Wednesday, April 27, 2011

Large Deficits, Deficits Everywhere—Well, Almost Everywhere

The European Union statistics agency yesterday released new information about deficits and debt in 2010.  Despite severe austerity measures, Greece is still running a budget deficit of 10.5% of GDP.   Spain and Portugal had deficits of slightly more than 9% of GDP.  It is not news that these nations have serious fiscal problems.  But perhaps surprising is that Britain’s deficit is as large as Greece’s, at 10.4% of GDP.  (The U.S. deficit is in this ballpark.)  The new government in Britain has slashed spending, yet economic growth has been stagnant, and the deficit remains huge.

What was even more striking to me was the figure for Ireland, which has a budget deficit equal to 32.4% of GDP.  That’s 32.4%, not 3.24%!  Not long ago Ireland was the darling of supply siders.  Its extraordinarily low corporate tax rate enticed many multinational corporations to set up operations there.  The country’s rapid economic growth was the envy of the other developed countries.   Yet bubble conditions spread to the banking system, and as occurs with most busts, unsustainably rapid credit growth lend to excessive expansion and speculation.  Its burst bubble and collapsing GDP made its relative deficit explode.

But not all developed nations are fiscal basked cases.  Sweden, not thought of as a paragon of capitalism, is running a budget surplus.  Canada, though not in surplus this year, has a deficit of only about 2% of GDP, and it has been in surplus or close to it in recent years. 

The U.S. deficit, in contrast, is about 10% of GDP, and Standard & Poor’s is threatening a ratings downgrade of U.S. government debt.  Perhaps the U.S. can emulate the Canadian experience from the last two decades.  In the early 1990’s, Canada had large deficits and growing national debt.  By the mid 90’s, Canada’s debt was downgraded.  That was a national embarrassment to Canadians, who reached a political consensus to take tough action.  The budget was back in surplus by 1998, and the country’s debt was again rated AAA by 2002.  Could the same thing happen in the U.S., politically polarized as it is?  I can dream, can’t I?

Steve Lehman

S & P 500:  1355
Russell 2000:  858

Thursday, April 21, 2011

Widespread Complacency, Yet a Sense of Unease

Investors decide, from numerous potential factors that might affect markets, what matters to them at the moment.  They might be concerned about geopolitics.  They might be concerned about potential inflationary consequences of central-bank policies.  They might be concerned about a potential scarcity of oil at anywhere close to current prices, and consequences of high inflation and sluggish economic growth.  Or they might decide to set such concerns aside and focus on positive company earnings, and buy stocks.

That seems to be happening now.  Corporate earnings are again impressively strong, which would make this the seventh consecutive quarter of stronger-then-expected earnings.  In recent days technology companies (Apple, IBM, Intel, et al.), Verizon, G.E., McDonald’s, and Johnson & Johnson among others reported solid gains in profits.  (The banking sector is a notable exception despite relying on huge reductions in loan-loss reserves to boost earnings.)  The ability of large multinational companies to continue to produce such growth is why I’ve thought they are the most attractive part of the market (instead of small-capitalization stocks).

As stock prices climb despite various big-picture issues, it is easy to be complacent.  Yet, I have a nagging sense that the second half of the year will be rougher for markets.  I don’t know whether stock markets are topping here or are poised for another (final?) leg up before a major decline.  The S & P 500 Index, e.g, is bumping against resistance for the third time since February (though the Dow Jones Industrials have broken out to a new high).  Foreign stocks (EAFE Index) also are at a major resistance level.  Copper and agricultural commodities (Rogers Index) topped out in February.

This leaves me confused.  So it might be a good time to withdraw a bit from markets and wait for better values in stocks or corrections in precious metals and commodity markets.  I just can’t shake the sense that something significant—and unexpectedly disruptive—is ahead.

Steve Lehman

S & P 500:  1336
Russell 2000:  844

Monday, April 18, 2011

Agriculture: A Long-Term Investment Theme

Two recent items reminded me again of the serious challenges facing the world’s food output and the positive investment consequences.

The first is personal, though trivial in the context of global affairs.  Last week I noticed that the price of sunflower for my bird feeders had jumped by 25% in a month.  The proprietor explained that sunflower growers in the Midwest had shifted acreage to corn because of the roughly 75% increase in corn prices since last summer.

Such a shift in acreage is not uncommon, given the vagaries of crop markets and growing conditions.  But while year-to-year vagaries will no doubt continue, I think there is a long-term change taking place in the supply and demand conditions for agriculture.   There are two main reasons:  greater demand for meat, and a surge in demand for crops used for biofuels.

Meat-based diets require vast amounts of grain.   In developmental economics, rising affluence leads to rising demand for meat.  China and India fit this developmental model, which will cause a surge in grain demand to produce the meat.  In the U.S., annual consumption of meat is 130 kilograms per capita, while in Europe it is about 100.  In China it is only 55 kilograms, but it was only 39 kilos a decade ago.  In India it is only 7 kilograms.  Both countries will likely consume much more meat in the future, based on the developmental model and the example of Taiwan.  In 1980, Taiwan was about where China is today, with per-capita meat consumption of 43 kilograms.  Since then, it has doubled to more than 90 kilograms.

It takes about six kilograms of grain to produce one kilogram of beef.  It also takes vast amounts of water (an estimated 4,000 gallons per kilogram of beef).  Unfortunately, I haven’t found any outstanding publicly traded investment opportunities in the water area.

In addition to an inexorable increase in food demand, crop demands for use as biofuels have already driven up prices and seem likely to continue to do so.  The second recent news item was a New York Times story about the diversion of cassava root production for fuel in Asia.  Since 2008 the price of cassava has roughly doubled, as 98% of cassava chips exported from Thailand have gone to China to make biofuel.

In the U.S., forty percent of the U.S. corn crop is used for ethanol (a huge public policy mistake of providing a $.45 per gallon subsidy that costs taxpayers $6 billion per year).  Warren Buffett said that “ethanol from corn is about the dumbest idea I’ve ever heard of.”  Corn ethanol generates 1/3 less energy than a gallon of gasoline, and the reduction in oil imports resulting from the use of ethanol is equivalent to estimated savings from properly inflating the country’s auto tires or by increasing the average fuel economy of autos by 1.5 miles per gallon.  Also, why doesn’t the U.S. doesn’t drop the  tariff on cheap, efficient, Brazilian sugar cane-based ethanol to reduce our oil imports?  

The consequences of these forces driving demand for farm crops are enormous for hunger, economics, and geopolitics around the world.  Soaring food prices have caused riots or contributed to political turmoil in a number of poor countries in recent months.  To use the cassava example in Asia, if the price of cassava rises enough, farmers could well divert production to that instead of rice or other vegetables.  While it is an inconvenience for many in the developed West to absorb rising food costs that are part of processed foods, for many of the world’s poor the effects can drive millions more into malnourishment or starvation.

It is a major public policy dilemma:  food versus fuel, and to what extent to subsidize food prices.  It also poses a challenge to ethically-inclined investors.  Is it ethical to profit from—and even contribute to—the hardships of others, through sharp increases in crop prices? 

From purely an investment perspective, despite the sharp increases in agricultural commodity prices over the past two years, agricultural commodities are still historically cheap in inflation-adjusted terms.  This has not been lost on many investors already, as land prices in Iowa, e.g., have soared, as have the stock prices of the relatively few companies in this area, such as Deere and Potash Corp. 

But for long-term inflation protection and protecting the real value of cash reserves when stock prices are high and yields on cash are near zero, instruments tied to agricultural commodities prices (or precious metals) seem like a good way to protect capital.  An additional appeal is that most are priced in U.S. Dollars, and if the dollar declines over time, the prices of agricultural commodities will rise accordingly to compensate producers for the dollar’s decline.

There are ETFs that allow investors to share in increases in the commodity prices.  Two of my favorites are notes whose prices are linked to underlying agricultural commodity prices.   The first is issued by an arm of the Swedish government and whose price is linked to the price of the Rogers Intl. Commodity Index—Agriculture Total Return (RJA: $11.11).  The index is a basket of 20 agricultural commodity futures contracts.  The other ETN is the Barclays iPath Dow Jones-UBS Grains Subindex (JJG:  $54.50), whose price is linked to the prices of corn, soybeans, and wheat.

Both of these notes have risen sharply over the past year, so accumulating them on a correction or slowly over time seems prudent.

Steve Lehman

S & P 500:  1299
Russell 2000:  818

Tuesday, April 12, 2011

Rising Corporate Mergers: A Good or Bad Omen?

News of company acquisitions recently has enlivened otherwise dull trading days for the stock market.  Corporate acquisition announcements tend to give a boost not only to the stock prices of the companies involved, but to the stock market overall.  While the result is usually a substantial jump in the target company’s stock price, the result for the acquirer and the market over time, however, is substantially negative.

The main reason for the poor results for the acquiring company and for the overall stock market is the same reason for investment success or failure overall—the price that is paid.  Merger and acquisition activity tends to be at its most frenzied near stock market tops.  For the Standard & Poor’s 500 Index, cycle peaks in merger and acquisition activity occurred in 2000 and 2007, both years of historic market tops.  The S & P 500 Index has fallen 12% since the top in September 2000, nearly eleven years ago.  It also has fallen 14% since the more recent top in October 2007.  And this is after a doubling in stock prices in the last two years!  Conversely, the cycle lows in merger and acquisition activity occurred at historic lows in the stock market, in the early 1990’s, 2004, and 2009.

What might explain the proclivity of CEOs to seek acquisitions near market tops?  Market tops tend to occur when business conditions are favorable, enthusiasm is widespread, and credit is available.  Such conditions also lead CEOs to convince themselves of the likelihood of “synergies” from the combined entity.  Synergy potential usually is a combination of cost savings from eliminating redundant operations as well as from economies of scale and cross-marketing opportunities. 

But things rarely turn out that way.  The record of corporate acquisitions is generally poor, as acquiring companies pay too much for the target company, resulting in “goodwill” added to the asset side of the balance sheet to account for the premium price paid.  In subsequent years, much of this goodwill is written down to reflect a more accurate value of the assets acquired, and a large charge-off to earnings follows.  As a result, there is little, if any, growth in book value per share, a measure of the effectiveness of a company’s management. 

One of most egregious examples of this was AOL’s purchase of Time Warner for $164 billion at the height of the Internet mania and near the peak of the stock market.  It remains the largest corporate merger in American history.  When the business value of AOL plummeted, the company was forced to take a massive writedown of goodwill that resulted in a loss of $99 billion in 2002.  By late 2005, the combined company’s market capitalization—which was $350 billion at the time of the merger--had fallen to just $20 billion.  When Time Warner spun off AOL as a freestanding company in 2009, AOL’s market cap. was just $2.6 billion, or less then 1% of the market value of the combined company at the time of the merger.

There are, of course, counter examples of successful corporate acquisitions.  Berkshire Hathaway, Danaher, and Emerson Electric have fine records of integrating numerous acquisitions over the years.  Many of these tend to be smaller, “bolt on” acquisitions that aren’t too disruptive to the existing company.  The major drug companies, on the other hand, have spent hundreds of billions over the last decade on major acquisitions with little benefit to shareholders.  The overall record of corporate acquisitions is mixed at best.

For these reasons, takeover announcements are indeed to be cheered by holders of the target company’s shares.  For the acquirer in most cases, and for the stock market overall, they should receive a Bronx cheer.

Steve Lehman

S & P 500:  1314
Russell 2000: 825

Saturday, April 9, 2011

Market Sentiment

“There is no fear out there,” a trader in Barcelona said yesterday.  “The bulls are happy to focus on the underlying growth picture, which remains benign, and dismiss short-term negative headlines.”

That is one impression of market sentiment today.  Having a good sense of a market’s mood is crucial for investment success.  The odds of success in entering a cheap, lagging, unpopular market are much greater than they are in entering an expensive market that has already surged, where everyone seems to believe it is a sure thing.

Yet, sentiment measures are generally useful only at extremes.  Even at that, widespread optimism is not necessarily a signal to sell.  Markets in which most participants are bullish tend to continue to rise beyond what one might think is reasonable.  These conditions tend to be associated with a prolonged, rounded period that is marked by double or even triple tops that constitute a broad market top.  Widespread pessimism is, however, typically an excellent signal to buy, as it is usually associated more with an abrupt market bottom.

A longstanding sentiment measure for the stock market is provided by Investors Intelligence, which surveys the sentiment of investment advisors.  It is fairly common for more than 50% of advisors to be bullish in the survey.  The record of market tops being associated with periods when 50% or more advisors are bullish is mixed, with some periods close to stock-market tops, others not at all.

The opposite end is much more conclusive.  Extreme levels of pessimism have been outstanding times to buy.  When the level of bullish investment advisors falls to about 30%, those have been major buying opportunities.  There are numerous examples back to 1973 of such low levels that were followed by substantial rises in the stock market over the following two years, ranging from +20% to +75%.  I found 16 instances—all with gains—that had an average two-year gain of 40%.  They include late 2008/early 2009, late 2002, mid 1997, mid 1994,  October 1987 (after the market crash), and the summer of 1982 (beginning of the great bull market).  I couldn’t find a period when extreme pessimism was not followed by a significant gain in stock prices over the following two years.

Market tops are tricky to identify at the time.  But the next time you notice that the Investors Intelligence survey shows only about 30% bullish advisors, just buy stocks.  (It was recently above 50%.) Don’t worry about the certain negative news headlines at the time.  Just buy.

Steve Lehman

S & P 500:  1328
Russell 2000:  841

Wednesday, April 6, 2011

Baby Boomers Need Help

Interest rates on savings are near zero, real median income has been stagnant for a decade, and baby boomers are starting to retire.  What should one do?  Invest for income and income growth, with a portion allocated to commodities and precious metals.

Only 11% of the 77 million Baby Boomers said in the Associated poll that they are strongly convinced they will be able to live in comfort.  Four times that number—44%--expressed little or no faith they’ll have enough money when their careers end. 

With U.S. Treasury bond yields at historically low levels and money markets yielding almost nothing on savings, it’s a huge challenge.  And with stock prices having doubled over the last two years and valuations based on actual earnings on the high side, what can an investor do?

There are still select, high-quality stocks that provide attractive dividend yields and the prospect for income growth.  Abbott Labs (ABT) and Rogers Communciations (RCI) are examples.  Over time, such investments will likely do much better than domestic fixed-income investments.

Investors also need to protect the purchasing power of their assets.  Even though gold just hit a record high in nominal terms, gold and agricultural commodity prices seem likely to rise sharply in the years ahead.  A substantial portion of one’s cash can be held in these non-income-producing areas, since cash yields almost nothing.

In addition, foreign investments (such as Rogers of Canada) or the Canadian dollar will likely maintain their value over time.  In the meantime, I would try to be patient for the next major decline in stock prices. The entry price of an investment is crucial for success, and those with resources available to take advantage of depressed prices will be glad they had them.

Steve Lehman