Investment Advice For 2012: Buy Equities, Sell US Treasurys

12/16/2011 @ 11:36AM 

Article from Forbes

I came across this interesting 23 page client report from HSBC Global Asset Management in London that had me thinking of my own portfolio and my fear of buying more as a teeter on facing a maintenance call in my margin account if things get even a little bit worse.  The report says a lot of the obvious — institutional investors are focused on the short term of under a year, which of course makes it hard for long term buy and hold investors to see any capital gains.  Too much selling pressure.  There’s the case made for dividend yielding equities, especially in emerging markets.  As an aside, take Brazilian telecom company Vivo (VIV) — now known as Telefonica Brasil.  It pays about an 11% dividend yield.

The growth outlook for developed markets has deteriorated, with much of the blame being put on Europe. As a result, developing economies will also see their economies slowing down even though they have more fiscal and monetary policy tools at the ready to avoid severe slowdowns.

One of Warren Buffet’s many famous quotes about investing is ‘be fearful when others are greedy and greedy when others are fearful’.

So for individual investors with money on the sidelines to put to good use, here are some takeaways on next year’s trends from HSBC’s report released this week. In short — go long dividend paying high volume equities, including those in the emerging markets, and get rid of those government bonds, especially if they’re European.

The Case For Equities

U.S. equity dividends are yielding just over 2%. Emerging markets, about 3%.

If you can look through the short-term fog, equities offer some excellent opportunities for building wealth in the longer term, as part of a balanced portfolio. Companies, in contrast to governments and the consumer, have been managing themselves extremely prudently. While the former were building debt to unsustainable levels, companies were paying down borrowing and building cash balances. Equity dividend yields currently stand at attractive levels – as the chart below shows – compared with government bonds, while company balance sheets are enabling them to grow dividends – a very attractive combination in a low interest rate environment. Valuations are also extremely low by past standards, as illustrated by the chart below. To some degree, this is justified with growth in developed economies likely to be somewhat lower than it was historically. But focusing on lower growth rates in developed economies ignores two key features. First, companies in developed markets are increasingly global in their outlook. They are not just a play on the economic growth of the country of their domicile, but instead can benefit from higher global growth.”

The Case Against Government Bonds

Bonds have been the beneficiary of an almost perfect storm – a long-term downward shift in yields, accelerated by investors’ pursuing safety in the short term. However, surely just as the bond evangelists’ calls for structurally lower yields become more vocal, investors with a long-term outlook should be avoiding this category given the prospect of negative real long-term returns.While inflationary pressures look muted in the near-term as austerity packages in the West kick-in, we see the structural downtrend in inflation coming to an end. Wages in many emerging markets are now rising rapidly as these economies grow richer and their workers demand higher wages. Also, as the global economy rebalances over the long term, the flows into western government bonds of recent years are unlikely to be repeated.”

Positive Outlook For U.S. Equity (6-12 months)

The outlook for the U.S. economy remains tough, particularly as unemployment is stubbornly high at about 9%, with consumer spending a key driver of growth. However, the U.S. does appear to be seeing stronger growth than other developed economies. This may provide some support to 2012 corporate earnings, at least compared with other developed markets, especially if economic stimulus measures are extended into 2012. Although valuations are somewhat higher than for other developed markets, with a 2012 forecast price/earnings ratio of 10.9 times, we consider this a fair premium given the stronger economic momentum. Political deadlock has been a severe impediment to the US dealing with its budgetary problems, with the country standing alone among major economies in not enacting fiscal austerity. 2012 sees presidential and congressional elections and we would hope that post the primary stages of the contest, which are likely to see candidates appeal to their narrow party bases, they seek common ground and realistic ways of resolving the long-term budget pressures.”

Positive Outlook For EM Equity (6-12 months)

HSBC likes oil and gas rich Russia despite political risks in an election year, sees a soft rather than hard landing in China, and notes that Latin American governments — particularly Brazil — have good balance sheets and plenty of tools remaining to fix the economy. 

Powerful longer-term phenomena such as industrialisation and urbanisation, as well as more robust fiscal positions, underpin our positive view on emerging market equities. We continue to see stronger growth from emerging economies compared with developed economies in 2012, albeit at slower rates than previously. Emerging market equities have underperformed developed market equities in 2011. There is some risk that further downward revisions in global growth could lead to them continuing to trade as higher-risk plays rather than reflecting the superior structural features of their economies. However, valuations are attractive with aggregate emerging market equities trading on about 9 times next year’s earnings, against a 10-year average of about 11 times. We favour Chinese equities where valuations are low in our view, with the market trading on about 8.2 times 2012 earnings, significantly below the market’s 10-year average of about 12.5 times. There are risks in that the rapid rises in residential real estate prices could reverse and become destabilizing to parts of the economy, but overall, we forecast a soft rather than a hard landing for the economy and forecast 2102 economic growth of about 8%.”

Negative Outlook On U.S. Treasurys

U.S. government bond yields remain extremely low despite investors losing confidence in the role of political institutions to tackle fundamental budgetary problems. The U.S. Congressional Budget Super Committee failed to reach a bipartisan deficit reduction agreement after three months of intense negotiations, despite a similar political deadlock over the summer leading to the U.S. credit rating being downgraded by one notch by Standard & Poor’s. More positively for treasuries, the Federal Reserve decided to lengthen the average maturity of its treasury holdings by selling $400 billion of short-dated securities and purchasing longer-term bonds. They also committed to keep Fed fund rates low for a longer period of time. Notwithstanding Federal Reserve actions that are currently supporting prices, we remain cautiously negative on US treasuries as an asset class. We believe the positive surprise seen in economic data can continue and should the Eurozone reach agreement on a lasting solution to its sovereign debt crisis, the safe haven premium embedded in U.S. Treasury prices may start to evaporate. This would force yields to rise to levels more reflective of the current economic and fiscal backdrop.”

Article from Forbes

Beat the Stock Market with Bonds

Bond Investing

By Andrew Mickey

Friday, December 9th, 2011

Article from The Wealth Daily

The U.S. Census Bureau’s American Community Survey found the national median income is down 5.1% over the last decade.

It also found the number of Americans developing and collecting passive income has fallen to levels not seen in decades. Only 24.2% of American households collect income from rent interest or dividends. That’s down from more than one-third of the country a decade ago.

At the same time, more households than ever are becoming dependent on passive income to maintain their quality of life. Tens of millions of baby boomers crossing into retirement will have to earn more income from their investments just to maintain their standards of living.

And many have already started: Massive amounts of money have been pulled out of stocks since the downturn in 2008. Investors have put more than $670 billion in new capital to work in bond funds in the last three years — a massive amount compared to the normal range of $30 to $50 billion per year over the last decade.

The search for yield is going to keep the bond market booming for years to come...

And it’s going to pay off handsomely for investors looking at “boring” bonds now.

Interest Rates: How Low Can You Go?

The primary reason we expect the bond bull to continue is that the dominant market trend for the next decade is financial repression.

Remember, financial repression brings with it negative real interest rates, increased government involvement in the economy, reduced access to capital for businesses and consumers, slow GDP growth or worse, and a global economy that jumps from panic to panic for years — if not decades — to come.

You’re feeling it already. Low interest rates, minimal yields, and heightened stock market volatility are all part of it. After all, why can’t you get any yield in CDs, government bonds, or anywhere else?

Interest rates are being held artificially low to “help” the economy.

This didn’t work in Japan for nearly 20 years. It helped drag down economic growth throughout the Great Depression. And it hasn’t helped much in the past three years.

But if the recent actions by central banks are any indicator, rates are going to be held as low as possible for years to come. And it’s going to keep the bond boom going strong.


Not “Junk” Anymore

Corporate bonds have done extremely well —  and are poised to do much better than the overall markets.
I know what you’re thinking...

Bonds are boring. Most don’t pay much interest. And if interest rates rise (which they will eventually), the value of bonds will be destroyed very quickly. (If interest rates double, bond prices are cut in half.)

But there’s the thing: High-yield bonds are performing exceptionally well.

Now, I realize high-yield bonds usually yield a high rate of interest because they’re risky. The perceived risk of default is normally far greater than government bonds and investment-grade corporate bonds issued by cash cows like IBM and Wal-Mart.

They are called “junk bonds” and have an equally terrible reputation.

During certain time periods, however, they perform exceptionally well.

A period of low interest rates — like the one we’re in now — is one of those times.

For example, the SPDR Barclays Capital High Yield Bond (NYSE: JNK), an ETF which follows the junk bond market, currently yields 7.43%.

That’s nearly three and a half times more yield than the 10-Year U.S. Treasury Bond.

And despite the implied risks of higher interest rates, junk bonds have been doing extremely well. Since the stock market topped in October 2007, the S&P 500 is down almost 20%. Junk bonds, as a whole, have returned more than 34% over the same time period.

And this will continue because despite their performance, high-yield and junk bonds are particularly cheap right now.

Anatomy of a Bond Price

The key to determining the value of a high-yield or junk bond and the interest rate you should expect in return is the default risk.

After all, if you’re lending to Greece, you’re going to want a 30% (or more!) interest rate to cover the high risks of default.

Corporate bonds, however, are much more reliable than debt-engulfed sovereign debts...

The National Bureau of Economic Research recently published a study which found corporate bond default rates are surprisingly low. It found the average default rate is about 1.5 percent between 1866 and 2008.

If you take out a few major panics like the Great Depression and 1870s railroad crisis, when total default rates soared to above 30%, default rates are even lower.  History tells us that bonds are remarkably consistent and safe.

Even during the current economic malaise, bonds are set to continue their extremely reliable run.

Moody’s just announced it expects an increase in global corporate bond defaults to 2.4% next year. For high-yield and junk bonds, the numbers are even better. The default rate on junk bonds is on pace to post a near-record low of about 2% in 2011. That’s below its long-run average of 5%.

Remember, central banks are doing everything they can to keep the gears of credit lubed as efficiently as possible. Defaults are the sand in the gears — and what they're doing everything in their power to prevent.

The net result is the continuation of a trend most investors who only focus on stocks will never realize: During tough times, bonds can deliver far better returns with much less risk.
This trend will only continue to improve.

Revealed: The 128% Bond

Back in August, right when post-QE2 volatility began to surge, we first started talking about alternative investments where you can get extra return safely.

One of those areas was to combine bonds and Closed-End Funds (CEFs) to get into a diversified portfolio of bonds at a discounted price.

In "If You’re Buying Stocks, You’re Making a Big Mistake," we found:

This often overlooked corner of the market is currently safer than stocks. It offers significantly more upside than stocks. And when it has fallen to current levels in the past, investors were handsomely rewarded.

At the time, the euro-induced selling fever had pushed the discounts on CEFs to relatively extreme highs not seen since the 2008 credit crunch. And the CEFs, which invest primarily in diversified portfolios of corporate bonds (which makes them inherently less risky than stocks), were trading at even greater discounts than many.

The fund we focused on was a bond fund that buys convertible bonds — bonds that can be “converted” to stocks if the underlying company’s stock price goes up. We like this fund because it has been a consistent performer, even in the toughest markets.

Since your editor initially bought it, the Calamos Convertible and High Yield Fund (NYSE: CHY) has returned more than 100% in capital gains and more than 15% in dividends income.

The total return over the three-year period: 128% — that’s right,  more than double your money from bonds.

Bonds are great, but they aren’t perfect... No investment is.

The Worst-Case Scenario

Now, I realize bonds are at extreme highs and their yields are at extreme lows.

As we looked at last week, Treasury Inflation Protected Securities (TIPS) have negative yields.

It would appear there is only one way for interest rates to go: up.

And when interest rates rise, bond values can fall very quickly.

Of course, interest rates are at historic lows and can stay at them far longer than most investors expect. At this point, it looks like they will.

That’s why high-yield bonds are appearing better than stocks, even if interest rates rise.

A study by Fidelity Investments found that during the last period of rising interest rates (1941 to 1981), bonds only fell four out of those 40 years. And each year bonds fell, the worst was a loss of 5%.

As I said before, bonds aren’t perfect; but they will be about as close as you can get to "perfect" for the current market environment.

Join the Yield-Chasers Now

In the end, investing and speculating is nothing more than predicting which assets will be in demand in the future — and buying them now.

There are all sorts of assets that will be in demand going forward. For example, gold, silver, and commodities like oil are going to become increasingly popular as inflation pushes real asset prices up (another impact of near-zero interest rates).

Finally, high-yield and junk bonds will continue to increase in demand as the population gets older. Retirees’ disposable income is declining, and they’re going to be induced by central bank policies to search out maximum yield to maintain their standards of living.

There are still opportunities in this market. The yield-chasing trend is still in its early stages. If you are looking for safe and consistent gains, the time to buy is now.
Good investing,

Article from the Wealth Daily

Warren Buffett: Investing In Common Stocks, Bonds And Arbitrage Situations

Dec. 08, 2011 |
Article from Guru Focus

Dated back in 1986, Warren Buffett had discussed different categories of investment and his simple reasoning following each type of investments. It would be extremely helpful with only several page of reading for any Buffett wannabes. At that time, Buffett’s insurance arms had purchased around $700 million of tax-exempt bonds, with the maturity from 8-12 years. Readers might think that huge amount of money indicated his enthusiasm for bonds. But that was not the case. He explained that at best, the bonds were mediocre investments. They just seemed to be the least objectionable alternative at the time he bought them. 

As any new money came in, Buffett said that there would have only five choices: (1) long-term common stock investments; (2) long-term fixed income securities; (3) medium-term fixed income securities; (4) short-term cash equivalent; and (5) short-term arbitrage commitments. Buffett seemed to prefer common stock the best. He commented: “Common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests. This statement in no way translates into the stock market prediction: we have no idea – and never have had – whether the market is going to go up, down, or sideways in the near – or intermediate term future.” 

He believed on the boom and burst cycle, happening occasionally in the market, along with the fear and greed, which he described as “two super-contagious disease." That would forever occur in the investment community. However, even knowing it would happen, no one can predict the timing of those events accurately, it was so unpredictable. That is why he never try to anticipate the arrival or departure of either disease. A simple goal was stated once again: "To be fearful when others are greedy and to be greedy only when others are fearful.”

Even in the short-run, the bull could make the stock market advance like crazy, and everybody loved the market just so much. But the very fundamental truth was that the stock couldn’t outperform businesses indefinitely. Actually, the stockholders as the whole over the long run would underperform the companies that they own if taking into account the transaction costs and the investment costs they have to bear. “If American business, in aggregate, earns about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.”

The second investment category was the long-term bonds. Buffett said he didn’t get interested in those type of investments except it was very special situation such as the Washington Public Power Supply position that Berkshire Hathaway had purchased before. He stated: “Our aversion to long-term bonds relates to our fear that we will see much higher interest rates of inflation within the next decade. Over time, the behavior of our currency will be determined by the behavior of our legislators. This relationship poses a continuing threat to currency stability – and a corresponding threat to the owners of long-term bonds.”

In addition, Berkshire Hathaway sometimes employed cash in the arbitrage field. But according to Warren Buffett, it was not like common arbitrageurs, who purchased a lot of securities each year. Berkshire only bought a few, restricting to some large deals that have been announced publicly and not betting on the outcome. That was why the potential profits might be apt to be small, but along with the luck, the disappointments would also be few.

He discussed that arbitrage could be considered to be the alternative to Treasury bills as a short-term packing place for money — a choice that combined potentially higher return with higher risks. Till the time of writing, the returns for Berkshire Hathaway from arbitrage positions had been many times higher than if leaving it into Treasury Bills. But the risk was that “one bad experience could change the scorecard markedly.”

Buffett at that time view medium-term tax-exempt bonds as an alternative to short-term Treasury holdings. Buying those bonds, he would run a risk of significant loss if he had to sell many of them well before maturity. Nevertheless, he believed that the risk was more than counter-balanced because of several points. 

First was because much higher after-tax returns currently realizable from these securities in the comparison to Treasury bill, and second, because the possibility that sales would produce an overall profit rather than a loss. “Our expectation of a higher total return, after allowing for a possibility of loss and after taking into account all tax effects, is a relatively close call and could well be wrong. Even if we sell our bonds at a fairly large loss, however, we may end up reaping a higher after-tax return than we would have realized by repeatedly rolling over Treasury Bills.”

About the author:

Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Article from Guru Focus