Thursday, March 29, 2007

Analysis of Bernanke's Inflation Outlook

Here is the transcript from an interview from last nights Nightly Business Report on PBS.
This discussion is interesting because it shows the current debate concerning the strength and direction of the markets. Battipaglia's outlook is very pessimistic and he currently has over 30% of his client's allocation in cash (50% of his client's 60% equity allocation is in cash plus a percent of the bond portfolio). His firm is really expecting the markets to correct substantially. Market timing, to this extent, leads to under performmance.

Enjoy
The Financial Pragmatist
Libby Mihalka

Joe Battipaglia of Ryan Beck & Brian Wesbury of First Trust Advisors
Analyze Fed. Chairman Bernanke's Inflation Outlook

Wednesday, March 28, 2007

SUSIE GHARIB: More analysis now on Bernanke's testimony today and market reaction. Joining us, Joe Battipaglia, chief investment officer for Ryan Beck and Brian Wesbury, chief economist at First Trust Advisors. Brian, Joe, thanks for joining us.

BRIAN WESBURY, CHIEF ECONOMIST, FIRST TRUST ADVISORS: Good to be with you.
JOE BATTIPAGLIA, CHIEF INVESTMENT OFFICER, RYAN BECK: Good to be with you.

GHARIB: Brian, let me begin with you. Do you agree with Ben Bernanke's assessment of the economy that inflation is the risk of not weaker growth?

WESBURY: I do. I think that we've seen a slowdown in housing. We've seen what I would call an inventory correction, which is caused industrial production and durable goods orders to fall over the last few months, slow down the economy a little bit in the last few months. But the real risk to the economy in the next six, 12, 18 months is inflation.

GHARIB: Joe, Wall Street seems to have thought that that slowdown in housing, now that the economy is really slowing, evidenced by all the sell- offs we've had this week. What's your analysis of what Bernanke said?

BATTIPAGLIA: The street wants it both ways. They want a soft economy and ultimately rate cuts and what a good situation that is for stocks. My worry, actually, is the economy. The Fed has never engineered a soft landing. The data is more troubling than they are letting on too. They've already changed their language to that effect and I think it's a credit- driven problem in that consumers are tapped out, and so this may well be a consumer-led slowdown with the potential for a recession at 50 percent. The market certainly not looking for that and that's what's going to be more troublesome in the next several months. Add to that the persistence in inflation. You've got a very dangerous mix here.

GHARIB: But Brian, the message from Bernanke seems to be that the next move that the Fed makes on interest rates, when it does decide to move, that it will be up. It will be a rate hike not a rate cut. Is that your take on what Bernanke said today?

WESBURY: Well, I would argue that what he really said is that he wanted more flexibility. In fact, that's almost a direct quote. And that's why they sort of pulled back. But more importantly, one of the things he wanted to do was have the market stop being telegraphed the Fed's next move. He wants the market to be a little more uncertain about what the Fed might do. And one of the reasons that he wants that to happen is he wants long-term interest rates to go up. Remember, Alan Greenspan called the low, long-term interest rate the conundrum. Ben Bernanke has theorized that maybe it's happening because of a global savings glut or something like that. He's trying to get long-term rates up and one of the ways to do that is to increase uncertainty in the markets and I think that's one of the things he's trying to do today.

GHARIB: He did say that. He said he's going to give less guidance on interest rate moves. Joe, what does that mean for the market? Is it going to be much more volatile going forward?

BATTIPAGLIA: Oh, I would say so because if he is data centric here and looking for the next bit of news on the economy and on inflation, then he's no better off than the rest of us are in trying to figure out what happens next and right now his credibility is on the line because on the one hand, he wanted to be more transparent. If you want to be more ambiguous, that's not transparent. And the other is he wanted inflation below 2 percent but he doesn't have that. He's at 2.7 or 2.3, depending on how you measure it. Credibility at the Fed is at risk, Ambiguity is a problem and the economy itself has got very weak signals coming on, six months of slowdown in durable goods and a consumer that is gliding down the path of less houses being bought, less cars being bought, retail sales slowing down.

GHARIB: Brian, Bernanke also said that he didn't see any evidence that this whole sub-prime mess is affecting the broader economy. Is that really the case or was he just trying to reassure everyone?

WESBURY: No, I think he's correct about that. I think the sub-prime issue is a problem, but it's not a problem that will have a contagion effect that drags the entire economy along. And I think this is an important point. One of the reasons that we're in the mess with mortgages and housing that we're in is because the Federal Reserve lowered interest rates to 1 percent back in 2003. You can't drive interest rates down that low without causing people, some people to make decisions that they can't live with if interest rate goes back to normal and that's exactly what's happened. But interest rates today aren't high. And that's why I won't go as far as Joe does. Interest rates today, in fact, are still very low, especially given the inflation rates that we have seen. And, therefore, I don't think we're on the front edge of a recession or a big consumer--

BATTIPAGLIA: Here's the tip of the spear on this. I need to interrupt because most people are saying the same thing, except that the biggest asset that people own are their homes. Those prices are only starting to fall and they fall by 5, 10 or 15 percent or more depending on the market. And interest rates on the teaser side are going to be adjusted up, even with the low rates that Brian speaks to, they're going to double or triple from here and they can't refinance because their home values --

GHARIB: Joe, let me jump in. We just have a few seconds. Real quickly Joe, are you changing your investment strategy because of your views on what Bernanke said and the economy?

BATTIPAGLIA: We came into this with 60 percent equities 40 percent in defense of asset classes. In our equity programs we're at 50 percent cash looking for future opportunities. So we re definitely defensive and we've lowered our S&P target for the year down to 1430. So we're essentially looking for a flat year.

GHARIB: We're going to have to leave it there. Gentlemen, thank you very much, I appreciate your thoughts.

BATTIPAGLIA: You're welcome.

GHARIB: My guests tonight: Joe Battipaglia, chief investment officer for Ryan Beck and Brian Wesbury, chief economist at First Trust Advisors.

Who is Profiting in this Economy? Not the Middle Class

Food For Thought

The creation of the middle class is widely credited with pulling Europe out of the Dark (Middle) Ages. A strong middle class is the working back bone of this country. Our constitution works because it is a social contract that citizens believe allows them to work hard and prosper. The American promise is if you work hard that you will succeed, rags to riches. What happens if that no longer is true.


Statistically speaking, it has never been more difficult to work your wat out of poverty into the middle class. Is the rags to riches story dying? Leakage down has increased. In other words, you can fall into poverty but it is unlikely that you and your children will ever dig their way out.


The two main factors that kept people out of poverty were a college degree and owning their own home. As a parent, I know I will do what ever it takes to instill a love of learning, teach them how to work hard and a instill in them sense of duty to family and community. I feel it is my responsibility to get them through college and hopefully shepherd them into their first house. I don't want to see them leak down into a level of poverty from which they won't be able to rise. The trick will be not bankrupting our own retirement plans in the process.


I know I haven't addressed the impact of the trends on the social fabric of our country. The disappearance of the middle class could spell the end of democracy. People only obey rules if they believe they are fair.


I am afraid we will only see more articles like this one that appeared in today's New York Times. Where all this will lead us a s a country I don't know but I do know what it means in my household: a commitment to education and hard work.


The Financial Pragmatist

Libby Mihalka



New York Times
March 29, 2007
Income Gap Is Widening, Data Shows
By DAVID CAY JOHNSTON


Income inequality grew significantly in 2005, with the top 1 percent of Americans — those with incomes that year of more than $348,000 — receiving their largest share of national income since 1928, analysis of newly released tax data shows.


The top 10 percent, roughly those earning more than $100,000, also reached a level of income share not seen since before the Depression.


While total reported income in the United States increased almost 9 percent in 2005, the most recent year for which such data is available, average incomes for those in the bottom 90 percent dipped slightly compared with the year before, dropping $172, or 0.6 percent.


The gains went largely to the top 1 percent, whose incomes rose to an average of more than $1.1 million each, an increase of more than $139,000, or about 14 percent.


The new data also shows that the top 300,000 Americans collectively enjoyed almost as much income as the bottom 150 million Americans. Per person, the top group received 440 times as much as the average person in the bottom half earned, nearly doubling the gap from 1980.


Prof. Emmanuel Saez, the University of California, Berkeley, economist who analyzed the Internal Revenue Service data with Prof. Thomas Piketty of the Paris School of Economics, said such growing disparities were significant in terms of social and political stability.


“If the economy is growing but only a few are enjoying the benefits, it goes to our sense of fairness,” Professor Saez said. “It can have important political consequences.”


Last year, according to data from other sources, incomes for average Americans increased for the first time in several years. But because those at the top rely heavily on the stock market and business profits for their income, both of which were strong last year, it is likely that the disparities in 2005 are the same or larger now, Professor Saez said.


He noted that the analysis was based on preliminary data and that the highest-income Americans were more likely than others to file their returns late, so his data might understate the growth in inequality.


The disparities may be even greater for another reason. The Internal Revenue Service estimates that it is able to accurately tax 99 percent of wage income but that it captures only about 70 percent of business and investment income, most of which flows to upper-income individuals, because not everybody accurately reports such figures.


The Bush administration argued that its tax policies, despite cuts that benefited those at the top more than others, had not added to the widening gap but “made the tax code more progressive, not less.” Brookly McLaughlin, the chief Treasury Department spokeswoman, said that this year “the share of income taxes paid by lower-income taxpayers will be lower than it would have been without the tax relief, while the share of income taxes for higher-income taxpayers will be higher.”


Treasury Secretary Henry M. Paulson Jr., she noted, has acknowledged that income disparities have increased, but, along with a “solid consensus” of experts, attributed that shift largely to “the rapid pace of technological change has been a major driver in the decades-long widening of the income gap in the United States."


Others argued that public policies had played a role in the shift. Robert Greenstein, executive director of the Center on Budget and Policy Priorities, an advocacy group for the poor, said that the data understates the widening disparity between the top 1 percent and the rest of the country.


He said that in addition to rising incomes and reduced taxes, the equation should take into account cuts in fringe benefits to workers and in government services that middle-class and poor Americans rely on more than the affluent. These include health care, child care and education spending.


“The nation faces some very tough choices in coming years,” he said. “That such a large share of the income gains are going to the very top, at a minimum, raises serious questions about continuing to provide tax cuts averaging over $150,000 a year to people making more than a million dollars a year, while saying we do not have enough money” to provide health insurance to 47 million Americans and cutting education benefits.


A major issue likely to be debated in Congress in the year ahead is whether reversing the Bush tax cuts would slow investment and, if so, how much that would cost the economy.
Mr. Greenstein’s organization will release a report today showing that for Americans in the middle, the share of income taken by federal taxes has been essentially unchanged across four decades. By comparison, it has fallen by half for those at the very top of the income ladder.
Because the incomes of those at the top have grown so much more than those below them, their share of total income tax revenue has risen despite the reduced rates.


The analysis by the two professors showed that the top 10 percent of Americans collected 48.5 percent of all reported income in 2005.


That is an increase of more than 2 percentage points over the previous year and up from roughly 33 percent in the late 1970s. The peak for this group was 49.3 percent in 1928.
The top 1 percent received 21.8 percent of all reported income in 2005, up significantly from 19.8 percent the year before and more than double their share of income in 1980. The peak was in 1928, when the top 1 percent reported 23.9 percent of all income.


The top tenth of a percent and top one-hundredth of a percent recorded even bigger gains in 2005 over the previous year. Their incomes soared by about a fifth in one year, largely because of the rising stock market and increased business profits.


The top tenth of a percent reported an average income of $5.6 million, up $908,000, while the top one-hundredth of a percent had an average income of $25.7 million, up nearly $4.4 million in one year.

Tuesday, March 27, 2007

Small/Mid Cap International Investing

Historically, international investing has focused on Large Cap stocks. In the mid and late 1990s, a few initial research articles were published suggesting that small/mid cap international stocks diversified the risk of a well balanced portfolio and had the potential for generating superior returns. Over the last ten years, this research has been shown to be correct. Small/mid cap international stocks have generated returns far in excess of their large cap international brethren.

There are few mutual funds that invest in this segment of the international markets. There are few analysts that follow small and mid cap companies in Asia, Latin America and Europe. Many international exchanges inefficiently handle transactions involving smaller and more illiquid companies. (These issues are also an opportunity to make substantial returns because inefficiency always equals opportunity). It is also an expensive strategy to execute. The result is that few investors have small/mid cap international exposure.

Altamont Capital Management has been invested in Small and Mid Cap International stocks for years. Many of the submanagers and mutual funds we use to implement this strategy are not available to the retail investor but there are a handful of funds worth considering. Laudus, Forward and T. Rowe Price Discovery have international small/mid cap funds that are open and available to the retail investor.

Here is a paper by Laudus Funds that discusses further the merit of small/mid cap international investing.

http://www.laudusfunds.com/common/reportDownload.asp?doc=ISMCAPWhtPpr

The Financial Pragmatist
Libby Mihalka

Friday, March 23, 2007

Private Equity Risks and Dislocations

One reason the market hasn't fallen further is liquidity. The U.S. and International markets are awash in cash. It is easy to borrow at low rates. Until credit is tightened, it will be difficult for the market to sustain a significant correction.

Heavily leveraged Private equity and hedge funds are trolling the markets looking for any arbitrages or acquisitions. As the amount of money chasing opportunities increases so does the risk. It will become more and more difficult for these groups to deliver the 30% plus returns their investors have come to expect. This wall of cash may cause dislocations (deals done at unsustainable premiums) that will hasten a correction. The back end of all this will probably not be pretty.

A credit squeeze will of course also hasten a correction by drying up this excess liquidity.

Here is an interesting article that discusses this topic in greater detail.

The Financial Pragmatist
Libby Mihalka

Has success spoiled private equity?
By Sharon Reier
Friday, March 23, 2007

'Fortune favors the bold," wrote Virgil, the classical poet who glorified the power of Rome. These days few are bolder or have gathered more fortune than the private equity groups that have accounted for more than 20 percent of the merger activity so far this year in the United States and a growing proportion of it overseas.

But just as a string of record-breaking private equity bids made news from Britain to Australia — and major firms like Blackstone Group prepared initial public offerings of shares to individual investors — the risks were also climbing. Experts are apprehensive that the current easy financing via low-grade, high-yield debt could become more costly and less secure, while political opposition to the swashbuckling ways of private equity is growing.

This is not the way that the elite, insiderish, secretive private equity club might have expected things to go. But the changes reflect the fact that private equity is now in the mainstream of capitalism, and will increasingly be expected to play by the rules.

"Given the size of the industry, the level of public scrutiny has reached unprecedented levels," said Javier Loizaga, chairman of the European Venture Capital Association, at a meeting of private equity investors in Geneva this month. "Not everybody likes us. Not everybody will like us."

Certainly over the past few years private equity has delivered superior, and sometimes outstanding, returns on investment. Long-term the funds look for 15 percent returns after fees, better than investors have done in the equities markets, said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth. But over the past three years, some of the better-known firms like Blackstone and Carlyle Group have achieved annual returns of 40 percent and higher on some deals.

The theory behind private equity is that the ownership model is better and more efficient than the traditional public-shareholding model. "Asset managers and equity investors are pretty passive," said Pierre-Etienne Lorenceau, publisher of Décideurs, a magazine that covers private equity. "Investors depend on the communication policies and bullishness of the CEO and the mood of the market, and it is a very uncomfortable position."

Private equity, by contrast, gives control of the company to a small group of people: general partners, or the executives who run private equity firms and take the bulk of the risk and reward, and limited partners, or investors in private equity funds. The limited partners "know their money will actually be at work," Lorenceaux said — because if it isn't, the general partners will not hesitate to fire management or sell the company.

The sound bites may be new, but the structure is not.

In the 1980s, enabled by high-yielding junk bonds, leveraged buyout funds bought public companies with small amounts of equity and dollops of debt. Some returns were spectacular; other deals crashed. The poster child for failed deals was the $30.6 billion hostile takeover of RJR Nabisco in 1989. Chronicled in the book "Barbarians at the Gate," the deal barely eked out a profit for the winner, Kohlberg Kravis Roberts — in large part because KKR overpaid in the first place, and because problems in the junk bond market in 1990 made it impossible to refinance the debt.

Over the past few years, the financial stars have been aligned perfectly for private equity deals. Able to buy assets at low prices earlier in the decade, firms displayed an impressive ability to leverage the deals with debt, then re- leverage them to pay a dividend to investors or sell them in IPOs and to other private equity companies.

Enticed by high returns, investors like pension funds, insurance companies, funds of funds and wealthy individuals deluged private equity partnerships with money. Last year the firms raised $432 billion to put to work in deals.

Supplementing that war chest is the great wall of money available from income investors, desperate for higher yields than they can get on investment-grade credit, who have eagerly invested on the debt side. So eager have they been to buy into these leveraged loans — packaged into collateralized loan obligations, known as CLOs— that they have accepted relatively low premiums over base lending rates.

Buyers of this debt have also taken on the additional risk of what are what are being called "covenant-lite" terms. Covenants set forth legal guidelines concerning financial measures like ratios of debt to cash flow. Covenants enable lenders to declare borrowers in default if guidelines are violated.

"This is unprecedented," said Ray Kennedy, managing director of high-yield investment at Pacific Investment Management, or Pimco. "I don't think we have ever seen this level of give-ups."

The result of this overheated lending is that it has created a silly season in which private equity firms have been able to increase leverage from five and six times cash flow to as much as eight and nine times, greatly increasing the stakes — and the returns needed to pay off the debt.

It has also enabled the firms to contemplate bigger deals, like the blockbusters announced this year: $45 billion for the Texas utility TXU; the much-discussed £11 billion, or $21.6 billion, bid for the British supermarket icon J. Sainsbury; a bid of 11 billion Australian dollars, or $8.9 billion, for Qantas, the Australian flag-carrier airline.

Bigger deals, of course, mean higher fees. And Blackstone's public offering will give investors the chance to participate in the profits along with management.

But individuals will want to look before they leap into any private equity investment, experts warn, as the chances of a major change in the financial climate are increasing — thanks in part to the debacle in U.S. subprime lending market, which has cast all risky loans under a cloud. Last Friday, in fact, J.P. Morgan Chase recommended that investors reduce their holdings of collateralized loan obligations backed by high-risk, high-yield loans — the kind of debt typically used to finance leveraged buyouts.

So far the top private equity firms are confident that they can get these deals done because of continued liquidity from oil money, government surpluses from Asia and the Middle East, and hedge funds, according to Edward Altman, professor of finance and director of fixed income and debt research at the Salomon Center at New York University.

But Altman, who studies what he calls the "mortality rate" of debt, warned that more than 50 percent of the loans tied to highly leveraged transactions in 2006 involved companies whose bonds or loan financing received a CCC rating, the lowest and most risky given to new financings.

"Traditionally these result in a fairly high default rate," Altman said: A third of CCC- rated bonds default within three years of issuance, and about 50 percent default within five years.
"Investors have been accepting spreads far too low for the risk involved," Altman said.

The fact that creditors have been accepting fewer covenants on this kind of debt also means more risk — and, potentially, more recklessness. Kennedy at Pimco said that "a company could have a bad string of earnings and there would not be a default. And such conditions will mean that management teams can take more risk and won't have a lender breathing down their necks."

Then there is the growing chorus of criticism as the private equity model spreads globally. Reactions by labor groups in Europe have tended to be particularly sharp: Private equity firms are estimated to indirectly employ 19 percent of private sector workers in Britain, according to a study by the British Venture Capital Association, and between 7 percent and 9 percent in France, according to French unions.

"In Europe if people see you are getting 25 percent of 30 percent returns, they say: 'What is going on? It can't just be management wizardry,'" said Adam Lent, head of economics and social affairs for the Trade Union Congress, a federation of 62 British unions representing 6.5 million workers. "The question we are raising is, 'Who is bearing the risk?' We are pretty sure that it is not the 10 or 15 men who run the funds."

But as always, private equity is trying to keep ahead of the curve and increasingly is moving into emerging markets. Last year KKR did the largest major leveraged buyout in India — the purchase of the software business of Flextronics International for $900 million — and more private deals are thought likely to follow. Sabine Schaffer, vice president at Evolvence Capital, a private equity company in Dubai that has many investments in India, said that the prevailing view is one of cooperation.

"They are not seen as locusts," Schaffer said, referring to the epithet applied to private equity by a German politician, Franz Müntefering, in 2005. Today in India, Schaffer said, "the economy is booming. You won't see people being upset about any of the deals."

And until a major deal goes wrong, or the debt market closes, expect private equity firms to raise even more money and remain hyperactive.

"The attitude in the industry," Blaydon said, "is that when the cookie tray gets passed, you've got to take some."

Copyright © 2007 The International Herald Tribune www.iht.com

Monday, March 19, 2007

U.S. Small Cap Stocks Appear Over Valued

Small Caps appear due for a correction. They have outperformed their Large Cap brethren since the dot-com bust. It is now time for Large Caps to prevail. I have discussed this trend several times in my blog and newsletters. See last quarter's newsletter posted at our website: http://www.altamontwealth.com/newsletters.html

Here is a New York Times article that further bolsters this argument.
The Financial Pragmatist
Libby Mihalka


March 18, 2007
Beyond the Bubble, With Small-Cap Stocks
By MARK HULBERT


SMALL-CAP stocks are significantly overvalued. In fact, they are even pricier, on average, than they were in March 2000, just before the Internet bubble burst. In contrast, the average large-cap stock is moderately undervalued.


This picture of a highly bifurcated stock market is painted by data from Ford Equity Research of San Diego, which tracks around 4,500 publicly traded companies in the United States. Among companies that have been publicly traded for at least seven years, the firm reports that 55 percent have higher price-to-earnings ratios today than they did in March 2000. The bulk of these pricier issues, however, are in the smaller-cap sectors. Among the very largest companies, the average P/E ratio is now just a third of what it was seven years ago.


If investors focused only on the broad stock market averages, however, they might conclude that the entire market is undervalued. According to Standard & Poor’s, for example, the P/E ratio of the S.& P. 500 currently stands at 17, based on trailing 12-month operating earnings. The comparable ratio at the end of March 2000 was 31.1, almost double the current level.
Though the S.& P 500 includes many large-cap stocks, it also contains smaller-cap issues. Why is the index’s P/E ratio nevertheless so much lower than it was seven years ago?


The answer lies in how the index is put together. The S.& P. 500 is a capitalization-weighted index, meaning that each company’s contribution to it is a function of the company’s size. That would not necessarily skew the average P/E ratio for the index itself, if the average valuations of both larger and smaller stocks were similar. But that’s not the situation today, according to Ford Equity Research: the 50 companies in the S.& P. 500 with the smallest market caps have an average P/E ratio that is much higher than it was seven years ago, while the ratio for the 50 largest-cap stocks in the index is significantly lower.


According to Ford Equity Research, the average P/E ratio among the 50 largest-cap companies is now 19, about a third of the average of 60.7 for the biggest 50 in March 2000. The average market cap for the 50 largest companies is now $123 billion, versus $153 billion in March 2000.
Contrast those numbers with those for the 50 smallest companies in the index: their average P/E ratio is now 30.7, versus 20.3 seven years ago. And their average market cap is now $3 billion, versus $1 billion.


In other words, the smallest-cap stocks in the S.& P. 500 are significantly more overvalued today than they were seven years ago. Yet their higher P/E ratios barely affect the ratio for the index as a whole. That’s because the combined market capitalization of the 50 largest stocks account for nearly half the market cap of the entire S.& P. 500, while that of the 50 smallest stocks add up to just 1.2 percent of the total.


“Investors who pay attention to the P/E ratio of cap-weighted indexes such as the S.& P. 500 therefore need to exercise great care when drawing conclusions about stocks’ relative valuations,” Richard Segarra, director of research at Ford Equity Research, said in an interview. “At best, the P/E ratios for such indexes shed light only on their largest-cap stocks; we should avoid drawing any inference from a cap-weighted index’s P/E ratio about the valuations of its smallest-cap members.”


MR. SEGARRA found that the index’s prevailing pattern also holds true across the universe of stocks that his firm tracks. As a result, an investor who emphasizes market sectors according to relative P/E ratios would have a very different portfolio today than in March 2000. Back then, he would have favored small caps over large caps — and been handsomely rewarded for this choice. The trend is seen in the annualized total returns since March 31, 2000, of three Dow Jones Wilshire indexes: 10.1 percent for the U.S. Microcap Index and 7.2 percent for the U.S. Small-Cap Index, but only 0.5 percent for the U.S. Large-Cap index.


Today, however, according to Mr. Segarra, that investor would favor large caps over small caps. Not only is the average P/E ratio of large-cap stocks only a third as high as it was in March 2000, it is nearly 10 percent below its average level of the last five years. There’s no guarantee, of course, that large caps will outperform small caps over the next five years — but there’s a good argument to be made that they will.


Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.

Weekly Review and Outlook

Here is the weekly review by Bob Doll is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock Investments. I read alot of summaries, this one captures all the major market highlights and I agree with his insights. Happy Reading!

The Financial Pragmatist,
Libby Mihalka

Blackrock Commentary
Disappointing retail sales figures, ongoing problems in the subprime mortgage
market and higher inflation numbers all pushed stock prices lower last week, with the Dow Jones Industrial Average falling 1.4% to 12,110, the S&P 500® Index declining 1.1% to 1,387 and the Nasdaq® Composite dropping 0.6% to 2,373. After last week’s declines, stocks are down just over 2% for the year and are about 4% lower than their highs for the year.

The corporate earnings picture has changed somewhat over the past few weeks. From the second half of last year through early February, consensus expectations for 2007 earnings growth hovered just over the 10% mark, but then began falling. Expectations have since stabilized at around the 6.5% mark, close to where we forecasted they would be at the beginning of the year — certainly lower than in previous years, but still at a positive level.

The idea that the economy is slowing is not the debate these days, given problems in the housing market (and the associated financing issues), slowing manufacturing activity, declining retail sales and some evidence of a weakening labor market. The question facing investors now is: Does the slowdown represent a transition from a few years of above-trend growth to a period of more sustainable, but slower growth, or does the slowdown indicate that a recession is on the horizon?

Concerns over the subprime lending business have highlighted the possibility of an economic recession. Up until now, problems in the housing market have been relatively confined, and the residential real estate slowdown has not had a significant impact on the overall economy. Many observers, however, are worried that tightening lending standards could make it more difficult for the housing market to recover, potentially triggering additional credit problems and resulting in a recession. In our opinion, this outcome is unlikely. Despite all of the problems
in the housing sector, consumer spending levels have remained reasonably strong, corporate balance sheets are still in good shape and non-U.S. economies (particularly developing economies) also are quite strong. We believe that these positive factors will outweigh the negatives and that the U.S. economy will avoid a recession, although we believe a “growth scare” could still rattle the financial markets. The Federal Reserve will be meeting later this week, and we expect that the central bankers will begin adopting a more dovish tone given increased signs
of economic weakness. The Fed remains concerned about inflation, but in our opinion, inflationary fears are easing. We believe the Fed will enact an interest rate cut before the end of the year, which would help support equity markets.

Against this backdrop, we continue to believe that the long-term outlook for stocks remains good. Although we recognize that a number of risks remain, and we retain our view that short-term market action is likely to remain choppy, we do not believe that the bull market we have been experiencing since late 2002 is set to end anytime soon.

Wednesday, March 14, 2007

Bank Loan Investment Funds

Two years ago I started investing in bank loan mutual funds for many of our clients. They are a great way to diversify a portfolio without giving up bond income. Last year our bank loan investments earned approximately 9% versus the Lehman Bros Aggregate ishares which earned only 4%. Not bad for a bond fund that is senior secured debt and regularly resets for interest rate changes.

Senior floating rate loans are loans made by U.S. Banks and other financial institutions to large corporations. Floating rate funds are less susceptible to interest rate risk than fixed rate bonds because rates are periodically reset to the prevailing interest rate. So if interest rates increase slowly this fund is less apt to generate a negative return. These loans are the senior source of capital in a borrower’s capital structure (they are first in line if the company goes bankrupt) and have some of the borrower’s assets (real estate, machinery, investments) pledged as collateral.
So if the borrower defaults on the loan the assets become the property of the mutual fund. The value of the collateral may not offset the full value of the loan but the Eaton Vance fund has tried to minimize the risk of default by monitoring creditworthiness of the borrowers carefully and spreading risk by investing the fund in over 450 separate loans. Rarely does a loan represent more than 1% of the fund’s assets. This broad diversification helps to minimize the impact of default.

Year-to-date the Instituional shares are up 2% versus the Lehman Bros Aggregate ishare ETF (AGG) which are up 1.7%.

Attached is a write up by Eaton Vance regarding bank loans.

http://www.eatonvance.com/alexandria/2096.pdf

The Financial Pragmatist
Libby Mihalka

Sam Stovall Interview

Sam Stovall's insights are right on point in this interview he did for Nightly Business Report on Tuesday March 13, 2007.

There is no reason to panic in fact I see the market correction as a great opportunity to put cash to work.

Here's the transcript.

The Financial Pragmatist
Libby Mihalka

SUSIE GHARIB: Joining us with analysis of today's market sell-off, Sam Stovall, chief investment strategist of Standard & Poor's. Hi Sam.

SAM STOVALL, CHIEF INVESTMENT STRATEGIST, STANDARD & POOR'S: Hello, Susie.

GHARIB: Are we looking at a correction here in the markets or is this the beginning of a bear market?

STOVALL: I think it's the correction, not the beginning of a bear market. I think certainly this has been something that's long overdue. On February 27 we snapped a 949 straight day period in which the market did not decline by 2 percent or more in one day. And normally we see an average of four of them per year.

GHARIB: But how big a problem is this sub-prime mortgage market?

STOVALL: Well, I think certainly because it bleeds it leads, and it is a cause for concern. And as a result it's, I think, triggered this slump in sentiment for investors right now primarily because of the uncertainty surrounding what kind of an impact it could have on the other areas of mortgages and mortgage-backed securities markets. So in general I believe investors are worried that possibly they did not anticipate this and that the uncertainty is that it could be worse than they're currently forecasting.

GHARIB: You talk about the impact on other mortgage markets. There's also concern about its impact on the economy and on corporate earnings. Do you see a huge spillover effect here?

STOVALL: Not really. Because when you break up the U.S. consumer into quintiles, the bottom 20 percent represents only about 8 percent of consumer spending and that's the category that typically would be involved in the sub-prime lending. Whereas the top 10% represents about 40% of consumer spending and that's the area that's not really being affected by this and is in the prime category.

GHARIB: I was talking to another market strategist the other day who was saying that he was very optimistic about the markets, saying because there there's so much liquidity out there, although today there seem seemed to be more people talking about a liquidity crisis. Which is it?
STOVALL: Well, I think there is the concern which could be exacerbating the markets decline today. Why financials fell 3 percent, why all 10 sectors in the S&P declined on the day is because people are worrying that the engine of growth, global liquidity, as you just mentioned, could start to dry up as lenders worry about extending credit where the credit is not due or at least not likely to be paid back. We at S&P basically believe that we're still likely to see a 15-10 target for the S&P 500 at the end of this year and we remind investors don't bail out of a lot of large financial institutions. Companies like Bank of America, like Citigroup, like Wachovia offer dividend yields that actually rival the 10- year yield on the bonds. So it's not just looking good compared with the S&P 500 but you're looking at 4.3, 4.4 percent dividend yields and quality rankings that are superior because over the past 10 years they have been able to increase their earnings and dividend growth.

GHARIB: Just a few seconds left. Some people think a cut in interest rates by the Fed would end all this selling. In a few words, what do you think?

STOVALL: I think certainly it could improve overall sentiment and add to the liquidity.

GHARIB: All right. We'll leave it there. Sam, thank you so much for coming on the program.

STOVALL: You're welcome, Susie.

GHARIB: We've been speaking with Sam Stovall, chief investment strategist of Standard & Poor's.

Monday, March 12, 2007

Pictet Investments Market Outlook

Here is Pictet's Investment Outlook. Pictet manages the international funds for Forward Funds. I am adding Forward International Equities to many client portfolios. As I said in the last posting, this fund has experienced management and a small asset base. A combination I love because it enables an experienced portfolio manager to quickly maneuver his way through any market. It has allowed Pictets' managers to outperform Artisan International and deliver a performance comparable to Thornburg International Value (Morningstar has previously named the managers of these two funds as International Managers of the Year).

Enjoy the summary!

http://www.forwardfunds.com/pdf/pictet/200703-PGERX-commentary.pdf

The Financial Pragmatist
Libby Mihalka

Large Growth International Funds


Harbor International Growth and Marsico International Opportunities are managed by the same team lead by Jim Gendelman. They are both managed using substantially the same style and investments, but Harbor International Growth has much lower fees. I do not use either of these for my International Large Cap Growth option. As an alternative to these two funds I would strongly suggest researching Forward International Equity (FFINX). It is managed by Pictet Investments and has substantially outperformced Harbor over the last eight years (see attached chart). Forward funds is represented by the red line and it has earned an annual compounded 9.3% return versus Harbor's 0.5% return for the same eight year period.
Forward has a small asset base compared to Harbor and Marsico which gives it the added advantage of being very nimble.
Below is a fund research report by Lipman Gregory on Marsico and Harbor. Enjoy!
The Financial Pragmatist
Libby Mihalka
FUND UPDATE:

Marsico International Opportunities (MIOFX) and Harbor International Growth (HAIGX)


Category: International GrowthManager: Jim Gendelman

Date of Interview: 2/8/07

With: Jim Gendelman


Gendelman buys companies that he believes have earnings-growth potential not recognized by the market at large. To find these companies he sometimes utilizes themes. One such theme is based on his view that there is a global “thirst for yield,” which will benefit “asset-based” business models.


Gendelman believes there is a thirst for yield because real interest rates are generally at historical lows across the globe, lowering income from risk-free investments such as Treasuries. This demand for yield, he says, is driven by aging baby boomers and large institutions—the former increasingly seeking income to meet their retirement needs and the latter needing a rate of return that allows them to meet their pension liabilities. To meet their objectives, both groups are seeking yields that are higher than what they can get from risk-free alternatives. Gendelman thinks demand for high-yielding products will be sustained over the long term unless real rates rise significantly from present levels.


The possibility that an increase in real rates will endanger his theme is low, in Gendelman’s view. He points to the “unprecedented priming of the monetary pump” globally and says, “the world has been awash with liquidity for over four years.” During this time, emerging-market countries have shown strong growth. Still, he notes, “you haven’t seen evidence of real inflation.” He adds that while there’s been some asset and commodity-based inflation, in the major economies inflation concerns are not at a point where rates are going to go up a lot. Gendelman says even if rates, and consequently yields, were to rise 100 basis points (which would be significant from current rate levels), they will still be lower than the yield expectations of individual retirees and pension funds in general. A much larger rise in real rates, while possible, is a low-probability risk in his view.


A new purchase that plays into Gendelman’s thirst-for-yield theme is Macquarie, an Australian bank. It has been “one of the early adopters and leaders in buying an asset, packaging it with a yield, and selling it to shareholders.” Basically, Gendelman explains, the bank scours the world to acquire long-term income-generating assets, such as toll roads, and then captures their underlying cash flows into a fund-like vehicle that provides its shareholders with a yield superior to that of a risk-free security. As a result, many institutional investors and individual investors find Macquarie’s financial products attractive. While other large banks outside Australia have started imitating this “unique business model,” in Gendelman’s view, Macquarie has an edge over them. In addition to having the first-mover advantage, it holds and operates the assets it acquires rather than selling them as some of its peers do. As a result, Macquarie can afford to pay its shareholders a “bit more” yield than its competitors because a recurring cash flow is worth more in present-value terms over a longer duration than over a shorter one.


Macquarie currently trades at around 14x to 15x next year’s earnings, a premium to other Australian banks, which trade in the low teens. Gendelman argues this premium is deserved because none of Macquarie’s Australian peers has its highly profitable asset-based business. Gendelman believes that if he is right about his thirst-for-yield theme, Macquarie could easily grow earnings in the mid teens over the next several years. He says its stock could be valued even higher if its asset-based business grows more robustly than he expects, though he is not counting on this. Macquarie looks attractive to Gendelman even if its stock just compounds returns in line with its earnings over the next several years.


A strong contributor to the fund’s performance last year was Shangri La, a Hong Kong-based hotel company that owns, operates, and manages hotels in a number of countries outside Hong Kong. Gendelman says its business model is similar to that of Four Seasons, a successful hotel operator that Marsico owns in its domestic portfolios and knows well. “We felt they were creating a Four Seasons-type model in China, meaning that they were not only going to own some of their own hotels but also going to franchise out their model and have a predictable, higher-margin earnings stream from just managing hotels for other people,” says Gendelman. While the underlying attraction to Shangri La remains intact, what’s changed is valuation. Since the fund’s initial purchase over three years ago, Shangri La has more than doubled and had started to trade at 11x to 12x EV/EBITDA (enterprise value/earnings before interest, taxes, depreciation, and amortization), which was in line with its peers but high relative to its history. Given that valuations appeared “rich” but the underlying growth story remains attractive, Gendelman trimmed Shangri La from 1.5% of fund assets as of September 30, 2006 to about 1% as of January 31, 2007.


From a regional and country perspective, Marsico International Opportunities has a low- to mid-teens allocation to emerging markets, which is in line with its index, Vanguard Total International Stock Index Fund. It is significantly underweighted to Japan and overweighted to Switzerland relative to this index; both positions are a byproduct of stock selection and reinforce the point that the fund takes large active bets relative to its index and, as a result, its performance can be out of sync with the index over shorter periods.

Litman/Gregory Opinion


Year to date through February, Marsico Inter-national Opportunities Fund is down 1.7%, compared to a 1% gain for Vanguard Total Interna-tional Stock Index Fund and a 1.1% return for MSCI AC World ex USA Growth Index (its style index). In 2006, the fund gained 24%, lagging the Vanguard index by 2.7 percentage points but outperforming MSCI AC World ex USA Growth Index by 0.5 percentage points.


Gendelman started managing Marsico International Opportunities Fund in July 2000. Since that time, the fund has beaten Vanguard Total International Stock Index Fund by over three percentage points, annualized. But we give less weight to the first two years of Gendelman’s track record because some aspects of his process were still evolving and we think Gendelman’s approach after June 2002 is more reflective of what we can expect in the future. Since July 2002, the fund has slightly lagged the Vanguard index, but has outperformed MSCI AC World ex USA Growth Index by almost two percentage points, annualized. This performance has come with volatility similar to the Vanguard index. The fund’s returns rank in the top decile over five years and in the top quartile over three years versus its international growth peers. Overall, the fund has performed strongly over the period we consider most relevant for performance analysis.


In our last update we noted the departure of an analyst from Gendelman’s team. This was a concern given that Gendelman had a relatively small team of just three dedicated analysts. Having discussed this issue with Gendelman we are less concerned for two reasons. First, he has access to Marsico’s larger pool of domestic analysts, who evaluate their industries from a global perspective, making them a valuable resource in some situations. Second, Marsico’s research culture is very intense, which some may find difficult to adjust to. (The last departure seems to be related to this issue.) This leads to the question of how Marsico ensures that the people they hire are a good cultural fit. The firm has interviewed a lot of candidates and it is clear to us that they are being very selective. In addition, Gendelman’s minimum qualifications for a new hire are unchanged from what he described to us over two years ago, so, it is good to see that the firm is neither dropping its hiring standards nor becoming impatient. We will continue to monitor team dynamics going forward.


Another concern has been the sharp rise in Gendelman’s international assets under management. International assets have gone from about $1.5 billion in early 2004 to almost $12 billion now. Much of the rise has come from existing sub-advisory relationships. As a result, Gendelman says the demands on his time in terms of marketing and client service remain low, allowing him to remain focused on investing, which is what we’d like to see in the future as well. Moreover, the fund’s opportunity-set remains sufficiently broad and Gendelman continues to run a relatively concentrated portfolio of about 50 stocks. So, while we continue to monitor asset growth and how that growth impacts Gendelman’s strategy, at this point it is not a material concern.


We remain impressed with Gendelman. He has a flexible approach to growth investing, which provides access to a broad universe of opportunities. His approach is somewhat theme-driven, though bottom-up stock picking is the much larger influence on stock selection. Gendelman and his team do thorough work to understand businesses and do not cut corners in their research. Gendelman’s overall portfolio management skills impress us as well. We think he does a good job of collecting different data points to come up with good insights at the macro and company level, which make their way into the portfolio in a thoughtful manner. Both Marsico International Opportunities and Harbor International Growth are similarly run and remain Recommended. Readers should note that Harbor International Growth, which is managed similarly to Marsico International Opportunities, has lower expenses and significant loss carryforwards and is unlikely to make capital-gains distributions for the next few years.


—Rajat Jain, CFA

Quick Re-cap of February 2007


Sorry for the lack of posts. Tax season and the market have been keeping me busy. I promise to make up for the lack of posts in the next few days. Here is a quick summary of February's market performance.


Domestic equities lost ground in February with larger-caps down about 2% and smaller-caps down almost 1%. International equities were flat, but domestic investment-grade bonds and emerging markets local-currency short-term bonds performed better, gaining 1.5% and 1%, respectively. Commodity futures held up the best of all the asset classes we own, returning more than 3%. Current valuations are attractive, which should limit further downside; if stocks materially decline from this point,
I would consider it as a buying opportunity.
The Financial Pragmatist
Libby Mihalka