We are off to a good start in the still New Year of 2004.
Last year finished out nicely as 2003 was the first year that equity
investors made money in the markets since 1999.
The U S economy has been improving in recent months after several very
difficult years, and it appears to us that the recovery will be
sustainable although there will be the inevitable setbacks.
In our Commentary “THE FED’S 2003 DISINFLATION CONCERN AND A LOOK BACK
TO MARCH 1933” dated May 17, 2003, we wrote:
“Since September 11, 2001 Americans have again been presented with
enormous challenges, as this country has not been able to fully recover
from those attacks. This fact is reflected in our economy and in stock
and bond markets.
“For the stock markets to have a sustainable recovery there are two
primary requisites:
 | Confidence in the stock markets and the players – the
investment bankers,
the corporate CEOs, the Exchanges, the accountants, the analysts, et
cetera.
Will the $1.4 billion settlement be enough to make Wall Street change
its
ways without holding CEOs personally accountable? ….
|
| Corporate profits must show a real promise of improving –
despite the Fed’s Disinflation Concern.
|
“The operative words of the last requisite are “real promise.”
Signs of economic recovery continue to be paltry as May’s unemployment
rate was 6.1%. The June 6th Labor Department release showed unemployment
to be at its highest level since July 1994.”
On January 9th the Labor Department announced that the U.S. jobless rate
is now 5.7%. Lackluster job creation, however, continues be a serious
problem, and many major U. S. companies continue to hire cheap labor
abroad.
Positive factors continue for stocks:
| An improving economy. |
| Higher corporate profits and productivity. |
| An improving, albeit ragged, employment outlook. |
| Higher levels of consumer and investor confidence. |
| Interest rates that are still near 45-year lows. |
| A continuing lack of attractive alternative investments.
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2004 is an election year that should prove to be very interesting.
The financial community will also continue to provide us with non-stop
entertainment as Richard Grasso, Martha Stewart, Andrew Fastow, formerly
Enron’s chief financial officer, and a constant parade of others march
into the headlines and over the airwaves.
Recently the New York Stock Exchange has called on NY Attorney-General
Eliot Spitzer and the Securities and Exchange Commission to investigate
its former Chairman Richard Grasso’s $187.5 million pay package given by
the not-for-profit organization.
We wonder if they were surprised when Mr. Spitzer raised the prospect on
January 13th that NYSE board members who approved Grasso’s compensation
might be liable for part of it when he said “Board members who acted
improperly could provide a piece of the recovery.”
Jurors are being picked for Martha Stewart’s federal trial. Not many
realize that Martha was a governor of the New York Stock Exchange at the
time of her alleged misdeeds.
Mr. Fastow and his wife will do time in jail – 10 years for Mr. Fastow.
The government is hoping that his cooperation will assist in convictions
of other Enron big fish.
We note a major scandal that is only several weeks old: Parmalat, the
gigantic Italian dairy company, collapsed in December. With drama
comparable to a fine opera, Parmalat’s founder, accountants and lawyers
have managed to make almost $13 Billion vanish. It’s the largest scandal
in European history, and the tale is just beginning to unfold.
In keeping with our objective of Preservation of Capital, it is always
time to be cautious when universal euphoria takes over. The reality at
this writing is that stock prices are high vis-à-vis traditional
valuations.
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THE BOND QUANDARY
Asset allocation is always an extremely important part of portfolio
management, and bonds have worked very well for us.
Bonds, for example, have outperformed stocks in recent years as “The
five-year average annual return for the S&P 500 through 2002 was a
negative 0.6%, versus an 8.55% gain for 10-year Treasuries.” (BARRON’S,
January 6, 2003) This occurred as interest rates fell to 45-year lows
and bond prices rose.
We now anticipate a rise in interest rates. The question is when, not
if.
The Federal Reserve has kept short-term rates at 45-year lows. We do not
think that Chairman Greenspan and his colleagues will increase them
anytime soon as that could be damaging to the recovering economy.
We believe interest rates will rise despite the Fed’s position. The
market will cause interest rates to rise if the economy continues its
climb and deficit conditions worsen. A sharp fall in the dollar could
lead to higher interest rates that would dampen the economy.
Rising interest rates will result in lower bond prices, perhaps sharply
lower bond prices as the interest rates and bond prices move in opposite
directions.
We were astounded when we saw the following poll results:
“Bethesda, Md. - June 26, 2003 – A survey conducted by Harris
Interactive on behalf of ProFund Advisors LLC finds that, although most
U. S. investors (57%) believe interest rates will rise in the next two
years, nearly two-thirds (65%) are unaware that rising rates generally
have a negative impact on the value of bond investments.”
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WHAT’S WRONG WITH THIS PICTURE? or HOW FAST THINGS CAN CHANGE!
Last year at this time General Motors, the world’s largest automaker,
had the world’s largest unfunded pension liability - $19.3 billion.
Then on June 26, 2003 GM sold $17 billion of bonds - the largest amount
of bonds ever sold in the corporate debt markets.
The purpose, in large part, was to offset about $20 billion of GM’s
unfunded pension liabilities. While the hole was plugged for the time
being, GM’s stockholders are left with the obligation to repay the
borrowing and pay the interest on it for up to the next 30 years.
“GM bonds tap into ‘wall of money’” according to the June 23,
2003 Financial Times which then reported “Car giant benefits
from buying frenzy as cash-rich investors ignore shares and scramble to
buy bonds in search of higher returns.”
Later from the same article:
“Disillusionment with slumping stock markets has caused investors to
migrate in droves toward the bond market, with the result that fund
managers have mounting piles of cash waiting to be invested but not
enough new bond issues to absorb it. And the dramatic decline in
interest rates is making investors increasingly desperate for yield.”
Total orders for the GM and GMAC, its financing arm, amounted to $30
billion with European demand strongest in the 30-year bonds. The bonds
apparently appeared to be extraordinarily attractive investments because
of their yield. GM bonds were sold to buyers who were in a frenzy to buy
bonds 1) having a long life and 2) having a much lower than “investment
grade” rating at a time when the bond markets were at or close to all
time highs.
Aside from professional traders, many of the GM/GMAC bond buyers have
chosen to disregard the bonds’ inherent risk or did not care about
taking large risk in their passion for higher yields. It is possible
that some simply did not understand the risk they were taking when bond
yields were at almost half-century lows --- just as stocks never looked
better than when they were at their all time highs in March 2000.
After the power-ball financing, it appears that a return of 9% will be
necessary to keep the $83 billion fund from slipping into negative
territory.
Now for a financial decision equivalent to a Hail Mary Pass: On December
15, 2003 General Motors and its external consultants announced a target
return of 9% from its pension fund. In 2002 the fund fell 7%.
The pension fund will now be investing in hedge funds, junk bonds,
emerging markets, real estate and other vehicles offering high returns
and high risk. Perhaps GM bonds?
GM “has decided the best way to maintain the annual 9 per cent return it
needs is to invest in riskier assets. A side benefit is that, thanks to
portfolio theory, it believes the risks will cancel out.”
(FT 12/15/03)
BUT WHAT IF INTEREST RATES RISE?
We, of course, wish the General Motors pensioners the very best of luck.
John W. Hamilton
January 20, 2004
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