Don’t Be Afraid to Rebalance Your Portfolio

With the S&P 500 having advanced 20.4% year to date as of 10/16/2009, and the MSCI EAFE index up 28.2% over the same period, it is legitimate and prudent to question the sustainability of this advance. The equity markets have been fueled by liquidity, a steady diet of improving news flow about the economy, and bona fide improvements in corporate performance. Nevertheless, after such a torrid advance from the lows of March, there is scope for a pullback, suggesting that investors should practice prudent portfolio rebalancing in order to keep portfolio risk aligned with their tolerance and capacity for volatility.

A few notable observations have crossed my desk in the last few days:

S&P 500 Fair Value

According to Bank of America Weekly Strategy Insights dated 10/19/2009, Bank of America strategists believe the fair PE multiple for the S&P 500 is 16.5x (this is based on 6% real cost of equity capital). According to this multiple, at 1097.25 the market is implying $66.00 in normalized earnings, in line with the current quarter’s annualized EPS. However, Bank of America believes that the current quarter’s earnings are still cyclically depressed, and they expect that the S&P 500 will grind higher as investors raise their expectations for the S&P’s normalized earnings power.

Visitors to the Standard & Poor’s website will see that S&P’s estimate for 2010 S&P 500 operating earnings is $73.55 (as of 10/19/2009). Using the Bank of America Fair PE Multiple of 16.5x on this earnings estimate would imply a fair valuation of 1214 at some point over the next six to nine months.

I have often used the “Rule of 20” to calculate a fair value multiple for the S&P 500. The crude assumption behind this rule is that 20 minus the rate of inflation represents a fair value multiple for the S&P 500. Using the yield of the 10 Year Treasury minus the real yield on the 10 year Treasury Inflation Protected Securities (TIPS) one can derive today's market expectation for inflation of 2.05%. (10 year treasury yield 3.37% - 10 year TIPS yield 1.32%). This yields a fair value multiple of 17.95x using the Rule of 20. While this is somewhat higher than the Bank of America Fair PE it is within the same ballpark.

Regardless of which method one uses to calculate a fair value multiple, the market appears to offer upside from here if earnings do not disappoint versus current expectations.

The Rush to Buy Bonds

In this weekend’s Barron’s, Michael Santoli pointed out that there have been $11 dollars in net inflows to bond mutual funds for every net dollar into equity funds over the past three months.

Bonds are an important part of most investor portfolios. Treasury bonds because they offer tremendous liquidity and are backed by the full faith and credit of the U.S. Government, and other types of bonds (Investment Grade Corporate, Municipal, Mortgage, Senior Secured Loans) because they can offer income and portfolio diversification benefits alongside cash and stocks. Amidst the recent market turmoil, many investors have reintroduced themselves to this asset class in search of the previously mentioned benefits. We have supported this notion. However, we cannot overlook the current love affair that investors of all stripes are showing toward this asset class and not point out that this supports the overall attractiveness of equities.

Equities remain an asset class that is vitally important for many investors who possess the goal of growing the value of their principal and preserving its purchasing power versus inflation. With a nod to the above data point from Barron’s, it is fair to say that investors have not been rushing to buy stocks despite the significant advances year to date, and particularly from the lows. This, combined with valuations that certainly appear reasonable, continues to support the case for owning equities, as well as bonds, and not being afraid to rebalance in the direction of equities for investors who possess the capacity for the potential volatility.

Important Legal Information:

Past performance is no guarantee of future results. Investing involves the risk of loss. This material should not be used as the basis for investment decisions on its own. Prior to investing, an investor should assess the specific risks of given instruments and determine (with his or her professional advisors) if the investment is suitable for his or her circumstances.

Taylor Thomas

10/20/2009

Are we faced with another bubble in risky assets?

With the recent sharp rallies in virtually all risky asset classes the question has come up several times about whether or not we are now in overvalued territory or on the cusp of another financial markets bubble.

One needs look no further than the U.S. market that has seen the S&P 500 advance 51.68% from its March 9th trough as of 8/21/09. The more volatile BRIC markets (Brazil, Russia, India and China) have advanced by an average of 59.83% during the same period.

In recognition that markets are subject to short term fluctuations based on technical patterns such as overbought and oversold levels, and also with regard to the fact that September is historically the poorest performing month in the U.S. stock market, how “safe is the water” for taking advantage of a potential pullback to put additional cash to work? (According to Bespoke Investment Group data, September and February are the only two months that have seen a negative average monthly return for the Dow Jones Industrial Average over the past 100 years.)

In trying to answer this question, Standard Chartered Bank U.S. Economist John Calverly's “Checklist of Bubble Characteristics” is a useful tool. This was published in his 2004 book Bubbles and How to Survive Them when the author was Chief Economist at American Express Bank.

Checklist: Typical characteristics of a bubble (assessment by the author of this comment in italics)

1. Rapidly rising prices » stocks yes, housing no, commodities no
2. High expectations for continuing rapid rises » no
3. Overvaluation compared to historic averages » no
4. Overvaluation compared to reasonable levels » no
5. Several years into an economic upswing » no
6. Some underlying reason or reasons for higher prices » prices still below highs
7. A new element, e.g., technology for stocks or immigration for housing » no
8. Subjective “paradigm shift” » no
9. New investors drawn in » no
10. New entrepreneurs in the area » no
11. Considerable popular and media interest » no, still fear and doubt
12. Major rise in lending » no
13. Increase in indebtedness » no, savings are rising
14. New lenders or lending policies » perhaps central banks
15. Consumer price inflation often subdued (so central banks relaxed) » yes
16. Relaxed monetary policy » yes
17. Falling household savings rate » no
18. A strong exchange rate » no
Source: John P. Calverly, Bubbles and How to Survive Them, p.13.

No apparent bubble in Emerging Markets:

As of August 18th Global Emerging Markets (GEM) had rallied 56% since OECD lead economic indicators troughed in December 2008, making the current rally about twice the average seen after previous episodes when OECD lead indicators troughed. However, the trough valuation for GEM in December 2008 was 1/3 lower than in previous cycles, and GEM valuations are only now at just 5% above their average when lead indicators bottom.

GEM Historical P/E – now versus previous cycles when OECD leading indicators troughed

Source: Datastream, OECD, Credit Suisse Estimates published in Credit Suisse Asia Daily 8/18/2009

No apparent bubble in U.S. Equities:

In the U.S., stocks have advanced by 51.68% from their March 9th closing low as of 8/21/2009 according to Bespoke Investment Group. This naturally causes worries about a bubble. However it appears far premature to give this label to the present market.

The S&P 500 valuation now resides at 18.89x 2009 using Standard & Poor’s current $54.40 bottoms up S&P 500 operating earnings forecast. For perspective, the same multiple of operating earnings was consistently in the high 20’s during 1999 through the first half of 2000 as the S&P 500 was topping out at the peak of the last bull market. For even further perspective, a look back to the Nifty 50 era of 1972 shows that the original Nifty 50 traded for between 46 and 92 times earnings according to Forbes magazine. Therefore it seems that there is plenty of scope for stock valuations to move higher before we can be considered to be in a bubble; particularly if there is a steady diet of positive news flow.

No apparent bubble in Investment Grade Corporate Bonds:

As highlighted by Argus Research on August 24th, as of July 31st the average yield spread between a AAA-rated corporate bond and the U.S. Government long bond was 185 basis points. Over the past 55 years this spread has averaged 80 basis points. For BBB rated bonds, the average spread was 353 basis points as of July 31st, versus a historic average of 178 basis points (as published in Argus Market Watch 8/24/2009).

Conclusion:

With few conditions for a bubble present, and financial markets exhibiting inexpensive to normal valuations, there are no signs of a bubble in any of the aforementioned risky assets – U.S. stocks, emerging markets stocks or corporate bonds.


Absent an external shock such as a terrorist attack, or significant problems with a major trading partner, and assuming continued improving economic news, stock and corporate bond markets offer scope for solid returns from these levels despite the healthy advances of the recent past.


Important Legal Information:

Past performance is no guarantee of future results. Investing involves the risk of loss. This material should not be used as the basis for investment decisions on its own. Prior to investing, an investor should assess the specific risks of given instruments and determine (with his or her professional advisors) if the investment is suitable for his or her circumstances.

Taylor Thomas 8/30/2009

Enter Goldilocks?

A recent conference call by the Fixed Income strategists at a major NY investment bank set forth the following forecasts for interest rates and inflation:

• CPI inflation is likely to return to positive by year end 2009. However, slack labor markets and low capacity utilization at factories will cause core CPI (ex food and energy) to remain negative through 2010.
  
• The U.S. Federal Reserve is likely to engineer a gradual increase in the Fed Funds rate, but this firm did not expect the Fed Funds rate to reach greater than 1.25% by year end 2010.
  
• Because inflation expectations will remain anchored with the aid of a negative core CPI, 10-year treasury rates are not expected to surpass 4% between now and year end 2010. In fact, they may fall from current 3.5% to 3.00% within 12 months. (They are already down from 3.80% at the time of the call earlier this month.)
  
• The flattening of the yield curve is expected to lead the way higher for risky asset (stocks).

All of the above makes sense in my opinion, yet it is critically dependent on the ability to keep inflation expectations firmly anchored. The extremely high levels of liquidity that have been injected into the system by the Federal Reserve and other central banks will need to be artfully removed. We heard the first on this from the Fed in their statement following their meeting last week. In addition to making generally positive comments about the decline in the rate of deterioration in the overall economy, they also did not expand their program to purchase treasuries, mortgage backed securities, and U.S. Government Agency Debt. Not expanding this program was viewed favorably by the markets that have been looking for a carefully crafted exit to these potentially inflationary programs.

For those looking for a guidepost, the spread between the 2-year treasury and the 10-year treasury's interest rates is a usesful place to start. This has contracted since early June when the 10-year yield was 3.71% and the 2-year yield was 0.97% for a spread of 274 basis points. As of June 26th that spread stood at 242 basis points with the 10-year yielding 3.52% and the 2-year treasury yielding 1.10%.

Firmly anchored inflation expectations accompanied by economic data that is neither "too hot" nor "too cold," may well usher a new Goldilocks era.

Gold and Economic Freedom

A friend recently reminded me of an article written by former Federal Reserve Chairman Alan Greenspan in 1966 titled "Gold and Economic Freedom" It makes the case for gold as a store of value and a protector of purchasing power.

Only a few years after Greenspan wrote this piece, the U.S. abolished the gold standard that had preserved the convertability of the U.S. dollar into gold at $35/ounce. Over the ensuing years, salaries, property values, stocks and the price of many commodities have advanced dramatically, but the purchasing power of the dollar has eroded greatly. Here are several charts that illustrate how much less gold and oil a dollar buys today than it did in 1969.

At present, the economy appears to be working through a period of near deflation, but the expansion of the monetary base that is being engineered by the U.S. Federal Reserve (see chart), and other central banks, is likely to lead to inflation. Should this occur, holdings with cash flows that are leveraged to inflation, be they commodities, natural resources, real estate, or timber should protect purchasing power better than cash.

Parting Wisdom from a 20 year veteran of Merrill Lynch - Investment Strategist Rich Bernstein

Parting wisdom can sometimes be insightful. I found Rich Bernstein's parting words well worth the read. Enjoy.


*************************************************************************************
Tomorrow will be my last day at Merrill Lynch. I want to sincerely thank my colleagues and clients for the opportunity to work with them. It is because of them that my 20 years at the firm have been so rewarding.
As a last report, here are what I view as 10 of the most important investment guidelines I've learned in my time at the firm:

1. Income is as important as are capital gains. Because most investors ignore income opportunities, income may be more important than are capital gains.
2. Most stock market indicators have never actually been tested. Most don't work.
3. Most investors' time horizons are much too short. Statistics indicate that day trading is largely based on luck.
4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.
5. Diversification doesn't depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.
6. Balance sheets are generally more important than are income or cash flow statements..
7. Investors should focus strongly on GAAP accounting, and should pay little attention to "pro forma" or "unaudited" financial statements.
8. Investors should be providers of scarce capital. Return on capital is typically highest where capital is scarce.
9. Investors should research financial history as much as possible.
10. Leverage gives the illusion of wealth. Saving is wealth.

A Different Way to Look at Portfolio Risk

Recent data from the Federal Reserve highlights that the U.S. saw a 12.5% increase in the population aged 55 to 64 between 2004 and 2007. Near retirement, and typically beyond their largest earning years, this group faces tough decisions about their investing and spending even in good times. Today, because of large declines in the value of the stock market and residential real estate, those decisions are harder than ever. Traditional assessments of portfolio risk have been inadequate for a long time, but for this group it is even more relevant to discuss the importance of relating the assets to the liabilities of the investor.

I recently came across a compilation of articles from the Journal of Portfolio Management that were published in a 1998 compendium called Streetwise (Princeton University Press). A 1984 article, "A New Paradigm for Portfolio Risk," by Robert Jeffrey, caught my eye.

In "A New Paradigm..." Jeffrey argues against using only portfolio volatility as the measure of portfolio risk. His underlying assertion is that risk is a function of a portfolio's liabilities as well as its assets, and in particular of the cash flow relationship between the two over time.

The new paradigm that Jeffrey argued for in his 1984 article never occurred. For the past 25 years it has been standard for individuals to construct portfolios that offer the promise of the greatest return for the maximum tolerable amount of risk, defined as portfolio volatility.

For the most part, individuals have not been encouraged by mutual fund companies and large brokerage firms to think about their portfolio risk in terms of their liabilities. The business models of these firms can be called "manufacture and distribute." What they manufacture are the mutual funds and other products that they market to individual and institutional investors. Most likely, the asset based approach to risk management, generally advocated by these firms, is a product of the fact that portfolio assets are what they manufacture. Yes large brokerage houses do offer mortgages, but in my experience this is a discreet function, perhaps facilitated by the client's sales rep, but not incorporated into the portfolio risk discussion.

The problem with volatility based risk measures, as Jeffrey points out, is that they say nothing about what is being risked as a result of the volatility. Said another way in the same article, "the determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss."

The 50 or 60 Something investor, who faces tough decisions about investing and spending, needs to be considering the consequence of loss as highlighted above. This is a very personal exercise that requires a thoughtful breakdown of the timing, magnitude and predictability of future cash requirements. A competent advisor who works with the proper incentives can be an invaluable resource in this process by asking the right questions and highlighting opportunities for savings or realignment of assets. An objective, knowledgeable advisor is in a position to show investors the best of what is out there to meet their needs.

As always, investors should "consider the source" when receiving investment advice. In addition to educational background and years of experience, some key questions are; How much time does the person that I am working with spend trying to understand my whole financial picture? How is the advisor compensated? Does the advisor offer an "open architecture," or are the recommendations constrained by his or her firm's product line? Does my advisor receive commissions when I purchase something that may color his or her incentives? Is he charged with acting as a fiduciary?

Individual client risk management is improved by considering assets and liabilities together. Advisors who practice this approach can be invaluable in helping their clients with this.

U.S. Royalty Trusts for Income-Oriented Investors

There are several publicly traded U.S. Royalty Trusts with interests in the oil and natural gas sector that are worth a look for investors seeking high current income. Their projected next twelve month yields are in the range of 8-10%. They also hold appeal for investors who would like to own assets whose performance is linked to the change in oil and natural gas prices without exposure to a leveraged corporate balance sheet, or the potential for poor corporate management.

San Juan Basin Royalty Trust (NYSE: SJT), and Permian Basin Royalty Trust (NYSE: PBT) are the two U.S. Royalty Trusts that this article will focus on, though there are a number of others. There are detailed descriptions of the trusts available on the trust websites and in documents available at the SEC website (http://www.sec.gov/). The goal of this piece is to provide a concise description of each, and a summary of why it might be an attractive investment.

San Juan Basin Royalty Trust:

Principal Asset:

This trust owns a 75% net overriding royalty interest in certain properties located in Northwestern New Mexico. These properties are virtually 100% natural gas producing.

Unit Information:

Recent Price $14.99 as of 3/17/2009

Number of Units Outstanding 46,608,796

Market Value $698,665,852

2008 Distributions $3.069833

Most Recent Monthly Distribution $0.09889 per unit paid 3/13/2009

History of the Trust

The trust was formed by Southland Corporation in November 1980 to contain the royalty interests on the above mentioned properties. The income producing properties are operated by Burlington Resources Oil and Gas (BROG), a division of Conoco Phillips. BROG retains a 25% interest in the properties.

Production outlook

The actual production of the properties linked to the trust has exceeded the trust’s published production outlook since its inception in 1980. Current estimated future net revenue per unit is $15.83 (2008 10-K).

Going back 10 years to 1998, the estimated future net revenue per unit was $5.18 yet actual distributions per unit have totaled $20.40 during the intervening period. (Based on SEC filings) This means that someone who purchased a unit of SJT at its 1998 high price of $9.37, and still held it today would have received $20.40 in distributions and would own a unit with a market price of $14.99. Today the estimated future net revenue per unit is $15.83 and the current unit market price is $14.99, so the units are available at a multiple of estimated future net revenue of 0.95x. This compares with a multiple of estimated future revenue of 1.8x in 1998, so on this basis the units are cheap relative to that time.

Income Potential in the near term

Borrowing from the work of well-regarded energy analyst Kurt Wolff, he estimates that distributions per unit over the next 12 months will be $1.25 (http://www.mcdep.com/). Should he prove correct then the yield for the next 12 months is a potentially tax advantaged 8.33%. While only an estimated income based on estimated monthly distributions, this is an appealing yield relative to many other income-related alternatives, particularly since this comes with no balance sheet leverage.

Tax Benefits

There is favorable tax treatment of the distributions for individuals who hold the units in taxable accounts. Depletion allowances provide an opportunity for taxable investors to shield close to 100% of the unit distributions from income taxes in the early years of ownership. Investors should consult with an accountant to obtain a better understanding of these.

Permian Basin Royalty Trust:

Principal Asset:

The trust’s principal assets are a 75% net overriding royalty interest in oil and gas producing properties in Crane County Texas and a 95% net overriding royalty interest in other oil and gas producing properties carved out by Southland Royalty Company from its properties in Texas. The production from these properties is approximately 2/3 oil and 1/3 natural gas.

Unit Information:

Recent Price $9.94 as of 3/17/2009

Number of Units Outstanding 46,608,796

Market Value $463,291,432

2008 Distributions $2.39136

Most Recent Monthly Distribution $0.04356 per unit paid 3/13/2009


History of the Trust

The trust was formed by Southland Corporation in November 1980 to contain the royalty interests on the above mentioned properties. Burlington Resources Oil and Gas is the operator of record for the properties in Crane County, Texas. The Texas Royalty Properties consist of royalty interests in mature producing oil fields. They contain approximately 303,000 gross and approximately 51,000 net producing acres. Riverhill Energy performs all accounting operations related to these properties and Schlumberger Technology Corp. performs summary reporting of monthly results.

Production outlook

The actual production of the properties linked to the trust has exceeded the trust’s published production outlook since its inception in 1980. Current estimated future net revenue per unit is $6.906 (2008 10-K).

Going back 10 years to 1998, the estimated future net revenue per unit was $2.01 at that time yet actual distributions per unit have totaled $10.96 during the intervening period. (Based on SEC filings) This means that someone who purchased a unit of PBT at its 1998 high price of $5.19, and still held it today would have received $10.96 in distributions and would own a unit with a market price of $9.94. Today the estimated future net revenue per unit is $6.906 and the current unit price is $9.94 so the units are available at a multiple of estimated future net revenue of 1.44x. This compares with a multiple of estimated future revenue of 2.6x in 1998, so on this basis the units are cheap relative to their valuation in 1998.

Income Potential

Borrowing from the work of well-regarded energy analyst Kurt Wolff, he estimates that distributions per unit over the next 12 months will be $0.97 (http://www.mcdep.com). Should he prove correct then the yield for the next 12 months is a potentially tax advantaged 9.8%. Given that this comes with no balance sheet leverage, this is appealing relative to many alternatives in the market place. Of course, the risk cuts both ways in that if commodity prices fall further then the yield will not be earned as expected.

Tax Benefits

There is favorable tax treatment of the distributions for individuals who hold the units in taxable accounts. Depletion allowances provide an opportunity for taxable investors to shield close to 100% of the unit distributions from income taxes in the early years of ownership. Investors should consult with an accountant to obtain a better understanding of these.

Note: As of 3/23/2009 clients and principals of South Shore Capital Advisors are now holders of San Juan Trust (SJT)