Paul McCulley, portfolio manager at Pimco, made a rather astute comment that stuck with me, “You can only eat what’s in the cafeteria, and right now the cafeteria doesn’t have anything particularly appetizing in it.” That metaphor certainly rings true in today’s market. Many economists are predicting a very strong US GDP result for 4th quarter 2009, a statistic that is mostly attributable to massive government intervention and the restocking of inventories. The longer term question remains: will top-line sales provide earnings growth going forward rather than corporate cost cutting. In addition, we have highly respected economists such as Paul Krugman stating that a recession in the second half of 2010 after fiscal and monetary stimulus fade has a “30 to 40 percent chance”. These uncertainties mixed with the fact that the government will be stopping its buying programs and will also be forced to term out its massive debt will put upward pressure on interest rates. With this sort of backdrop, what do you invest in?
- US Equities (SPY): Equity markets are hitting 52 week highs after a historic 67% rally. The dividend yield is a rather anemic 2.07% with a P/E ratio of 24.66 which is well above a historic average. Uncertainty creates volatility, and volatility can create misery.
- US Treasury Securities (TLT): 4.6% 30 year yield even though US marketable debt increased to a record $7.17 trillion in November from $5.8 trillion at the end of 2008? No thank you.
- Junk bonds (JNK): I know a wave of defaults is going to continue on, but it seems that a lot of very poorly run companies with no prospects of surviving have been able to term out their debt and buy plenty of time. An 11% yield should compensate investors for interest rate risk and default risk for now.
- Preferred Shares (PGF, PFF): I loved PFF when it was offering a 16% dividend yield, but now that it has drifted down to 7.5% it seems that being exposed to rising interest rates along with equity type risk is no longer very appealing. Financial preferreds (PGF) are offering a higher rate and may still have some juice.
- Corporate Bonds (ITR, LQD): Another asset class I loved in 2009 when credit spreads were still at lofty levels, but with sub 5% yields the interest rate risk is becoming a bigger factor in their appeal. I might put on more corporate exposure, but I will be sure to hedge some of the interest rate risk with treasury futures or short treasury bond positions (TLT).
- Selling Volatility(VIX): With the VIX at 20%, selling volatility will most likely make money, but I do expect some very large spikes in coming months. It would be very odd to have such a large dislocation in 2007/2008 and then a “return to normal”.
- Commodities (DBC, GLD, SLV): The rally in the dollar has provided another opportunity to offload some of the inflation risk that is lingering out there. Gold and silver can move like racehorses, so it is crucial to take their volatility into consideration. I do not like holding inanimate objects without dividends, but in this environment I think it is prudent.
- REITS (IYR): A little bit of inflation protection over time, but with dividends. They have had a strong rally and I am not looking for great performance, but a 4.4% dividend yield helps a lot. Inflation should be passed on through that yield.
- Foreign Currencies (CAD, AUD, BRL, KRW, NOK): Get out of the fiat currencies with the biggest risks. Look for stronger balance sheets.
Possible Good Choices
- Emerging Markets (EEM, FXI): I know these will create a lot of contention, but I look at this as a bubble. If China continues to peg the Renminbi (which it will), the other countries with similar policies will follow suit. This will create asset bubbles in the real estate markets as well as in the stock markets. Take them for a ride and get out when they falter. It does not have to fundamentally look like a great investment choice to be one.
This is a US centric look at where the markets currently reside, but a lot of these themes play out around the globe. Asset prices have climbed quickly, but the uncertainty still lingers. I still like having some cash on the sidelines because all good things do come to an end. At the same time, we have to make the most out of the hand we were dealt, so hoarding cash is not an option. In these uncertain times, I think the best strategy is to play the relative value of these asset classes against each other.