Time of Greed

"It's Too Expensive to Be Defensive" is the headline in today's Breakout on Yahoo Finance.

Insurance is a wonderful thing — especially when you need it. But it's definitely not free. In fact, the cost of protecting your assets in the stock market has become really expensive, which is why some investment pros are of the mind that the cost of protection just isn't worth it anymore.

The cost of insurance for stocks is put options. With volatility low, that cost remains quite reasonable. However, the author is of course referring to the opportunity cost of not investing, instead of the costing of insuring the downside of an invested portfolio. That cost had certainly been very high for the past few months.

"It's too expensive to be defensive." But too expensive for whom?

Does it mean not investing or under investing will be costly in terms of clients' portfolios? Or does it mean the asset manager will lose his job because he is under-performing? Here lies the conundrum for professional fund managers. Not investing is simply not an option.

I am certain that most investors have heard the famous quote from Warren Buffett, "Be greedy when others are fearful. Be fearful when others are greedy." It seems we have once again entered the time of greed. It proves once again how hard it is to actually implement the wisdom of the the most famous investor. Judging by the speeches of his recently concluded annual meeting, the doctor is also having a tough time heeding his own advice.

Apple Issues Debt

Apple was in the market yesterday to sell a record amount of bonds in 6 different tranches, including floating rate notes of 3 and 5 years and fixed rate papers of 3,5, 10 and 30 years in duration. For a company with $145 billion in cash on the balance sheet, why would it even consider issuing bonds? The reason is of course most of Apple's cash is sitting overseas and can't be easily repatriated without adverse tax consequences. So to return money to shareholder, Apple has to resort to the bond market.

NEW YORK (AP) -- Apple Inc. sold $17 billion in bonds Tuesday in a record deal spurred by the company's plan to placate its frustrated shareholders.

The Cupertino, Calif., company sold the bonds in its first debt issue since the 1990s to raise money to pass along to shareholders through dividend payments and stock buybacks. The payments are part of an effort to reverse a 37 percent drop in Apple's stock price during the past seven months amid intensifying concerns about the company's shrinking profit margins as it faces more competition in a mobile computing market that Apple revolutionized with its iPhone and iPad lines.

Apple has $145 billion in cash, more than enough for the $100 billion cash return program it announced last week. However, most of its money sits in overseas accounts, and the company doesn't plan to bring it to the U.S. unless the federal corporate tax rate is lowered.

With interest rates so low, it makes sense for Apple to borrow a large sum of money rather than pay a big tax bill.

Apple bonds are well received by the market place. All the papers are currently trading at a slight premium to the issue price. For example, Apple's 10 year 2.4% bond is trading at 100.4 to produce a yield to maturity of  2.36%. While Apple is AA+ rated by S&P, its bond is actually trading at comparable yield to the AAA rated Microsoft. For those who are chiefly concerned with principle risk, I think the AA- rated IBM bond presents a slightly more attractive option. Its 7% 2025 bond trades at 142 and has a yield to maturity of 2.93%. On balance sheet strength and leverage ratio, IBM certainly looks weaker than Apple or Microsoft. However, one may very well argue that even though the short and intermediate term security of Apple is very high, its long term prospect carries greater uncertainty than IBM. Apple's products carry short refresh cycle and must rely on constant innovation just to stay relevant. With a few missteps, Apple is not far from becoming RIM or Nokia.

However, for those who are not only concerned with principle risk, but also the risk of diminishing purchasing power, it seems the stocks of IBM and Apple offer much more compelling risk and reward than their fixed income counterparts. In fact, even after a significant rally, blue chip stocks in general offer dividend streams comparable to highly rated corporate bonds. The deciding factor that favors stocks over bonds is due to the fact that dividend streams grow over time.

It is Real Money

IBM is the owner of one of the most resilient business models in information technology. Over the past few decades, it has gradually transformed from a hardware company to a software and service focused company. It is also the business model the likes of HP and Dell aspire to. No wonder it has become one of the few tech companies found in Warren Buffett's portfolio.

On Friday, the stock of IBM was down over 8% after a less than stellar earnings report. The disappoints came mainly due to the effect of a weaker yen and delayed software sales. CNBC published an article detailing the amount of loss at Berkshire due to IBM.

It's been a tough week for Warren Buffett's big investment in IBM (IBM).

Big Blue's stock plunged 8.3 percent Friday to $190 per share after the company reported disappointing first quarter revenues.

According to its most recent portfolio filing , Buffett's Berkshire Hathaway (BRK-A) owned 68.1 million IBM shares as of the end of December.

Assuming Berkshire's stake is still around that size, Friday's slide cut the value of those shares by $1.168 billion to $12.94 billion.

That's on paper, of course. Berkshire won't actually lose any real money until it sells the shares, and given Buffett's buy-and-hold track record that won't happen until years from now, if it happens at all.

When the price of a stock one owns trades down, that is often called "paper loss." When a stock is sold at a loss, that is called "realized loss." However, both forms are losses of real money, as real as if your bank accounts had been hacked and as real as if Warren Buffett had lost his wallet containing $1.2 billion. In Behavioral Fiance, the term anchoring refers to making decisions based on irrelevant information. It is precisely a commitment of anchoring when investors allow the purchasing price to effect one's sell decision. Long term investing involves the assessment of a company's intrinsic value. When the intrinsic value is above the current price of a stock, the long term investor would sell. Short term investing involves the study of a company trading momentum and technical factors. The purchasing price is relevant in neither process.

So Much Expected So Little Delivered

Amid the more headline grabbing data of weak retail sales and consumer sentiment, the US Labor Department released March Producer Price Index. Here is a report from Reuters.

The Labor Department said its seasonally adjusted producer price index fell 0.6 percent last month, the largest drop since May, after increasing 0.7 percent in February.

Economists polled by Reuters had expected prices received by the nation's farms, factories and refineries to fall only 0.2 percent. 

In the 12 months through March, wholesale prices were up 1.1 percent, the smallest rise since July. Prices had increased 1.7 percent in February.

Underlying inflation pressures also were muted, with wholesale prices excluding volatile food and energy costs rising 0.2 percent for a third straight month.

With central bankers around the world working overtime in the quest of greater currency production, it has been widely predicted for a very long time that inflation will eventually pick up. However, eventuality does have a habit of toiling with her pursuers and is never in a hurry to arrive. The liquidity that has been created with extreme low interest rate has flown mostly into supporting asset price instead of increasing consumption. In turn, the elevation of asset price is justified by the sustainability of low interest rate. By policy, the US Federal Reserve controls in short end of the interest rate curve and now quantitative easing, it also exerts the greatest influence on the long end. The Feds have stated very clearly that the ending of QE depends on two variables, inflation and unemployment rate. With unemployment rates still high and inflation under control, the foundation of the bull market remains intact.

Debate Within Fed

The March FOMC meeting minutes were released early today which showed active debate among Fed officials on the fate of $85 billion monthly bond purchasing program. Here is a report from the Wall Street Journal.

The minutes, which were released early Wednesday rather than in the afternoon as usual, showed that "all but a few" Fed officials agreed at the central bank's last policy meeting that they wanted to keep the program going "at least through midyear." But after that, officials had a wide range of views about how they might proceed.

Some at the March meeting felt the Fed would be able to begin tapering the program down around midyear. Others saw the Fed continuing through September before tapering down, and a few wanted to keep the program going at its current pace through 2013 and into 2014. Some also held out the possibility of increasing the program if the economic outlook deteriorates.

As the meeting was held on March 19 and 20, data released after the meeting have generally showed that economic conditions have mostly softened. Thus, strengthening the argument for those who want to extend and even expand the quantitative easing program. That is of course why the stock market is once again reaching new heights and the Fed minutes were all but ignored.

Onto the Fed wagon, stocks have hitched a ride. In Fed we trust that where ever the wagon goes, there shall be no roads that the Fed can't not navigate. Amen!

 

 

Measure of Greatness

In his typical well thought out piece posted on Pimco's website last week, Bill Gross pondered the age old relationship between epoch and her heroes. For those who enjoy a bit intellectual self reflection, the entire article is well worth reading, so here I quote at length.

So time and longevity must be a critical consideration in any objective confirmation of “greatness” in this business. 10 years, 20 years, 30 years? How many coins do you have to flip before a string of heads begins to suggest that it must be a two-headed coin, loaded with some philosophical/commonsensical bias that places the long-term odds clearly in a firm’s or an individual’s favor? I must tell you, after 40 rather successful years, I still don’t know if I or PIMCO qualifies. I don’t know if anyone, including investing’s most esteemed “oracle” Warren Buffett, does, and here’s why.

Investing and the success at it are predominately viewed on a cyclical or even a secular basis, yet even that longer term time frame may be too short. Whether a tops-down or bottoms-up investor in bonds, stocks, or private equity, the standard analysis tends to judge an investor or his firm on the basis of how the bullish or bearish aspects of the cycle were managed. Go to cash at the right time? Buy growth stocks at the bottom? Extend duration when yields were peaking? Buy value stocks at the right price? Whatever. If the numbers exhibit rather consistent alpha with lower than average risk and attractive information ratios then the Investing Hall of Fame may be just around the corner. Clearly the ability of the investor to adapt to the market’s “four seasons” should be proof enough that there was something more than luck involved? And if those four seasons span a number of bull/ bear cycles or even several decades, then a confirmation or coronation should take place shortly thereafter! First a market maven, then a wizard, and finally a King. Oh, to be a King.

But let me admit something. There is not a Bond King or a Stock King or an Investor Sovereign alive that can claim title to a throne. All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience. Since the early 1970s when the dollar was released from gold and credit began its incredible, liquefying, total return journey to the present day, an investor that took marginal risk, levered it wisely and was conveniently sheltered from periodic bouts of deleveraging or asset withdrawals could, and in some cases, was rewarded with the crown of “greatness.” Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.

Suppose we gather the population of the world and engage in a single elimination coin tossing contest. Those who keep throwing heads may continue and those who throw a single tail are eliminated. We shall crown the eventual winner or winners who have perhaps tossed 35 or so heads in a row, as the coin tossing king. Perhaps a whole industry will develop around the coin tossing techniques of those winners. The initial velocity of the toss, the angle of ascend and spin rate will all be analyzed to ensure the desired outcome. The advanced coin tosser may even consider subtle adjustments after studying ambient temperature or air moisture content.

Are what we consider to be great investors in fact great at finding investment winners? Alternatively, are they merely great because of the chance meeting with lady luck like our coin tossing champions?

As investment professionals, our craft is by nature a statistical endeavor. As a result, investment greatness can only be reasonable suspected over a long period of time and may never be assured even over a lifetime of accomplishments. Even within the epoch of credit expansion and general economic growth, many have over-levered themselves and thus failed to survive episodic credit crunch and general panic. Some become so tethered to a thematic outcome and failed to consider the very basic nature of supply and demand and competition. And most still toil in mediocrity and prefer the safety of the herd. Mr. Gross with his investment tenure and record has certainly distinguished himself and I personally believe his image is firmly established within the pantheon of great investors. Consistent and sizable out-performances over long time frame even within a single epoch are accomplishments claimed by very few. 

Stockton Syndrome

Yahoo Finance's Daily Ticker show spoke of the latest ruling by a federal judge allowing the city of Stockton to proceed under bankruptcy protection.

A federal judge earlier this week gave the green light to Stockton, Calif. to restructure under bankruptcy protection despite protests from creditors. The Wall Street Journal reports the judge signaled that Stockton may have to cut payments to its pension fund, which could set a precedent for other cities. The fight also has pitted California’s pension system, CalPERs, against other bondholders and the Wall Street firms that insure them.

“This really hasn’t happened before,” Matt Fabian, managing director of the Massachusetts-based Municipal Market Advisors, tells The Daily Ticker. “We are further along the road toward some potential haircut for bondholders. In all the bankruptcies that have happened in modern history, there haven’t been any haircuts for regular government bondholders – in general people have always gotten their principal back.”

In muni investing, sounds like one should be shifting to essential service revenue bonds from general obligation bonds. Personally, I have always had a bias against government or quasi-government type of bonds whether it is issued by a country, a city or an Indian reservation. The analysis of such bonds invariably involves accessing the will to pay in times of distress by the leaders of such entities as it is impossible to repossess a city or a country. In contrast, mortgage bonds or corporate bonds are much more dependent on underlying asset value. I find it much easier to access asset value than will power.