor's 500 easily could fall into the 400 to 600 range over 2010-'11, after a bounce that takes it to 1,050 or so. But the upside is limited because the fundamentals aren't there.
Gabelli: So it's up 10% and down 50%.
Falling oil prices are central to what has happened in the markets, if not the economy. You're a commodities man in some ways. Where do you think oil is headed?
Zulauf: The price of oil has tumbled much more than I expected. I thought it might be cut in half in this cycle, which would have meant a price of around $75 a barrel, not $35-$40. Oil will bump along around $40 for a while, with rallies up to $70 or so. It will build a range for some years, until demand and supply get back into balance. So far, producers are behind in adjusting production to weak demand. Buy oil for a trade but not for an investment. Lower oil prices are one of the big pluses in the economic equation, because consumers will pay less for gasoline and fuel.
Q: Is OPEC pretty much out of the picture?
Zulauf: It is cutting back. There was a struggle within OPEC [the Organization of Petroleum Exporting Countries]. The Russians didn't behave as the Saudis wanted. The Iranians didn't behave as the Saudis wanted. Now the Saudis are playing hardball with other OPEC members. But OPEC, as announced, will cut production. It isn't interested in having oil prices get too low or too high. It thinks a price of $60 a barrel or so is reasonable.
Gross: We always root for lower oil prices because they restore consumer purchasing power. But cheap oil also impacts oil-producing nations and the global economy.
Zulauf: It plays havoc with their budgets. The boom in the Middle East is over. Government finances in the region will go into deficit. These are not politically stable countries. A large part of the population in the region is dependent on government finances. A drop in oil prices could further destabilize the Middle East.
Cohen: Is there a policing mechanism to make sure OPEC members cut production? So far, it hasn't worked.
Zulauf: Swing producers like the Saudis can cut back as they bring other OPEC producers in line. But it takes time to cut production by three million or four million barrels.
Faber: Some people say they have to cut by seven million barrels.
Gabelli: Either way you have a demand problem, even as oil companies have invested in new production. Petrobras [Petroleo Brasileiro] has spent hugely on its new field off Brazil.
Zulauf: At current oil prices, you can forget it. A lot of projects around the world have been postponed or canceled altogether, and that's true in all commodities markets, including metals.
Gross: Does extracting oil from tar sands make economic sense, with oil at $45?
Zulauf: You need a price of $60. Getting back to equities, dividends will be cut in the next few years, but dividend yields will be higher than today, despite the cuts.
Zulauf: Investors should keep their powder dry. Sit in fixed income. Buy five-year investment-grade corporate bonds in less-risky industries that service daily necessities, such as telecoms, oil and food, and blend them with medium-term government bonds. Check company balance sheets. I wouldn't buy long-term government bonds, except maybe German bonds. My one recommendation for the longer term is physical gold. Consider the basic set-up: World economies are so weak that we are seeing government stimulation of historic proportions. At first this is deflationary, but it will become inflationary. Gold is the only currency that won't get devalued. It will be revalued.
If the Fed's liabilities had to be covered in gold, it would sell for more than $6,000 an ounce. We aren't going back to the gold standard, but the markets won't trust the central banks anymore. Gold is in a very slow bull market. The year-end price has been higher each year since 2001. The gold market could have a shakeout in the next six months, and the price could fall back to $700 an ounce or below from today's $850. But two years from now it will be a lot higher. It is one of the few commodities that held up during the forced liquidation of almost everything else. We have talked about the risk of currency devaluation. If you were a citizen of Iceland and your currency went down by 50%, consider how gold performed in your currency. Gold functions as a protection against your central bank doing stupid things.
Schafer: Did gold hold up because it wasn't a part of leveraged structures?
Zulauf: To some degree. You don't own it in a leveraged way. It was helped by the forced liquidation of other things. There was some forced liquidation of Comex futures contracts, but at the same time there was a massive move into physical gold. Gold will stay in a bull market. It can't be manipulated like a currency you can keep printing.
Q: What about central-bank sales of gold?
Zulauf: You can sell it, but unlike a currency, you can't make it out of thin air. You have to dig hard to get it out of the ground, and there is a limited quantity available. Historically, jewelry accounted for about 70% of the demand for gold. That will decline as hoarding increases.
Gross: How many years will it take for gold to double?
Zulauf: Two, but don't blame me if it takes three. If you're a little more adventurous, you can buy gold stocks, but put the core of your holding in physical gold. Gold-mining stocks have underperformed physical gold for more than a year, due to rising production costs. Production costs should decline slightly because of lower energy prices.
Q: Fred recommended the Market Vectors Gold Miners ETF. Do you like it, too?
Zulauf: Yes. It is a diversified portfolio of major mining stocks. The total market capitalization of the industry is only $150 billion.
Last year I recommended shorting both sterling and the Swiss franc against the U.S. dollar. These trades worked well. Now short the Hungarian forint against the euro. All the Eastern European countries, excluding Russia, are running large current-account deficits. A current-account deficit is basically a loan from the outside world. In a credit crisis, credit gets pulled and the economy and currency adjust downward. Because all these countries want to join the European Union, they are all trying to defend their currencies.
Q: Why pick on Hungary?
Zulauf: Among European countries, it has the largest percentage of public and private credit -- 57% -- denominated in foreign currencies, largely Swiss francs. That's public and private credit. Probably 70% of mortgages in Hungary are Swiss-franc denominated because of the interset-rate advantage. The Hungarian central bank is trying to defend the currency and doesn't want to devalue it, which would create more pain. They raised interest rates from 8% to 12% in the fall in the midst of the worst economic recession in modern times; rates are now down to 10%. When the pain eventually becomes too great, they will cut rates and the currency will decline.
The forint isn't in the worst shape, but it is the most liquid among Eastern European currencies. The currencies of the Baltic states and Romania are much worse fundamentally, but more difficult to trade. Hungary has made good progress since the Berlin Wall came down. Per capita income is about 70% of the average income in the European Union. The Hungarian economy was stabilized in the late 1990s and inflation brought under control. Short-term interest rates declined from 35% in the mid-1990s to a low of 6% by 2005. It has risen since, due to inflation. The currency has been stable since 2000 in a trading range against the euro.
Q: What is the current exchange rate?
Zulauf: The forint has traded between HUF235 and HUF275 to the euro. The current price is HUF266. The forint could move out of its trading range in 2009. I would have recommended shorting the forint against the Swiss franc, but I have some concerns about the franc due to the banking situation in Switzerland.
Here are some trading ideas for '09: Trade beaten-down commodities like oil, which has a shot at rebounding to $70 or so, after which it will retreat. You can trade energy stocks, the big integrated oil companies, via the Energy Select Sector SPDR, or XLE. It sells for 50, and my expected 12-month range is 40 to 60. Oil has come down 75% from its high, and the XLE is down 60%.
Another good trade is Asian equities. Asia is in a severe recession that won't end for a while. But Asian stocks are cheap. They offer good dividend yields and are a good way to have a foot in these markets. Buy the iShares MSCI Hong Kong Index, or EWH. It is selling at 10.79, and I expect a range of 9 to 13-14. The iShares MSCI Singapore Index, or EWS, trades for 7.25.
Q: What do you think of housing?
Zulauf: House prices in the U.S. will reach a low in 2010, some 10% to 15% below today's level. Housing in other nations, particularly in Europe, has much more downside. Prices in Spain or the U.K. could fall 30% from here. The housing bubble has been a global phenomenon, and it has involved leverage and low homeowners' equity not only in the U.S. Countries like Germany that didn't have a housing bubble are in better shape.
About 45% of U.S. home owners don't have a mortgage, which means 55% do. Almost half of those have no equity or negative equity in their homes. The National Association of Realtors' Affordability Index is a theoretical number, because the appetite to buy a house is so different now, even if you could afford it.
Gross: I agree but offer a counter-argument. To the extent that the 30-year mortgage rate acts as a discount-pricing mechanism, if you can bring it down to 4.5% to 4% to 3.5%, you have a theoretical basis for supporting housing.
Q: The ITB, or iShares Dow Jones U.S. Home Construction index, is up 50% from the lows. What do you make of that?
Cohen: In the U.S., we are three years into the housing correction. The home-building stocks got very cheap.
Zulauf: When you go down 95%, it is easy to have a 50% bounce.
Q: Thank you, Felix. Abby, let's hear more of your views.
Cohen: With regard to the economy, chances are we're seeing the worst numbers now on production and consumer demand. The official recession may be over before the end of 2009, but growth rates afterward will be sluggish. A good deal of this ugly scenario already has been priced into stocks. Using a dividend-discount model or a price-to-book-value basis, our sense is fair value for the S&P 500 may be 1,100 or 1,200 in 2009. There is notable upside, but that doesn't mean the market goes back to its highs. Because consensus earnings expectations are too high, the market may come under some pressure again. But in the next several months we expect share prices to be higher, not lower.
Q: What is your S&P earnings estimate?
Cohen: About $55. The '08 number was about the same. The consensus is about $10 higher than we are for 2009. S&P earnings could see some recovery in 2010.
Valuation isn't a timing device. Also, even though the market offers value, valuations across the market are uneven. In the past six months, better-quality names often went down more than lesser-quality names because they were easier to sell. As a consequence, we are looking primarily at larger-capitalization stocks for 2009. In addition, we're looking for companies with a domestic orientation. The U.S. moved into recession earlier than other countries, and we may move out of it earlier. The incoming Obama administration will provide greater detail shortly on plans that may be viewed as positive in terms of economic growth. These may focus in the short term not just on job creation but the prevention of additional job losses. The administration also will be working on things that have an impact two to three years out.
One peculiar thing in the markets last year was very high correlations. Everything was correlated to everything else. The single exception was U.S. Treasuries. Correlations will move lower this year, and differences in fundamental performance and valuation will come to the fore. That creates opportunities for security selection both in the equity and fixed-income markets. Finally, the public markets really took it on the chin in 2008 because they were open for business and that's where the liquidity was. There could be some big snap-backs.
Cohen: We are going to see consolidation in many industries. Companies with strong balance sheets will be in a much better position, regardless of industry. Even though the credit situation will be improving, there is still a lot of operating duress. Companies under duress could be involved in strategic mergers and acquisitions.
Regarding specific ideas, I'll pick up where Bill left off in talking about distorted valuations in the fixed-income markets. There is general agreement around this table that U.S. Treasuries don't offer good value now. We would rather look at corporate bonds. I have three, all single-A-rated, all trading at significant spreads over Treasuries, all in financial services. Investors should stick with the senior securities within the capital structure. The Bank of America 5.65s of 2018 are trading at a [yield] spread of 325 basis points [3.25 percentage points] above Treasuries. The JPMorgan 6s of 2018 are selling at spread of 275 points over Treasuries. The Travelers' 5.75s of 2017 are selling at spread of 345 points.
Schafer: Treasuries have a negligible yield because they've become a safe haven. An analysis of yield spreads is less relevant than usual.
Cohen: My next comment was going to be that spreads are expected to narrow. That could occur as Treasury yields rise, and as the absolute yield on these securities falls. Not just the coupon but the potential of price appreciation is available here.
Bank of America common equity is interesting, as well, from a valuation perspective. It yields in excess of 15% because investors are nervous about it. The stock is down 65%. We all know about the banking sector's problems, and credit-cycle issues will take a while to play out. In Bank of America's case, there are three phases to the credit cycle. The first was problems related to mortgages and home equity. The bank had 43% of its loans in the housing sector. The next phase of concern will relate to construction and commercial lending, and the third phase to losses related to consumer loan books, such as credit cards. The bank has material consumer exposure and delinquencies are increasing, but it becomes a question of what is priced in.
Zulauf: Does it yield 15% after they cut the dividend?
Cohen: Yes, and they may cut it more. This is a controversial stock, and it is priced as one. [Note: According to government and company announcements Friday morning, Bank of America, which already has received $25 billion in TARP money, will get additional funding and a loss-sharing agreement on impaired assets because of problems at Merrill Lynch, which are worse than had been expected when BofA struck a deal last fall to acquire Merrill. As a result, BofA's capital position has been significantly weakened. Bank of America also is cutting its dividend to a penny a share. According to Abby, Goldman Sachs analysts say BofA may have other capital options available as it seeks to reduce leverage. It could reduce stakes it holds in other financial institutions, such as CCB, BlackRock or Itau. Pro forma tangible book value is about $10. Extensive government involvement likely will mean current shareholders aren't a top priority.]
Duke Energy, an electric utility, offers good income potential. It yields about 6%. We're not expecting much if any earnings growth because of the weakness in the economy. We're forecasting GDP will fall 1.6% in 2009. On the other hand, with a 6% yield and long-term earnings growth of about 5%, Duke isn't a bad place to be. Along with some other utilities, Duke has been proactive about energy efficiency, sustainability and such. It may get some attention as a consequence, with a new administration coming to Washington and talking about the need for infrastructure spending, and a new national grid.
Q: What else looks good this year?
Cohen: Pharmaceutical companies are facing significant concerns about a lack of innovation and, at the same time, major patent expirations. There are also concerns about health-care reform and what it might mean for these companies. Wyeth is a good place to be in this industry. It has less exposure to patent expirations than other large U.S. pharma companies. It has a significant biotech initiative. The company's vaccine and biological division is growing at about a 20% annualized rate and generating strong cash flow. There is a potential for a dividend increase; the current yield is about 3%. The P/E is 10.3. The pharma industry could see consolidation. Given its biotechnology endeavors and strong cash flow, Wyeth might be an appealing candidate for some other companies.
Next, I've got some stocks that could benefit from a better economy. I began by saying we're in a recession, but the equity market is a discounting mechanism. At what point do we feel comfortable looking at these names? ITT looks appealing over a 12-month horizon because of its special products. It has a strong defense business, which will account for more than 50% of earnings. It is involved in aircraft avionics and such.
The water business is attractive. Longer term, the Obama administration may focus on the water and waste-water infrastructure in the U.S., and ITT is a leader in the category. Earnings could grow 10% to 12% long-term. The P/E is about 12 times earnings.
Q: On this year's or next year's earnings?
Cohen: This year's. The yield is about 1.4%. To the extent that there is increased spending on defense and water infrastructure, ITT fits these themes. I'm sitting next to Fred, so I'd love to hear his comments on my next pick, Applied Materials. You have to believe in this case that the economy will turn up in 12 months. This is an early cyclical. The semiconductor-equipment industry doesn't look attractive right now. However, orders are likely to trough in the first half of 2009 and things will look better in the second half. The company has a backlog of $4.85 billion, including $1.5 billion in solar thin-film used on solar panels. The solar area was hyped a few years ago, and it could become more important now. With this backlog, there could be some cancellations.
Hickey: There will be a lot of cancellations.
Cohen: Applied has $4.2 billion of net cash, equal to 25% of its market cap of $13.7 billion. The yield is 2.4%.
Black: Even though Applied Materials is the big Kahuna in semi equipment, estimated earnings of 20 to 25 cents a share for this year aren't enough to justify an $8 or $9 stock in the short term.
Schafer: If you take out the cash, $9 is $7.
Cohen: This is a transition year. You have to look at 2010.
Hickey: It's too early. This is the biggest disaster we've seen, and we've seen a lot of disasters in the semiconductor market, particularly in the companies driving that backlog. Taiwanese DRAM and flash-memory makers are near-bankrupt. There is no cash available. Everyone is canceling everything. The turnaround might take well into 2010, and then you could lose market share. Black: Applied Materials is a great company with great technology. There's just no customer demand to drive the stock.
Cohen: My final name is intended to be controversial. Assuming oil averages $45 a barrel this year and $70 next year, companies like Petrobras and Hess could benefit. Hess has demonstrated significant leverage in earnings and share-price performance to rising energy prices. At $45 a barrel there isn't much earnings growth. If crude goes higher, earnings growth could be significant. There isn't much of a yield -- 0.7% -- so it's really a play on higher oil. The stock has jumped to 57 from 50 in the past few days. Maybe the move is over and I should have pulled it from my picks folder, but if you see some light at the end of the tunnel in terms of economic activity and energy prices move up, Hess could do well.
Zulauf: Some European energy stocks offer fantastic yields, even if earnings go down. Italy's ENI [ENI.Italy] yields 8.5%, and the payout ratio is probably 30% or so. Royal Dutch Shell [RDS] is yielding 5.2%.
Cohen: The U.S. equivalents would be ExxonMobil [XOM] and some others. They performed well from the end of October through the middle of December. But if the economy starts looking better in the second half of this year, you want something more leveraged to the price of oil.
Q: Thank you, Abby.
