A Threat to Global Economic and Financial Stability

January 29, 2010
There is an emerging real-estate bubble in China. Ultra-loose monetary policy in the U.S. and an over-the-top stimulus plan in China, coupled with a pegged yuan, have created optimal bubble conditions. BusinessWeek reports that in Beijing’s Chaoyang district, a typical 1,000-square-foot apartment sells for 80X the income of the average resident. Sound troubling? The Chinese leadership is concerned. Monetary policy is being tightened, and the government is reimposing a tax on home sales. A hard landing for the Chinese real-estate market is a real risk to global economic and financial stability. If China falters, there will be blowback across global financial markets. Is your portfolio protected? In my monthly strategy reports, I provide specific guidance on how to insulate your portfolio from global economic risks. If you are not already a subscriber to both of my monthly strategy reports, I invite you to join us by clicking here for Intelligence Report and here for Global Investment Strategy.

A Guide to 2010 Investment Returns

In 2010, the monetary policies of the world’s three largest central banks are likely to play a big role in the performance of global equity markets. The vast majority of the world’s wealth—close to 80%, by some estimates—is concentrated in the U.S., Japan, and the euro area. My chart shows that the GDP-weighted risk-free rate in these three economies is only 0.14%. A 0.14% T-bill rate would not be a concern if the global economy were still in free fall, but it isn’t. The global economy bottomed in the second quarter of 2009. The IMF projects that the global economy will grow by 4% in 2010. When a risk-free interest rate of 0.14% is being offered to investors who own 80% of the world’s wealth, and real economic growth is 4%, you can be assured that capital will flow from low-yielding, risk-free T-bills into risky assets that offer higher prospective returns. How and when the Fed, the European Central Bank, and the Bank of Japan remove policy accommodation will likely determine which markets perform best in 2010. If monetary policy is kept easy for too much longer, you are likely to see asset bubbles develop in the world’s fastest-growing economies. If monetary policy is tightened sooner rather than later, as it should be, look for a flight to quality trade.

Investing in an environment where returns are so dependent on monetary policy is most unwelcome. To invest successfully in such an environment, you want to invest for income or where an embedded secular trend is supportive of growth. Special situations, including distressed securities, which don’t always move in lock-step with broader equity markets, are another area to favor.

In Young Research’s Global Investment Strategy, we help subscribers navigate today’s difficult investment environment. If you are not already a subscriber please join us by clicking here.

Jeremy Jones, CFA, is the Editor of Young Research’s Global Investment Strategy and the Chief Investment Officer at Richard C. Young & Co., Ltd., Investment Advisors.

How to Boost the Yield on Your Portfolio

January 22, 2010
Punishing yields of 0.05% on three-month T-bills and .85% on short-term Treasury notes are devastating to the millions of investors who rely on income from their portfolios to fund living expenses. The temptation for many of these investors is to reach for yield. Some investors are loading up on long bonds. You can pick up an additional 3% in yield by moving into long bonds, but you also add an extraordinary amount of risk. If rates move up, investors in long bonds will get creamed. I’m talking about losses that dwarf what many investors experienced in the recent bear market in stocks. If long rates increase by just 1%, 30-year Treasury zero-coupon bonds would fall by 25%. If rates rise 2%, forget it-your portfolio is toast.

There is a better way to add yield to a fixed-income portfolio. Individual issue selection is the key. The idea here is to move down in rating and up in yield without sacrificing quality. You want to own a portfolio of both highly rated issues and those rated below investment-grade where there is tangible value to protect your principal in the event of default. In Young Research’s Global Investment Strategy, we recently recommended a five-year corporate bond with a yield of close to 7%, or 4% more than comparable treasuries. The bond is backed by a portfolio of some of the most valuable energy resources in North America. If you are retired or soon to be retired and are looking for ways to boost the income on your fixed-income portfolio, please join us. You can sign up for a three-month trial of Young Research’s Global Investment Strategy here.

The World’s Most Profitable Trade

January 15, 2010
In 2009, one investor earned more than the combined profits of Exxon Mobil, Microsoft, and Wal-Mart by employing a common Wall Street trading strategy-the carry trade. The carry trade is a strategy where an investor borrows money at a low rate and invests the proceeds at a higher rate. To make substantial profits from the carry trade, you have to use gobs of leverage. The investor I am talking about used leverage of more than 40 to 1-enough to make even Goldman Sachs blush. What investor in his right mind would use leverage of 40 to 1 so soon after the worst credit crisis in U.S. history? The Central Bank of the United States, of course. The Federal Reserve made over $52 billion in profits in 2009 by borrowing short and investing the proceeds in mortgage-backed securities (yes, the same instruments that almost destroyed the U.S. financial system) and Treasury securities.

The Fed borrows virtually without limit at close to nothing through the creation of currency and bank reserves, and invests the proceeds in high-yielding mortgage-backed securities and treasuries. The Fed earned a return on equity of 100% in 2009. There is not a more profitable trade in the world. There is also not a more risky strategy, but the risk is borne by you and me, not Mr. Bernanke. The Fed’s unprecedented move to lever up its balance sheet risks insolvency and runaway inflation. The Fed is an unaccountable and dangerous organization. I support Ron Paul’s calls to end the Fed, and I would advise every American to pick up a copy of Congressman Paul’s book, End the Fed.

Pull Your Head Out of the Sand

In a recent speech to the American Economic Association, Fed Chairman Bernanke offered his explanation of the causes of the housing bubble. Mr. Bernanke contends that easy money in the early years of this decade did not cause or even significantly contribute to the housing bubble. He also contends that the housing bubble was caused by a global savings glut and the growth in non-traditional mortgage products-option ARMs, Alt-A mortgages, and negative amortization loans. Mr. Bernanke ran through simulations and mortgage statistics, and he even broke out fancy equations. His explanation was very academic in nature.

But Chairman Bernanke has his head in the sand. His explanation of the housing bubble is naive. Of course, the growth in non-traditional mortgages contributed to the housing bubble, but this was a symptom of the Fed’s easy money policies. Investors and banks alike were being forced to take exorbitant risks to earn a decent return. Who would have bothered originating and investing in toxic mortgages if a decent return was available on T-bills? The banks likely knew what they were getting into, but they had been conditioned, based on 20 years of Fed policy, to expect an easy-money bailout as soon as things started to get ugly. And look where we are today, back on the easy-money train. There has been more pain in the banking sector during this crisis than during the last, but banks were once again bailed out. The Fed chairman does not fully appreciate the dangers of ultra-loose monetary policy. We need hawks at the Fed, not ostriches.

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Jeremy Jones, CFA, is the Editor of Young Research’s Global Investment Strategy and the Chief Investment Officer at Richard C. Young & Co., Ltd., Investment Advisors.

Harry Reid’s Resignation?

January 8, 2010
While today it appears probable that Senate majority leader Harry Reid (D-NV) will be defeated in his 2010 bid for reelection, an increasing number of Americans must in fact want to see Senator Reid resign. The Senate health-care bill transfers massive regulatory power to the federal government, erects massive federal controls over private health insurance, dictates the content of insurance benefits packages, reduces many seniors’ access to Medicare benefits and services, provides federal funding for abortion, and increases the Medicare payroll tax for individuals making $200,000 and families making $250,000 per year. The Reid Senate bill at its heart restricts the personal and economic freedom of each and every American. The bill is clearly unconstitutional and will meet a Supreme Court test if passed. See the Heritage Foundation’s concise “Backgrounder” executive summary of the Senate Democrats’ health-care bill. It’s right on the money. The Barack Obama-led Radical Progressive Movement champions the socialist content of both the Senate and House bills. You may enlighten yourself more completely by delving into the conclusion, entitled “Priorities for Action,” of a borrowed copy of Robert Creamer’s Stand Up Straight. Every member of the House and Senate voting to approve this radical progressive blueprint of income redistribution and restricted personal and economic freedom must be voted out. And Harry Reid leads the list. The TEA partiers will carry the message forth to the people as a massive changing of the political guard gets underway in 2010.

Investment of the Decade

Trust has been kicked to the curb by Washington and Wall Street. Not a smart move, as the former prepares for mid-term elections and the latter feels the effects of investors voting with their feet. Many clients and brokers have fled the big Wall Street firms for independent advisors. Washington and Wall Street may realize too late that trust is a terrible thing to waste.

The bailout of Bear Stearns, Lehman’s bankruptcy, the controversial merger between Merrill Lynch and Bank of America, and Citigroup’s near collapse had little to do with their client brokerage accounts. In fact, brokerage accounts seemed to have been forgotten pre-crash, since as much as 50% of revenues for some of these firms came from trading in their own accounts, not the accounts of their clients.

Brokers are leaving and taking their clients with them. The reasons are obvious: concerns about their firms’ futures and their employee stock options, which have cratered. Boston-based research firm Cerulli Associates projected that brokers leaving major firms would take $188 billion in client accounts to independent advisors in 2009.

Individual investors aren’t stupid, and have moved on, tired of wondering if their brokerage firms will be in business tomorrow. “Financial statements from the biggest brokerage firms, including UBS AG and Bank of America Corp.’s Merrill Lynch Wealth Management, show a collective net outflow in 2008 of about $20 billion in client money, counting both money removed by departing brokers and money withdrawn by clients whose brokers didn’t leave,” reports The WSJ.

In the three years ending in December 2008, the number of brokers serving individual clients at major firms fell by 14% while the number of independent advisors rose by 29%. Brokers want flexibility in their product offering and not pressure to sell from a menu of products pushed by the firm. And advisors’ clients take comfort in the fact that advisors are held to a higher fiduciary standard, not just the suitability standard to which brokers are held.

In the last decade of the 21st century, the Dow lost 9.3%. This was the worst decade for stocks since the 1930s. Bonds were the big winner as treasuries (10-year total return index) were up 85.4%. Gold was up 279.6%, and the dollar (J.P. Morgan dollar index) lost 12.8%.

Anyone who thought a balanced portfolio was boring may want to look at the numbers of Vanguard Wellesley-my winner for the investment of the decade. It has a 10-year average annual compound return of 7%-a compound rate that doubles in just over 10 years.

Over the past 52 weeks, Wellesley is up 16.88% and currently offers a yield of 4.38%. Young Research’s Retirement Compounders program, which includes 32 dividend-paying common stocks, was up 30% in 2009 and currently yields 5%. At our family investment company we are laddering corporate bonds, keeping maturities short, and buying through Fidelity’s institutional desk. We like Vanguard’s Short-Term Investment-Grade and GNMA funds. For simplicity, I recommend investors not working with an advisor stick to bond funds . We own gold through the SPDR Gold Shares (GLD) exchange traded fund, and other commodity names probably not found in a fund like Wellesley, so make sure your portfolio is counterbalanced.

Bonds face a serious headwind, with rates less than zero when factored for inflation. Ironically, as of November, $4 billion was withdrawn from stocks, and $285 billion was added to bonds. Is there any doubt how investors feel about this environment? Ultimately, 2010 is the year of trust: trust in who you vote for and trust in who you invest with. Wall Street and Washington may find it is a terrible thing to waste.

E.J. Smith is Managing Director of Richard C. Young & Co., Ltd. an investment advisory firm managing portfolios for investors with over $1,000,000 in investable assets.