The Federal Reserve’s latest Flow of Funds report showed that the net worth of U.S. households exceeded $66 trillion at year end, the highest level since the recession began in late 2007.  This is further evidence that the economic recovery is real, even if it has been sluggish by historic standards.   The asset gains came in stock prices, mutual funds and real estate owned by households.  Everyone knows that the real estate market has been terrible, but that is changing.  Homeowners’ equity in their homes now exceeds 46% of the home values, and bankruptcies have fallen approximately 50% in the last year.

The market naysayers are concerned that the current stock market rally could soon enter the recessionary phase of the cycle.  The U.S. budget deficit is unparalleled for us, and the discord in Washington shows little reason to expect improvement.  But individuals and businesses are breathing a little easier, and the gradually improving labor picture points to more people working and spending.  Keep in mind that the consumer is responsible for two-thirds of our GDP, so increased consumption in a low-inflation economy will be a powerful elixir.  And corporations are on course to send a record $300 billion back to consumers in the form of dividends and stock buybacks.

Positive or negative comments may all depend on the messenger.   Both sides can make a logical case, but you would do well to consider the political motives of those warning of perpetual gloom.  For the investor the loss of future gains from throwing in the towel now could be significant.  Consider the alternatives.  Cash and short-term fixed income investments provide miserable returns.  Bond yields are not much better, and on a historical scale they are unbelievably low.  The mechanics of bond pricing means that any increase in inflation or interest rates in the future will result in big declines in existing bond values.  Meanwhile, stocks and real estate are enjoying impressive gains.  This gives rise to the concerns that the rally is about to run out of gas.  Maybe, but remember that extended rallies have happened before, and with rising employment,  stronger household balance sheets and rising corporate profits, the ingredients are in place for a lot more life from this bull market run.

The conclusion for the investor will depend on each person’s criteria -- optimism or pessimism.  As you consider what to do with your investments, remember this aphorism: Ships in the harbor are safe, but that’s not what ships are for.  Think guarded optimism.

The last two days have seen a sharp change in the market’s direction.  The likely cause seems to be concerns raised by several members of the Federal Reserve Open Market committee over the extent of Quantitative Easing.  The Fed’s purchases of bonds since the easing program began in 2009 have helped keep interest rates at historically low levels and have increased the supply of funds available for loans.  The effectiveness of the strategy has been the subject of debate, and the infusion of money into the system could fuel inflation in the future.

The economic recovery is one of the worst in our history, and despite very low interest rates, consumer demand for money has been modest.  Meanwhile, the stock market has more than doubled since the lows of 2009 and since last summer’s lows, has risen 16.9% before dividends, even after the sell-off of the last two days.  Naturally, some investment strategists are suggesting that the market is due for a correction.  We are already past the point when the average bull market has come to an end.  And when we consider how poorly Congress and the Administration have managed fiscal policy, one conclusion is that the party may be over.

Current bulls disagree.   The overall climate may hold potential problems, but many individual companies are doing well.  Now, add the fact that investors have been on the sidelines for several years, building huge cash reserves with virtually no yield, and you have the potential for an extended stock market run.  A review of individual stocks shows many companies with good growth potential.

Two important questions come to mind.  First, are current prices a reflection of underlying financial strength, and second, are stock price levels sustainable?  To address the first, look at two important ingredients to corporate health, earnings prospects and the strength of the balance sheet.  The chart below from the Federal Reserve Bank of St. Louis shows corporate profit growth for the last 10 years.  American corporations are doing well.  During the recession companies slowed investment growth, focused on productivity and margin control and importantly, built their cash reserves and reduced their debt.  Corporate balance sheets currently are exceptionally strong.

The second question of sustainability needs to consider investor sentiment.  Prices reflect investor attitudes toward company growth prospects, and the pent up consumer demand from the last phase of the cycle will play an important role in supporting growth. 

One market strategist thinks we are far from the end.  The February 16, 2013 New York Times reported that Laslo Birinyi, a seasoned stock market strategist, thinks the current bull has another one to three years to run.  His reasoning involves more detail than we can address here, but through a combination of technical and fundamental measures, he concludes that the money flows supporting this market are sustainable.  According to the article, he thinks sees a better than even chance that the S&P 500 will reach 1600 this year from its present level of 1512.  

As is usually the case, there are good arguments supporting both the bull and the bear outlooks.  Investors may not want to lose the gains of this recovery.  They have an incentive to sell now.  But the ingredients are in place for continued growth in corporate profits and for a further shift in investor funds from the safe haven of cash reserves to equities.  Company fundamentals and the flow of funds support a strong stock market.  Don’t be too quick to cash out.

With concerns about the U.S. fiscal cliff, political discord and the instability of the European Union, talk show commentators do not need to show much imagination to create doomsday scenarios.  As a result investors have flocked to money market funds and Treasury bills.  Those are safe but expensive choices. 

Alternatives that will work for almost everyone have three objectives: capture cash flow, participate in economic growth and insulate against inflation.  Equities satisfy all three while fixed income securities offer predictable cash flow with more price stability than stocks. 

Each investor’s risk sensitivity is the key to deciding the percentage mix between stocks and bonds, but equities should play some role in every portfolio.  As confirmation of this, consider that trust departments almost universally require equities in their accounts.  As fiduciaries their liability far exceeds that of the typical broker.  Most will conclude that an equity position that is less than 20% to 30% poses too much inflation risk.

Bonds are a logical place to look for yield, and bond mutual funds or fixed income ETFs are the simplest choice for most individuals.   Many of these charge little or no commission, have low management expense ratios and offer a wide range of quality.  Established investment firms such as Fidelity, Vanguard, Janus and many others offer funds along with tutorials on the mechanics of bond investing. 

The caveat is that rates are at historic lows, and bond prices will fall if rates rise.   But funds with durations of one to five years such as Janus’ Short Term Bond fund, JASBX, Vanguard’s Intermediate Term Investment Grade Bond fund, VFICX, and its Short Term Investment Grade Bond fund, VFSTX, pose relatively modest interest rate risk, and have yields ranging from 1% to 4%.  Fidelity’s Strategic Income fund , FSICX, has a longer average maturity and higher yield but is still investment grade.   High-yield funds such as Vanguard’s High Yield Bond fund, VWEAX, and Fidelity’s High Income Fund, SPHIX, are below investment grade, but that can be appropriate for many portfolios.  Both currently have yields of 7% to 8%.  With a mix of maturities and a position in high-yield bonds, investors can have good cash returns and still have liquidity.  These funds are examples of your available choices; there are many others.

Equities can also offer good yields.  Real estate investment trusts (REITs) offer cash flow and growth potential.  Vanguard’s REIT Index ETF (NYSE:VNQ) and Cohen and Steers Major Real Estate index ETF (NYSE:ICF) are two examples.  Both have SEC yields near 3%. 

Master limited partnerships (MLPs) are another source of income.  These are a common structure among oil and gas pipeline companies, and many of these have shown excellent growth in revenues, earnings and dividends.   Two examples are Enterprise Product Partners (NYSE:EPD) and Kinder Morgan Energy Partners (NYSE:KMP).  Both have excellent long-term records of dividend increases and current dividend yields of approximately 5%. 

Preferred stocks funds also provide cash flow.  Nuveen Quality Preferred Income 2 (NYSE: JPS) and Market Vectors Preferred Securities (PFXF) have yields above 6%.  There also are blue chip stock funds with relatively high dividend yields and a good record of dividend growth.

Many investors have increased their cash equivalent positions currently because of the economic and political uncertainties.  Their trade for less risk is a lower cash flow. As you decide the stock/bond/cash mix that is best for you, remember this, yesterday’s yields may not be available anymore, but there is seldom a need to limit your portfolio to money market returns.

The Investment section of your favorite bookstore is certain to have many titles to entice you.  Such was the case a few years ago with a book titled, Shaking the Money Tree.  This guy’s writing was fun, colorful and had good current suggestions.  In one passage he tells about a guy lamenting to his friend that the country is in the throes of a heroin epidemic.  The friend asks, “Who sells the needles?” 

The paragraphs that follow are my own and probably bear no resemblance to the book.   The truth is that I have completely forgotten the book’s message, but the question about the needles carries a message that all research directors know.  A good analyst’s or money manager’s instincts can pave the way to investment success. 

Now, think about where the question above was leading.   Lesson 1: Go where the money is.  Willie Sutton said he robbed banks  “. . .  because that’s where the money is.”  If the economy is in a growth mode and the demand for technology seems insatiable, buy technology stocks.  Utilities may be great for some reasons, but they do not project growth.  Tech stocks do.  Likewise, energy and health care will face growing demand for years.  Take advantage of demographic, technologic and societal changes.

The next step in your effort to get the low hanging fruit from any tree is to look for the second derivative players.   That field includes suppliers and facilitators.  Lesson 2:  Pick the companies that make money from the companies making the money.    For example, Exxon is a major oil company.  Who helps Exxon get the oil?  Companies like Schlumberger and Halliburton.  There are hundreds of others.  Use your imagination in picking your stocks.

Now take that a step further.  Some of the suppliers might be the big boys.  Both SLB and HAL are industry leaders.   SLB has 1.33 billion shares, and HAL has 923 million shares.   Lesson 3:  Look for companies that offer the investor leverage through a more significant ownership position.   Who else participates in the exploration and production effort?  There will be hundreds of companies in the process that takes the product from the ground to the consumer.  Maybe one or more of these will be the goose that has your golden egg.

There are likely to be some undiscovered jewels among the market choices.  Many people have been enamored by Wal-Mart’s success.  We can easily see the reasons.  Their growth, their delivery methods and their inventory control have been extraordinary.  But history has shown us that there seldom is just one solution to the market’s challenge.  Maybe Target’s numbers and market acceptance offer similar growth opportunities at a better price.  WAL is also one of the leading grocers in America.  But what about Kroger?  It has been equally competitive.  Maybe other stocks in this business also offer growth opportunities.  Lesson 4:  Find the overlooked alternatives.  You can run the same drill in the pharmaceutical business, in telecom, consumer discretionary and throughout the market.   There are winners everywhere, and weak stock markets like todays offer an opportunity to look beyond the obvious. 

Finally, good quarterbacks complete passes by throwing the ball where the receiver is going to be, not where he is when the play starts.  Lesson 5:  Invest where the market is likely to evolve.  Example.  If energy independence is a valid goal, and if oil shale holds enough energy for U.S. needs for the next 1,000 years, maybe we can find examples of lessons 1 through 4 in shale production and delivery.

The answers are out there.  Your challenge is to be like the winning quarterback.  Make your investment where the action is going to be.

My disclaimer is that I am writing this from the Llano River Ranch in Kimble County, Texas, two hours west of San Antonio and surrounded by mesquite trees.  Shale activity in South Central Texas has been rampant for well over a year, and my bias is to the companies that are likely to be where the action is heading.

Tom Mongan, CFA
May 26, 2012

 

                                                           Tom Mongan is a financial analyst in Houston, Texas

You can usually count on the Sunday morning TV talk shows to ignite the passions of political junkies, and today’s were no exception.  One brief comment on high taxes for the wealthiest 1% caught my attention because I had just finished reading an interesting comment by economist Scott Grannis in a Seeking Alpha.com article titled “Some Additional Perspective on Europe.”  Grannis, who was the chief economist for Western Asset Management for years and who was an economist under John Rutledge at the Clairmont Institute, writes regularly as the Calafia Beach Pundit.  His work is always insightful and thought provoking. 

This article looked at the disparity in industrial production between the U.S. and Europe.  The industrial production of both groups had sharp declines following the recession in 2008.  Both then turned to gains in 2009, but the paths separated last year, and one obvious reason is the serious financial strain that Europe is facing. 

Nothing too surprising up to this point.  Then Grannis shows the path of industrial production for several major EU players: Germany, France, UK, Italy, Spain and Greece.  This is where the record gets more interesting.  His chart follows.

                                     


Germany’s success versus the plight of the other nations is making the news daily.  Many of the countries are facing a serious collapse of confidence among investors, and in some cases the solvency of their major banks is in question.  The main reasons are austerity, tax policies and work ethics.  Higher taxes alone will not solve the problems and neither will austerity.  Countries must produce their way out of decline, and high taxes can be an impediment.

Grannis then notes that Ireland’s industrial production has fallen only 7% since 2007, and that is after rising 300% in the past two decades.  Their strength has stemmed from the sharp cut in their corporate tax rate.  On a drive through southern Ireland a few years ago, I had to think whether I was in County Cork, Silicon Valley or Austin, Texas.  The tech companies apparently liked the environment.

In contrast, the U.S. has the highest corporate tax rate in the world, and many see a solution to our huge deficits as a tax increase.   One of the most perilous examples currently is California.  If anyone would like to read a genuine horror story, look at Michael Lewis’ book, Boomerang.  His discussion of Vallejos’ disasterous situation should be a must-read for anyone planning to vote in the upcoming election.

Neither author is maing an overt political statement.  Their perspectives are economic and financial.  You can draw your own conclusion from the numbers.

Tom Mongan
May 20, 2012

Tom is a financial analyst in Houston, Texas

The president is going to great lengths to sell his tax plan to the voting public.  The argument resonates with many people because it appeals to their sense that a privileged group is taking something that should be theirs.  The plan’s popularity developed momentum when mega-billionaire Warren Buffet said that he paid less in taxes than his secretary.  The tax code seems biased when big earners can use various deductions to dramatically reduce their taxes.

Obama’s plan hopes to implement the Buffet Rule, which says that those earning more than $1 million per year should pay 30% in taxes.  Very few people earn more than $1 million, so this is bound to sound like a reasonable way to attack our exploding deficit.  Conservatives have been quick to say that there just isn’t enough potential tax revenue from this idea to make a difference in the deficit.  The total take will only be about $5 billion, a pittance compared to our $1.3 trillion deficit.   They say further that any increase will likely create an investment disincentive in the group most likely to put funds and people to work.

The president acknowledges that the plan will not eliminate the deficit, but in the interest of fairness this new tax source will matter.  This sounds a lot like Al Gore’s complaint several years ago about “those who take so much and give so little.”  You can imagine that this plan will raise the ire of many people who struggle each month to stay afloat.  Let’s look for a moment at just how little the top earners actually give, keeping in mind that many top earners pay big tax bills.  They all basically are in the top tax bracket of 35%.  The chart below comes from the Heritage Foundation’s Fact Sheet #85 entitled, “Taxes Are Not Too Low: It’s the Spending, Stupid.”

This was taken from IRS data, and while the numbers are several years old, we have little doubt that they are still relevant.  One number that should jump out is that the top 1% pays 38% of all Federal income tax.  The top 10% of earners are carrying 70% of the load.  If you are having trouble connecting this information to the fairness appeal, you are not alone.  But fairness, or unfairness depending on your political stance, has yet another dimension.  In 2010, the latest year that the Heritage Foundation included in its calculations, 49% of our population were not included in the tax rolls.  That means more than 150 million Americans paid no taxes at all.   In 2000 only 34% paid no taxes, and in 1980 the number was 15%, a disturbing trend.  So where does it end, and what are the limits to fairness?

Try to put this issue into perspective.  The president is proposing what amounts to a new bracket for the much derided alternate minimum tax.  He is inciting his base with an argument that is tantamount to class warfare.  If the Buffet Rule becomes law, there will be relatively little economic impact.  There may be a much greater impact at the polls in November.  We expect tactics like this from the rival parties.  But when the person leading the charge is the president, a leader whom we hope will make decisions based on the good of the country, the result for many is disappointment. 

T R Mongan
4/13/2012

The investment results for the first quarter of 2012 were excellent.  They helped rebuild both capital and confidence for investors who have seen their net worth decline over the last four years.  The S&P 500 increased 12.1% before considering dividends.  If we look back to the lows of October, 2011, the gain is 29%.  In the wake of last year’s flat line, investors who stayed with the market have every right to feel vindicated.