We have chronicled the damage that Bernanke’s pursuit of QE and near-zero rates have done to savers. Mainly, we’ve focused on short-term implications for those investors who rely on their savings to create income for immediate consumption. But what about the folks who are looking at the pie charts and the promises of over a millions dollars in retirement income? Ah, the powers of compounding. Yes, I have in front of me the literature from 2 national financial service firms that strongly suggest that you too can retire a millionaire for as little as $60/week. Of course there are no guarantees, but the details and assumptions to this rosy scenario on steroids are buried in fine print that you’d need an electron microscope to read.

The obvious conclusion most people draw is that interest rates fluctuate and the phenomenon we’ve witnessed over the past year or so will be transient and eventually higher rates will cycle in and restore the cash flows of fixed income investors. After all, that is what has always happened before, right? Not so fast. There are a couple of reasons to believe this won’t happen anytime soon.

As the graphic below outlines, the Treasury Dept (including debt service) is the third largest line item in the actual FY 2009 budget, at over $700 billion. According to Treasury Direct, the interest paid on the national debt in FY2009 was around $383 Billion. This constitutes an average interest rate of just over 3.1%. Doing a little projecting, if the deficit runs at the estimated $1.5 trillion for FY 2010, the Treasury will need to pay out an additional $431 Billion to service the debt assuming the same 3.1% average interest rate. If early results mean anything though, the amount might be much higher. In the first four months of FY2010, the Treasury has already paid out $164 Billion in debt service, which is setting a pace for nearly $500 Billion. For FY2009, tax revenues were $2.211 Trillion and interest payments on the debt ate up 17% of tax receipts. If the current trend in FY2010 continues, debt service will gobble up around 22% of tax receipts by the time the fiscal year ends next September 30.

While 17% doesn’t sound too bad, think about paying nearly 1/5 of your net income every year to credit card companies. Not a real appetizing thought, but certainly this application of sanity couldn’t apply to the federal government.

The Problem

The problem here lies in the fact that the national debt is forecast to increase dramatically in the next 10 years. Estimates range anywhere from $18 to $23 Trillion depending on whose forecast you’d like to use. Let’s use $18 Trillion as our test case. At this level, assuming an average interest rate of 3.1%, debt service by 2019 will cost around $558 Billion per year. If tax revenues don’t change, debt service will eat up 25% of tax receipts. The conclusions that can be drawn from this simple analysis are pretty clear. If the government intends to provide the same levels of service on entitlement programs and maintain other government spending, the deficit will need to increase each year just to accommodate the additional debt service. This is called a spiral. It is akin to the family taking cash advances on a VISA to pay off Mastercard. I am sure there are many who will disagree with this rationale and call me all sorts of vile names for suggesting that we’re spending beyond our means and that somehow this really isn’t a good thing. Unfortunately, in reality, this situation is actually worse than the above paragraph indicates for a second, less publicized reason.

Artificial Interest Rates

Let’s start at the beginning here. Interest rates are payments given to lenders of capital for the privilege of using their money for a period of time. At a very minimum, the interest rate should ensure that the lender’s purchasing power doesn’t diminish due to making the loan. In other words, at the very least, interest rates must equal inflation. Such a situation is generally referred to as ‘free money’ since the lender isn’t actually being compensated for the loan in real terms.

When discussing the federal government and its inclination to spend beyond its means, interest rates are a very important topic at the US Treasury, as they should be. This is one of the reasons why government officials, Fed chairmen, and the absentee press generally try to temper inflationary expectations. If lenders expect inflation, then they’re going to want to see higher interest rates.

I have argued for several years now in this column that inflation in the US is grossly understated, and that it is done for both political expediency and out of absolute necessity, especially in an era of ballooning government debt. John Williams at shadowstats.com estimates (using previous BLS methodologies) that price inflation in the US is currently around 6% per annum. If we had free market interest rates, we would expect the yield curve to start somewhere around 7%, assuming John’s numbers are accurate, and there is no reason to believe that is not the case. It is very easy to see the implications this would have for debt service.

Let’s assume for a moment that under a free market interest rate environment, the US Government could achieve an average borrowing cost of 6.7%, allowing for a similar spread between price inflation and the mean interest rate as what we observe now. Debt service in FY2009 would have been $831 billion and devoured 38% of tax receipts. In 2019, using the same assumptions as previously mentioned, debt service would be $1.2 Trillion and eat up a whopping 55% of tax receipts. I understand there are many assumptions made here, many of which might fluctuate over the period, but the goal of the exercise is to make the simple point that the US cannot afford market interest rates.

It should now be easy to see why inflation is consistently understated, and why the FOMC and its minions are quick to temper inflationary expectations. While that might work to a limited extent when dealing with the general public, does anyone think for a minute that investors around the world don’t know what is going on here? Most of them are doing the exact same thing, albeit to a lesser extent, so you can bet they do.

In Conclusion

Many might look at the above analysis and wonder why it is any big deal. Keep the rates buried at near zero and we can keep getting ‘free money’, right? The problem is that mispriced capital leads to misallocation of the same. The gross misallocation of capital is one of the main ingredients of the ongoing financial crisis. It was willfully done by the Fed previously and it is being done again. These actions will virtually guarantee more misallocation of capital, more bubbles, and more unpleasant results. For savers, the news continues to be bad. We have demonstrated why it is in the government’s interest (a necessity really) to keep rates as low as possible. That means a continuation of the ridiculously low money market, CD and savings account rates. No doubt the pie charts referenced at the top of the essay will need some changing; it seems someone’s taken a few slices away.

This Week in the Markets

US equity markets are getting hammered early this Thursday morning on news that first time jobless claims jumped to 496,000 last week. First time claims have been trending upward over the past few weeks. Yesterday, new home sales put in the worst performance in the history of the data series. This despite the extension of the tax credit program for first-time (and now other) homebuyers. Bad weather was blamed for much of the sour performance. It seems recently the weather is getting blamed for any data point that isn’t in line with the ‘slow but steady recovery’ mantra being put out by the establishment. Oil is back at the $80 mark after being beaten down over the past couple of weeks. On the demand side, petroleum product demand appears to be bottom bouncing; any serious increase in demand will be bad news for consumers at the pump this summer. Forecasts are already in for an average pump price of $3.25-$3.50 this summer.

The Dollar – The Ultimate Opportunist?

It should not be lost on even the most casual of observers that the US Dollar is dead. How can I say this when it is in the middle of yet another ‘rally’? And aren’t the folks in Washington telling us how strong the Dollar is more and more vapidly and with greater frequency? The fact of the matter here is that the Dollar has, for quite some time now, not been able to rally itself based on its own merits. Remember that currencies are essentially a zero-sum game. Their value is measured in terms of other currencies. One goes up, another must go down. Taking a look at recent Dollar rallies, they’ve happened essentially because bad things have happened in Euroland or elsewhere, whether it is the latest debt crisis with the PIGS (an unfortunate acronym, but who wants to be called a BRIC anyway?) or the massive liquidation of 2008. These were not exhibits of the Dollar’s strength, but rather of a mental model that still hasn’t adjusted to the fact that the Dollar’s run is over. Add to that the lack of an available substitute and voila – instant dollar ‘strength’.

Think of it this way: if our currency were strong for fundamental reasons, say for example gold backing, genuine budget surpluses free of accounting chicanery, trade surpluses, and similar positives, then countries wouldn’t be sneaking around backrooms around the globe forging agreements to sidestep it. Foreigners wouldn’t be twisting their brains trying to figure out how to get out from under their pile of US Treasuries without upsetting the apple cart. Put mildly, a wheelbarrow full of plutonium would be received better in most financial centers these days than one filled with US Dollars.

Beware of Greeks bearing Debt?

If anyone here in the US still has doubts about what ultimately happens when a nation abuses credit and engorges itself with debt, all they need to do is look at Greece. The small Mediterranean nation needs to raise about $73 Billion in new money this year. While that seems like a mere pittance, it constitutes about 20% of Greek GDP. Greece also faces bond redemptions of $8 and $9 billion in April and May respectively. While Greece has by far the worst debt problem (at the moment) in the EU, it doesn’t stand alone. Portugal, Italy and Spain are also having issues of their own and the whole mess is threatening Euro stability, and by function helping the US Dollar.

These are real problems for sure, but what is amazing is the continued complacency by media and policymakers alike when it comes to the US and our debt levels. Our level of official borrowing will tally around 12% of GDP in 2010, however, if you look at the GAAP deficits and the resultant borrowing, it is always much higher than advertised. There is an important distinction to be made between Greece and the US, however, and that is the fact that Greece is essentially a hostage of the European Central Bank where the USGovt has a bank willing to issue as much rope as we can possibly need to hang ourselves. We’re hostages of the Fed, but most people aren’t easily inclined to look at it that way. We’ve been trained to believe that when we run deficits we’re borrowing from ourselves. Back in the era when we used US savings bonds to fund government activities, there was at least a modicum of truth to that. However, since we’ve gone overseas and to the internationally-owned Fed for more and more help, we’ve been slowing ceding our national sovereignty to foreigners much in the same way Greece et al have given themselves over to Brussels.

This is why every freedom-loving person should have a healthy fear of global central banks and even regional currency blocs. The very survival of the PIGS now rides on the whims of Merkel, Sarkozy, and Trichet. Flashback to the weekend of September 13th 2008 when Lehman Brothers here in the US was in the same shoes as Greece is today and then ask yourself how much we’ve really learned over the last 18 months. This is what happens when you globalize and intertwine the fortunes of nations and then base it on the fraud of a fiat currency system, the casino mentality, and a healthy dose of public ignorance.

So now the Europeans are left in a pickle. They have to come up with the right words to soothe the markets. They’ll need to offer words that promise all sorts of coordinated actions and large applications of money while actually doing nothing because they can’t afford it. Their economies are now stumbling out of recovery because there never was a recovery, just a shell created by inflation and debt.

America should take heed. It was easy to ignore when it was Argentina, Zimbabwe, and Iceland. However, we’ve done the same thing here. Our government believes that borrowing and saber rattling will force the economy to grow. Europe is the latest shining example of the utter failure of such thinking.

]]> http://www.sutton-associates.net/blog/2010/02/12/club-med-and-the-dollar/feed/ 0 http://www.sutton-associates.net/blog/2010/01/28/keeping-your-options-open-and-valuing-them/ http://www.sutton-associates.net/blog/2010/01/28/keeping-your-options-open-and-valuing-them/#comments Thu, 28 Jan 2010 14:51:07 +0000 TwoCentsEditor http://www.sutton-associates.net/blog/?p=352 It is often said that there is nothing new under the sun. Truly, economic events of late have demonstrated this in spades. There is little that is new, just different flavors of the same. So, in the absence of anything substantially new to add to the collection of events this week, I am going to take an opportunity to return to some of the analytical topics that I’ve had but a few precious chances to deal with over the past three and a half years. The last foray dealt with some hedging strategies involving options and inverse funds. This week I’m going to dig deeper into the options side of hedging and look at some of the various pricing models available for consideration. Then we’ll take the models for a spin and create ourselves a hypothetical situation and see how things play out.

As previously discussed, options can be used to hedge portfolios against moves that are contrary to that portfolio’s orientation. For example, buying put options can be used to hedge a portfolio that is on the long side of the trade. Oppositely, buying calls can be used to hedge a portfolio that is primarily focused on the short side.

The difficulty in assessing options is figuring their value at a given point in time since they lose part of their extrinsic value as their witching (expiration) day approaches. Fortunately, there are a couple different models we can use to make quantitative predictions.

Binomial Option Pricing Model

The Cox, Ross, and Rubenstein Binomial Model is probably the simplest of the mainstream models available, and is flexible in that it works both on options that can be exercised over a period of time such as American options, but also on options with specific exercise dates such as Bermudan options. The model is built on the simple assumption that a stock can move in one of two directions in a given time period. The price can move up Su with a probability of p or it can move down Sd with a probability of (1-p). The figure below shows 3 generations of such binomial possibilities at each stage. Once the binomial lattice is constructed, the probabilities at each time point can be calculated at various standard deviations from the mean.

When pricing options, it must be considered that you’re really dealing with several axes; the first being the price of the underlying asset as it compares with the option’s strike price and the second being the time factor. Let’s look at some other models, and then run a few live examples.

Black-Sholes Option Pricing Model

The Black-Sholes Model applies to equities whose price follows Geometric Brownian Motion or a stochastic price process. For simplicity’s sake, the prerequisite for using the model is price action characteristics that are often observed in financial instruments such as equities.

There are several assumptions that the Black-Sholes model makes, some of which are not able to be met in the real-world investment environment, but similarly to the notion of the perfect competition / pure monopoly continuum, such constructs can be valuable despite the fact that they are seldom achievable in their purest forms.

• Borrowing can happen at will at a constant and known risk-free rate.

• The price follows a Geometric Brownian motion with constant drift and volatility. (This is extremely rare in our markets)

• Transaction costs are set to zero.

• There are no dividend payments to navigate. (Dividend harvesting strategies often upset predictable Brownian motion)

• All securities are perfectly divisible. (Fractional shares such as in a DRIP type setting are available)

• There are no restrictions on short selling.

• There is no opportunity for arbitrage.

There are several variations of the Black-Scholes model; one that deals strictly with the price of the equity security, and a partial differential equation (PDE) that deals with derivatives of an underlying equity. While the formula is shown only for reference purposes, the general idea is to understand that one can use this modeling process to estimate the value of the derivative security (in this case an option) at a specific known point in time.

Bjerksund-Stensland Model

This model comes in handy if you happen to be dealing with options whose underlying securities pay dividends. It is a hybrid of the Black Model, the Black-Scholes Model, and the Garman-Kohlhagen Model. However, there are still some assumptions that are not realistic. The model depends on constant dividend yields, discrete dividends, and continuous dividends. While there is a negligible amount of securities (if any) that fit these assumptions entirely, the model has through repeated study shown itself to be more accurate than the Quadratic Approximation Formula in nailing the value of long-dated options.

I mention this model due to its applicability to dividend paying stocks and its affinity to long options for those interested in using it for analysis of LEAPS options.

Exercises

For the purposes of this piece we’re going to run two simulations; one with the Diamonds as our core investment and a single protective put option and the second (also with the Diamonds) using what is known as a Butterfly, which actually involves buying two options and selling a third. We’ll see how the various strategies predict gains at different price levels a year from now according to the three aforementioned models.

Let’s list our assumptions for the first exercise:

-We’re going to buy 1000 shares of DIA

-We’ll buy 25 puts on DIA, which expire on 12/21/2012 with a strike price of $90.

-We will setup our price point analysis as follows:

$140.00 (assumes the Dow makes a new high – bullish case)

+10%, live, -10% of today’s price

$65.00 (assumes a retest of 3/6/2009 lows – bearish case)

-Interest will be set to the “risk-free” (sic) rate of 4.56%, which equals 30-year Treasury Bond yields on 1/27/2010.

-We assume the trades are made today at market prices and we’re looking at P/L one the trades one year from today.

Here are the results:

Black-Scholes Model

Binomial Model

Bjerksund-Stensland Model

What all three of these models are telling us is that the best way to make money with this setup is if the Dow moves big in one direction or the other. If the Dow maintains the status quo and stays within +/- 10% over the next year, this allocation will lose money. The tools are predictive, but the user has to provide the assumptions. If you have a strong belief that the market is going to go down and retest those March 2009 lows, then you can use these models to build yourself a hedging program and then predict the results of such a program. You can tweak the variables, interest rates, etc as well. You can even add additional positions and see how the scenarios play out. This is one of the techniques that we’ve used over the past few years to mitigate periods of market downturn in our newsletter’s portfolio model.

Changing the Strategy

Obviously the first exercise provided a significant amount of risk and depended greatly on us being right in our prediction. If we’re wrong, we could lose a significant amount of money. Clearly there has to be a better middle ground; and there is.

Let’s change up the variables a bit and see if we can’t get something a little more balanced. For this comparison, we’ll use what is known as a Butterfly. Essentially what a Butterfly does in our case is purchases 1000 shares, buys 10 puts at $100 strike price, buys 10 more puts at $80 strike price and sells 10 puts at $90.

Let’s look at the results; again. We have added some price levels between the $65 and the $92 range to give a better illustration, however, all computational variables are the same as before.

Black Scholes – Butterfly

Binomial – Butterfly

Bjerksund-Stensland – Butterfly

Obviously the butterfly strategy worked very well in terms of smoothing the returns across a wide variety of prices. Keep in mind in both cases we were working with around a $100,000 corpus of capital and limiting the action to +/- 1% is especially beneficial if that capital happens to yield more than the Diamonds and you’re collecting significant dividend income.

So, depending on your intentions and purposes, you can either use your option strategy to make a bet on the overall direction of the market and try to make a profit off of it or use an option strategy that allows you to collect dividends without worrying so much about a major market downturn diminishing the value of the underlying assets.

Some Potential Pitfalls

If you decide to investigate any of these types of strategies, you are going to want to keep your eye on a few things:

1) Does the derivative security appropriately represent what it is you’re trying to protect? For example, in our newsletter’s model portfolio, we have 21 dividend producing assets. Obviously, creating a butterfly strategy might be to our advantage. Not all of our components are equities, and many don’t have option chains so we’ll need to find something that does. But what options should we use? Using the Diamonds puts discussed above might work IF the relationship between my portfolio and the Diamonds is somewhat analogous. If it isn’t, then I might not end up where I should be even if the models happen to be spot on. The importance of this issue cannot be emphasized enough.

2) Use options that come from well defined option chains and are not thinly traded whenever possible. If you are working with an option that has just a few hundred contracts of open interest and low volume, authentic price discovery can be a problem because of wide bid/ask spreads. This is not to say it is impossible if the options are thinly traded, but it makes life more complicated.

3) The options pricing models are not always correct; especially in times of acute distress in the markets since the normal Brownian, stochastic oscillations of securities are disturbed and therefore, a portion of the predictive value of the models is lost.

Conclusions

It must first be pointed out that you don’t need fancy trading platforms or expensive financial software to use these models. While it is exceedingly complicated to do the calculations manually, there are websites on the Internet where you can download Excel Macros and add-ins that will allow you to enter the parameters and the custom software will do the rest. Go to your favorite search engine and key in the name of the model you’re interested in and you’ll quickly find a plethora of potential solutions.

We have presented two approaches to hedging, both with options and with drastically different results. For our purposes here at the firm, the Butterfly strategy obviously makes a lot of sense since a growing portion of our work centers around income investing. Being able to mark time with capital while raking in stellar dividend income is obviously something every fixed income investor would like to be able to do. In this era of near-zero interest rates, which just got stretched out by at least another month by the Fed today, it is not always an option to bail out of a sick market, especially when the income is needed to finance someone’s standard of living.

Framing the Discussion

Once again it becomes necessary to properly define terms and concepts since failure to do so will almost certainly result in the forthcoming analysis being misconstrued.

The establishment of the corporation as an ‘artificial person’ by the Supreme Court in 1819 was used to give the corporation (an assembly of individuals of indeterminate size) certain rights that were normally reserved for individual people or ‘natural persons’. For example, a corporation can enter into contracts, file suit, and be sued. Corporations can even be charged with and convicted of criminal offenses, although generally, criminal charges often pass through the corporate veil to members of management as well. The corporation as it were cannot commit a crime of its own volition, but only by the action or inaction of someone entrusted with making decisions for it. One right that has not been conferred to corporations is the right to physically vote in political elections, however, corporations have been able to financially support political candidates for quite some time now.

Until the mid 1800’s, the government issued all corporate charters, and the applicant had to demonstrate that what they were doing or proposing to do would be in the public interest (a novel idea). How many corporations today do you think would fail this acid test? Even in the era of the public interest doctrine as we’ll call it, there were many folks including Andrew Carnegie and John D. Rockefeller who sought to skirt the public-interest doctrine by organizing as limited partnerships or Trusts.

The Issue

At issue for the Supreme Court to decide was a 20-year old ban on corporations and labor unions providing money for campaign advertising. The Supremes took it a step further and also struck down part of the McCain-Feingold campaign finance reform law that banned corporate and union-paid ads in the closing weeks of political campaigns. While on the surface, this looks like a victory for the First Amendment; I think it does little more than pave the way for corporations to buy even more politicians; and to do so under the protection of the law.

The entire issue comes down to the corporation as a person. Is the corporation entitled to all the same rights as a natural person? The very fact that the Supreme Court in 1819 designated corporations as artificial persons rather than natural ones indicates that they are not. Keep in mind that the spirit of corporate law is largely centered on limited liability, not enabling the corporation to wield disproportionate power in the political process (which arguably was already happening anyway). Take our largest corporations, with billions of dollars in quarterly profits. They are generally controlled by a Board of Directors and major shareholders; the number of which is comparable to those in attendance at a typical Little League baseball game. It is naïve to think that the American people can muster as much financial influence in Washington as even one large company, let alone all of them. The bottom line here is that a corporation is a creation of man and is not entitled to all of the same rights that are imbued in us by God. The framers of the Constitution, following along this line of reasoning, focused the founding documents on individual liberties rather than commercial ones.

Detractors of this line of thinking will accuse me of being hypocritical because on one hand I urge government to get out of the affairs of business, yet on this issue I encourage it to do the opposite. To reconcile these two disparate positions, one must understand the intended purpose of government. Our government was designed to protect the rights of the individual and to prevent people from running roughshod over each other. With that in mind, it would stand to reason that government shouldn’t be telling firms the maximum amount they can pay employees. It shouldn’t be bailing those companies out when they fail either. But it certainly should be preventing companies from stampeding the American people by making the electoral and legislative processes available to the highest bidder.

In conclusion, it is my opinion that what happened yesterday was misconstrued as being a First Amendment issue when it really is an issue of equal protection. Granted, groups like the NRA and other issue-specific groups have been shut out of certain political advertising in the days leading up to elections. That is wrong because those groups are speaking (hopefully) on behalf of their members as a cooperative. A corporation really can’t make that claim at the same level. The White House immediately issued a statement decrying the ruling, and although I agree in this instance, it must be pointed out that every single President in the corporate era has gotten money from corporations for their campaigns. That generalization can be extended to nearly every other political office in the country as well. The bottom line is that this activity was already going on anyway, but now the way has been paved for it to accelerate and increase in magnitude.

Yesterday’s ruling will allow corporations to dump unlimited funds into the coffers of political candidates and overtly buy the legislative process, using the government as a tool to enrich corporate bosses. It is easy to see why the power elite who controls the major corporations was most dissatisfied with the public interest doctrine in place in the 1800s. They greatly prefer that their companies be held to the doctrine of shareholder interest since any action that increases shareholder value is deemed appropriate and acceptable even if it encroaches on the rights of other citizens. Make no mistake about it; the government has already largely been purchased by the highest bidder. Yesterday’s decision legitimizes this previous illegitimate activity and gives the green light to a complete takeover of our government by large corporations.

I’d like to close with two quotations by Thomas Jefferson:

“Experience hath shewn, that even under the best forms of government those entrusted with power have, in time, and by slow operations, perverted it into tyranny.”

“I have the consolation of having added nothing to my private fortune during my public service, and of retiring with hands clean as they are empty.”

However the news is not all bad. As I chronicled in the first piece of this series, there are ways to find income – even in this environment. And contrary to the popular investing misinformation you don’t have to take on a boatload of risk to get it. The goal of this essay is to discuss in generic terms some of the methods I’ve used to find income over the past few years and introduce one of the more obscure income vehicles for those investors who might be interested in a little risk. With CD rates still in the basement, and investors in US Government bonds losing 3.5% in 2009, most people are probably looking for some new ideas to make money in our brave new financial reality.

Preferred Stocks – A Well-Kept Secret?

If you’re willing to spend a little time doing research, you will find literally hundreds of preferred stocks from food companies to manufacturers to financial and insurance companies. Many are eligible for 15% tax treatment making their comparative yields even higher. Speaking of yields, they will vary greatly based on both the type of company offering the preferred stock, the rating, and the supply and demand dynamics for the security. The following is not meant to be an inclusive, exhaustive description of all the characteristics of preferred shares, but is intended to provide some basic information about preferred shares to frame the discussion.

Preferred stocks are really a hybrid of common stock and bonds. Preferred stockholders generally don’t get voting rights in company matters, but are first in line for dividend payments. Some are cumulative some are non-cumulative. Cumulative preferred shares accumulate dividends in the event payments are suspended for any reason. In the event payments are reinstated, preferred shareholders are paid first and they’re paid for any dividends accumulated during the payout stoppage. The preferred stocks of major companies are generally listed on exchanges, but there are also many that are available Over-the-Counter (OTC).

Preferreds are like bonds in that their stated yield is based on the face value of the stock. For example, a preferred that pays $1.00/year and has an face value of $25.00/share would have a yield of 4% and be designated as such. If you discover this stock a year later at $26.00/share and buy it, your yield based on the purchase price would be a bit lower at 3.85%. Conversely, if you buy in at $24.00/share, your yield would be higher at 4.17%.

Two ‘Preferred’ Model Portfolios

Let’s look at two ‘model’ portfolios. These have been constructed over the past few years when it became obvious that we were heading into a period of near-zero rates due to the Fed’s propensity for putting the liquidity hammer to the floor.

The first consists of just 4 issues – all preferred stocks of utility companies in equal proportions:

Due to the fact that one of the components was only issued less than 2 years ago, we only have that period of time to compare the model to the benchmark S&P500 and Dow Jones Industrials. From a risk and volatility perspective, the model comes in with a standard deviation of 12.82% while both the Dow and S&P comes in at nearly twice that with the S&P at 23.87% and the Dow at 24.32%. In terms of return, the Dow and S&P both lost around 7.5% annually for the period while the model gained nearly 9% annually during the same time. So to frame the comparison, the model beat the indexes by roughly 33% with about half the volatility during the worst financial crisis in recent memory. The chart below graphically displays the returns:

Admittedly, during the ongoing bear market rally, the indexes have beaten the model soundly, but remember the purpose of the model – income. The model yields just over 6%. The charts above show that the model did an excellent job of protecting capital while providing stable income. And it was done with very little in the way of volatility except for a 2-month period in late 2008 when the globe’s financial system stood on the precipice. It must be noted that many investors have chosen to use this type of investing strategy for growth as well, opting to use their cash distributions to purchase more shares. Compounding at 6% sure won’t win many awards on CNBC, but in the real world where people are trying hard to protect their savings, it is a valid construct to consider.

Let’s now take a look at a second model: one that has a bit more history behind it. It consists of 2 utility company preferred stocks, a telecom preferred, a no-load special purpose mutual fund, and a preferred stock ETF – in equal proportions. As a general rule I don’t favor mutual funds because of excessive fees, confusing sales charge structures, black-box management, and high expense ratios, but there are a couple of funds that exist for a single purpose, don’t have the other detriments listed above, and as such are suitable for inclusion in portfolios.

Much like the first model, this one has a much lower volatility than the benchmark S&P/Dow. Annualized Std Deviation is 9.44% compared to 22.01% for the S&P and 22.57% for the Dow. On the return side of the ledger, the model provided an annualized return of 7.02% while the Dow and S&P were both around -9%. The data on this model goes back to August 2007 – before the market’s top. The chart below graphically illustrates the comparison between the model and the benchmarks.

The cumulative return for the model was 16.94% over the 2.3-year period as compared to a loss of 20.44% for the S&P and a loss of 19.74% for the Dow. The model beat the benchmarks by 36% on average yet sported less than half the volatility of those benchmarks.

There are countless other combinations that can be explored. These two models were focused on utilities. Truth told, we construct similar models across a variety of industries that would perform similarly, and in fact do so on a regular basis to provide effective portfolio diversification.

ELKS – Hidden Income or High Risk?

A rather obscure income vehicle that generates high levels of income, but unfortunately, also carries significant risk is the ELK or Equity Linked Security.

ELKS are derivatives of the first degree in that their performance is directly linked to that of an underlying security – usually a stock. The main selling point of ELKS is that they generally sport much higher distributions than the underlying shares and mature in a year.

So what’s the catch? Terms will vary depending on the particular issue, so you will want to be sure to read and thoroughly understand the prospectus before clicking the ‘Buy’ button. The size and nature of the principal repayment for an ELK is linked to the share’s performance during the time period before the ELK matures.

Let’s say for example you purchased an ELK that was linked to Company ABC’s stock. Let’s say the ELK was issued when the price of the shares was $20/share. The ELK might be structured that you will receive back 100% of your principal (plus the distributions, which are received regardless) if the price of ABC’s stock is at all times at least 90% of what it was when the ELK was issued. In this case, you will want ABC’s stock to stay above $18/share. If this condition is not met and the stock drops below $18 (even before maturity), you will receive a pre-determined number of shares of ABC stock for each ELK you own as opposed to your principal in cash.

Sounds like a rip-off doesn’t it? Not necessarily. Let’s say you really wanted some shares of ABC stock because they pay a solid dividend. You buy the ELK, collect the enhanced dividends for a year, and if the stock does drop below the threshold, you have your shares. If not, you have your cash and a stellar return and can go share hunting later or buy another ELK. If this is your intention, then make sure you’ll be adequately compensated in shares in the even you don’t get your principal back in cash.

There certainly are drawbacks. First, ELKS are issues of Citigroup Funding, Inc. and as such you are dependent on Citigroup’s solvency for your payments. Right now no one seems to be concerned about bank liquidity, but that is likely to change moving forward. Secondly, due to the structure of the ELKS, there is an incentive for Citigroup to issue ELKS for those shares it holds in its various dealer accounts that it wants to unload and has a belief will go down during the time the ELK is active. This may not be true in every case or even at all, but it needs to be mentioned regardless. That is why, as a general rule, I don’t consider ELKS unless I’m interested in owning the underlying shares because ending up with them is a very real possibility. Another drawback is that if the price of the underlying shares skyrockets, you don’t get to participate fully in the move. You just collect your distributions, and then your principal at maturity. Obviously, if the underlying shares tank, as can happen, you could theoretically end up with shares that are worth much less than your initial payment for the ELK – even with the distributions included.

From a taxation perspective, ELKS are often subject to favorable tax treatment. First, part of the distribution payments are considered as option premium payments and as such don’t need to be declared until the ELKS mature. So you get deferred tax status on a portion of your distributions, which is nice. Secondly, if the price threshold is broken and you receive shares instead of your principal at maturity, then the portion of the payment associated with the distribution (treated as an option premium) reduces the stock basis and isn’t counted as income.

In conclusion, it is possible to find income in this environment without taking on inordinate amounts of risk. Granted, preferred stocks and ELKS carry more risk than a bank CD, but given the graphs shown above, the two models registered little more than a slight bump during the worst crisis in 100 years yet outgained CD’s by several fold. ELKS are a bit more complicated and carry some additional risks, but the potential rewards are commensurate with those risks. Investors should always seek a thorough understanding of the nature of any investment and consult with a qualified adviser before making any investment decisions.

What does this mean? It means more reliance on foreigners for everything from food to fuel, to consumer trinkets. It means larger trade deficits (since you can’t export government – although it would really be nice to export the whole doggone thing right now!), and further pressure on the US Dollar.

However, there is a new twist this year. Retailers are crying the blues for some different reasons. First and foremost, according to many industry groups is the fact that credit card companies are cutting limits and turning down applications as they prepare for provisions of the new CARD Law regarding their conduct to take effect next year. According to America’s Research Group, nearly $9 Billion in holiday sales are in jeopardy because of these actions.

Consumer Credit Contraction

In fact, the availability of consumer credit has dried up significantly in the past year, down to $3.6 Trillion from $4.7 Trillion; a decline of over 23%. During this same period, consumer credit outstanding (the amount of the aforementioned credit actually deployed) has dropped over $92 Billion. This has been the first such drop in the history of the series, dating back to 1943.

In fact, so much of a threat is any curtailing of consumer borrowing to the overall economy that the government has taken some unprecedented steps to get banks lending and consumers borrowing. So far it hasn’t really worked, with the notable exception being housing, but there are signs that the housing rally is starting to run out of steam as well.

What the CARD law does (and doesn’t do)

One of the biggest impacts of the new credit card law will be to stop the concept of universal default. If you have a card from bank A and miss a payment on bank B’s card in the past, bank A would raise your rate because they now categorized you as a default risk even though your late payment had nothing whatsoever to do with them. The same went for car, mortgage, and even utility payments. One little mistake anywhere in your financial life and you paid dearly on the credit card front.

The new law also limits the scope of changes that can occur to cardholder agreements without significant notice time given. Just as a personal note, I recently received a booklet, and I do believe that is the correct term, filled with changes to my cardholder’s agreement. At the end, it said I could refuse the changes by cancelling my card. Fair enough. The changes didn’t affect me, but I read the pamphlet anyway. In essence, this particular bank, which shall remain nameless, is paving the way for a bevy of new fees and credit limit cuts. It is my understanding this is going on throughout the entire industry.

Also put in check are random and capricious interest rate hikes not only for new purchases, but on existing balances as well. Perhaps most importantly, when a consumer has multiple interest rates in affect across their outstanding balances, payments will be applied to the highest rate portion first, then downward. This will help prevent a small balance from essentially becoming a perverse annuity for the card issuer.

It is pretty much a no-brainer that many of the consumer-friendly changes listed above will cut bank revenues because they address ways in which banks have scalped consumers for easy cash in the past. What is pretty much left unsaid and completely unaddressed is what the banks might do to maintain their profit levels on consumer credit cards. Unfortunately, the banks and card companies are going to respond in general by making it harder and more expensive for people to get and use credit cards, including even the most responsible borrowers. Rewards programs are likely to be cut or eliminated, and the 30-day grace period may become a thing of the past. Credit is likely to dry up at the margin where people have lower FICO scores and maybe a bankruptcy or two. Deadbeats are liable to lose their 1-3% cash back incentives for using the cards. What also might see an ugly return is the annual fee. Annual fees pretty much disappeared during the orgy of consumption because banks could make money in so many other ways.

If nothing else, the CARD law and the fallout will present a unique opportunity and hopefully some solid incentive for people to dump credit cards in general. It would certainly be better for our savings patterns if we did. It has been demonstrated time and time again that when people use cash, they’re more mindful of the money they spend.

Solutions

Sometimes, however, dumping the cards totally isn’t a viable option. There is a definitely a convenience factor in place with credit cards and much of our economy has shifted in this regard. So unloading your wallet of those plastic shackles might not be something you want to do.

One solution I always give people is to purchase pre-loaded cards. You can get them at most retailers in denominations generally up to $500. You pay the retailer $500 in cash plus a small activation fee and you have yourself a credit card. You can go shopping online or in a store and use it just like a credit card with one limitation: when the funds are used up, you’re done shopping. The card is indexed to what you can afford unlike most credit cards. Another benefit, especially if you shop online, is that if your number is swiped, much less damage can be done. Unfortunately, in the case of the prepaid card, whatever money was on the card is likely gone if someone does get the number.

Another related solution is to use your ATM card for purchases since it is linked directly to your bank account and you can’t overspend. However, there have been countless cases where people have cleaned out their bank accounts to make impulse purchases only to reap the whirlwind when the mortgage comes due.

Another solution, and this is one that has vexed retailers is that people actually SHOULD be cutting back on discretionary purchases. Retailers are mad at Congress for imposing limits on the card industry because it’ll keep people from using cards for purchases they wouldn’t make otherwise. Here’s a news flash. If you need a loan at 20% to buy something then you shouldn’t be buying it! The people on the margin that will be most likely to lose access to credit cards are the ones that will probably benefit the MOST from the CARD act since they’ll be less able to get themselves into credit card trouble.

As we approach the time of year when people celebrate the birth of Christ, it is probably not a bad idea to take a lesson from the Bible as it relates to debt. Romans 13:8 states: Owe no man any thing, but to love one another: for he that loveth another hath fulfilled the law. Maybe this year and forward we could set down the credit cards, live within our means and continue to repair our balance sheets regardless of what Congress, retailers, or banks say. After all, they’ve demonstrated a complete inability do be financially responsible. Perhaps we could lead the way this time.

I’d like to take this opportunity as I put the cap on my pen for the last time in 2009 to wish everyone a safe and relaxing Holiday Season and to thank you for reading My Two Cents; I’ve enjoyed being here.

-AS

Gulf petro-powers to launch currency in latest threat to dollar hegemony

Theme #1 for 2009 – The blowout federal deficit

“In a classic journalistic transgression, the Congressional Budget Office stole most of the thunder of our first theme for 2009 – a blowout in the Federal deficit as the government, almost out of options, pulls out all the stops and piles it on taking the national debt curve parabolic.”

I’ll readily admit I should have spent some more time on this, but the CBO had in fact just released a report on the projected 2009 FY budget that was actually carried in a spirit of journalistic honesty unrivaled in recent years. The media, for a week, became deficit hawks. After that they resorted to just gawking at the monthly Treasury shortfalls and commenting how it was ‘necessary’ to get the economy going again. The ending FY 2009 deficit was indeed massive: $1.4 trillion.

This year, we’re in a similar situation; the CBO came out this week with a report identifying a $292 Billion shortfall for the first two months of FY 2010. If this trend holds out, the FY 2010 shortfall would be in the $1.75 Trillion area. I’m inclined to go even higher and predict a greater than $2 Trillion deficit for several reasons:

1) Another stimulus is in the works. Reeking of Madison Avenue marketing, this third stimulus in just two years is not even being called a stimulus, but a jobs plan. If you read the fine print, however, you’ll see that it differs very little from its most recent predecessor. While details are sketchy at this point, I’ve been asserting for the past few months that they’d propose another stimulus and it would be a whopper: probably a trillion dollars or more. I’m sticking to my guns on this one.

2) The actual ‘cost’ of the existing programs is much higher than their price tags, resulting in a dramatic and spectacular piling up of shortfalls. For example, the 2009 stimulus carried a $787 Billion price tag, but a total cost somewhere in the neighborhood of $3.25 Trillion according to the CBO.

3) Healthcare Takeover. Again, details are sketchy at this point, but the nationalization of America’s healthcare system is likely to sport a price tag of near a trillion dollars, with the actual cost likely somewhere between here and Saturn since it is not a one-time program, but one that will run essentially in perpetuity. Don’t be fooled by assertions that this measure will prevent the insolvency of Medicare and Medicaid either.

All of these factors (and many others) point to a continued increasing slope of the public debt curve. Not to mention that at this point in the debt curve, which is essentially a mathematical function, deficits beget larger deficits as compounding kicks in. Another buffalo nickel goes out to whoever accurately predicts the year when we cross the $100 Trillion mark on the national debt. In truth, the currency system we’re under may well end before we reach that point, but it is an interesting study nonetheless.

Theme #2 for 2009 – States Circle the Wagons for bailouts

“California, New York, and as many as 29 other states are already in fiscal extremis as revenues plunge due to unemployment and decreasing tax receipts. States are faced with difficult choices in 2009. They can raise taxes, cut services, beg for a bailout, or in all likelihood all of the above. And in a typical ironic twist of fate, the market for municipal bonds is drying up just when the states are going to need the money most. To make matters worse, yields on municipal bonds blew out to nearly 2.2 times the yields on corresponding Treasury issues. This is more than twice the .96 historic level normally observed. Obviously, the message here is that the perception of security is gone. We pointed out this likely eventuality when MBIA and AMBAC came under duress and saw their credit ratings cut back in June. Not only are the bonds questionable, but their insurance is as well. The bottom line here is that if bond issues can be sold, investors will command much higher yields resulting in greater debt servicing costs. Initial forecasts for 2009 indicate that there will be a 6% decrease in new bond issues sold, taking the total down to around $364 Billion.”

Again, absent Madison Avenue marketing, we’d have seen this for what it was. The 2009 stimulus was largely a de facto bailout for many states that lined up to grab the federal dollars. However, several spurned the freebies in heroic fashion, realizing that there were too many strings attached. Granted, not much has been made of the downgrades of AMBAC and MBIA since they happened and on top of that muni bond yields have fallen so much that on many points along the yield curve, they’re actually bringing in less than their Treasury counterparts. However, if you adjust for the 28% tax rate equivalent yield, muni bonds are still sporting a hefty spread at the long end of the yield curve: 1.42X the 30-year Treasury bond.

As for the issue of cutting services and raising taxes, we were spot on. The media landscape in 2009 was littered with stories of cities, states, and municipalities cutting all sorts of services, even police, fire, and EMS in many cases. New Jersey, California, and Michigan were just a few states that gave public school teachers pink slips in 2009; a nearly unprecedented move. On the revenue side, many areas have resorted to increasing and adding fees as opposed to raising funds through the more traditional taxing systems already in place. NYC led the way in this regard, raising fees on everything from parking to taxi cab rides. And the rest of us haven’t been immune either. Fees and surcharges are being raised all over the country in an effort to patch broken budgets from Omaha to Oregon without raising broader tax rates, which are much more in the public eye.

The one portion of the municipal story that we seem to have been a tad early on is the overt purchase of muni bonds by the government. However, given the fact that California virtually begged the Treasury for TARP money and the Treasury’s CPP (Capital Purchase Program) has poured over $26 Billion into California banks, it is probably not a completely unreasonable assumption that at least some of that money went towards California ES and GO bonds held by the aforementioned banks.

Theme #3 for 2009 – Creative Financing to Induce Borrowing

“Creative financing will be back in 2009. And I don’t just mean 0% interest loans. Any machination that allows payment to be put off until a later date will do. 12, 24, and 36 months interest-free. No payments for 12 months. Partial payments for 12 months. No down payment and we’ll make the first 3 monthly installments for you. We’ve already seen these before, but they’ll become commonplace in 2009. Look for new ones as well with longer payments terms, which ironically means you’ll end up paying even more for the items. However, the focus will be on the ‘low monthly payments’. Stimulus checks may not be checks at all, but may rather have a requirement for consumption attached. All indications are that the framers of the last stimulus package were unhappy because not enough of the money was spent. Apparently some people actually paid bills and/or saved the money. Maybe Wal-Mart and Home Depot Gift Cards will be the delivery method for the next economic stimulus. I’m only half joking about this.”

Cash for Clunkers. Need I say more? On other fronts, the Fed has led the charge to induce home buying through the purchase of $854 Billion (to date) worth of mortgage bonds. Not to be outdone, the feds have thrown in their own incentive in the form of tax credits for first time home buyers. These folks will do anything to raise the dead and buried notion that home ownership is the epicenter of wealth and prosperity. There have been various incentives to purchase all manner of home improvements centered on energy efficiency. This might be perhaps the most innocuous of the government’s attempts to urge people to spend money. We were spot on with regards to cash handouts; they didn’t happen because the government wants to guarantee that people actually spend the money. So instead of mailing checks, the feds will give you a kickback if you spend your own money or even better, borrow and spend someone else’s.

Retail chains have done their part by slashing prices to induce spending. Creative financing arrangements are out there, but are not quite as prevalent as we had expected at the outset of the year save for the auto sector. Consumer spending has remained tame at best, and the consumer’s willingness to take on more debt to finance large living has diminished significantly. Consumer credit outstanding – one of my favorite indicators in terms of predicting consumption patterns and GDP growth ex government spending has seen 8 consecutive months of declines; the first such occurrence of a sustained decline since the series began in 1943. The mainstream has of late picked up on this storyline mostly because the declines in recent months have been less severe which fits into the mantra of ‘not as bad’ economic reports being spun as great news.

For sure as we close out the first decade of the new century and millennium, the spin will be on the increase. Few things will be as they appear. News reporting has already taken on a frighteningly 1984-ish aura complete with glitzy marketing props and plenty of subterfuge. Economic statistics released by the government will become more and more irrelevant. Even now, press releases from BLS and the Commerce Department in particular are littered with asterisks about changes in reporting, methodologies, and data gathering. It would seem those responsible for providing us with accurate data have hired the Enron crew to cook the numbers for them.

You can have all of this spin and subterfuge decoded for you each week on ‘Spin Cycle’. I host the show and debunk economic reports and bring on guests to talk about the important issues of day as they relate to media bias and misinformation. For more information or to listen, please visit Contrary Investor’s Cafe