Fed Acts to Head off Recession, Stock Market Investment Implications
Stock-Markets / Investing Sep 23, 2007 - 07:16 PM GMTBy: Roger_Conrad
You can throw out your economic models, quantitative analysis and research reports. It really just boils down to economics 101: The Federal Reserve is prepared to do whatever it takes to head off a credit collapse and potential recession.
This economy and market still have some bumps ahead. But the key to stanching any credit crunch is to provide more credit. And with the Fed apparently willing to do anything short of throwing bags of money out of airplanes, the odds of a global economic catastrophe are fading fast.
The signature event came this week. Chairman Ben Bernanke and his lieutenants at the nation's central bank pushed through a half-point cut in the widely watched fed funds rate. The move was far more radical than anything attempted by the regime of former Fed Chairman Alan Greenspan, and its aggressiveness harkened back to the day of Paul Volcker more than two decades ago.
As for Wall Street, the overwhelming consensus was the central bank would cut the rate by a quarter of a point at best. The widely watched fed funds futures contract—which reflects investor expectations of Fed moves—gave a half-point cut virtually no chance.
Speculation about the Fed's motives began almost immediately after the cut. Some said they were acting to stanch really bad potential news on the horizon. Others said the Fed panicked and was now rewarding unholy speculators.
On the whole, however, investors treated the event as extremely bullish, bidding up stocks sharply immediately following the announcement. And the positive momentum has generally held in there throughout the week.
At this point, the key question is whether or not the Fed will have to do more to avoid recession or if it's already done too much. In my view, you can make a case for either, depending on your bias reading the tea leaves.
The figures we saw for August inflation this week certainly indicate that it's not currently a big problem, at least not yet. Overall Producer Price Inflation (PPI) fell 1.4 percent from month-earlier figures. That was well above the Wall Street consensus of a 0.3 percent drop in producer prices and contrasts sharply with the 0.6 percent jump for July. The so-called “core rate”—which excludes food and energy—rose at a rate of 0.2 percent, slightly above the consensus of 0.1 percent but still very well behaved.
Consumer Price Inflation (CPI) was equally well mannered. The overall August CPI fell 0.1 percent, compared with the consensus forecast of 0 percent and July's 0.1 percent. The core rate was 0.2 percent, right in line with the consensus and last month's tally.
These are, of course, lagging indicators of inflation. But in view of the dramatic rise in the price of oil and other commodities in recent years, they're indicating a remarkable amount of slack in the economy. That, in turn, gives the Fed leeway to cut interest rates to fire up growth.
The Central Bank may not do so if there are enough signs the economy is steadying. But it should have some latitude, should conditions warrant. And given the aggressiveness of the Bernanke Fed this week, they're not likely to hesitate to act.
Just because a major calamity is unlikely doesn't mean there's not plenty of bad news ahead for the economy, and probably the stock market as well, in the coming months. I suspect there are going to be major blowups ahead, particularly in sectors most sensitive to the consumer.
For one thing, the US mortgage market and housing industry still appear to be sinking, and we're still seeing blowups of exposed companies in the financial sector. Bear Stearns, for example, posted atrocious earnings this week for its most recent quarter. Meanwhile, the collapse of a major British bank—and subsequent bailout by that country's monetary authorities—is a pretty clear sign that vulnerability extends well beyond national boundaries.
For many years, economists have worried that, when the housing “bubble” deflated, falling home prices would create trouble for the retail sector. Recent figures indicate there may be at least some truth to that and that Christmas shopping season may be weaker than expected.
Companies that are involved in these sectors are vulnerable to posting disastrous results. And it's quite possible we still have some bankruptcies ahead, particularly among the weaker retailers, home construction outfits and financial companies.
Battered sectors are always where the real value in any market lies.
And no doubt many of today's beaten-down financials are going to soar in coming months as recession and credit crunch worries fade.
But these are all sectors where investors should definitely tread with caution, at least until we see a turn in the housing sector.
And that may take a while.
If you're going to play financials, look for undervalued gems like Regions Financial. Steer clear of any bets on the whole sector, such as exchange traded funds (ETFs).
The other worry now is the US dollar. I'm certainly no doomsayer for the buck. The US is still the world's most important economy and will be for some time.
Developing Asia, for example, depends heavily on its ability to export to us. And the dollar also remains the world's chief reserve currency.
Since the Nixon shocks ended the Bretton Woods system of pegging currencies and US dollar gold convertibility, we've seen plenty of ups and downs for currencies, with the trend often lasting several years. The US dollar was a literal basket case during the late 1970s before soaring to new heights in the early '80s. It then proceeded to crash against the major European currencies in the late '80s, only to rebound to new heights in the '90s.
It's true the Bush administration is spending a lot of US dollars in Iraq, which appears to be no closer to peace than it was when we invaded in 2003. Our federal budget hasn't been close to balance since Mr. Bush took office, while the national debt has basically tripled.
It's also true we're spending more dollars than ever abroad for energy. And with environmentalists whipped up to a fever pitch to block any and all expansion of coal use, we're going to spend a lot more in coming years. A bunch of wind plants isn't going to cut it for us any more than it will for Germany should it elect to shut down all of its nuclear plants under current law.
All of these things have weighed on the international value of the US dollar for some time, as more dollars have left the country than come in. Now with the Fed cutting interest rates—reducing the interest rate differentials with other companies' paper—the greenback's drop has accelerated. The euro exchange rate, for example, has fallen to where one euro now costs more than $1.40.
That's remarkable considering the euro sold for just 80 cents US in mid-2001.
The Canadian dollar—which sold for as little as 60 cents US just a few years ago—actually went above parity this week. Short of massive intervention by the country's central bank, it looks like it's headed higher still. And even with the Canadian dollar, the impact is likely to be only temporary, as is all such intervention.
Sooner or later, however, the US dollar is going to bottom and turn higher. No one will ring a bell when it does. But it will ultimately recover, just as it's done every time previous since it became a free-floating currency in 1971.
There are several investment areas, however, that will be vulnerable until it does. One is foreign companies that compete with US companies in North America.
We've already seen several Canadian companies take hits because the rising Canadian dollar has pushed up their costs sharply against those of US-based competitors. We're likely to see the same thing happen to companies from other countries as well and across a whole swath of industries. VOLKSWAGEN, for example, is now planning to build factories here in order to reduce its costs to US dollar terms as enjoyed by US rivals.
The other sector to watch out for now is US government bonds. If any investment class has benefited from the past couple months of credit worries, it's been Treasury paper. Backed by the full taxing power of the US government, these are still considered the ultimate port in the storm during financial crises. And this year has been no different.
After looking like it would break above 5.5 percent early in the summer, the yield on the benchmark 10-year Treasury note plunged as low as the 4.3-to-4.4-percent range. Since the Fed acted, however, the yield has jumped sharply higher, and we're now moving close to the 4.7 percent level, from which the yield spike started earlier this year.
That may not be a sign of rising inflation worries, given the extremely benign figures for August and signs that US economic growth may slow in the second half. It may not even be a sign that investors are starting to bet heavily against the US dollar. But it is something for all income investors to keep an eye on, and Treasurys are generally an investment to avoid.
WHERE TO GO
In the September issue of my monthly advisory newsletter, Utility Forecaster , I wrote that the ideal income investment now should meet two basic criteria: First, it should be financially stable enough to survive whatever additional economic and market weakness lies ahead as the Fed tries to fire up growth. Second, it must be prepared for the possibility of Fed overreach, in which efforts to spark growth wind up setting fires of inflation.
This second scenario is exactly what happened nine years ago. In 1998, the Asian contagion finally reached these shores, after triggering the bankruptcy of the Russian government and the collapse of the infamous hedge fund Long-Term Capital. With the S&P 500 down 20 percent and falling fast, the Greenspan Fed swung into action, along with central banks of still-solvent countries the world over.
The immediate result was a flood of liquidity into world markets that basically ended the global liquidity/credit crisis and restored order. But it also had the effect of creating inflation pressures, which the Greenspan Fed quickly moved to counter.
The upshot: Even as the Nasdaq Composite doubled in 1999, income investments in general slumped badly. Only those able to grow managed to avoid losses of 20 percent or more.
If the Bernanke Fed has succeeded in calming the markets with its moves thus far, we're unlikely to see anything of the magnitude of 1999's income investment weakness. Moreover, just as the '90s favored growth, so this decade favors income in the minds of investors. Even if growth and inflation do accelerate in the coming months, investors are unlikely to throw their stable, yield-generating investments overboard to buy tech stocks with no earnings as they did in 1999.
That said, however, we could still see some selling—particularly to no-growth income investments—as the markets lose their fear of a credit crunch. And the more the Fed has to act now to bring things under control and prevent recession, the greater the reaction is likely to be.
My view on income investing has always been simply that trading doesn't work. There are times when income investments provide huge capital gains. We've seen that from real estate investment trusts (REITs) since 2000 and utilities since 2003.
But by and large, the biggest returns come from holding for the long term—both to capture distributions, as well as to benefit from strong businesses getting stronger and raising dividends. Moreover, trading is punished with higher tax rates on both capital gains and dividends.
Pressure to perform every quarter is the main reason why open-end utility mutual funds trade frequently. And that's why virtually none pay decent yields and radically underperform the potential of their holdings. They just have to do too much buying and selling to keep up with the Joneses. And that's not counting the cash they have to keep on hand to meet daily redemptions or the management fees that sometimes range as high as 2 percent of assets or more.
Buying and holding individual income investments isn't without risks or high anxiety. Even the most stable and solid company can take a dive if management miscalculates, business conditions deteriorate or even just plain bad luck intervenes. The downfall of a company doesn't often come from outright lying. But sometimes, even the most careful investor can overlook vital information and suffer the consequences.
Unfortunately, you can't factor out risk with individual stocks, bonds or preferred stocks. The best you can do is to maximize your odds of success by getting to know the underlying businesses of your holdings and sticking to the highest quality possible.
Sector risk is equally impossible to factor out. Everyone in the investment business is constantly searching for the next best idea, and there's a lot of information available to try to figure out what that might be. There's absolutely no way, however, to know for certain how a sector is going to perform or whether or not it might get hit by the unexpected.
The unexpected is certainly what happened to Canadian income trusts on Halloween night 2006, when that country's government announced a plan to tax trusts as corporations beginning in 2011. The result was a sharp decline and period of underperformance. And although trusts outside energy production have recovered since, energy producers continue to be impacted by slumping natural gas prices.
Clearly a strategy focused solely on Canadian trusts would have been in bad shape. Damage would have been far worse to someone who focused solely on the popular energy producer trust sector--or worse still on one or two trusts in that sector.
In contrast, investors who held diversified portfolios of income investments—including trusts—actually made money in the fourth quarter of 2006. True, the trust portion of their holdings took a bath. But the money that left trusts went into other income investing groups, pushing up their prices.
As a result, overall portfolios were in solid shape as the year ended. And those who kept their high-quality trusts as part of their diversified portfolio have enjoyed a solid recovery since.
Some Americans have taken what happened to trusts as a lesson to never trust Canada again and to avoid income trusts all together.
Instead, they're now plowing their portfolios heavily into some other income investment group, such as bonds or limited partnerships (LPs).
Sadly, they're setting themselves up for the same disaster that befell them in trusts. There's nothing inherently wrong with bonds, LPs, utilities or any other income investment group. But they all have their risks. Trouble can strike any of them.
The only way to really protect yourself is to follow that simplest and most time-tested of investment rules: diversify. Own some utilities, but also own some LPs, bonds, Canadian trusts, REITs, energy stocks and even a few battered financials.
Buy only the best quality you can find in each sector--that is, dividends that are backed by good businesses. Then you can really sit back and watch your portfolio build wealth in any economic or market environment, including the volatile period we're going through now. Don't overweight, unless you can afford the possibility of being wrong.
With that in mind, here's my outlook and strategy for the major income investing sectors:
UTILITIES —This remains my favorite group for weathering whatever economic weakness lies ahead. They still seem to be sold off whenever particularly worrisome news appears. But overall, the trend has been up for the past month or so.
Utilities have sharply de-levered, and dividend risk has fallen as well in recent years, as companies have gotten back to basics. And their revenue streams are secure in all economic environments, particularly with deregulation being rolled back.
The key with this group, however, is to look beyond the current economic weakness to prepare for the possibility of Fed overshoot, i.e., more growth and inflation. That means focusing on the growth stories of the sector, particularly those that now appear to be undervalued. I count AQUA AMERICA in that camp for water, and AES CORP and DUKE ENERGY for power. SPECTRA ENERGY is also very cheap for gas.
Limited Partnerships—I usually turn off from hot groups as they surge or as Wall Street pumps out more product to meet demand. That's happened to the LP sector this year. But if you're selective, there are still bargains to be had.
I'm most attracted to LPs that have been around a while and are in utility-like industries. This is the group whose core businesses are most conducive to paying out large amounts of cash flow to perpetuity. There's no such assurance with, for example, oil and gas producer LPs. My favorites include all the LPs in the Utility Forecaster portfolios.
ENERGY PRODUCERS —This is a group that's suffered with credit concerns and recession fears, as well as continued weakness in natural gas prices. But with oil prices crossing a new threshold—and still not apparently triggering much US inflation—it's only a matter of time before both concerns fade.
In the meantime, the companies best positioned to weather further market weakness are the Super Oils like CHEVRON CORP. The cheapest plays on the market are selected major Canadian trusts like ENERPLUS RESOURCES and PROVIDENT ENERGY, which yield well in the double digits. They're also more than pricing in additional taxes to be paid in 2011 and not pricing in at all the various ways they have to avoid paying the full rate, such as extensive US operations.
REITs —As credit rater Standard & Poor's noted this week: “These Days, Single Family Pain Is Multifamily Gain.” Specifically, “it wasn't very long ago that for-sale single-family housing in the U.S. was sprinting along and multifamily rentals were wheezing, partly due to strong conditions that favored home buying. Just four years ago, phrases like ‘lack of demand,' ‘excess supply' and ‘concessions' were commonly used to characterize the rental market.
Well, what goes around comes around, and today multifamily rental housing, with the exception of some outlier markets, is on fairly stable footing as rentals benefit at the expense of for-sale housing.”
S&P's opinion is well reflected in recent apartment REIT results.
Ironically, they're still being thrown in with all REITs as vulnerable to a recession. That's set up a golden opportunity to buy MID-AMERICA APARTMENT. Canada's real estate market is also red-hot and ripe with bargains.
CANADIAN TRUSTS —In addition to the energy producers and REITs, a host of other Canadian income trust sectors are also cheap, including power generation, energy infrastructure, timberlands and YELLOW PAGES INCOME FUND. These trusts also aren't vulnerable to ups and downs in energy prices, which make them good recession hedges.
But it's critical to be very selective. A lot of junk trusts were issued in 2006 when the group was hot, and that means potential blowups. But you won't find a cheaper or higher potential group of income investments for the risk.
FIXED INCOME —The key to making money in fixed income has always been staying off the beaten path. The huge recent discounts to net asset value of closed-end mutual funds have narrowed considerably over the past couple weeks, as reason has returned to the market. But ING PRIME RATE TRUST still looks like a deal.
In the individual bond and preferred stock category, you can't beat comeback utilities like SIERRA PACIFIC RESOURCES or EL PASO ENERGY.
The best open-end fund now is VANGUARD GNMA, immune from mortgage market mayhem but cheaper for it because of misperceptions of risk.
TELEPHONES —I like this group. Growth continues apace in the industry, and the number of real players has dropped enough to restore pricing power. The best buys are the Big Three: AT&T, COMCAST CORP and VERIZON COMMUNICATIONS. But for yield, CITIZENS COMMUNICATIONS is attractive.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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