TeraDime NEWSLETTER

 

 

December 2006 TeraDime Newsletter

 

The End of the Year Update

 

Six months ago, in June of 2006, I came up with some themes for the rest of 2006.  Here is what I had written back then:

 

“So, the strategy for the next 6 months:

 

1.                  Cash is OK (CDs, money markets, etc…)

2.                  Closed end municipal bond funds that are not leveraged and trade at discount. This is specially good strategy if you have decent income and live in a high tax state like NY, NJ, CA. Login to www.etfconnect.com to search for these and other closed-end municipal bond funds

3.                  Cut down on risk by investing more into Large Cap Value stocks vs small caps growth stocks.

4.                  Gold and Commodities should represent a small part of your portfolio as a hedge against inflation. Commodities are very volatile and 2% - 3% daily swings in price are not uncommon.  That is why only very small portion of your portfolio should be invested in it.

5.                  Relax and enjoy the roller coaster ride. The stock market will not rally dramatically until Federal Reserve stops interest rate increases and markets stop worrying about inflation”.

 

At this point, when only a couple of weeks left until the end of 2006, it is appropriate to review the above strategy.

 

1                    Cash was of course OK. You were able to find the money market rates around 5% and even now some of the banks provide the money market savings accounts that yield above 5%.

2                    Closed-end municipal bond funds that were trading at discount have done really well too. For example, including tax free dividends and income appreciation, NY closed end municipal bond funds are up 11% from June!  This is a pretty good return for tax-free “boring” municipal bonds. (Did I mention that you do not have to pay tax on distributions?)

3                    The Large Cap Value stock index (represented by the VTV exchange traded fund) is up 15% since 6/15/2006, while the Small Caps (represented by the Russell 2000 Index ETF IWM) is up 13% since 6/15/2006. So, both small caps and large caps performed pretty well, although, Large Cap Value did beat the small caps by 2 percentage points since June.  By the way, the S&P 500 index is also up 13% since June of 2006.

4                    Gold was very volatile and is up 8% since June. It managed to go up 14% from June 15^th until July 10^th and then drop like a rock from +14% to -2% in three months. This is a swing of 16% (on the way down!). Commodities are not for someone who cannot handle risk and should only represent a very small portion of your portfolio.

5                    June 30^th marked the last interest rate increase for 2006. The current federal funds rate remains at 5.25%.  As I mentioned above: “The stock market will not rally dramatically until Federal Reserve stops interest rate increases and markets stop worrying about inflation”. S&P 500 was up 1% from January 1/1/2006 until 6/30/2006 during the Federal Reserve’s tightening cycle and took off sharply right after the last rate increase by rising 12% from 6/30/2006 thru 12/10/2006.

 

Here is what I have written about Microsoft and Google Six months ago:

 

“The price of Microsoft Stock moved nicely in the desired/predicted direction (down) and as of yesterday it was trading at $21.88 which is just below our target of $22 per share.  This really presents a great buying opportunity for value investors.  MSFT did absolutely nothing for the past 8 years. If you were holding the stock since 1998, you are exactly where you have started + dividend. So, if you thought that MSFT was a great buy in 1998 with P/E ration of 50 and price of $21 per share, then it is a steal with the current P/E ration of 17 and the price of 21 now.

 

 Microsoft, as a company, is just as great as it was in 1998, the only difference is that it was priced ridiculously high then, and it is fairly priced now.  This clearly shows that even great companies can be bought “on sale” if you wait long enough.  Something to think about the next time you put the buy order for Google at $384 per share and PE of 68! By the way, if you thought that Google was a great buy at $475 per share in the middle of January, then paying $384 per share now should be a no-brainer. That is a cool 19% discount. Note: as you know I like to stay on the value side and Google at $384 is still steep, no matter how you look at it.”

 

As I look at Microsoft today, in December of 2006, the stock is trading at $29.50. This represents a 34% increase in price (not including dividend) from June of 2006. This is what you call Value Investing 101.

 

Google is currently trading at around $484 and it is up 26% since June. If you read above, I thought 6 months ago that MSFT provided a better value then Google and it was an excellent call. At today’s prices I would not be buying either Google or Microsoft (which does NOT mean that the price of these companies would fall).  I just do not see Microsoft as a pure value play anymore.  However, if I were to own Microsoft (which I do not), I would not sell it either.  I think that Microsoft is fairly priced.  Google, however, is a time bomb – a major trouble waiting to happen (I just do not know when). 

 

 

Economic overview:

The Federal Reserve stopped raising rates at the end of June 2006. The current Federal Funds rate is at 5.25%.  The current 30 year fixed mortgage rate is around 6.5% which is historically pretty low.  However, the bubble in the housing market is starting to unwind and the only hope is that Corporate America will keep chugging along, providing enough jobs for people so that poor souls that over-leveraged with 0% down and interest-only loans are able to make the payments once the interest rates on these mortgages start rising. 

 

If you own investment property in Florida, how do you know when to get out? A very unsophisticated, but a proven method is to put the property for sale when you see the following headline in Time Magazine: "Home $weet Home: Why We're Going Gaga Over Real Estate." This article was published in June of 2005.  I think summer 2005 was the peak of the modern Real Estate bubble.

 

Fast Forward to November 1^st 2006 article from Fortune Magazine: “Can the Economy Survive the Housing Bust?” How do we know that the worst is not over? Well, when New York Times or Time Magazine will start writing about housing bust and why it is time to Sell Real Estate, then you know the worst is over and it is probably the time to start buying Real Estate. Knowing how “well” these magazines and newspapers cover the economy, do not wait for this type of articles from these established publications in the near future.

 

The economy is slowing down, and since Real Estate and Real Estate related expenditures represent a huge portion of our economy, I believe that it is important to watch what will be unraveling on the Real Estate front to measure the health of the overall economy. For now, the only casualties (besides the poor souls that actually live in the houses with no equity in them and cannot pay the mortgages) are the stocks of the home builders.  They sold off about 40% as a group in the first half of 2006.  Since July lows however, these stocks rallied back with the overall market, gaining 25%.  Overall, Home Builders are off 17% year to date.  Is the worst over for homebuilders and house related stocks? (Home Depot is down 7% year to date for example, while S&P 500 is up 13%) I do not think so. I think that we will be happy to see flat-to slightly positive housing market in a best case scenario, and in the worst case scenario, this is just the beginning of the housing slump that will last another 3 – 6 years.

 

 

Marker Review

 

All the major indexes: S&P 500 (SPY), Nasdaq 100 (QQQQ) and Dow (DIA) are firmly in the bull market.  This bull market is 4 years old, which means that caution is prudent at this point.  On the bright side, technical indicators are excellent, which makes a paranoid and skeptical investor like me even more paranoid and even more skeptical. What is wrong with this market? Absolutely nothing on the surface! And this is exactly what is wrong with it. Corporate earnings are strong, valuations are solid, and stocks are not expensive (they are not cheap either, however).  Corporate balance sheets are in excellent shape – this is one of the reasons why there is a boom in Leveraged Buy Outs (LBOs). This is when private equity firms take public companies private, leverage them (borrow against companies balance sheets), take the cash out (divide it among LBO clients as a “special” dividend), and then sell a company back to investors as IPOs in a much worse financial shape and collect the cash from IPO as yet another “special” dividend.  How do they create the value for investors? They do not! Creation of value for average stock market investor is not their responsibility.  An LBO firm’s responsibility is to create value for their clients and owners - NOT for an individual retail investor. Individual investors are schmucks that are there to buy these overleveraged companies from LBO firms and make couple of 25 year old MBAs wealthy in the process.

 

This Private Equity/LBO boom is not going to end on a high note.  Some big LBO firm or a hedge fund that does private equity investment is going to blow up and hopefully the market will be able to absorb it and some people will learn a valuable lesson.  Unfortunately, markets do not easily absorb anything, and people usually do not learn much.

 

Several words about the dollar: the good news is that the dollar is falling, which creates competitive advantage for this country – it makes our products cheaper for our foreign trade partners.  The bad news is we have to buy stuff from overseas (since, besides MBAs, we really do not make anything tangible) and the dollar is falling!  Effectively, a falling currency in an export dependent country (that would be us) is a pretty BAD thing, since we can buy less and less with our currency and our standard of living keeps falling with the dollar.  The falling dollar is a hidden tax, just like inflation.  We do not really see it yet (except for the price of oil), since we import most of the consumer goods from China (which pegs its currency to dollar – one day they will stop doing it – and we will be in big trouble). However, if you want to by Italian Furniture – it will cost you dearly. So, I suggest you convince your wife to buy two sets of Chinese furniture (you know – one set for parts) instead of one set of Italian furniture.

 

In all seriousness this country needs to get a handle on a sliding dollar. Raising interest rates did not work – and it looks like the Fed is done raising rates, at least for now. The only other way is to stop borrowing and get our fiscal house in order. Stop spending tax dollars and getting into debt! The only hope is that with the divided government (Republican President and Democratic Congress) nothing will get “done”.  The less that gets “done” in Washington, the better it must be for all of us.

 

The sliding dollar is a major concern for our economy and our stock market.  The way to deal with it is to get our national finances under control. Get out of perpetual budget deficits and start paying off debt.  Our Federal Debt as of December 12, 2006 is

 

$8,663,015,867,912.95 (it is basically a bit over $8.6 Trillion)

 

The estimated population of the United States is 300,444,102.  This works out to $28,834.04 per citizen. The average family (4 people) owes our lenders (China holds $1 trillion out of $8.5 trillion) about $115,336.  I guess those Chinese toys, DVD players, computers, and other manufactured goods that you were panning to buy for Christmas are not that cheap anymore, are they?

 

 

Investment strategy for the first half of 2007

 

Investors that follow asset allocation strategy should not change anything.  Review your portfolio and get back to your target allocation by selling winners and buying losers. Yes, you heard me correctly – in order to keep your target allocation you will have to sell winners (realize gains) and buy losing investments (dollar cost average).  I am sure this was not in your plan since “normal” investor would keep the winning investments and get rid of the losing investments.  I just want to remind everybody that “normal” investors were the ones who were buying internet stocks in 1999 and 2000.  In this business, it literally pays to do the opposite.

 

Investors with aggressive asset allocations had an excellent 2003, 2004, 2005, and 2006. At this point, we should be prepared for some potential pain if your asset allocation is aggressive and the stock market heads south.  No pain – no gain.

 

Unfortunately, this time around, I do not have any novel ideas that I have not presented 6 months ago.  So, it is pretty much the same story for first half of 2007:

 

1                    Cash and Cash Equivalents (money market accounts) are pretty decent bet for your short term investment part of the portfolio. Cash pays around 5%.  It is not great, but it is risk free.

2                    Bonds – I still believe that closed-end municipal bond funds provide good opportunity. Six months ago we could find municipal bond funds that yielded over 6%.  This is not the case anymore. It is hard to find anything that yields over 5%. Also, discounts on these closed-end funds used to be over 10%, now you can hardly find anything discounted more than 6-7%.  It is good news if you actually bought these funds six months ago. However, from this point on these funds are already pricing in slowing economy and ¼ point drop in short term rates.

3                    As far as stocks are concern: I would still overweigh on the Large Cap Value Funds vs. Small Cap funds. I just think that at this point of the economic cycle, there is much less risk in owing Large Cap Value stocks vs. Small Cap Stocks.

4                    If you want to bet against the dollar, then you can invest in the Foreign Value index (ticker EFV).  If the dollar falls, this stock fund will move up in price.

 

Good luck and Have a Great 2007!