Start talking about stocks, and the average person is saying, “the market is a mess,” or “wow, things are really down.” Almost every sector has taken a hit, and for many who hold stocks, the portfolio is down, no matter what you’re holding. Long story short, many people think it’s a bad time to be in stocks, or this is proof that stocks are not the place to be.
I couldn’t disagree more. I think it’s a great time to be shopping. Moreover, it’s a great time to step back and see what we have learned over the last year and ask, how we can use what we’ve experienced in the last year to make better investments in the future?
I believe that stocks move in patterns. A good part of stocks is psychology, and I think there are patterns there as well. I read lots of stock articles, and these days, you hear a lot of stock pundits saying, “well, this looks like 1990” or “this looks like the savings and loan crises… ” and so forth. Yet there’s very little detail about what the warning signs were, or how we might have predicted the turn in markets that we’ve seen over the last year. Economic memory seems to be weak, but history does repeat itself. So, here are my notes on how to be a better investor during the next down cycle. And guaranteed, 150%, there will be another down cycle.
The Warning Signs
When I started this series, I argued that everything happens in cycles. Of course, that begs the question, how do you know the cycle has ended? Looking back, I think there were some signs. And granted, we can’t predict everything, but it’s a useful exercise to see what guidelines we can gather for the next time.
One point of clarification before we proceed. Here, we’re talking about an overall economic cycle rather than a cycle in a particular sector or stock.
When you talk to most money managers, 15%, on a consistent basis, is considered very, very good, far ahead of the pack (and at 15%, you would double your money in about five years). Warren Buffett, considered the best of them all, has a return of 24%.
Record Results in Financial Stocks.
You might ask why I’m focusing on financials after having just stated that we’re talking about an overall economic cycle. If you think about it, financials are an integral part of any economic cycle. That’s because growth eventually leads to excess cash that in turn leads to excess spending. With lots of cash floating around, the financial stocks start having a field day. And the signs should be obvious – “ record IPOs, record merger deals, new financial instruments that promise extraordinary or seemingly riskless returns. Think about it – “ companies always want to go public when there’s lots of cash sloshing around, because that means people will pay top dollar in an initial public offering. The same is true with mergers – “ when there’s too much cash lying around, invariably management starts saying, “Let’s buy a company!” And then there’s always the new, seemingly riskless financial instrument. This time, it was the real estate backed instruments, sold with the argument that “the risk is really low” or that “people will do anything to keep their homes”. Does this all sound familiar? Not long ago (last summer, in fact), this was exactly the situation.
Why would all these indicators work?
Because the economy, and earnings, can only grow so fast. It’s like the salary that most people receive; it only goes up so much every year. And so what’s a good measure? If you put your money in the bank, you would have gotten, at the most, 3.5-4.5% over the last few months (that’s likely to drop as interest rates drop). If you talk to a manager that has high net worth clients, he would probably say you should expect a return of 7-8%. When you talk to most money managers, 15%, on a consistent basis, is considered very, very good, far ahead of the pack (and at 15%, you would double your money in about five years). Warren Buffett, considered the best of them all, has a return of 24%. So when you hear of high returns, let’s say 10% or more on a consistent basis, it’s time to be a little cautious. Above 15%, you should be skeptical. Before the subprime crisis, a lot of hedge funds were boasting of returns in the 30-40% range. I don’t think we’re hearing from them today.
Generous Financing Terms
Once there’s too much money around, you’ll find that financing terms become increasingly generous. That’s because the financing market is competitive. So financiers and banks start saying, “Well, we’ll relax that restriction, or this covenant.” This was most obvious with real estate – “ low teaser rates and lax documentation requirements were common over the last few years. In particular, companies were lending based on “stated income” – “ meaning that you didn’t have to prove that you can the income to make mortgage payments. Look at how different the market is today. Even for those with good credit, it’s now hard to get a loan. And the costs have increased as well. Normally, the difference between a conforming loan (less than $417,000) and a non-conforming loan (above $417,000) is only 0.25%. Today, it can be as much as 1%.
This is also true of the corporate market
Last summer, there were many deals that had very generous financing terms. For example, a PIK, or payment-in-kind clause was very common. That means an acquiring company, if it cannot handle the interest payments, can pay the bondholder by issuing more debt. In tougher environments, not being able to pay interest usually triggers default.
Also common were covenant lite clauses
Normally, if a company can’t pay interest on its bonds, then the bondholder can demand a restructuring or force a repayment of debt. In a covenant lite deal, the bondholder doesn’t have these rights. Another version of the same idea is an accordion, a clause that would allow the borrower to increase the amount they are borrowing. Investors don’t want this because they want to make sure that the borrower doesn’t take on too much debt. Finally, in the last few years, investors were accepting a lot of second liens, which are a lot like second mortgages. In this case, the investor only gets paid after the original debt holders get paid.
You can see how too much money was being lent and put into the system. And that brings us to the next topic. With all the excess money sloshing around, the cost of that high-risk debt fell.
The Spread between Quality and Junk Debt
Let’s say you have a couple friends who want to borrow money. One – let’s call him friend A – manages his money well, has a very good credit rating, and almost never needs to borrow money. Friend B is always in debt, doesn’t always pay interest on his debt on time, and spends money like water coming out of a spigot. Let’s assume you’re going to lend both friends money, and because friend A is not much of a credit risk, you’ll lend it to him for 7%. So the question is, what interest rate would you charge friend B? In normal times, you’d charge him about 5% more, so let’s say 12%.
But when there’s a lot of money around, there’s a lot of willing lenders. Maybe friend B has someone else who is willing to lend him money for only 9%. This other lender says, “I have the money, I might as well lend it out for 9%, otherwise I’m only going to get 4-5% if it sits in the bank.” You make the same calculation, match the interest rate, and offer to lend your friend money for 9%. So now, the spread between friend A, who we’ll call “quality” debt, and friend B, who we’ll call “junk” debt, has fallen from 5% to 2%. Now, the risk of lending to friend B hasn’t changed at all, but you’re getting paid less for taking on that risk.
This is, again, exactly what happened last summer
According to Merrill Lynch’s high-yield index, the spread between junk debt (defined as debt that is rated Baa3 by Moody’s and BBB- by Standard & Poor’s) and Treasuries (safe, government bonds) fell to a record low of 2.42% in May, 2007. The average over the last five years ending May, 2007, has been 5%, and the spread was as high as 10% in 2002. As of January, 2008 that spread was an average of 7.48%. A very big difference in a year, huh?
By the way, the spread between quality and junk debt is also a very good indicator of economic weakness. Think about it – “ when the economy is weak, the risk of defaulting is higher, and so the spread increases. As mentioned, the spread was as high as 10% in 2002, and about that high back in 1990. With the spread at 7.5% or so, I think spread is headed up. You can check the spread by going to Bloomberg and searching for “Merrill Lynch High Yield Index.”
The Inverted Yield Curve
Last March, there was a lot of talk about the inverted yield curve. The yield curve is basically a graph of the return on Treasuries over time. Usually, short term money is less expensive than long term money. So if you buy Treasury bonds, you would get a lower interest rate for a one, two or five year bond then for a ten or thirty year bond. If you think about it, you should get a higher return on a longer term bond, because there’s more risk over more time.
Here’s the current yield curve from the US Treasury website. You see that the interest rate is lower in the short term, higher in the long term.
|Date||1 mo||3 mo||6 mo||1 yr||2 yr||3 yr||5 yr||7 yr||10 yr||20 yr||30 yr||02/01/08||1.75||2.10||2.15||2.13||2.09||2.22||2.75||3.13||3.62||4.31||4.32||02/04/08||2.15||2.27||2.22||2.17||2.08||2.23||2.78||3.18||3.68||4.37||4.37||02/05/08||2.22||2.19||2.13||2.06||1.93||2.08||2.66||3.08||3.61||4.32||4.33||02/05/08||2.12||2.10||2.10||2.05||1.96||2.11||2.67||3.08||3.61||4.36||4.37|
At certain times, the yield curve has inverted, meaning that interest on short term debt is actually higher than interest on long-term debt. Last March, the press made a big deal of this because often, an inverted yield curve precedes a recession. It’s not a perfect indicator, but has often been true in economic history. Last year, we had the inverted yield curve.
So again, we have to ask, why would the inverted yield curve work as an indicator? The first and most obvious answer is that the market thinks interest rates are going down. And that usually happens in a weak economy as the Fed tries to stimulate growth.
But I also think something else is going on. With fair warning, this is a Ming Lo theory, I haven’t really heard it anywhere else. If you think about it, a high short term Treasury yield means that there is low demand for short term government bonds. The yields are higher to attract investors. That means investors think there is a higher return available elsewhere – “ perhaps those seemingly riskless subprime debt and CDOs? In other words, the short term yield is high because there’s a lot of competition out there for money. Another sign that investors might be overdoing it.
It’s always interesting to see what the “whales” – “ the really successful, rich investors are doing. Not only Warren Buffett, but big players like Blackstone and real estate mogul Sam Zell. Blackstone went public last summer, meaning that they decided to sell. Many people were saying, should I buy into the IPO? And a savvy investor might say, when someone like Blackstone sells, it’s the top of the market. Sam Zell did exactly the same thing. Today, they look very smart, don’t they? Need I say more?
So those are my indicators to look at. Nothing is ever perfect, but taken as a whole, I think they’re a pretty good set of indicators. So save this article, file it away for next time. That’s probably five to ten years away.
Next time, we’ll look at how the market behaves in the midst of it’s turn. Basically, what happens after the warning signs.
I continue to hold Huntsmans stock. Recently, the acquirer indicated that it would take an extension option that was included in the original merger deal. My guess is that the government is reviewing the merger for any anti-trust issues. Huntsman stock dropped because of this announcement (because it will take longer to close the deal), but that in itself doesn’t worry me. If you hold this stock and are concerned, protect the downside by buying puts.
I’m quite fond of Boeing stock but I sold at about $79.60. It’s in my retirement fund, so I don’t have any tax consequences right now. Because of production delays, I don’t think much will happen until summer, and with the weak economy, there many orders anytime soon. I’m looking to buy the stock again when 1) new orders come in; and 2) the company can expect on-time plane deliveries.
Altria continues to be my biggest position. I still hold the stock, and on dips, I think it’s a buy. There will be a spin off next month, and the international and domestic divisions will become separate entities. Those that own the stock will get shares of both, and I believe you can hold shares of one, the other, or both.
I continue to hold several tech stocks, including Dell, Intel, Cisco and Oracle. Frankly, I missed the sell off in tech, and I do think it will take a while for tech to come back (tech needs a catalyst to spur stock prices, and I don’t see one anytime soon). So I will continue to hold and perhaps buy the lows.
Earlier I wrote that 2008 would be a time to buy banks, and in particular, Citibank. I favor the banks over the investment banks, because the Fed rate cuts will immediately lead to profits for the banks. For the investment banks, many of there business lines will see lower activity, so it will be harder for them to come back.
I heard someone say that it’s time to buy Citibank when 1) the dividend has been cut; the price to book ratio approaches 1x; and bad news emerges and the stock does not go down. I think those are reasonable indicators, and I think we are close. I’m looking for an entry point into Citibank and US Bancorp. Other banks also look attractive here.
Other stocks I’m researching at this point are Loews, which will be spinning off its tobacco unit, and McDonald’s.
Happy Chinese New Year. Thanks for reading, and until the next time, sleep well.
Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.
All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.