1. Here and Now Method of Valuation: While other long time investors may disagree with this observation, I have noted that investors who focus on the here and now are the ones who normally dominate pricing of securities. The here and now crowd are the ones who value stocks during a recession with the assumption that currents conditions are likely to continue indefinitely into the future. In a boom time, valuations are made as if recessions have never happened in modern history.
For particular companies, a firm that grows earnings for two years at 20% is valued as if a 20% growth rate is achievable over 10 years even though that has rarely happened. Microsoft may be one of the few exceptions in its earlier days. The converse is also true. A bad quarter or year is projected into the future as a norm.
Sometimes, it will be a reasonable forecast because the firm is failing. For those companies likely to survive a recession, the current unfavorable earnings will not be a normal data set to predict earnings. While I may be making some obvious points here, you would not know it based on the observed behavioral patterns of investors in either good times or bad.
For particular companies, a firm that grows earnings for two years at 20% is valued as if a 20% growth rate is achievable over 10 years even though that has rarely happened. Microsoft may be one of the few exceptions in its earlier days. The converse is also true. A bad quarter or year is projected into the future as a norm.
Sometimes, it will be a reasonable forecast because the firm is failing. For those companies likely to survive a recession, the current unfavorable earnings will not be a normal data set to predict earnings. While I may be making some obvious points here, you would not know it based on the observed behavioral patterns of investors in either good times or bad.
While the predominance of the here and now method of valuation, the bird in hand is better than two in the bush, is apparent when applied to stocks, it also has significant influence in valuing bonds. Many long term bonds are being valued now as if the historical data set for inflation over the past 100 years or the past 20 did not exist, as if inflation has been finally squashed by the wisdom and competence of central bankers. Why? Well, the CPI numbers have been negative or low most of the time for the past year. So, the here and now method will take the most current numbers, as if history did not exist, and forecast a continuation of that trend into the indefinite future.
Another issue crops up when comparing fixed rate coupon bonds with bonds from the same issuer that floats by a certain percentage over CPI. I did an analysis last night of several bonds from Prudential maturing in 2018, in an effort to determine which bond may present the best opportunity now. Comparing Prudential Floating Rate Bonds Tied to CPI and Fixed Rate Coupon Bonds Maturing in 2018/ CIT Rescue? While I do not know what inflation will be over any short duration, I can predict a reasonable range over a ten year period. A range of 2 to 3% as an average for a decade seems reasonable to me.
By simply assuming an average CPI rate of 2.5%, the 3 CPI floaters from Prudential would pay more over the next nine years in interest even though the fixed rate coupon bonds pay more now, due to the low CPI readings for the past year. The CPI floaters had a much better capital gains potential due to their greater discount to par value, and at least provided some protection against a higher than expected inflation rate, which is always a consideration in their favor compared to the fixed rate coupon bond. None of this is an argument to buy any Prudential bond, but merely an argument for preferring one over another with the same or similar maturity, once the chains of the here and now are broken.
By simply assuming an average CPI rate of 2.5%, the 3 CPI floaters from Prudential would pay more over the next nine years in interest even though the fixed rate coupon bonds pay more now, due to the low CPI readings for the past year. The CPI floaters had a much better capital gains potential due to their greater discount to par value, and at least provided some protection against a higher than expected inflation rate, which is always a consideration in their favor compared to the fixed rate coupon bond. None of this is an argument to buy any Prudential bond, but merely an argument for preferring one over another with the same or similar maturity, once the chains of the here and now are broken.
Notwithstanding that analysis, I have to recognize that pricing decisions are constantly being made by those who give the most weight to what is happening now, or in the recent past. This would mean that the low penny rate for a CPI floater now will act as a restraint on any upward price movement.
Conversely, when the CPI numbers start to come in much higher, and the penny rate rises, a CPI floater may sell at a narrower discount to par value, or even at no discount provided concerns about credit risk for the issuer has subsided to the point of no concern at all. This might then make the fixed rate 2018 maturity issues a better value, particularly if the inflation increase causes selling and the discount to par value expands substantially from current levels. A nimble individual investor, cognizant of this ebb and flow, who remains open minded and flexible, can profit from it.
Conversely, when the CPI numbers start to come in much higher, and the penny rate rises, a CPI floater may sell at a narrower discount to par value, or even at no discount provided concerns about credit risk for the issuer has subsided to the point of no concern at all. This might then make the fixed rate 2018 maturity issues a better value, particularly if the inflation increase causes selling and the discount to par value expands substantially from current levels. A nimble individual investor, cognizant of this ebb and flow, who remains open minded and flexible, can profit from it.
There is of course uncertainty to taking a longer view, trying to measure normalized earnings or an average inflation rate for a decade, but in the final analysis that is a more reasonable approach than saying things are bad now and will never get better or things are good now and will not ever get worse.
Another difficulty, in addition to making the forecast, is a timing issue. I may be able to wait to buy PFK at about the same or a lower price for as long as the here and now crowd see low CPI numbers. The low inflation prediction may be the most reasonable one for the next several months, but I do not know that for certain. Maybe I can wait or maybe not. At some point, I am confident that the here and now crowd will make the transition to concerns about inflation. So, the way that I deal with that uncertainty is to make gradual movements out of a Pru long bond maturing in 2033 into the CPI floater maturing in 2018, while keeping my short term Pru bond position stable. So, my positions are spread out, some in bonds maturing in 2012 that pay monthly interest, and then close to equal amounts based on current pricing of the CPI floater maturing in 2018 and the fixed coupon bond maturing in 2033 bought at opportunistic prices.
Back in the Fall of 2008 and early March 2009, the price of PFK was being more heavily influenced by credit concerns then sweeping the market, particularly for financial firms, and the price of PFK fell to close to $11. The recovery in price to the current level of over $18 is in my view an alleviation of those credit concerns for Prudential. Another CPI floater that I have discussed, OSM, is still being significantly influenced by concerns about SLM or Sallie Mae. If those concerns prove to be unjustified, and only time will tell, then there is room for price appreciation due solely to more comfort that SLM will pay off this note in 2017 at par value. The note is now selling at close to 1/2 of its par. That kind of price, for a note maturing in less than eight years, can only be due to significant credit concerns.
2. Conference Board's Leading Economic Indicators: The Conference Board reported this morning that its index of leading economic indicators rose for the third straight month, rising .07% in June. This was higher than the estimate of .04%.
3. Increasing Taxes to Partly Pay for Healthcare "Reform": One thing to keep in mind is that the Democrat's plan already assumes an increase in the surtax in the event cost savings turn out to be less than expected, which I would take as a guarantee that the increase provided in the current House bill is sort of a minimum increase. If this legislation is passed, I would expect the Democrats to gradually lower the adjusted gross income amount and to increase the surtax as years go by. Moreover, it is apparent that this will not be the last effort to soak the top 1% or even the top 10%. When I started to make serious money, the year was 1978, and I recall that the Democrats had me paying a maximum 50% tax on earned income. The marginal rates were higher than 50% on unearned income. The Dems thought that they were being generous by putting a lid of no more than a 50% tax on wages. This is where they are headed now. More tax hikes are planned in the Obama budget. And, as I have said, where is the money going to come from to fund the enormous unfunded liabilities for social security and medicare? The Democrats are back to thinking that the top wage earners are a bottomless well that will keep on giving to them, no matter how much they repeatedly dip into it.
I mentioned in an earlier post that the 50% maximum tax rate on earned income did not discourage my work effort but it made me surly at the times when I was a young man. But, I recognized that when the tax rate started to hit 40% or higher, the incentive was to work or produce less. When the state and federal government becomes your 50/50 partner, or worse which is where many will find themselves soon, a premium will start to be placed on more leisure time. The government will end up taking in less money from those who actually create the wealth. I have also mentioned that a 2 or 3% increase in total taxes on the higher incomes will not be disastrous, provided it stopped at that. he problem now is that it will not stop, for it is only just starting at lower levels just for one new Democrat program.
I also believe that many will end up paying twice under the Democrat "reform" proposal. This would be true for a small business that does not currently provide health insurance but where the husband and wife have combined incomes which would trigger the surtax. Notwithstanding Obama's rhetoric, I find that that his proposals are extremely hostile to modestly successful small businesses and will likely become increasingly so.
While this may sound like I am a republican, I am not a republican or a democrat. My criticisms of W, particularly on the IRAQ invasion or LBJ on Vietnam or for his guns and butter approach to fiscal responsibility, were far more stringent.
4. The Desire for Income: I am finding now that my decisions are being increasingly influenced by a desire for current income compared to potential capital gains. For most of this morning, I have been combating a desire to sell the two baby Berkshire shares that I just bought, for about a $300 gain, and to invest the proceeds into a bond. When I was 30, 40 or even 50, that thought would have barely lodged in a brain cell for more than a nano second, before disappearing deep into the subconscious, never to be seen or heard from again. Now, it is almost impossible to shake loose from the domineering nature of that thought. Once I buy a bond, I know what my return is going to be, provided the company stays out of bankruptcy and I hold until the note matures. That measure of certainty becomes more appealing as one grows older and even more pronounced after the drubbing that stocks have taken since October 2007. I have made a really nice return off my individual bond investments since the immolation of stocks. I am not alone in preferring not to see my money burned to a crisp.
5. BOUGHT 100 JBK AT $16.15: (SEE DISCLAIMER TO THE RIGHT): I mentioned in a prior post that I did not want any more Goldman Sachs bonds. That was then, before I started to obsess about income this morning. I bought 100 of the TC JBK at $16.15 this morning, a TC that I have discussed in prior posts. I would just reference that discussion:
Item # 2: Bought 50 of the TC JBK/
This security started out as a synthetic floater. I now believe that the swap agreement creating the floating rate has been terminated and the owner of JBK is now entitled to receive the interest of the underlying bond, a fixed coupon junior bond from Goldman Sachs maturing in 2034. The TC has a $25 par value.
At a total cost of $16.15, just for ease of calculation since my brokerage commission is so low, my current yield is about 9.82% plus another $885 of so at maturity in 25 years. This yield to maturity needs to be compared to the other TCs with the same GS bond in them: Goldman Sachs 6.345% Junior Debenture Maturing on 2/15/2034
At a total cost of $16.15, just for ease of calculation since my brokerage commission is so low, my current yield is about 9.82% plus another $885 of so at maturity in 25 years. This yield to maturity needs to be compared to the other TCs with the same GS bond in them: Goldman Sachs 6.345% Junior Debenture Maturing on 2/15/2034
These calculations are made by Marketwatch based on the prices shown below:
GYA 7.51% AT $19.97
PYC 8.14% AT $18.43
PYY 8.17% AT $18.37
PYK 7.17% AT $22.10
HJJ 7.59% AT $19.75
HJL 7.81% AT $19.21
HJN 7.85% AT $19.5
I did not check the yield calculations provided by MarketWatch. Why would anyone buy PYK as opposed to say PYC? Do these prices make sense compared to one another? After all, they are all Trust Certificates, containing the same bond, and mature at the same time. JBK provides the best yield and capital gain at maturity, with the termination of the swap agreement due to Lehman's bankruptcy.
It remains to be seen whether or not I can resist selling a non-income producing security like BRK-B for a short term profit.
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