HOMEX FOR GROWING MEXICO

In every market correction, crash or significant downturn, there is at least one spectacular collapse. In this one, we have had many, from the bankruptcy of Lehman Brothers to near demise of AIG, Mae (Fannie) and the Mac (Freddie ). In Canada, one of the most significant event was the sale of AIC; a mutual fund company known for its buy, hold and prosper strategy. Other than Warren Buffet, you will be hard pressed to find a manager associating himself with buy and hold strategy these days. And even the Oracle(of Omaha) has been known to do lot more than simply buy and hold stocks; he has dabbled in silver, futures and quite a bit of trading. Is this strategy really dead or have most interpreted it wrong?

For AIC, buy hold and prosper was a great marketing strategy, not to be taken or followed literally. Investment strategy should be commensurate with asset type, region, markets and sectors. Buying and holding anything in the pulp and paper sector would surely have sent you to a poorhouse. In fact, virtually anything other than cash and bonds in the U.S. failed. Not so if you happen to be in markets like China, India or even Mexico. For these are the markets where demand has been growing steadily over the last couple of decades, placing them significantly higher than a decade ago numbers,, even after a similar or an even more pronounced trouncing they got last year. It is growth that is the key missing ingredient if you practice buy and hold here in the developed market. In other words, a buy and hold strategy is highly dependent upon the momentum in the stock market and the economy. If you hold on to an asset no matter where, that is growing steadily, producing positive earnings, the strategy works beautifully.

So, when last year a friend told me that he had bought a house on the beach in Mexico for under $50 K long before the market blew up in California where an average house went for over a million, I wanted to know who is doing this. First of all, Mexico does fit with the scenario I just described, a region where demand is likely to persist for generations not just years or decades. And practicing buy and hold in such a region should pay off and in fact has. To get in, You could go buy the country index ETF (exchange traded fund) but you have to be careful as impact of US juggernauts has made most indices in the world US like. That is one reason most markets are correlated, i.e. they go up and down at the same time. There has not been a place to hide in this mayhem. So a simple “buy the country and hold” may not be as effective as picking sectors or stocks in a growing region.

One sector that used to be a barometer of market and economy here in Canada and U.S., is real estate and construction. Unfortunately it truly has become a has been sector now; if you think the average price of a Vancouver house will continue to rise at double digit rate from the current base of over $800,000, you obviously haven’t learnt much. My thesis is to look for housing stocks in countries like India, China and Mexico. I haven’t found many Chinese construction stocks yet, but a company I have written about a few times here, Homex Development Corp. traded as an ADR (NYSE:HXM) , continues to prosper. It was Homex that built my friend’s beach front property.

Economy Stinks but Market is Up, What Gives?

The market is going up for reasons similar to the ones that drove it down last fall and this winter; uncertainty. Here is a simple example, in March most analysts thought that Bank of America will not survive, or it will lose money for many years. The stock was driven down to under $5. The company and some analysts now believe that BA will survive and may make about $1 per share next year. That is far lower than $5 estimated a year ago but is much higher than zero or a loss. So majority of investors believe that to be the case now and are willing to pay $11 today. 

Do this same exercise for all of the stocks in the DOW and you will come up with the answer to your question. Bottom line is, today most investors believe that they got it wrong in March when they sold everything and thought the world economy will be in a depression for years. Is there a chance that the current wisdom will prove to be wrong again? Quite likely.

 

As for the economy and the factory output, they will keep going down but as long as they are not getting worse than last fall, investors will be positive.

 

One reason my clients have done better than the rest is because I never bought into the depressed scenario in March and sell everything at the bottom nor am I buying into the euphoria and buy everything. On the whole I am waiting for a recovery in China to take hold. That will repair a lot of problems for exporters to China like Japan and Europe and Canada and Australia and even USA. With this as a foundation, economies will start to build themselves again. This won't be easy nor quick, making the current strategy of dividend payers and bonds a reasonable one. Although investing in China is my next objective when a second bout of pessimism hits the market which could happen any time.

 

Can I be wrong in this wisdom? Quite likely.

Do stocks still face deflationary collapse?

There is a saying in the investment world; stock markets have predicted nine out of the last five recessions. Something similar is true of depressions and Mr. Prechter. Let’s just go by facts. 

Drops in GDP, employment levels and trade are serious but no worse than any of the previous recessions. I lost my last paying job in the last recession in 1990 and I can definitely tell you that this one is not worse than the 90, 80 or even the 70’s recession. In the thirties, unemployment went to 20% and GDP dropped by 10% per year. Sure, we could get there but that is assuming all this money being thrown at the problem worldwide will not work. I doubt that. 

But Stock markets don’t follow the economy. We will have ups and downs as he suggests. But does the SP500 go to 333, or the DOW to 4000? That would mean earnings of the 500 largest companies will drop by 50%, which means all manufacturing, computer, software, oil and gas and agriculture will drop by 50%.  I doubt that too.

I do agree that government bonds are overpriced and stocks have become quite risky for now. I think that most US companies will still be around except GM and Chrysler although even they will survive in a different form. This tells me that we should be okay with good quality corporate bonds and preferred shares which pay good dividends.

 

Debt is a problem and toxic debt at the banks and mortgages which may still be in trouble will keep the economies in a soft mode for some time but does that mean people who are making a lot of money (per capita 40K +) will stop buying iPhones and plasma tv’s? Problem loans will have trouble for the banks again and they will react the same way as they did last six months or so. And yes, people will dump stocks but end of the world? Not really…

This is a probability game, so there is always a chance that every one panics and does the wrong thing with a depression to follow. Chance is less than 5% in my opinion. This is also known as the Black Swan event. So keep some cash handy to buy things if he does turn out to be right.  I think chances are most who follow Prechter will end up regretting having missed one of the better opportunities’ to buy. Gloom and doom sells newspapers and letters.

Another saying in my world; even a broken clock strokes true twice a day.

Here's the original link if you want to verify this article:
http://uk.reuters.com/article/companyNewsMolt/idUKTRE54D4IL20090514

Stocks still face deflationary collapse: Prechter

What Worked in the 30's?

Greed and fear are the two most significant mover of markets; more important than sales, earnings, debt and return on equity. It is only when emotions are operating at an even keel that you can talk of fundamentals or even technical parameters to gauge which way your holdings will move. Just as rampant speculation and bubbles are inevitable, so is abandonment of common sense and simple logic. It is the latter oversight that you should keep an eye on, if you want to cherry pick investments when everyone else is jumping ship or hiding under the desk.

 

In normal corrections and bear markets, you can pick out sectors, even countries or regions which have been improperly shellacked and where you may find gems. However over the last two decades culminating into the current melt down, most markets, even asset classes have become highly correlated. So, if you thought your bank shares will give you protection, you know that didn’t happen. Gold didn’t offer you any shelter and neither did can’t-slow-down world economies like China, India or the Middle East. They are all down. The knock-on effect has not been limited to regions but also asset classes like real estate and fixed income securities like preferred shares and bonds.

 

While there is good reason for even the developing world to suffer if U.S. is in trouble as we are now a fully globalised economy, trashing income producing securities like bonds and preferred shares has been quite inappropriate. For, although stocks can under difficult circumstances chop their dividends but before a company stops paying dividends on its preferred’s or interest on bonds, they have to be in dire straits. In most cases only under bankruptcy, can a company stop or defer such payments. That leads me to believe that the current thrashing of bonds and preferred shares is excessive and assumes that many corporations including the so far solid Canadian banks will go bankrupt. We can’t rule anything out but having all banks, insurance companies and telephone utilities going into bankruptcy is expecting something even worse than the great depression.

 

To invest in fixed income products, you must first orient your thinking; it is a little upside down. The value of such securities is inversely related to interest rates, i.e. if interest rates go up, their value goes down and vice versa. Now, here is the problem, government interest rates are now nearly zero in the U.S. and 1% in Canada. And yes, government bonds both here and in the U.S. are scaling new heights. Unfortunately this boon has not filtered through to the corporations. The interest rates charged by the banks or investors are at near record highs, sometimes 6% higher than government of Canada bonds. This is awful for the economy and corporations but does represent an investment opportunity for you. The only thing you have to assume is that not all of these companies whose debt you invest in, are going under and can not pay the bills. In Armageddon, that could happen but as I have argued before the economic world is not coming to an end. Actually it is better than our situation even in the dirty thirties.

 To really understand the scope of fixed income mispricing that has happened, you need to look at a picture in chart 1. In this chart I compare corporate bond yield this decade with the US government bond yield, both with  a ten year maturity period. As you can see, corporations always have to pay more than the more secure government but the spread is usually in the 2% to 3% range. Even during the 9/11 crisis, the spread did not exceed 3% in spite of a gloomy psychology pervading the world. You may recall that the then US Fed Chairman Greenspan slashed rates to virtually nothing and the markets including corporate bonds responded smartly. 

2008 is however writing history as even the most drastic cuts in interest rates by US Fed has had no impact on corporate rates until last month. If the recent drop in corporate bond yield at the end of the chart is an indication of a final thawing of this historic mispricing, we may have finally seen the worse. This may not be an all green sign to go on and buy stocks just because there is a downturn in corporate bond yields, but I do conclude that the Fed’s efforts will eventually be successful. This success will show up first in corporate bonds. Before we discuss how to take advantage of this strategy, let us revisit what happened during the 1929 crash. 

Chart 2, shows the yields on corporate and government papers from 1928 to 1936. As you can see, this was the time when the government actually raised rates after the crash making corporate money even more expensive. It wasn’t until 1932 that they came to their senses and started cutting rates furiously and finally the corporate bond yields responded. If you had the foresight to buy these bonds when the crisis was in full bloom, you collected 11% per year in income and a final capital gain of over 50% in four years. Not a bad deal, particularly when the rest of the market just kept dropping for years. In fact, stock owners didn’t make their investment back until 1954.

So, is the current stock market malaise another opportunity for fixed income investors? Barring a full blown bankruptcies across most sectors and regions, a well diversified portfolio of corporate fixed income securities like investment grade bonds and preferred shares is likely to be a big winner.

 

There are a few things you should watch out for, particularly if you decide to invest in individual securities rather than exchange traded or closed end funds. Information on fixed income is much more difficult to get. Even most brokers or advisors may not know all the covenants (clauses like early call back, redemption, retraction, reset features, subordination etc.) You should check thoroughly before investing in an individual bond or preferred share. The most glaring and recent example of such covenants costing investors much grief is the failed acquisition of BCE. There was a little clause put in by the bond holders which required a “solvency opinion” prior to the deal. Had you heard of this before the event? Neither, it seems a lot of analysts and fund managers. So, reading the prospectus over and well is critical.

 

Alternatively, you can leave that job to a manager for a fee and either purchase the exchange traded fund or closed end funds specializing in corporate bonds and preferred shares. Some frequently traded ishares, which I own for my clients and personally are iShares CDN Corporate Bond Index Fund (XCB, TSX), iShares CDN Long Bond Index Fund (XLB, TSX), Claymore 1-5 Yr Laddered Government Bond ETF (CLF, TSX) and Claymore S&P/TSX CDN Preferred Share ETF (CPD, TSX). Each has a unique blend of securities. XCB holds corporate and government bonds of short to mid term maturity (around 6 years) and pays about 5.7% yield. While government bonds have shot up, these are still far lower than its 52 week high. XLB is a longer term corporate and government bonds which have also a lot of room for capital appreciation and income of about 5%. CLF is an interesting ladder structure using 1 to 5 year bonds which is much less volatile  yet lets you participate in income (3.5% interest yield) but the potential for capital gains is lower. CPD is a portfolio of preferred stocks paying 6.5% dividend.