Wading in Turbulent Waters for Investment Opportunities
Clifford L. Caplan, CFP
Any discussion about possible investment opportunities in 2009 must be prefaced with a warning: fundamental analysis is not pertinent for investment decisions until the economy shows signs of stability. With that caveat in mind, for patient investors, with an intermediate to long-term horizon, there are compelling values to be found across a broad investment spectrum.
Compared to the meltdown in equities that occurred in November, volatility has greatly subsided. But continued losses in the banking sector have greatly limited the availability of credit. As a result, consumer spending has significantly declined resulting in the latest round of escalating unemployment. Meanwhile, the Dow Jones Industrial Average continues to vacillate around 8,000.
The economic crisis began with a credit crunch and recovery will begin with the loosening of credit. As such, the first sustainable recovery should and has already occurred in investment grade bonds. As credit rehabilitation permeates down into all facets of the economy, there is a strong expectation that below investment grade issues will be the next asset class to rise and eventually experience equity type returns.
Given the continued economic uncertainty, where are the opportunities? Time parameters for holding investments must first be established before options can be analyzed. For investors with a 12- to 18-month time horizon, the attractive yields on investment grade corporate and municipal bonds provide a stable and potentially appreciating asset. In particular, yields on investment grade municipals are 140 percent of Treasuries in contrast to historical spreads of approximately 80 percent and the interest is tax-free. The media has also focused much attention on dividend paying blue chip stocks. However, given the plight of dividend paying financials in this environment, the question beckons: what criteria define a blue chip stock? Certainly, former financial giants such as Bank of America and Citigroup can be eliminated for obvious reasons. High quality stocks such as Procter & Gamble and Heinz are very attractive with product lines that dominate markets and are replenished often. Also, many energy stocks continue to pay high dividends despite the precipitous decline in their stock price that began early last summer. Many of these companies maintain very strong balance sheets that forebodes well for future distributions. With OPEC reducing production, oil prices should continue to rise. Energy stocks represent great value with the bonus of attractive dividends.
During this crisis, a lot of attention has been directed to the relative safety and dividends generated by preferred stocks. In fact, much of the infusion of capital provided by Warren Buffet to firms such as Goldman Sachs and General Electric was in the form of investments in preferred stocks. These stocks offer a preferred cumulative dividend and are more secure in the capital structure in the event of bankruptcy. With prices of preferred stocks also down significantly, yields have increased to very attractive levels.
For investors with a growth objective but fearful of continued decline in equities, the answer to this dilemma may be high yield bonds, bank loans and convertible bonds. These fixed income vehicles experienced significant declines based largely upon the fear of massive defaults. Default rates of more than 30 percent are factored into the current prices of high yield or junk bonds resulting in yield spreads of between 14 to 18 percent as compared to Treasuries. A strong case can be made that if defaults significantly exceed 30 percent, investors would be subject to yet another rout in the stock market. In other words, the very low values for junk bonds may be the result of over estimating default rates and could provide patient investors with equity type returns with less risk than stocks. Meanwhile, while waiting for stability to return to the markets, investors are rewarded with double digit yields.
Despite the attention on performance of US stocks, international equities experienced even lower returns in 2008. Some of this performance can be attributed to the emerging markets reliance on exporting commodities. But manufacturing and service economies like China and India experienced stock market declines of more than 60 percent, this despite the fact that GDP growth rates are expected to be 8 percent and 3 percent respectively in 2008, as compared to -3.5 percent for the U.S. during the last quarter. A lasting rebound is likely to occur first in Asia and Latin America while Europe lags the U.S. as a result of severe banking problems and deteriorating economies.
Many analysts concur that the dollar will resume its decline against most foreign currencies as a result of de-levering of the American economy that is resulting in sizeable declines in the value of all assets. This development should greatly benefit investors of foreign bonds, particularly emerging markets bonds, as many of these underlying economies remain strong and maintain tremendous cash reserves.
The search for non-correlated assets remains one of the more daunting issues for all investment advisers. In 2008, seemingly all assets were correlated as financial firms held fire sales to meet liquidity needs and all assets seemed to decline at once. However, some alternative investments produced moderate losses or even sizable gains in some cases. Assets that produce solid consistent cash flow for long time periods tend to maintain prices that reflect this consistent behavior and are not based on the vagaries of an irrational market. Furthermore, in a fundamentally unsound investment climate where fear and panic often prevail, the ability to earn profits by shorting asset classes can produce handsome returns. While gold has proven to be a terrible long-term investment, its value in a portfolio is realized during economic crises. In the event that asset values continue to decline, conventional wisdom suggests that an allocation to gold can offset losses resulting from a deflationary economy. Going forward, in my opinion, it is imperative for any growth-oriented portfolio to include a 5 to 20 percent range in alternative investments.
Prior to the economic crisis, much attention had already been paid to investments in infrastructure. While debate rages on regarding the benefits to the economy, it is clear that commodities firms such as steel and mining companies stand to benefit greatly from this expected surge in spending. This infrastructure story is just one reason for all investors to consider dipping their feet back into the commodities pool. Contrary to popular belief, the wide swings in the commodities markets over the past year can largely be explained by the esoteric futures market. While commodities prices, especially oil, rose to unprecedented heights peaking last June, they recently fell to 5-year lows, all in a matter of less than 6 months. A rebound in all commodities prices is already underway. This arena is not for the faint hearted but opportunities do abound.
As history has shown, fear and panic give rise to tremendous long-term investment opportunities. While conservative moves in the short term, such as investment grade bonds, may alleviate short term volatility and produce solid and stable returns, the big long term winners require the conviction and patience of investors. For those willing to travel this long and winding road, the payoff will more than justify the anguish necessary to arrive at the desired destination.
Clifford L. Caplan, CFP, is with Neponset Valley Financial Partners in Norwood, Massachusetts.