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Monday, January 16, 2006
BARRON'S COVER
A Little More Bullish
By LAUREN R. RUBLIN
IS THE DOLLAR DOOMED? Will bond yields rise? Has America peaked? Don't you just love Mondays?
As a matter of fact, we do, and none more so than the second Monday in January, when the editors of Barron's, by tradition, sit down to talk shop with some of the world's smartest investors. So some of their views are a mite dour, even apocalyptic. Well, someone has to take the other side of the trade, especially with the stock market off and running in 2006.
To be fair, at this year's day-long gabfest, which took place in lower Manhattan, more than a few of our Roundtable guests were fairly bullish about the market's prospects. After all, price-earnings multiples are down, company profits are up, and rising dividends provide an extra kicker.
Their chief concerns: that the U.S. consumer will go on strike when the housing market tumbles; that the grass is greener on the other side -- of the world, that is -- and that oil, in great demand but diminishing supply, will exact a terrible toll on Main Street and Wall as prices inexorably rise. But don't panic yet; at a mere 10 cents a cup, Oscar Schafer wryly observed, crude still is cheaper than Starbucks.
Samberg (left) favors U.S. stocks, but Faber (center) and Hickey see more opportunities in non-dollar-denominated investments.
A jousting, jesting bunch, our crowd doesn't mark its views to market, or each other. No sooner, for instance, did Art Samberg predict U.S. stocks would rise 20% than a devilish Marc Faber declared he's in the 20% camp, too -- in the opposite direction. The case for -- and against -- bonds also got an unusually full airing, enlivened in large measure by Bill Gross' erudite analysis. (He's for some, and against others.)
In the pages that follow, you'll get all the highlights, as well as insights into how the best investors think about markets and the currents (not to mention currencies) that move them. You'll also get the investment picks of Gross, the top man at West Coast bond powerhouse Pimco, and Archie MacAllaster, perhaps the most knowledgeable investor in financial-sector stocks. He's got seven names to pique your, ahem, interest. Please read on.
Barron's: What kind of year are we headed for? John, let's start with you.
Neff: A good one in the economy, and a pretty good one in the market. I've got the economy up 3%-3½%, and the consumer still is in good shape to spend because of $5 trillion of liquidity. What galls me is the negative savings rate. True, it has fallen below zero, but it does not include appreciation in your common stocks or your home.
They're not guaranteed.
Neff: But the people who own stocks and homes are influenced by what has happened to both with respect to spending.
What do you think, Marc?
Faber: We have a fairly optimistic, unanimous consensus about the global economy for 2006. The forecast calls for benign inflation and a Goldilocks scenario in which things are just right. People dismiss the low savings rate and the U.S. trade imbalance by saying that as long as asset prices go up, there's nothing to worry about. As a result, the markets' risk premiums and volatility are low.
But, frequently, events happen outside financial markets that then have an impact on them. I've done some work on the war-cycle theory, which says commodity prices rise, international tensions increase, war results and prices go through the roof.
Is that what you're anticipating?
Faber: For the first time in modern history, both China and India are economic factors. China is the second-largest user of oil in the world, and India is expanding rapidly. Some people in the world, notably in the U.S., believe the U.S. is a superpower, but the rise in oil prices has changed the equation dramatically. Suddenly Hugo Chavez [president of Venezuela] has become a powerful man. [Iranian President] Ahmadinejad has become a powerful man. The U.S., measured by the number of nuclear warheads, may be the world's superpower, but Vladimir Putin today is much more powerful. If he were as smart as one of you hedge-fund managers, he would have cut oil production by 50% a long time ago. The price would have gone up two or three times, and he would still have the oil in the ground.
Luckily, he isn't as smart.
Faber: China gets 90% of its oil from the Middle East. The U.S. and Japan have formed a strategic alliance that has alienated the Chinese, who have carried out military exercises with the Russians. There is a Shanghai-cooperation organization consisting of China, Russia and five Central Asian republics: Kazakhstan, Tajikistan, Kyrgyzstan, Uzbekistan and Afghanistan. This organization had a meeting last July and has asked the U.S. to set a timetable for withdrawing its bases from central Asia. The U.S. has been expelled from Uzbekistan. The Chinese have applauded the military crackdown at Andijan by Uzbekistan's president, Islam Karimov. They applaud anyone who is a bit of an odd character, including Robert Mugabe of Zimbabwe. Tensions are rising because the Chinese and the Russians are interested in Iranian oil, as is India. The major event of the future could be a geopolitical event that would rock the financial markets.
Samberg: Is this your prediction for the first half or the second? [Laughter around the room.]
Faber: This is the appetizer.
Gabelli: Why will the Chinese continue to buy our dollars? At some point, won't they turn that tap off?
Faber: A year ago, the consensus about the dollar was extremely bearish. I said the dollar would go up. Once in awhile, you can be lucky. [The U.S. Dollar index was up 12.6% last year.] The situation at the end of 2005 was the opposite. Speculative long positions were at a low extreme, and speculative short positions, especially in the yen and euro, were at historic highs. The surprise for 2006 is the dollar will resume its downtrend.
Neff: "The consumer is still in good shape because of $5 trillion of liquidity."
In the last 10 days the Asian currencies have been strong. I'm still recommending Asian assets, including currencies. If the Dow Jones industrials and the U.S. housing market drop 10% one day, I have no doubt Mr. Bernanke [incoming Fed Chairman Ben Bernanke] will print money like water. Also, since 2000, U.S. financial assets have weakened vis-à-vis gold and silver. In 2000 you needed 45 ounces of gold to buy one unit of the Dow. Now you need only 20 ounces. If the Dow goes to 100,000, as the bulls wrote in those wonderful books in the late 1990s, you'll probably be able to buy it with half an ounce of gold. It won't happen this year. It will take a few years until gold is $200,000 an ounce.
Boy, you gave us all a scare there. Bill, do you think Bernanke will drop money from helicopters?
Gross: His reputation is as "Helicopter Ben." [In a speech in 2002, Bernanke famously suggested the Fed could drop money from helicopters, if necessary, to add liquidity to the financial system in a time of crisis.] Alan Greenspan faced a crisis when he was first appointed chairman of the Fed in 1987. He came to the rescue. Typically, the response of the central bank is to flood the market with liquidity. I agree that would be the response of Bernanke or any other central-bank chairman -- to provide liquidity.
The situation was different in '87.
Gross: It was entirely different. Today asset markets, at least in the U.S., dominate in providing the wherewithal for economic growth, and the support of those markets is critical. I don't necessarily believe it's the appropriate policy, as I suspect Marc does not. But if the bond market or the stock market or the housing market were threatened by some crisis -- or even by an 18-to-24-month rise in interest rates, which has already occurred -- then, yes, Bernanke as the new Fed chairman probably would come to the rescue by lowering rates late in 2006 because the economy had begun to slow.
I expect GDP [gross domestic product] to average 2% growth for the year -- stronger in the front half, weaker in the back, much of it related to the housing market. Greenspan has done an interesting six-year study and is a firm believer that the economy has been supported substantially by mortgage-equity withdrawals to the tune of $600 billion or $700 billion over several years. That's a lot of consumption.
Neff: It is very local, though. About 70% of the country has not participated.
Gross: It isn't necessarily related to where housing prices have gone up. The fact is, the American homeowner has learned to used his home as an ATM machine, whether in Des Moines or Miami or Las Vegas or Orange County, Calif. There is a lot of equity in Des Moines, just as there is in Miami. Homeowners have been able to extract it by taking out "funny-money" mortgages and by borrowing money at 1% and 2% initially.
Schafer: Are you worried about the amount of variable-rate mortgage debt and homeowners' inability to keep spending as their monthly interest costs go up?
Table: 2005 Roundtable Report Card1Gross: Yes, though you don't have to take an Armageddon-type view. Beginning in January of '06, a substantial percentage of adjustable-rate mortgages begin to adjust upward. They have had a grace period in the past year or two. We have a long stretch ahead of us in which prior Fed policy affects the economy, and that is unusual. Typically, when the Fed marches interest rates up, 12 to 18 months later there is a slowdown in the economy. We are beginning to see that, but the funny-money phenomenon and adjustables and the like have postponed the pain. Slower growth in '06, '07 and '08 will be the result.
Neff: The consumer has only about 14% of his income dedicated to fixed payments.
Cohen: To combine Bill's comments with John's, the issuance of most so-called exotic and variable-rate mortgages has been concentrated in the states of California, Texas and Florida, and in the Las Vegas area.
Faber: That is precisely the nature of a bubble. It is concentrated in a relatively narrow sector. The 2000 bubble in the stock market was concentrated in TMT [telecom, media and technology]. There wasn't a bubble in U.S. Steel or copper stocks or oil. The apologists for the housing-market bubble in the U.S. always point out that it is concentrated in a few markets, but that has always been the case. I don't buy that if the bubble in California, Florida and Texas deflates, it won't have an impact on the economy.
Zulauf: The question is how much debt the consumer will accumulate in '06. To keep the economy going in '05, the consumer accumulated about $1.3 trillion of new debt. For consumer spending to grow at the same rate in '06, that number has to rise to about $1.8 trillion. The consumer has to take out $500 billion more debt. This is highly unlikely. When you run the numbers, it is clear the consumer has to slow down, and probably decisively so during the year.
Schafer: Nowhere in this conversation have we talked about the impact of higher energy costs on consumers.
Hickey: Mortgage applications have been declining week after week after week. Refinancings absolutely collapsed. HELOC [home-equity line of credit] loan rates have gone from 4.75% to 7.75%, and those loans have fallen sharply. We're going to see a slowdown in the amount of debt taken on. The government is intervening to put a stop to some of the crazy mortgages that have been passed out in recent years.
Gross: "Bernanke, more than Greenspan, is aware of the leads and lags of Fed policy."
We are starting to see it in the economy. We are seeing it at the low end first. The people with $7 trillion of real-estate-wealth gains are still spending, but at Circuit City [ticker: CC] and Best Buy [BBY], while Christmas sales were good, store traffic was down, Wal-Mart's [WMT] same-store sales rose only 2% despite all the promotions. Auto sales are down. The question is, how fast does the high end slow?
Gabelli: On the outlay side, the consumer has an inordinate tax, which Oscar talked about. The gas bill for my house was up even in 45-degree weather.
Hickey: The average median gain last year in existing home prices was more than the gains in 2003 and 2004 combined. It was all fed on debt. The consumer will find that the asset prices are variable, but the debt isn't.
Samberg: Isn't there a difference between this and the TMT bubble? That was partially built on non-real companies delivering non-real products to non-real uses. A house is a core asset, and the Federal Reserve in its studies believes it is a bankable asset. Fred is probably right that the wind has gone from your back to your face, but people will not change spending patterns dramatically if they think their houses are bankable assets.
Neff: When you anguish about this, don't forget that the average equity stake in residential housing is 50%. It's not as if it is on 2% margin.
Hickey: But a lot of it is.
Neff: Oh, poppycock.
Affordability is at a 14-year low, and all you can say is "poppycock"?
Gross: Art, it is not the same as money in the bank. When someone equitizes that 50%, they basically do it by taking a loan. It is the cost of the loan that extracts a negative pull on the economy. It is not free money.
Cohen: It is also important to look at who the borrowers are. Upper-middle-income homeowners and above used conventional fixed-rate mortgages and are not likely to feel much pain. The real pressure will be on middle-income people and below, because they were much more inclined to use variable-rate mortgages to minimize monthly payments.
Zulauf: Two other economies, the U.K. and Australia, are running ahead of the U.S. in terms of housing trends. Their housing markets peaked about two years ago and are now flat. Retail-sales growth of 4% to 5% fell to zero to 1%. That's what's ahead in the U.S. The U.S. economy, will slow decisively during the course of the year, particularly in the second half and in '07.
What does this mean for the stock market? Scott?
Black: I look at it based on S&P 500 earnings and the dividend-discount model. My estimate for 2006 earnings, net of $4 in option expenses, is $76.25. I see the market up roughly 8% to 12%, and corporate profits growing in line with nominal GDP, at 6%. Based on Thursday's close [Jan. 5] of 1273.48, that gives me a multiple of 16.7 times earnings. That's slightly higher than the historical median of 15 to 16 times, but it is the lowest multiple we've had in 10 years.
Using my dividend-discount valuation model, and assuming 6% to 8% growth in dividends, the market was roughly 8% to 12% undervalued at the beginning of the year. On the high end the S&P could rise about 12%, which would take us to 1400. I'm moderately bullish. Real GDP will grow at 3%-3½%, and CPI will be up about 2½%, which gives us nominal GDP of 6%. But we have the worst fiscal policies under the Bush administration. The stock market has gone nowhere, and we've added $2 trillion of national debt. The Chinese keep growing at 8%-8½% a year and are going to keep the United States in the ballgame. They have a $200 billion trade surplus and need to create jobs. So I'm afraid Mr. Bush is going to get away with these huge deficits, both fiscal and trade.
Archie, what do you think?
MacAllaster: I see a decent year in the stock market. [General laughter.] This year the multiple on the S&P 500 is probably lower than 16.5. It's probably 15-15.5. Profit growth will be close to 10% again. Dividends will be up much more than 6%. Given the tax code, companies are going to pay out more. The market should be in good shape. But the most important thing -- and nobody has mentioned it -- is how things go with the war in Iraq. I almost said Vietnam. Our chances for improvement there are 50-50. If we don't make some progress in Iraq, I would forget the stock market this year.
We're going to start moving out before the election in November.
MacAllaster: If that were to happen, it wouldn't make a lot of difference in the deficit this year and next. But the anticipation would be bullish for the market. The market is not expensive. With tax efficiency, you're paying 15% taxes on dividends and 30%-35% on interest. Many companies are raising dividends by 40% to 50%. You're going to have a reasonable year.
Gabelli: "Dividends and deals will provide a margin of safety for the overall market."
Neff: How about versus alternatives? The bond market, particularly on the long side, is very unattractive. Commercial real estate has had a run.
MacAllaster: If you're making 4¼%-4½% on a dividend on a stock, it's much better taxwise than making 4½% on a 10-year bond. If we make some progress in Iraq, the market will finish higher.
Oscar?
Schafer: The market will surprise people on the upside this year for two reasons. A lot of other markets outperformed it last year. In a recent Merrill Lynch study, only 21% of global money managers wanted to overweight the U.S. The U.S. stock market has a way of fooling most people. Going up a lot would fool people.
Going down a lot would fool people, too.
Neff: What's your magnitude, Oscar?
Schafer: Low double digits. Let's say with dividends. That will get me off the hook.
Meryl, you've been too quiet.
Witmer: I look at the market from a bottom-up perspective, but I think it's 10% to 12% undervalued.
Schafer: One reason I'm kind of bullish is that we are finding a lot of stocks to buy.
Witmer: We are more invested, too.
Faber: The U.S. still accounts for over 50% of world stock-market capitalization. Japan is maybe 10%, and the rest of Asia, including China, India and Vietnam, is maybe 4%. It doesn't take a genius to see why global managers are overweight Asia, for instance, and underweight the U.S. All the Middle Eastern markets went up in the order of 100% last year. Russia was up about 80%. Even Latin American markets went up 50% to 80%.
That would argue against investing in them now.
Faber: They are still very cheap. In Malaysia, Singapore and Taiwan, the dividend yield on the stock market is higher than the bond yield. If your arguments about the U.S. are right, I'd rather be in Taiwan. There is a slight political risk, but if that risk comes true, it won't be good for any market in the world.
Samberg: Taiwan and China seem interesting. Why does that mean the U.S. is not?
Faber: Of all the major asset classes, the U.S. is one of the least attractive. Period.
Samberg: In the past two years it has gone nowhere. Japan was up 50% in the second half of last year. Multiples have come down.
Faber: In Asia, many markets are lower than they were in 1990.
Abby, what do you think of the market?
Cohen: My approach is similar to Scott's. Using the dividend-discount model, I come up with 1400 on the S&P 500 at the end of 2006. I am using among the lowest projected S&P earnings on Wall Street. I'm also assuming the bond yield moves notably higher. I'm using a 5¼% 10-year yield, which is higher than Goldman's house forecast but allows me to be conservative in the valuation exercise.
Do your earnings account for stock buybacks?
Cohen: We've tried to estimate the buybacks. Cash on corporate balance sheets has increased dramatically. First companies used it for defense purposes, such as dividends and share repurchases. About four-five quarters ago, companies started using it much more aggressively for capital-spending purposes. Personal-consumption spending decelerates this year to about 2%-2½%, in large part because of fewer home-equity withdrawals. But business fixed investment could grow 10%.
Hickey: I disagree that cap-ex spending will offset the consumer's weakness. Corporate surveys show very little pick-up -- maybe 2%, 3% increases in IT [information technology] spending. The reason is IT prices are plunging. There's just too much of everything. When personal-computer unit sales rise by double digits for three consecutive years, revenue is up only by single digits. Free open-source software has led to price compression in the software industry. Companies are shifting a lot of their service work overseas to places like India, where costs are a fraction of U.S. costs. Corporate execs say they're getting a lot more IT but not spending any more for it.
Cohen: According to industrial-production numbers, business fixed investment is growing 9% to 10% in dollars. In IT unit volume, it's running 20% to 25%, which is a function of price deflation. The worker who gets to use the new equipment doesn't care if the company spends an extra 9% or 25% for it. Some of this helps explain why productivity gains have remained stronger than expected.
Hickey: I don't believe those government numbers. I see Cisco [CSCO] sales going down, and the growth rate going down, down, down. Dell's [DELL] growth rate is going down. IBM [IBM] and Hewlett-Packard [HPQ] have single-digit growth.
Gabelli: Both of you are right. You're looking at servers and routers and I'm looking at servers and routers, but mine are called pumps and valves. Oil-equipment and aircraft expenditures and fixed plant and equipment are accelerating. Architects are planning numerous projects. Commercial construction is going up. State and local governments are ordering fire engines and ambulances and infrastructure, and Brazil, Russia, India and China are buying capital equipment. The companies I talk to that sell capital goods for water and infrastructure plays around the world are getting the benefit. In a narrowly defined way, Fred, you are right. Abby, your numbers are right. But the servers and routers we need to talk about are pumps, valves, equipment for liquefied natural gas and coal degasification, Boeings and Airbuses.
Hickey: IT is half of cap-ex spending.
Gabelli: Your glass is half empty. You are missing the part that is half full.
Faber: Mario, you're right but wrong. [Loud laughter.] Capital spending as a percentage of the U.S. economy is disappointing. Capital spending in China is almost as high as in the U.S. China has a high savings rate and invests in new plants and equipment, infrastructure and so forth. China has a capital-spending bubble, whereas the U.S. has an asset bubble. The Chinese will buy some goods from the U.S., but mostly they buy from Europe. Aside from Ralph Lauren, Asians buy luxury goods from Europe.
Gabelli: You're very parochial. You've never had bourbon, a great American product? A designer product.
Faber: Believe me, I have had enough bourbon in my life.
Bill, what is your view of the market?
Gross: My market is the bond market. I think the U.S. stock market is fairly valued, but if investors anticipate, as I do, that the Fed will begin to ease interest rates later in 2006, it becomes a bullish indicator. I'm not a glass-half-empty person on the market. As Art pointed out, the U.S. stock market hasn't gone far in 2005, and perhaps for several years. But it did better than was visible on the surface, simply because the dollar appreciated by a good 10%.
Bill Gross' Picks
1/6/06 1/6/06
Fund Ticker Price Yield
BlackRock Global Floating Rate Income Trust BGT $17.33 7.96%
Pimco Corporate Income Fund PCN 15.05 8.50
iShares MSCI EAFE Index Fund EFA 62.45 1.78
PowerShares FTSE RAFI US 1000 PRF 50.66 1.80
Source: BloombergIn 2006, if the dollar weakens, and that's my prediction, other non-dollar-denominated markets in Europe and Asia will participate more fully. They participate in the current global expansion, they are as cheap or cheaper than U.S. stocks, and they are denominated in currencies that are cheaper than the dollar. Therefore, U.S. investors should accelerate their exposure to non-dollar stocks, because the dollar as a currency is doomed.
Schafer: Will the U.S. market go up less than the dollar will go down?
Gross: I am not sure. We're importing an increasingly large percentage of our GDP from other countries, and to the extent that they are non-dollar-denominated, our purchasing power is declining. The U.S., in terms of its wealth and strong currency policy, probably is at an apex. That's not to say its prospects decline, but they decline relative to faster-growing economies, namely Asian economies.
Samberg: Last year I talked about Berkshire Hathaway [BRKA], and the stock did nothing more than the market. It's probably more attractive today than it was a year ago. Warren Buffett says he can't find anything to buy. In fact, if you look at what he did with his free cash flow last year, he put $12 billion into equities of all kinds, the second largest amount since 2002, when he invested $17 to $19 billion. So the man who says "I can't find anything to buy" is buying stocks. That gives me some comfort.
Fred, what do you think will happen to the stock market?
Hickey: I'm not sure. I'm more convinced of Bill's comment about the dollar being doomed. I put more than 80% of my own assets in non-dollar-related stuff because I don't want to have exposure to the dollar after last year's repatriation flows. [Companies received tax breaks on profits earned overseas.] I don't want to lose purchasing power. I look at foreign bonds and metals. Maybe the stock market rallies if Bernanke gets aggressive and cuts rates. But the dollar is going to get killed if that happens, and the metals will go wild. In the stock market in the short term, there is a lot of bullishness. We've had a big rally. We are due for at least a short-term setback.
Neff: If you are in the 10% to 12% total-return school, as I am, you've already gotten 25% of this year's gain. Stocks were up 3% in the past week. The S&P was up 3% last year, and 4.9% in total returns.
Cohen: The presumption here seems to be that it will be a reasonable year for bonds, especially in the second half. There is a chance we could have a selloff in the bond market first. There has been a good deal of foreign buying in the U.S. Treasury market. About 45% of Treasuries are owned by non-U.S. investors. The largest buyers by far in the last year have been investors based in the U.K. One reason could be U.K. pension accounting, which requires that long-term pension liabilities be matched with long-term pension assets. The other possibility is that petrodollars are being recycled. A lot of the OPEC nations have investment offices in London.
This also may help explain a conundrum -- why energy prices went up, yet bond yields went down. Some of these nations have been parking their money in Treasuries, and now may be thinking about other places to put it. Intermediate and long yields could go higher before we get to the happier portion of the year.
Samberg: I think the stock market's going up 15% or more. People don't understand how much asset reallocation has happened within the U.S. I sit on a couple of investment boards, and the amount of selling of U.S. assets by those premier institutions has been ferocious. If the general mood is correct, that you muddle through this year and earnings continue to grow, you could have a whoosh up in the market. It doesn't mean long-term problems don't exist, but in 2006 you could have a melt-up.
Faber: I also belong to the 10% to 20% school, but on the downside. The market will peak soon and then decline 10% to 15% into October. There may be a major low in October. I agree with Abby about bonds being vulnerable on the downside. It is unusual that we agree.
MacAllaster: What is your view of the Japanese market? Is it cheap today?
Faber: Japan is overbought. I turned bullish on Japan when I turned bearish on Japanese bonds in June 2003, because in Japan you need a decline in the bond market to squeeze the public out of cash deposits and money out from under the mattress and into real estate and stocks. So far, the money hasn't gone into domestic assets. The Japanese market has been driven mostly by foreign money, but domestic institutions are waking up. The market could still go to 20,000 but it's not as compelling an investment.
MacAllaster: That's 25%. That's not bad.
Zulauf: Yes, but it's not great. [Peals of laughter.]
Your horizons are too limited.
Faber: Other alternatives in Asia are more attractive than Japan.
Gabelli: Let's go back to the consumer. There are three billion consumers in the takeoff stage around the world. They are going to have an impact on consumption through a multiplier effect. American exports, particularly as the dollar weakens substantially in the second half of the year, will provide a powerful uplift.
Faber: These three billion consumers will have a huge impact on commodity markets, as they had in the past three years.
Gabelli: The largest U.S. exports are agriculture and entertainment. As for the stock market, don't ignore the impact of rising payout ratios on dividends or the large number of deals that continue to surface. Dividends and deals will provide a margin of safety for the overall market.
Where do all of you think oil's headed?
Schafer: Oil costs $65 a barrel. Recently in Barron's, Matt Simmons said it costs 10 cents a cup ["Twilight for Oil?2" Jan. 2]. If I were in the pair-trading business, I'd buy oil and short Starbucks [SBUX]. Oil will go up long-term, because the big fields are going to decline at a faster rate, and demand from India and China will keep rising. This year, it will trade between $55 and $75 a barrel.
A Little More Bullish -- Part II
The exhaustion of the Arabian fields is an arguable point.
Zulauf: There are about two trillion to 2.5 trillion barrels of oil in the world. We have lifted a little over one trillion, the first half-trillion between 1859 and 1982 and the second half trillion since. The theory behind Hubbard's peak is that once you have lifted half of the oil out of the field, you cannot increase production. We are running up against those technical difficulties, and oil's long-term trend is up. This year, due to the slowdown I expect in the U.S. and maybe in China, oil will stay between $50 and $70, plus or minus $5. Eventually, it will go a lot higher.
Samberg: Felix is dead on. Crude markets are nuts. They are volatile as hell, and financial buyers have come rushing in on top of the natural buyers. Most important, it's a nontransparent market. The largest incremental buyer on the margin is China, and nobody knows what's going on in China. Are they building a strategic petroleum reserve? The primary seller is Saudi Arabia, and nobody knows what's going on in those fields. You have a dynamic market that is essential to the world, with little transparency.
Faber: China's yearly per-capita consumption of oil is 1.7 barrels. U.S. per capita consumption is 27 barrels. Korea's and Japan's are 17 barrels. The U.S. has 740 vehicles per 1,000 people. In China there are three, and in India there's one. Demand is going up, and prices will be much, much higher than they are today.
Black: At the end of 2005, the world produced about 84 million barrels a day. By 2010, production is projected to rise to 94.4 million barrels a day. At the end of '05 China represented 8% of world oil demand, or 6.7 million barrels a day. Over the next five years, that will climb to 10.7 million barrels a day. India is at roughly 2.5 million barrels, going to 3.5 million. Almost all of the major fields in the world have peaked. The only fields with long-life increments in the next couple of years are Angola, Nigeria, Gabon and Brazil.
Witmer (above) and Schafer both say they're finding more stocks to buy.
Gabelli: In 1872 in New Bedford, we were running short of whales. Coal works. It just needs to be cleaned up. You'll start to see nukes [nuclear energy] and other alternative-energy sources around the world. Nothing will stay constant.
Cohen: Emerging economies use two to three times as much energy per unit of GDP as the developed economies. If energy prices stay high or move higher, these economies will see more dislocation from it than we will.
Zulauf: Here's something we haven't touched on. Markets with weak currencies did best last year. Japan had a very weak currency, as did Europe. They did extraordinarily well in local-currency terms. The U.S. had a strong currency and didn't do well. If the U.S. dollar rolls over in the second half and into '07, your market could do quite well.
Cohen: Nor have we talked about the cost of health care. Lots of people are talking about unfunded pension liabilities, which are small in corporate America. The unfunded retiree health-care problem is three to four times as large. A lot of it is concentrated among the usual suspects -- the auto companies and some other smokestack industries.
Gabelli: And states and municipalities.
Cohen: Significant retiree health-care costs will affect the ability of municipal and state governments to deal with their finances in the coming year.
Let's move on to your investment picks. Bill, what would you do if somebody gave you money, for a change, to invest?
Gross: It would depend on that person's age, wealth status and risk aversion. For the average person of 40 or 50 who was willing to take some risk and had time to absorb it, I'd recommend a combination of fixed income, equity and real estate, not housing-related. But I'd put the thrust of it in other countries, non-dollar denominated.
Which countries?
Gross: Asia -- Taiwan or Japan, or perhaps China, though there are liquidity problems with Chinese equities, and they haven't done well. Asia as a block can be purchased via exchanged-traded funds, which have low expenses and are attractively priced. I don't have a specific Asia-related ETF, but non-dollar-denominated equities and fixed-income vehicles are attractive alternatives in 2006.
There has been a lot of negative talk about bonds. Do you agree with it?
Gross: I agree with some of the concerns. Abby thinks interest rates on the long side are going up to 5¼%, based on the unwillingness of OPEC nations to continue to participate in our bond market. The U.S. market and the global bond market are a function of two bookends. One is central-bank behavior. In the U.S., and beginning now in Europe, central banks are tightening. They are willing to squeeze liquidity to cool asset markets, primarily housing, and ultimately preserve low rates of inflation. The other bookend has to do with what Greenspan called the conundrum -- why 10-year Treasuries are at 4 3/8%, why global rates universally are at levels that would have been deemed impractical and unbelievable 24 to 36 months ago, given the central-bank tightening just described and the rate of global economic growth.
Cohen's S&P 500 forecast for 2006: 1400. Bond yields, she says, could top 5%.
There are two interesting interpretations, one by Greenspan and the other by Bernanke. To the extent that Bernanke is incoming, and that we're a believer in his thesis, it pays to heed his interpretation. Greenspan would say 10-year Treasuries deserve to be at 4 3/8% because the market doesn't believe there is any risk to them, based upon inflation expectations.
What would Bernanke say?
Gross: His No. 1 priority is what he calls the global savings glut, the fact that nations such as China and Japan and the OPEC countries don't have the same investment opportunities they might if global aggregate demand were higher. In other words, there is too much supply relative to demand, so a Treasury bond becomes a more viable alternative. Global surplus reserves are being recirculated into the U.S., the U.K. and the euro, lowering real interest rates to levels that have never been approached in this type of global economy.
Based on Abby's view, the animal spirits will be revived in countries that now see U.S. Treasuries as a better alternative. I think otherwise, though I'm not bullish on bonds, or suggesting 10-year Treasury yields go to 4% and 3½%.
Cohen: Our official forecast is that bond yields go to 5%.
Gross: A bond lender such as Pimco certainly would prefer 5% or 5¼%. But in order to get those higher yields in longer-dated assets, you suffer some price depreciation. The fixed-income market in the U.S. and globally is going to be rather benign, and 4 3/8% is a decent level for 10-year Treasuries. It won't be the rate throughout the year but it might be the ending rate. The real difference probably will be on the short end. That doesn't mean Bernanke jumps in and lowers rates to 4% immediately, but by the end of 2006, with a slower economy, a Fed chairman wisely would begin to start speaking about lower interest rates.
The consensus is he's going to increase one or two times, and then stop.
Gross: I think 4½% is the top. Bernanke more than Greenspan is aware of the leads and lags of Fed policy, especially in the context of a housing-dominated market. He is fascinated with the Depression and the Japanese experience in the 1990s and he has perhaps an even more acute sense than Greenspan that in this finance-based economy, with high leverage, it is a dangerous game to continue keeping on. It is probably best to pause at 4½% and take a look. Whether or not that engenders animal spirits and juices the stock market and the housing market anew is a risk he is willing to take.
Hickey: Global savings is what's driving all these bond markets to such levels. Is it possible that irresponsible central banks are just printing money?
Gross: Some would suggest that Japanese monetary policy -- zero interest rates -- and the Japanese carry trade that allowed people to borrow at zero and reinvest elsewhere at higher rates was the nexus for lower yields on a global basis.
Faber: The notion of a savings glut is economic sophism. The cause of the savings glut is the growing U.S. trade and current-account deficits that feed liquidity into the world, leading to surpluses in Asia. Bernanke calls it a savings glut. It's really a liquidity glut coming from the U.S. as a result of easy-money policies.
Gross: Bernanke wouldn't disagree. He'd just characterize it slightly differently.
Zulauf: A big part of the savings glut is central-bank-originated in the U.S., and gets multiplied in Asia. In the past, if this had happened, inflation rates would have gone up dramatically. Because China has a huge capital-spending boom, which creates slack capacity in almost every industry, there is constant downward pressure in tradable goods and services. We've never seen before in modern times that central banks can run negative real rates and bond yields can stay low. It is a bonanza for stock markets.
Faber: For all asset markets, including truffles, art, collectibles and homes.
Bill, what do you make of the reintroduction of the 30-year bond?
Gross: When it was abolished three or four years ago, it created a hole in the yield curve. As Abby mentioned, pension funds have a growing need for longer-dated assets. We've seen that in the U.K. in the past few years as their pension and accounting standards were modified, and we are going to see it in the U.S.
Was that the inspiration for the reintroduction?
Gross: Primarily, yes, though you never know what's behind the Treasury's thinking. Some would say the Treasury is trying to take advantage of interest rates at historic lows. Also, to the extent that the Treasury might be looking at increasing deficits, it makes sense for the government to spread it out and not issue so many two- and five-year bills.
What fixed-income sectors do you like?
Gross: This isn't a year in which corporate bonds, which are narrow spreads, and high-yield bonds, which are lower-quality corporates, do particularly well. Treasuries, and especially mortgages, should do well. The highest yield in the high-quality market is in Fannie Mae, Freddie Mac and Ginnie Mae mortgages. Individuals have trouble buying these, but a good mortgage fund would be able to capture a 5½% yield for a triple-A piece of paper.
MacAllaster: "If we don't make progress in Iraq, I would forget the markets this year."
Also, I strongly suggest investors pay attention to cost. In a 4% to 5% to 6% world, a small investor can't afford to pay 1% in fees to have such low-yielding assets managed. It's too large of a bite.
Last year you liked municipal bonds.
Gross: I still like them, for a simplistic reason. Munis are the only bond-asset group that foreign investors haven't bought. They won't touch them because the tax-free advantages don't make sense to them. So yields on munis, especially on the long side, have not gone down like Treasuries. You buy what others haven't bought. It is the Buffett philosophy applied to municipal bonds.
Faber: Bill, Abby -- where will 30-year bond yields be between 2011 and 2015?
Samberg: Where will you be?
Cohen: They will be higher. We are near the bottom of the inflation and yield cycle worldwide.
Gross: I agree. The only way out is for the U.S. to reflate and depreciate its currency. If Bernanke tosses so much money from helicopters that the dollar goes down and inflation goes up enough to bail out U.S. liabilities, interest rates five or 10 years out will be higher.
Faber: Will yields be closer to 7% or 70%?
Gross: You are in Never Never Land when you talk about 70%.
Faber: Bonds have been in a bull market since '81 and interest rates are bottoming. There is a risk in the U.S. that yields will go much higher than anybody in this room thinks. In 10 years it is possible rates will be above their peak in 1981, when the 30-year yielded 15.4%.
Cohen: Anything is a possibility. Is it probable? No. Some of the policy mistakes that were made then are not likely to be repeated, at least to the same degree. Then, central banks were reflating in the face of higher energy prices. They viewed rising energy prices as a tax to be offset. This Fed has been tightening as energy rises.
Bill, how about some individual picks?
Gross: I have two closed-end bond funds and two exchange-traded funds. My first pick is BlackRock Global Floating Rate Income Trust. These are recently created funds that invest in bank loans. In many cases the assets are rated BB, Baa. You're not investing in triple-A assets, but these are loans banks made to viable corporations. They were issued on a floating-rate basis, and yields have gone up as the Fed has raised rates. If the Fed lowered rates, they might drop a little.
Typically, closed-end funds are issued at $15, or par. Within 12 to 18 to 24 months, they drop in value to a 10% to 15% discount to net asset value. The actual loans are selling at 85 or 90 cents on the dollar. The attraction here is the drop in price. Late last year, with tax selling, the price accelerated on the downside.
Archie MacAllaster's Picks
Price
Company Ticker 1/6/06
Capitol Bancorp CBC $38.19
Bank of America BAC 46.57
Allstate ALL 54.84
National City NCC 34.39
Fidelity Natl Title FNT 23.79
Doral Financial DRL 11.25
Old Stone OSTN 2.90
Source: BloombergThis particular fund is 30% invested outside the U.S. It's a currency play to some extent. Some of the largest holdings include emerging-market debt and Fannie Mae and Federal Home Loan Bank instruments. For the most part, it's double-B oriented. It's yielding about 8%. If I'm wrong and the Fed goes to 5% or 5½%, the fund will benefit because those loans are correlated with short-term rates.
My second pick is Pimco Corporate Income Fund. Most Pimco closed-end funds sell at premiums to net asset value. This one trades at net asset value.
What does it invest in?
Gross: The quality is a little better than the BlackRock holdings. For the most part it's a Baa investment-grade product. It can be purchased with decent liquidity, and yields 8.5%.
Let me throw out this caveat, however. Closed-end-fund investors rush in when they see a recommendation and may pay market price or market ask in the first day or two after this is published. Make sure you don't put in a market-based order and pay 5% or 10% more than you should. That reduces the yield to 8% or 7.5%.
Are you suggesting it will sell off after the initial burst of buying?
Gross: If an investor pays 5% too much, at some point that 5% will be given back.
Next, I've got ETFs, which I like because their fees, in most cases, are a fraction of what an investor would pay for an actively managed mutual fund. ETFs are an increasingly important part of the investment equation. My first pick is the iShares MSCI EAFE Index Fund, one of the largest ETFs in volume and outstanding capitalization. The symbol is EFA. You're buying the EAFE [Europe, Australia, Far East] here. Japan represents 25% of total holdings; the U.K. has 22%. This is an international non-dollar-denominated index fund, which trades at a liquid price and with expenses an individual investor can afford. The average annual expense is 0.35%. It's an equity play as well as a weak-dollar play.
Your second name?
Gross: There's a new phenomenon in the index business, introduced by Rob Arnott, who technically is associated with Pimco but basically runs his own shop. He's a brilliant asset allocator and the man behind Pimco's All-Asset Fund. Normal equity indexes such as the S&P 500 are capitalization-weighted, which means that as they go up in value, an index fund has to buy more shares of the stocks in the index. He argues, and I would agree, that in many cases stocks in the S&P, and the S&P itself, are overvalued.
Table: 2005 Roundtable Report Card2Arnott created an index that isn't cap-weighted. His index and this fund are weighted by sales, income, book value and dividends. He has back-dated the concept relative to cap-weighted indexes, and its outperformance is measurable. This fund is Power Shares FTSE RAFI U.S. 1000. It has a thousand stocks.
Cohen: One reason Rob's approach works so well is that he avoids the big mistakes, such as spending too much time in tech.
Gross: That's true. That's it for me.
Archie, your turn.
MacAllaster: My first stock, Capitol Bancorp, has been around for some time. It's in Lansing, Mich., and trades for about 38. The range has been 28.75 to 38.93. It has $3.5 billion in assets, and pays a 76-cent dividend, for a yield of about 2%. Earnings for 2005 are estimated at about $2.20 a share, and my estimate for this year is $2.60.
What is the market capitalization?
MacAllaster: About $550 million to $600 million. It's a 15% grower. The consolidation of the banking industry has loosened up a lot of competent bankers who don't like to go to big organizations. Capitol finances them [to start new banks], generally taking a 51% stake and selling the organizers and other private investors 49%. They operate them and handle the back-office work. After about three years, when they're profitable, Capitol buys out the rest of the stock with its own stock at about 1.5 times book value. The stock is selling for two times book.
So far, they have done 17 banks in 10 states. They expect to start about five new banks in the first seven months of this year. It's a great idea. The number of banks in the U.S. has come down from 15,000 or 16,000 to 7,000 or 8,000. A lot of these little banks start up and do well because they offer that extra service people are used to. If they're good at identifying good bankers, they can grow large.
Gabelli: Like a hedge-fund incubator, they are a bank incubator.
MacAllaster: Well said. By June, they will be in 12 states. They are being sued by their bank in California because it has done so well that their partners think it's worth more than 1.5 times book. Their total assets are now about $3.5 billion. In five or six years, they could be $12 billion.
Samberg: I love the entrepreneurial spirit.
Black: You're paying roughly 14 times this year's forward earnings. A lot of regional banks still trade for 10-11 times earnings.
MacAllaster: My second pick is Bank of America [BAC]. It's about 47 a share. The 52-week high is 47.44, and the low is 41.15. The '04 earnings were $3.69. My estimate for 2005 is $4.25. The company has raised its dividend at least 15 years in a row. It pays $2 and the yield is 4.25%. The bank just closed on a deal to buy MBNA. It's now the largest credit-card business in America. A lot of people view that as a negative. I view it as a positive because they will be able to finance a lot of that business on low-cost deposits from the bank, which will probably increase their spreads considerably. I think they'll raise the dividend again this year to at least $2.20, and by the end of the year will be paying at a rate of $2.40. The stock is worth $60 and at $2.40 would yield 4%.
Do you have another name?
MacAllaster: I recommended Allstate last year and it's up a little, at about $55. Book value is $35 a share, and the stock's range has been 63.22 on the high side, 49.66 on the low. It had a good first six months of '05 and looked set to earn over $6 a share for the year. Then it lost about $6 billion after three hurricanes. My estimate for '05 is about $2.40-$2.50; my '06 estimate is $6.50. Who knows about hurricanes? Maybe we'll get lucky this year.
Allstate is the largest publicly owned writer of personal property and casualty insurance and has a large life business. People thought they might sell the life business, but I don't and they say they won't. In the third quarter they bought in over 12 million shares. They've reduced their capitalization to 625 million shares from 885 million, and they've still got about $2 billion left in their buyback program. They will probably finish up this year buying in another 18 or 22 million shares. Allstate, too, has raised its dividend for at least 10 straight years. At $55, it's cheap.
How about another cheap one?
MacAllaster: National City is just outside of Cleveland. It trades for $34.50, and the range has been 37.85 to 29.75. It pays $1.48 a share in dividends, and yields 4.3%. It's going to raise the dividend again this year. It's a decent-sized bank, with about $150 billion in capital. It's very efficiently run. My 2005 earnings estimate is about $3.20, and maybe $3.25 for this year. The company is in the middle of the country. At this size, it ought to be attractive to somebody in the East, like Citigroup; the South, like Wachovia, or the West, like Wells Fargo. Because of the multiple, they could probably buy it and not have any earnings dilution. It's worth about 42 a share.
Cohen: Any concerns about the flat yield curve?
MacAllaster: The flat yield curve will yield flat earnings, as I noted. But it won't hurt them. This is a well-run bank, one of the best around. It has always had tough competition and it has always made good decisions. I have a feeling sometime in the next year or two it will be taken over.
Zulauf: "If the dollar rolls over later this year, the stock market could do well."
My next stock is a new name spun out of an old company: Fidelity National Title. It was spun out of Fidelity National [FNF] at 17.50 and sells for about 24. It makes over $3 a share, pays a dollar dividend, yields 4.1%. It's the leader in the title-insurance business in the U.S., with about a 35% share. It sells for less than eight times earnings. It will probably increase the dividend on a regular basis, so that yield will go up. This stock is not going to make you a lot of money, but if it goes to 30 from 24, that's better than 20%.
Gross: But it's housing-related. Are other title companies' dividends relatively stable or subject to housing volatility?
MacAllaster: They're stable, but they tend to keep dividends a little low because there are wide swings in earnings. Title insurers have enormous archives, and you can't start a company to compete with them. They also benefit because as the insured value of your house goes up, or you refinance, you have to buy insurance. Inflation works for you.
In June I recommended Doral Financial. It's down a bit, at around 11. The range has been 49.45 to 7.84. This is the largest mortgage company in Puerto Rico. It also has a bank in Puerto Rico and branches in New York City. Doral got into all kinds of trouble awhile ago. It had to change its last four years of financial statements, and indicated it would show losses of about $660 million. The stock went from the 40s to about 8. When they get through, they'll show $1.65-$1.70 in earnings for last year. They can make a little more next year. There is going to be consolidation.
There are four or five Puerto Rican banks. This one is the largest mortgage writer but the smallest bank. It will be bought out. The market cap is $1.1 billion. Book value is about $8.50 after the writeoffs. At one time it was $16 or $17 a share. Doral pays a dividend, 32 cents, and yields better than 3%.
Is that all, Archie?
MacAllaster: I have one more, a real speculation. It's a Providence, R.I., savings and loan, Old Stone, which was founded in 1819 and filed for bankruptcy in 1993. The bank took over some thrifts in the 1980s and the government allowed it to use its goodwill as capital. In 1992, the government changed its mind and forced Old Stone into bankruptcy. The bank sued and just over a year ago the federal court found in their favor for $192.5 million. The government waited for the last day it could appeal, and did.
The company has two securities outstanding -- about eight million shares of common, and one million of cumulative preferred. The preferred is $20 par and sells for about $37. But it has $34 a share in arrears on it. The case will be resolved this year or next. With the arrears, the bank would have to pay $57 million to the preferred shareholders. If they get the full $192 million, they'd be left with $140 million less lawyers' fees, leaving $80 million to $100 million for the common.
What does that sell for?
MacAllaster: The common sells for $2.90 to $3.10. You have a great chance to make money on it. Even if they settle or the court finds they're entitled to less, you will get more than your money back. On the preferred you should get it all back. But be careful. It trades thinly, about 5,000 shares a day. I would not pay more than $3.50 a share. I think you will get $8 to $10 for it.
The judge practically called the federal government crooks for not owning up to the fact that they forced the bank into bankruptcy. There have been some cases like this in California and the government has not won any of them.
That's encouraging. Time for lunch. |
