December 30, 2011
Commentary by Stuart Brown
For this week only…All is quiet
All is quiet the week before the New Year celebration. Could it be Europe has stumbled into a solution of their debt crisis with the circularity of the European Central Bank (ECB) lending billions to the banks, which in turn deposit the funds with the ECB (rather than face counterparty risk by lending to each other or businesses)? Or have the hedge funds, like Congress, simply taken the last week off?
The ECB, still at work, is quietly buying billions of Italian sovereign debt and that has helped keep rates tame. (If paying seven percent marks the end of the world, the debt problem can’t truly be solved.)
In the US, for all the brinksmanship and bluster of the year, the budget has barely been trimmed by a few billion. Bruised by the payroll tax debate, Congress went home leaving the President to quietly ask for another trillion dollar hike to the debt ceiling this week.
(In the spirit of getting something for nothing, who will ever want to see a thousand dollars less in their paycheck? Like the unfunded prescription drug add-on to Medicare, the payroll tax holiday is another Trojan horse bringing forward the day of insolvency.)
But next week, with the Iowa Caucuses, the volume of the political discourse will be turned up again. Congress reconvenes and Wall St. will get us back in the swing of things. There is a trillion dollars of European debt to refinance in 2012, along with another trillion of junk bonds and some hefty Treasury borrowings.
Everyone knows all the woes. Seems to me, that must then, be already priced into the market. It is what is not priced in the market that will prove important as the new year unfolds.
Stocks began the year with a P/E of 17 and ended at 14, or an Earnings Yield of over 7%, historically a tremendous value in light of the thirty-year treasury paying under 3%. Over the next few weeks companies will report their fourth quarter earnings, which are expected to be generally pretty good.
For all its gyrations 2011 was a lot of nothing. The New Year may still be volatile, but is starting from a better valuation and so may very well be more profitable.
I want to thank you for your continued confidence. I hope 2012 comes with great happiness and health and the joy of loving family and friends.
November 22, 2011
Commentary by Joseph Warren
The word amortization comes from the Latin word admortire, which means, “to kill.” Given the state of the housing and debt markets these days the derivation couldn’t be more fitting. Regardless of the origin, understanding how an amortization schedule is calculated and the influence of such a calculation on things like the housing market could not be timelier.
I’m not going to go through the entire amortization formula as it would take most of this piece. But know that the interest rate, the number of payment periods and the principal balance are the variables that calculate the monthly payment. (Visit our mortgage calculator at http://warcap.com/services/harmonyloans). Those variables also dictate the amount of interest vs. principal allocated within each payment: the amortization schedule. As you might deduce, the larger the number of payments (there are 360 monthly payments in a 30-year loan) the less principal allocated at the start of the loan. The nature of this formula and the fact that very few homeowners or mortgage brokers understand the formula is a primary reason for the current state of the housing market in this country.
Take a 30-year fixed loan for $500,000 initiated in November 2009 at 6%. The monthly principal and interest payment would be $2,997. While that is an important number, often mortgage brokers fail to properly explain that such a mortgage obligates the borrower to pay $579,190 in interest over the 30 years of that loan for a total repayment of $1,079,190. Today a qualified borrower could get a 30-year fixed mortgage for about 4.3%. While this is a significant rate difference, there is a dirty little secret hidden inside the option to refinance and most in the industry don’t want you to recognize it.
Two years of payments at $2,997 equals $71,928. But because of the magic of the bank’s amortization formula, the principal balance of this loan after two years is $482,922. Only $17,078 of $71,928 has gone to paying down the $500,000 borrowed. Moreover, refinancing into a new 30-year fixed mortgage immediately subjugates the borrower to another 360 monthly payments and a new amortization schedule. Under this scenario, after four years of payments totaling $129,480, the borrower would have a principal balance of $466,427. When you add back the $22,000 of closing costs the borrower would have to pay for both loans the total reduction of debt is de minimis. Here at Warren Capital, we believe this type of scenario should be avoided and we give our clients a much better solution.
Through our alliance with Mortgage Harmony Corp., we are able to offer our clients a unique type of loan that allows the borrower to reset their interest rate after they finance by simply clicking a button on their lender’s Web site. If interest rates change after the loan closes, which they always do, you now have the ability to take advantage of that new rate without refinancing. No credit check, no appraisal, no title work, no income or job verification and no new 30 year amortization schedule.
Our job at Warren Capital is to build and protect our clients’ wealth. Both asset and liability management are necessary to accomplish our job. There will be times when asset growth will be limited because of economic circumstances. During such times, you can be assured that we will use that opportunity to improve the other side of our clients’ ledgers and to make sure they don’t succumb to hidden financial pitfalls. While this is a unique approach for advisors in our industry, we know it’s the right way to help our clients build their net worth.
As always, I appreciate the continued trust and confidence.
September 12, 2011
Commentary by Stuart Brown
Since 1900, the stock market has averaged six percent growth per year, excluding
dividends. Seldom have stocks been priced as inexpensively as today. When at this valuation in the past, a year later, on average, the market was up over twice the historic average.
Most recently, in June 2009, a dollar invested in the S&P represented 1.7 times the yield on the thirty-year Treasury bond. A year later, the market had risen 28%.
Today, with reported earnings of $85.18 and the S&P at 1169 (an earnings yield of 7.3%) the market is priced at over twice the 3.5% yield of Treasuries.
The stock market has been similarly valued 46 times over the past century. Each following year, the market had rebounded sharply (with the exception of the early years of WWII). There are no assurances as to what the future might bring. But if things unfold the way they have in the past, this could be a very profitable time to own stocks.
There are ways, other than higher prices, for stocks to appear expensive, e.g. if interest rates soared above 9%, the market would no longer look as cheap in comparison. Or if a soft patch turns into full blown recession and earnings decline. There are three moving parts to this model: earnings are reported quarter by quarter, interest rates and the price of the market change moment by moment.
Most recently earnings have been reported for the second quarter and have generally been good. For the Dow Jones Industrial Average, earnings rose on average 14% on 10.5% higher sales. Not bad, but the market, concerned about where earnings might be next year in a slower economy, sold off some 15%. Money moved to bonds, driving the yield on the Treasury down from 4.7% to under 3.5%.
Irene blew her way up the east coast. While hurricanes aren’t known for doing much good, there may be one nice thing about a market decline; once again stocks are offered at a compelling price. Stocks are as cheap as they were in early 2009—at the recent market bottom.
May 01, 2011
Commentary by Joseph Warren
Given the close relationship we have with our clients and the amount of time we get to spend with each of them we often hear their worries about various economic issues. Having clients in the real world expressing their economic concerns to us holds immeasurable value as they are the true barometer of the level of fear in the markets. But often times the fearful topic du jour is not the issue to worry about as a more silent, less media-friendly matter emerges as a sure way to lose. Right now the looming debt vote in Congress serves as the former and inflation the latter.
For those not aware, the U.S. Treasury’s borrowing spree has a limit and it’s called the debt ceiling. The debt ceiling is a cap set by Congress on the total amount of indebtedness the Treasury may incur, currently $14.29 trillion. According to the Treasury, the cap will be met in the next 60 days. Two things can happen once reached: The debt ceiling can be raised like it has been done almost every year for the past five decades or the government can stop paying some of its bills.
I’ve written extensively in past editions about the inevitable path to insolvency the country is on with this deficit spending and the media has covered it ad nauseam. In reality there is no political benefit to the politicians balancing the federal budget as each representative gets elected by and is responsible to their own individual constituents. (I imagine allocating federal dollars to benefit the voters in the districts that elected you helps at re-election time.) As such, I doubt there will ever be a political consensus on government outlays vs. spending. So I can understand why clients are concerned about the pending ceiling vote on the Hill. But according to the markets, they should not be.
The most recent headline to spook investors regarding federal debt was Moody’s release that it was considering downgrading the credit quality of Treasuries. Losing its gold-plated AAA status would be a huge blow to Treasuries. But contrary to logic, the Treasury market has rallied since Moody’s release in mid-March as the yield on the 10-year Treasury has declined from 3.34% to 3.17%. While it’s not a big move, the mere decline in yield, or rally in price, proves the point. Treasuries are the world’s safe haven investment and even a threat of a downgrade to the ratings of Treasuries themselves doesn’t replace that notion. Furthermore, the paltry yield of 3.17% suggests that investors have no concern whatsoever about the government’s ability to meet its obligations. In comparison, 10-year yields on Greek and Portugal debt are 15.1% and 9.63%, respectively. Now I’m not saying it’s right, but the markets are telling you not to worry about the government defaulting. What is a concern and what we work to mitigate every day is inflation.
Inflation is a complicated matter as the cost of goods affects people differently depending on their direct use of those goods. That is why the consumer price index (CPI) may increase by only 2.7% in the past year while you are paying 28% more for gas. Whatever the measure, inflation is far more onerous than the government’s creditworthiness.
First, it is important to understand that the ultimate agent of stability, the Federal Reserve, faces consequences each time it eases. The Fed has absorbed $2 trillion of new assets since the financial disaster of 2008. In order to buy these assets, the Fed had to create new money. Increasing the amount of dollars in existence by 20% will eventually cause the value of each dollar to fall. We measure the value of a dollar on an index basis as it must be measured against a basket of currencies. At 73 it stands just two points away from its all time low!
Second, the value of the dollar has an inverse relationship to the cost of anything that is priced in those dollars. Hence, the recent sticker shock at the pump and the grocery store. The ultimate threat to any central bank is falling prices or deflation. One way to counteract the deflation we faced in 2008 is to add new dollars to the total amount of dollars in existence. This is guaranteed to lower the value of the dollar and will likely raise the price of anything denominated in that currency over time. What makes a falling currency so burdensome is the inflation it produces and the effect that inflation has on “real return.”
Many investors who manage their own money often cite the return they are receiving on their investments. While it’s a useful measure, it has less meaning than real return, a measure followed at Warren Capital. Real return accounts for inflation as it subtracts the inflation rate from the net return. From our perspective there is no point in evaluating how many dollars can be made on an investment without considering what those dollars will be worth when earned. Furthermore, measuring real return will continue to hold more creed going forward as Fed policy is poised to keep the value of the dollar low for some time.
Currently the Federal Reserve’s federal funds rate is targeted at zero percent. It’s pretty difficult to lower a rate beyond zero and, therefore, the Fed has no other stimulus available other than printing and buying, as noted by their recent QE2 effort. Given the anemic growth of the economy and comments from recent minutes released by the Fed, it’s hard to foresee any eminent policy designed to increase the value of the dollar or slow inflation. With CPI at 2.7% an investor would have to go out eight years on the Treasury yield curve to find debt that would break. By not considering this and owning investments with less than an equivalent yield you find a sure way to lose.
As always, I appreciate the continued trust and confidence.
Warren Capital Group is a registered investment advisor specializing in private wealth management and protection and growth for high net worth individuals, institutions, foundations, and corporations. Warren Capital Group wealth managers use their collective expertise to invest in stocks, bonds, real estate, money markets and other alternative assets on behalf of clients and advise them on mortgages, insurance and other aspects of their net worth. As a fee-based personal wealth management firm, Warren Capital Group assists clients with asset allocation, risk management, estate planning and liability management via mortgage services.
February 14, 2011
Commentary by Stuart Brown
How Goes the Recovery? So far 27 of the 30 stocks comprising the Dow Jones Industrial Average (DJIA) have reported earnings for the 4th quarter 2010. If this is indicative of the market and the economy, the results are encouraging. Earnings are up on average 18% on 8% higher sales. This continues the good news from the third quarter when earnings and sales were up 37% and 4% respectively.
Dow Jones 12000. Much is being made of the market breaking above 12000 for the first time since August 2008. Back then S&P; earnings were slipping from $64.67 to $15.73 by December 2009. Today’s higher earnings of $75.45 is consistent with a recovering economy.
Dow Jones 14000. When the DJIA hit its all time high in October 2007, S&P; earnings were $74 (down from $85 in June). So today there are greater earnings than when the market was fifteen percent higher.
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December 10, 2010
Commentary by Stuart Brown
Interest rates have risen as much as three quarters of a point across the yield curve. Barron’s estimates these higher rates will add $800 billion to the cost of financing our deficit. How much higher would rates now be were it not for $600 billion in QE2?
Is the economy stronger than it appears? Recent reports are encouraging. Third quarter earnings were the best ever. Retail sales look decent. GDP was better than first reported.
Are investors returning to risk-taking? Rates rise as sellers overwhelm buyers of bonds. As this occurred, the stock market rose. If banks don’t pay enough on savings, people look for alternatives. Foreclosures dampen enthusiasm for real estate. But a second year of double digit returns for equities and an improving economy encourage stock investors.
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November 10, 2010
Commentary by Stuart Brown
Qualitative Easing is an Indirect Stimulus. The Fed’s purchasing of $600 billion of Treasury bonds is target of much discussion and criticism. This is an indirect attempt to get the banks to lend. Normally the Fed stimulates a slow economy by swapping cash for bills and notes held by banks, (or conversely, soaking up cash from an overheated economy by selling to banks notes and bonds). What is unusual is the longer maturity of the bonds and the magnitude involved.
A Targeted Approach Would be More Directly Stimulating. If instead of buying Treasuries the Fed chose to buy “Bridge and Tunnel,” or “Water and Sewer” bonds, the economy would be benefit directly. Employment would improve and the benefits of a repaired infrastructure would benefit Americans for years to come.
These are Functions of Government. Revenue-strapped states have been cutting back on municipal financing.
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August 06, 2010
Commentary by Stuart Brown
How to Absolutely Get into Trouble with 3% Interest Rates. Demand 10%. All securities are priced off of the “risk-free” US Treasury. 90-day Bills today pay 0.15%. There is no risk as long as the US Treasury can pay at maturity. At maturity the investor simply reinvests into the next Bill. If 0.15% isn’t enough, there’s always the 30- year Bond (and every maturity in between), currently paying 3.9%. The additional risk here is fluctuating principal. If interest rates rise, the resale value will be less than par.
As uncertainty increases, so should the required rate of return. This is important to realize. If the Treasury pays 3% and an investment under consideration offers an enticing 10%, there is significant probability it fails to pay. If it currently pays (or has an earnings yield) less than 3%, it may be overpriced.
Similarly, a large amount of risk-taking is required for a retiree or a million dollar endowment needing to generate $100,000 per year (10%), in today’s 3% interest rate environment. Leverage is one tool which works great when it works and horribly when it doesn’t. Another is investing in lower rated bonds, real estate or stocks. The risk in each of these is loss of principal and a fluctuating resale value.
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May 01, 2010
Commentary by Joseph Warren
Every time I sit down to write a commentary it seems that some new debacle has emerged that threatens market value. Each has its own unique versions of potential peril and the newest one often seems more dire than the last. Yet the prior dilemma, however intricate and scary it must have been at that moment,has been overcome, or at least postponed. Nevertheless, wealth managers face new issues almost daily as the struggle between progress and restraint continues. What’s important, and what sets Warren Capital apart from it's competitors, is how we handle issues in this constant battle.
In my 2010 outlook piece, I predicted that risk would become a factor again as several countries would be unable to roll their debt as they have become overwhelmed from absorbing the losses of their respective banks. As we’ve noted in the past, simply moving bad debts from one balance sheet to another doesn’t mean the debts disappear. We knew aday of reckoning was coming and it looks like Greece is first in line.
Greece is currently in a major fiscal hole and theyield on two‐year Greek notes, which started at 5.21% this year, has blown out to 14.5%. While this may look insignificant to some, this is a colossal change in terms of sovereign debt. Greece will not be able to roll its debt withoutEuropean Union or International MonetaryFund aid. I would be willing to bet, however,that many Main Street investors are just becoming aware that Greece is on the brink of default and they are have no idea what this means to them. Investors are relying on their professional advisors to steer their assets through the Greece fire. The question becomes whether or not that reliance is the right decision. Therefore, I offer our analysis.
The first thing we do when a problem emerges is try to determine the effect of the worst case scenario. From our perspective, Greece is currently a relatively isolated issue. It is aminiscule portion of the total sovereign debt ofthe world, and European banks most likelywould absorb the default. (This is probably whythere is no actual policy in place to aid Greeceof yet as rhetoric has been the only tool implemented). Nevertheless, we have noexposure to Greek debt and we’ve avoided Portugal and Spain as well, who are next in lineif default contagion spreads. Up until the last few days the debt yield of all of these countries hasn’t come close to reflecting the potential default risk we believed possible. In addition, we can only speculate about a short‐term remedy as there are too many players involved. Some of our sources indicate that Greece will be dropped from the EU, revalue its own currency versus the euro and re‐enter sometime down the road. But this, of course, does absolutely nothing to fix the real problem in Greece. Which brings me to my second point: How can we use this incident to our investment advantage?
When we strategize about specific events affecting investment policy, we look to use those events to make a large gain with reduced risk or to protect principal for unforeseen consequences. The Greek incident offers opportunity for both.
The short term causes of Greece’s problems are all too common. Greece borrowed too much money, manipulated the manner in which it disclosed those borrowings and collateralizedits borrowings with its most prime assets. This type of irresponsibility leads to default. But it’s important to remember that investors don’t buy sovereign debt to take on risk. Most sovereign debt purchasers are willing to accept smaller interest payments in return for assurance. So, the possibility of Greek default requires us to examine the safety of even the most assured investments.
In normal times, sovereign debt would be considered the safest asset. But global recessions constrain economies. With enough pressure, long‐term fundamental issues bubble up and their bursting is accelerated. This is precisely what’s occurring in Greece.
Most economists assert that Greece overextended itself this last decade and the spending on which Greece embarked to combat the recession pushed it to the brink of default. While we agree that Greece is overextended, this bland assertion does nothing to identify how Greece got here. To find out why, we compared economies that are performing well against those that are constrained or contracting.
In 1980, the total population of Greece was about 9.7 million. Today it stands at approximately 10.7 million. That’s an 11% growth in population over 30 years. When compared to India, Brazil and Indonesia, whose populations have all grown nearly 60% or more over the same time, the fundamental reason why Greece is faltering becomes obvious: its population is not growing as vivaciously.
In terms of growth, there are no major economies other than China that can competewith the growth of India, Brazil and Indonesia over the last few decades. Given the tables below, it doesn’t take much to recognize the correlation between population growth and economic growth.(Note that the United States also enters into the growth arena as its percent of population growth has slightly eclipsed China.) Accepting this fact, if we can determine the similarities between countries growing in population, we can simultaneously identify areas of the world where the odds of investment return are increased and avoid areas where a governmentguarantee has limits.
After some serious inspection of a world map, the first two things I noticed were that all the aforementioned growth nations have massive amounts of land at their disposal and they all have direct access to the ocean. Therefore, they have room for population expansion and they can directly access the seas for shipping routes. The next similarity was a little less obvious at first but just as vital.
In India, the domestic currency is the rupee. Brazil has the real. Indonesia has the rupiah. China has the yuan, and we all know about the dollar. What’s important is that each of these countries has a central bank tasked to maintain the “value and stability” of their respective currency. Defining exactly what that task means in terms of respective policy for these central banks is beyond my ability. But one thing I do know is that each of these central banks has the capability to print their own currency in times of strife and all of them did during this last crisis. Greece, on the other hand, is part of the EU and, therefore, does not have the ability to print its way out of this corner. The EU can print Euro’s and they probably will. However, that’s way beyond Greece’s influence. So, the Greek government has little control over its own fate. In the longrun, austerity and restraint are the realsolutions to a national budget problem. But that doesn’t comfort anyone holding Greek debt right now. The only way we can prosper in the long term is to make sure our money is around in the short term. To my knowledge, no one has mentioned any of these root issues thatare pressuring Greece. But these basic points are way too stark to be coincidental.
In recent weeks many scathing headlines havecome out about the manner in which investment companies manage their clients’ money and where their moral responsibilities lie. I completely understand this scrutiny as we are in a high profile business, and the ethics and performance track records of many of our competitors are less than stellar. But let this piece stand as proof that not all of us in the industry are highly overpaid regurgitators of modern investment theory who simply spout the “buy and hold” mantra until a portfolio is decimated. Some of us actually enjoy applying thought and discipline to investment strategy. Land mass, direct access to the seas and central bank independence are factors that, I believe, increase our odds of success as we determine where in the world to deploy capital. I also realize that these observations might counter the opinion of the average investment professional. But that’s the point and why we will continue to produce original thought and results that better the average in this constant battle.
As always, I appreciate your continued trust and confidence.
Warren Capital Group is a registered investment advisor specializing in private wealth management and protection and growth for high net worth individuals, institutions, foundations, and corporations. Warren Capital Group wealth managers use their collective expertise to invest in stocks, bonds, real estate, money markets and other alternative assets on behalf of clients and advise them on mortgages, insurance and other aspects of their net worth. As a fee-based personal wealth management firm, Warren Capital Group assists clients with asset allocation, risk management, estate planning and liability management via mortgage services.
April 27, 2010
Commentary by Stuart Brown
The P/E began the quarter in the 70’s and ended in the 20’s, though the market rose 5%. This was possible because earnings are exploding. We now are getting 1st quarter earnings reports. So far they look very good. (see figs. 1 and 2)
The mountain of cash sidelined during the bear market has been reinvested. Funds moving from debt to equity (fig. 3), together with savings, might fuel a continued rise. Already long-term rates have risen to levels last seen in October 2007 (fig.4).
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