This week I am really delighted to be able to give you a condensed version of Gary Shilling’s latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary’s latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. His track record in this decade has been quite good. I want to thank Gary and his associate Fred Rossi for allowing us to view this smaller version of his latest letter.
If you are interested in his letter, his web site is down being re-designed, but you can write for more information at insight@agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get the full 2010 forecast with price targets, but an extra issue with his 2011 forecast (of course, that one will not come out until the end of the year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week’s Outside the Box….
John Mauldin, Editor
Outside the Box
2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell
(excerpted from the January 2010 edition of A. Gary Shilling’s INSIGHT)
Our investment strategies for 2010 follow from our forecast of continued economic weakness and deflation, as discussed earlier in this report and in previous Insights, especially our Dec. 2009 edition. We see the 2010 investment climate dominated by weak economic growth here and abroad, led by U.S. consumer retrenchment. More government fiscal stimulus and continuing Fed policy ease are likely in this setting. So is low inflation or deflation.
INVESTMENTS TO BUY
1. Buy Treasury Bonds. Long-term Insight readers know we started recommending long Treasury bonds back in 1981 when we forecast secular and huge declines in inflation and interest rates. So we declared back then that “we’re entering the bond rally of a lifetime.” The yield on 30-year Treasurys was 14.7% and our eventual target was 3%. Last year, yields blew through 3% to reach 2.6% at year’s end, so in our Jan. 2009 Insight we declared “mission accomplished” and removed Treasury bonds from our recommended list.
But then Treasurys sold off, pushing the yield on the 30-year bond to 4.7% at the end of 2009. So we’ve reactivated the strategy with our forecast of a return in yields to 3.0% or lower. Treasurys will continue to be a safe haven in a troubled world and benefit from deflation as well as their three sterling features. They are the best credits in the world. They are highly liquid. And they generally can’t be called by the Treasury, and calls limit price appreciation when interest rates fall.
A decline in yields from 4.7% at present to 3.0% may not sound like much, but the bond price would appreciate over 34%. If it occurs over two years, then two years’ worth of interest is collected, and the total return on the 30-year Treasury would be 44%. On a 30-year zero-coupon Treasury, which pays no interest but is issued at a discount, the total return would be about 64% — most attractive! Recall that in 2008 when 30-year Treasurys rallied from 4.5% to 2.7%, their total return for the year was 42%..
Treasury bonds way outperformed equities in the 1980s and 1990s in what was the longest and strongest stock bull market on record. The superiority of Treasurys has been even more so since then. Chart 1, our all-time favorite graph, shows the results from investing $100 in a 25-year zero-coupon Treasury bond at its yield high (and price low) in October 1981, and rolling it into another 25-year Treasury annually to maintain that 25year maturity. In November 2009, that $100 was worth $16,972 with a compound annual return of 20.1%. In contrast, $100 invested in the S&P 500 at its low in July 1982 was worth $2,099 in November for an 11.8% annual return including dividend reinvestment. So Treasurys outperformed stocks by 8.1 times!
Doubters
Many believe Treasury yields are headed up, not down. They think that all the bank reserves created by the Fed that have not generated bank loans will do so, flooding the economy with money and then create excess demand and inflation. They also think the continual heavy issuance of Treasurys to fund the nonstop federal deficits will push up yields. In contrast, we don’t foresee the rapid economic growth needed to induce chastened banks to lend and cautious creditworthy borrowers to borrow. And if we’re wrong, it will take at least several years to eat up global excess capacity during which the ever-inflation-wary Fed will no doubt remove the excess bank reserves, as Fed officials have already indicated.
We do expect large federal deficits for many years, in part because of pressure on government to create jobs and restrain unemployment in a slow growth economy. But those deficits will increasingly be funded by U.S. consumers as their saving spree continues. Although stock market bulls salivate over the prospect that increased saving will mean more equity purchases, we believe most of the money will continue to reduce the immense debt consumers have accumulated in recent decades.
Repaying debt will be attractive to many Americans in 2010 and beyond as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.
Another concern for Treasury bonds is that continued huge federal deficits and the required Treasury financing will erode confidence in these issues by Americans and foreigners, as noted earlier. This seems unlikely, especially before the end of this year. Also, as U.S. consumers save more and curb spending on domestic products and imports, the trade and current account deficits will continue to shrink. Earlier federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade and current account surpluses. The growing U.S. current account deficit measured the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.
But now, the current account and trade deficits are shrinking, and further declines will accrue in future years if, as we forecast, exports grow faster than imports. So foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will be financed by rising U.S. consumer saving.
With 3-month treasury bills yielding 0.046%, we’ve moved out on the yield curve for what is essentially cash positions in some cases. Sure, 5-year obligations are much more volatile than 3-month bills and do have risk of loss if interest rates rise. But we think the direction is down in that part of the interest rate curve, and 2.6% returns vs. 0.046% seem enough to offset the risks.
2. Buy Income-Producing Securities. This includes high-quality corporate and municipal bonds as well as stocks of utilities, consumer product companies, health care firms and others that pay meaningful dividends that are likely to rise. Master Limited Partnerships are also possibilities, but only if their underlying businesses are secure enough to continue significant income flows to limited partners and stockholders. Banks used to pay significant dividends but slashed them when their earnings collapsed. Nevertheless, their deleveraging and reversion to safer but less growth-oriented businesses will probably pressure them to again pay attractive dividends.
Utilities lagged behind the stock market last year, but at the end of November, the dividend yield on utilities averaged 4.5% compared to 2% for the S&P 500 index. That low return compares with 3%, which used to be the floor (Chart 2). Payout ratios recently have been essentially meaningless with the collapse in corporate earnings, but low, 31% in the third quarter of 2009. Under pressure from stockholders, dividend yields are likely to return to 3% or more. The current high level of corporate cash will also encourage dividend paying.. Also, the S&P utility sector has returned 53%, including dividends, since 2000 while the total return on the S&P 500 index has been a minus 11%.
With stocks likely to be weak this year, dividend yields may constitute 100% or more of total returns. Note, however, that although the prices of utility and other defensive stocks sometimes rise in bear markets associated with recessions, that’s not always the case. That was clearly true in 2008 when virtually every stock sector went down. Utility and other dividend-paying stocks and ETFs based on them, however, can be hedged against general stock market declines.
3. Buy Consumer Staples and Foods. Items like laundry detergent, bread and toothpaste are basic essentials of life that are purchased in good times and bad. In fact, as we’ve seen lately, consumers are buying more of their calories in supermarkets and they economize by eating at home rather than in restaurants. Note, however, that they are downgrading from national brands to cheaper house brands, and likely will continue to do so as a weak economy and high unemployment persist. Among retailers, the winners may continue to be discounters. Producers of national brands will need to continue to adapt to consumer downgrading by emphasizing cheaper “value” products.
4. Buy Small Luxuries. This is an investment concept we developed years ago. Consumers, especially when they’re hard pressed, tend to buy the very best of what they can afford, even if it’s within a low-priced category. We first noticed this tendency years ago, before apartheid ended in South Africa. We read that urban blacks there often carried the elegant, slim and expensive umbrellas typical of investment bankers in London. They couldn’t afford cars or maybe even taxi fares, but did achieve status and satisfaction with fine umbrellas. We also learned of a currently unemployed man who enjoyed the status of morning coffee at 7-Eleven six days a week. By reusing his cup and the one he takes home to his wife, he gets a 32-cent discount per $1.37 serving and saves $655 a year on this small luxury.
Companies are adapting to small luxury modes in various ways. Some are offering the same products with lower cost and selling prices. Coach is cutting ladies handbag prices and working with suppliers to reduce costs. Neiman Marcus is pressing suppliers for lower-cost versions of designer styles.
Others are putting their prestigious names on different products. C.F. Martin reintroduced its stripped down 1930s guitar for under $1,000. Average prices were in the $2,000 to $3,000 range and its top of the line guitar sells for $100,000. California winemakers are emphasizing cheaper wines as sales of those over $25 per bottle slump. Consumers are retrenching and dining out less at upscale restaurants where fine wines are sold. Tiffany sales of products over $50,000 are weak, but high-quality small items continue to sell well–always in its trademark blue box. Procter & Gamble has not cut prices on its top of the line products that sell at premiums but carry high-quality images. Consumers still splurge on such small luxuries as Gillette’s five-blade Fusion razor and Olay’s Pro-X moisturizer. But P&G has introduced cheaper “value” versions of Tide and other products to compete with the growing consumer interest in lower-cost national and house brands.
5. Buy The Dollar. Dumping on the dollar was the favorite sport of investors and the financial media until very recently. The financial meltdown in 2008 drove investors to the dollar as the global safe haven, but in early 2009 that status faded as fears of financial collapse melted. Buck-busters cited the record low short-term interest rates, with the fed funds target rate at 0-0.25%, even lower than in Japan. This made the greenback the preferred funding currency for the carry trade in which it is borrowed and then sold for other higher yielding currencies with rising interest rates. The falling dollar against those currencies enhances the profitability of those trades. Buck dumpers also emphasized the tremendous amount of dollars being pumped out by the Fed and the Treasury 70 in their attempt to revitalize the economy 68 and the Fed’s clearly-stated commitment to keep short-term interest rates low for an extended period.
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