2013 Year End Talk
Time once again for my year end round up. And the big news is the Fed will finally slow it's purchasing of government and mortgage paper it embarked on in order to artificially keep interest rates down. While the 10 year flirts with the 3.00% level, that's not a big move at retail. The Fed, wisely, gave more than ample warning. As the old joke goes, the operation was a success, but the patient died. From all of 2009 through the year end of 2012, $4.69 TRILLION of mortgages were refinanced by single family owners. (Two to four family homes are not included in this figure.) By my estimation, that would save over $5.5 billion per month in mortgage servicing costs. That is bigger than any proposed tax cut or stimulus that could be imagined, and it affects the middle and upper middle class the most, where it should have done the most good for spending and consumption. It hasn't. Corporations, as all of you bondholders know, have slashed their debt service dramatically as well. So have commercial property owners. The nation is swimming in liquidity and cash, but it's not being spent, and not being invested. Despite using every trick in the book and throwing a giant wall of money at the economy, we are still, after all of this time, deleveraging.
As of the latest figures available, credit card use is still declining, five years after the technical “end” of the recession. What is interesting to note here is how much of our economic “growth” depended on leverage, and few want to play that game again. And corporations are hoarding cash like Simon Legree. Record cash holdings by banks and corporations show both reticence to lend, and lack of demand for capital.
Which brings us to a disturbing prospect. While the statistics show economic growth, wages have either flattened or declined, cash is abundant, but demand is stalled. And it may be this way for a while. The term "structural stagnation" is being bandied about. I remember when people used to say that for all of FDR's efforts, it was WWII that got us out of the Depression. In other words, while progress was made, things weren't quite straightened out until massive defense spending put people back to work and off to war, and what happened in 2008 wasn't that much different than what happened in 1929. The only difference today is we have far more powerful levers and safeguards than we did, but restarting a fire that had a bucket of water thrown on it is a tough proposition. There are many disturbing currents in the economy- the inability of recent graduates to find work, tremendous shrinkage in professions like law (where they're not used to layoffs and bankruptcies), income disparity continues to grow. And companies would much rather boost dividends or embark on multi billion dollar stock buy backs ($500 billion and counting) than invest or hire. Only 16 companies in the S&P 500 did NOT boost dividends or perform share buybacks in 2013.
There is also this disturbing pattern:
Company Market Capitalization # of Employees
Google $343 Billion 46,421
GE 305 Billion 305,500
Boeing 104 Billion 177,700
Facebook 112 Billion 5,794
Twitter 32 Billion 2,300
In terms of earnings per employee, it's not hard to see a pattern of wealth concentration and shrinking opportunities for many in the “new economy.” Technology, while making life easier and everyone far more productive, means that one can do the work of many. Theoretically, worker productivity makes us all wealthier, and the economy, as a whole, may be. But it can't provide job growth. And that is a demand killer that feeds on itself. That's why the market is up, but the economy as a whole doesn't reflect the market. Actually, it never does, but most people expect some correlation. Just to punctuate this, labor productivity rose by 3% in the 3rd quarter. Wages declined by 1.4% at the same time. The advent of devices like 3D printing, which could be extremely disruptive to supply chain economics, self driving cars, and even the possibility of Amazon's proposed drone delivery service could augment this trend. There is a great deal of talk about manufacturing coming back to this country. Some of it is, but robots and automated processes do much of the actual work. So while an important economic metric like factory utilization keeps showing steady improvement and the market cheers, there's little to show in real employment gains. GDP is ahead of pre-crash levels, but 2 million jobs are still missing.
At the same time, the hoarding of cash also reflects a fear to spend or invest. People are still quite traumatized by what happened to the markets and the economy, and fear of commitment is palpable. There is a smattering of evidence that this trend may be slowing, but we'll need a few more months of data to confirm this. There is also a new dynamic in that we now see people of middle age afraid to invest in the markets. Aside from the risk fear (which of course, could be mitigated) the interest and joy in saving for a well anticipated, good retirement or growing assets to enjoy later on, or fall back on, is becoming a rarer undertaking. This is a big mistake. Obviously, anyone reading this probably doesn't share this view, even after experiencing the most hair raising markets of a lifetime, but the difference is you had the guts and the faith to stick it out, and let your assets grow again. Stock ownership is at a multi decade low, and that is indeed a waste for people who have managed to get their debt service down and their savings back up.
The point I am making is that if wage growth is stalled, and job promotion is rare, saving money and putting it to work for you may now be a person's BEST chance of improving their lot in life, and providing the upward mobility the economy or your career can't. Some of you have saved and invested enough that your portfolios produce more income than a second job. You continue to see the value of investing, and taking advantage of it. While it is disturbing that social mobility isn't what it was, it is becoming clear to me that earnings from assets held may greatly supplement- and for some, even exceed- the return one gets from their labors. Tax policy also aids and abets this: we are taxed lower on dividends and some income products than we are on our labor. In economics, this is called a “rentier” (pronounced Ron-Tee-Yay) society. If this sounds slightly Dickensian to you, it means you're well read. It also means that the way we think about life, careers and our prospects for the future may require re-evaluation.
People have still not internalized the meaning of the crash and it's aftermath. While I believe we are poised for more growth, and probably at a somewhat better clip for 2014, it won't clear the collateral damage of the past fast enough. As I mentioned last year, this makes for a good investment environment, if not an ideal social one. What is also interesting is the last quarter's GDP report: revised upwards to a nice number at 4.1%. That's NOT a weak showing. But no one FEELS or SEES the growth because it's being pooled in such a narrow channel, so the economy, again, as a whole, doesn't benefit. A government and central bank can only manage some economic problems, and can't ameliorate all of them. Americans have a difficult time accepting this.
I had the pleasure of attending a municipal bond conference hosted by S&P, and I met Jim Lebenthal, who opened the conference with a powerful defense of the municipal bond tax exemption. At 85 years of age, he spoke with enormous passion about the role bonds play in U.S. Infrastructure. You could see what made him a success- he spoke with such energy, he could sell tax free bonds to someone on the Earned Income Tax Credit. One couldn't help but admire him. I also shook hands with my idol, Tom Keene of Bloomberg Surveillance. He moderated a panel with his usual arch wit. In person, he looks every bit the rumpled professor.
Someone on the panel who managed $600 million (or so claimed) expressed the fear that “clients won't understand when their portfolios show a decline” if rates rise. First, you shouldn't be afraid of your clients, unless you're trying to hide something. Secondly, the thing to do is to EXPLAIN to the client what the effects of rising rates are on a bond, and if you're holding it to maturity or call, it doesn't matter that much what it says on the statement. Did the bond offer compelling value at the time of purchase relative to the availability of other alternatives? Is it suitable for the client? Does it fit their risk tolerance? THOSE are the things an advisor should fear not considering. The pitch was- since S&P was hosting this, and they make good money from syndicating their indexes to use for them- is that bond ETFs are the way to go and individual bonds are less attractive for the retail investor. The performance numbers say otherwise. Since ETFs and bond muni funds often have to perform forced liquidations when people are bailing out of the market, they become useful proxies for determining a good entry point. To me, that's all their good for. Remember- you want to buy when people are throwing these things overboard with no regard for their value. Rates may indeed rise, but trying to hedge against them is a fool's errand, simply because no one knows how soon rates may rise or how high they may go. My own outlook is this: with sluggish economic growth, stubbornly slow employment growth, and commodity prices from oil, natural gas, gold to corn and other crops hitting the low end of pricing, I do NOT see any justification for a rapid rise in interest rates even if the Fed backs off. The ingredients for an inflationary scenario just aren't there. By the way- we were informed there are now over 1000 bond ETFs, which is preposterous. Over 400 ETFs of assorted stripes closed their doors in 2013 due to a lack of interest but hey, it's the Street's flavor of the day.
Now this makes for a tricky time in the markets. Stocks have retraced handsomely, as the market as a whole, retraced all that it lost, and more, since Lehman Bros. folded. For the past year, I shifted more assets into equities, especially those with strong dividend flows, as bonds became overpriced, partly due to Fed policy, partly due to steadily strengthening credit, and most of all, billions flowing into these instruments in search of yield. For the most part though, we got there first, while these new investors overpaid. Those who get my regular fixed income e-mails of offerings have seen that the level of product had dropped to a trickle. As always: if I don't think it's worth it, you won't ever see it.
Here's how some big names performed this year:
Ray Dalio, Bridgewater Associates (hedge fund): 6% Bill Ackman, Pershing Square Capital (hedge fund, corporate raider): 9% Paul Tudor Jones, Tudor Investment (asset management, hedge fund): 12% S&P 500: 25%
I think I did all right, considering I don't charge you 2% of assets and 20% of your gains. Remember I don't try to "beat the market," and you shouldn't either.
The usual collection of Gold cranks lost millions, as the metal posted it's biggest loss in 30 years, as well as the ones predicting financial Armageddon who shorted the market. They'll be back on CNBC next year. God help the retail investor.
Our reliance on real estate based investments has paid off handsomely in both share price and dividends, although some share prices took a hit after Bernanke's warning and the ensuing “taper tantrum.” Here's where I have to make a decision: do I weather the movement in share prices and collect the income, or recommend paring down holdings? My feeling is for the most part, hold on. For one, while the bond market may go nuts once tapering begins, it will settle down afterwards particularly if job growth doesn't pick up. If it DOES pick up, there will be some market risk there, but housing could pick up along with it. My assessment for now is to keep the dividends rolling in. Asset values in real estate have rebounded nicely (over 1 million underwater homeowners became equity positive in the past year, for example) and I imagine these holdings will retain their value or grow. Its one area of investment where people are willing to commit strong money, at least for the time being.
What's funny about all of this taper talk and how the Fed has "hurt savers," is how it's going to mean precisely the opposite for us. Since the crisis began, for many clients, I've been buying low rated bonds at sharply discounted prices with fat coupons. There were some client portfolios I constructed in some years that had a 70% allocation in Fixed Income that STILL beat the S&P and the Dow. While that would be impossible in the kind of year we just had with stocks, going forward, it's going to be tough doing it with bonds. Even CCC rated bonds don't sport double digit or high single digit coupons anymore, and despite all the talk about "rising rates" we won't see it on the short end of the market, i.e., less than 3 years maturity, and the chief benefactor in yield will be on longer dated paper. But I'll venture to say it won't be as good as it has been to us, which is kind of ironic. For the buyer of AAA or government paper, yields should improve modestly.
The municipal bond arena posed some surprises for the wonkish, thanks to the City of Detroit's bankruptcy. Since these instruments were created, it has always been assumed that the "General Obligation" municipal bond, backed by the unlimited taxing authority of the issuer, were stronger credits than "Revenue" bonds, backed by tolls, for example, since revenue can fluctuate. Well, that didn't happen in Detroit, because while the issuer DOES have unlimited taxing power, there ain't nothing in the rule book that says they have to exercise it. So the GO bondholders are no more senior or safer than other creditors in this bankruptcy. While munis rarely default, this freaked out Muniland, who have all been trained to think one way for the entire span of their professional careers: that GOs are almost bulletproof, because taxing authority to cover the coupon, theoretically, can go to infinity. Also of interest here is that pension recipients may have to take a haircut. This, too, was held to be sacrosanct, but a judge ruled otherwise. It was later discovered that Detroit's judges are on a different pension system than that of the police, fire and clerical. Mirth ensued. For my clients who are attorneys, just a friendly reminder that municipal bankruptcies under Chapter 9 of the code are different in a LOT of ways than a Corporate one. By the way, there were some smart buyers out there who picked up bonds issued by the Detroit school system, whose values plummeted merely on the power of raw emotion from the City's troubles. But there was nothing wrong with the school's funding system, since it had nothing to do with the City's revenue stream, and once again, this shows if you can leverage fear in the market to your advantage, you can do very well. Also note: about 65% of all new muni issuance was in refunding (refinancing) existing debt, with little in the way of "new" issuance. This is expected to last for awhile, so the supply of munis is expected to contract, and some predict by a substantial amount. It's something to keep in mind. That could tighten yields down somewhat, even if rates rise. Last quarter's issuance was down sharply, which could foretell a trend. New York's issuance dropped by 18% to $36.4 billion, putting it in second place to California for the first time since 2010.
The role of social media continues to benefit me, and you, by allowing me to keep in touch with some of the leading institutional Fixed Income traders out there. Seasoned muni professionals have graciously shared research reports and information with me. One thing I feared when I went independent was the lack of working with other advisors who might have ideas to share. Technology has rendered that inconsequential. Aside from the fact I've worked alongside some crazy people, I now have the attention of market professionals who I can converse with almost any time. Again, they all must think I manage a few billion somewhere. But the professional courtesy I am extended is a wonderful thing, and much appreciated.
As long time readers know, I review regulatory progress with you. Every investor should be kept informed on this issue, and the good news is there's good news. I don't know if it was the election, (when the re-elected no longer had any use for industry largesse) or just the time it took to get the legal cases together, but a torrent of prosecutions and fines ushered in the year. Banks, brokerage firms and hedge funds have had their hands held to the fire. Massive fines for the banks- totaling over $13 billion for JPMorgan alone for assorted mortgage fraud were executed. Despite all the self congratulation by the SEC, many saw the $13 billion fine as a gift to JPM- they can expense most of it. It looks like JPM will settle for being Bernard Madoff's handmaiden in his fraud: $2 billion to skip a trial, and no public revelations. In addition to all this, the GSEs – Fannie and Freddie- have “put back” soured loans to many lenders, making them the banks' liabilities, not the taxpayer's. This undoes a good piece of injustice from the crisis. Profits from Fannie and Freddie have helped shrink the Federal deficit at the fastest clip since 1945, which shows, once again, that if the housing market and securitization process isn't abused, the system works wonderfully well.
Fines and convictions have become so commonplace, someone remarked that reading the Wall Street Journal was more like reading a police blotter than a newspaper. As of this writing, Bank of America is in talks with Freddie Mac over $1.3 billion worth of mortgage put backs. It's B of A's second trip to the woodshed with Freddie since the crash. Wells Fargo just took back $541 million in bad loans from Fannie. Insider trading convictions that DO carry prison sentences have been carried off. One estimate figures that the banks will have pay another $50 to $100 billion or so MORE in fines before all is done. In New York, the old insurance commissioner's office has been changed into one that also oversees the financial sector. This was an outgrowth of the AIG disaster- AIG was chiefly an insurance company under the control of an Insurance Commissioner, but it also traded derivative products, which meant no one agency had oversight, or knew what kind of risks they were taking. The Division is headed by one Benjamin Lawsky, which is not only the coolest name for someone in financial enforcement, he is one tough customer. Another breath of fresh air is the new SEC Commissioner Mary Jo White. Replacing a dead fish like Mary Schapiro (who also ran FINRA with the same incompetence and sloth as she did the SEC) is fairly easy by comparison, but it is clear she has little tolerance for the freewheeling risk taking and lack of risk disclosure that has gone on for years. Lastly is New York State's Eric Schneiderman, who is as tough as they come. The industry needed strong enforcement, and it's getting it. However, 2014 marks the point of the statute of limitations on prosecutions like these. Whoever got away with creating the crisis, now becomes untouchable. After all this, few actually went to jail, so financial types get different justice than executives at Enron, Tyco, Steve Madden, etc. The Volcker Rule- although modified so much, Volcker himself doesn't recognize it- was passed. This means no more gambling with client deposits, among other things.
As mentioned in last year's round up, the LIBOR rate manipulation scandal- which resulted in the mispricing of over $5 trillion in mortgage, debt and derivative products- has brought punishing fines, resignations, and disgraced executives. Some traders are due for sentencing in January. Other examples of outright market manipulation include Foreign Currency, Oil (which I have suspected all of my life, there being no correlation to price and supply) and precious metals. A lot of this took place in the EU. But it's beginning to dawn on even the industry's biggest apologists that these scandals are not exactly helpful to business- no one is going to come to a crap table when they know the dice are loaded. This harder line on enforcement is welcome, if somewhat belatedly, and in time, should put the fear of God into a business whose sense of self entitlement ruined investor confidence. All of the most "respected" or "old line" names in finance were caught and convicted: Barclay's, UBS, ING, Deutsche Bank, and of course, you know the domestic ones. People wonder out loud why Jamie Dimon still runs JPMorgan.
Fore the retail investor. here's another example of behavior that is tolerated:
In other words, if an “advisor” doesn't push the products with the highest margins for the firm, start looking for another job. It is interesting to note that “suitability” of an investment product is one of the most common offenses a broker can be tagged for. Of course, FINRA says nothing when the practice is institutionalized as it is here, the better to get the fines needed to support FINRA management salaries later on, when the brokers are punished for following orders. There is the germ of a movement to get FINRA decertified, and put the broker-dealer community under the supervision of the SEC. I support this wholeheartedly. FINRA is a cancer on the investment community. It's like the NCAA- it maintains the conceit it's a regulatory body, when it's main purpose is to enrich itself at the expense of the powerless people it supervises. Without irony, a headline came out last week from an article in the N.Y. Times: FINRA: Brokers May Not Be Able To Sell Things They Cannot Explain. But that's FINRA- any idiot can get licensed, and unfortunately, many do.
The rating agencies continue to provide amusement. Many clients will recall our investments in GMAC, now called Ally Bank, which was 70% owned by the US Government, and provided us with close to double digit yields in some cases. With the firm having simply been handed all of Chrysler Financial after the bailout for no money, auto sales hitting record highs, it's Subprime mortgage issues finally spun off, all legal issues settled, billions of high coupon debt either retired or replaced at less than half the debt service cost, Moody's has now deigned to put the firm on Credit Watch "Positive," but holding at their "B1" rating. Brilliant! Remember a few things about ratings: 1) they're usually stale, and credit quality can change quickly, well beyond agencies' ability to monitor it. 2) you can't tell the future by looking at the past backwards. 3) take advantage of this situation as the agencies fight tooth and nail to defend their turf and what little is left of their reputation. S&P is being sued for billions by the Feds over the AAA ratings they gave to junk mortgages taken out by unemployed hairdressers. They claim they're being persecuted. I think their lawyers are fools for even making such an utterance in public. (I'm being polite.)
Well, I hope I haven't bored you with this, but it's good to look back, think about things going forward, and communicate freely with you. Thank you, once again, for your patronage. Many of you have been with me for a long time, and these are indeed rewarding relationships. It's been a good year for the markets, and I hope the coming year brings nothing but good things for us all.
"I skate where the puck is going to be, not where it has been." Wayne Gretzky
Past performance is no guarantee of future results. This is not a solicitation or offering for the purchase of securities