Monday, December 7, 2009

Comments on Bary's Column on Income Securities/Long Term Secular Bull and Bear Markets/History of CEFs

The LB called a staff meeting this morning and as usual no one showed up. The RB said it does not do meetings. Possibly RB mused that it would consider the possibility of working around 12 noon for a couple of minutes if it feels like it. The LB is so embarrassed by the profile picture of the RB and wants everyone to know that the RB is some kind of alien, certainly alien to the LB, and the LB has no affiliation or association of a voluntary nature with it. When that picture was taken in 1951, why was the RB so happy anyhow? The Korean War was heating up with the Chinese intervention, the Eight Army was in peril, and the Marines were in a life and death struggle at the Battle of Chosin Reservoir at the time of that snapshot of the RB in December 1951. Inflation for 1951 was a torrid 7.9% but you would never know that looking at the dimwit. And, to top it off, Richard Nixon would soon be elected Vice-President. Actually, LB summarized its opinion by saying the word dimwit, just used to describe the RB, that is being too kind, more like a no wit. LB pleaded with the Headknocker to bring back the Old Geezer as Head Trader. While the OG was barely able to keep his eyes open during the trading day, and was certainly no Focus Machine like the LB, at least the OG was less of an embarrassment to the LB.

1. Bary's Recommendations on Income Securities in Barrons: There are a few caveats that I would offer to Andrew Bary's recommendations in his column in the Barron's issue. He has several bank preferred stocks including BACPRJ, WFCPRL, and BCSPRC (which he unhelpfully refers to by its series 4 designation rather than by the symbol). Readers of this blog would recognize these securities as equity preferred stocks. Before even thinking about their yield at current prices, an investor must first fully understand their risks. First, all of those equity preferred stocks are non-cumulative and perpetual. The dividend can be eliminated just like the common stock dividend. Second, these securities will be worthless in the event of a bank failure and seizure. Third, like any fixed coupon security, the price will likely fall with a prolonged rise in interest rates.

Lastly, are there alternatives from the same issuer that would be better for a fixed income investors? Bary mentions for example that these banks have trust preferred issues that are in essence bonds, and he comments that they will generally pay less interest. That would generally be a correct observation. But the junior bonds which are the underlying securities in the bank TPs pay cumulative distributions. They can not be eliminated but only deferred with interest accrued at the coupon rate on the deferred amount for a period no longer than five years generally. It is entirely possible for a bank to eliminate the dividends paid to its common and equity preferred shareholders and to continue paying interest on the TPs. Citigroup would be just one example. Another important consideration is that the TPs have maturity dates. If the bank survives, then at least the owner has some assurance of being paid a sum certain a specific date, which is never the case with a perpetual security, where there is no obligation to ever pay the owner par value.

Any investor who takes this seriously would compare every Wells Fargo TP with the yields on every one of its equity preferred stocks before making a decision. I own two WFC TPs. One issue, KTV, currently provides a yield very close to the WFCPRL mentioned by Bary. I would add the WFCPRL has a par value of $1000 WFC.PRL Stock Quote This is the link to the prospectus: Final Prospectus Supplement Wells has a traditional $25 par value equity preferred stock , WFCPRJ, that has a 8% coupon, and it closed at a slight premium above par value on Friday. WFC.PRJ Stock For an investor with a lot of funds, or someone who does not mind buying 2 shares of a $900+ per share stock, the one recommended by Bary, WFCPRL, would be the better value, given its slightly higher yield at its Friday's closing price even with a lower coupon, due to its discount to par value. (I will stay away from the WFC.PRL for another reason, however. It is a convertible security, but convertible into Wachovia shares, and that conversion rate changed when WFC acquired Wachovia. This is just too much trouble to figure out: serieslex4_7.htm)

But after deciding which equity preferred gives me the most bang for the buck, that does not end the inquiry. What TPs are available with a maturity date before say 2040. There are several. I mentioned KTV. That TP was originally an issue from First Union, which was acquired by Wachovia, and Wachovia was recently acquired by Wells Fargo. WFC is now making the payments. It closed at $24.75 on Friday to yield 8.28%. So, would you prefer having a TP yield 8.28% or a non-cumulative perpetual equity preferred stock from the same issuer yielding at Friday's close according to Marketwatch 8.17%? The TP, being in effect an interest in a bond, does pay interest whereas the equity preferred shares would be paying qualified dividends which does currently have a 15% tax cap, likely to change next year for persons considered well-off by the Democrats. One way that I resolve that issue is to put the TP in a retirement account and the equity preferred in a taxable account. If a U.S. investor has only a retirement account with funds to make the purchase, then the tax advantage nature of the equity preferred dividend is a non-issue.

I will occasionally buy both an equity preferred stock and a Trust Preferred from the same bank. For example, I bought a floating rate equity preferred stock from Zions in a taxable account, and its Trust Preferred in a retirement account. I also a fixed coupon equity preferred issue from Zions in a taxable account. My most important decision with that bank was trying to assess how much risk there was in these junior type securities given the bank's difficulties, and then allocating how much capital I was willing to risk and at what price. So, I ended up with 100 of the floater bought at a very good price of $7.8, which juices both the guarantee and the the value of the Libor float when it kicks in, with the 4% guarantee worth of almost 13% at my cost. Bought 100 ZBPRA at $7.8/Corrections Corporation Earnings If 3 month Libor hit say 6% during the computation period, then my yield would rise to 20%. As frequent readers of this blog know, I take all of those factors into account when making a purchase. In the retirement account, I was willing only to risk about a thousand dollars on 50 shares of the TP, ZBPRB, when it was yielding about 10%. When I made that investment, I discussed at length the priority issues involved with the Zions equity preferred stocks compared to the government's preferred stock, since I wanted to know where I stood in relation to the U.S. government who bought cumulative preferred stock with TARP funds given to Zions. Bought 50 ZBPRB in Roth at $19.9 The last purchase was just 30 shares of ZBPRC, a fixed coupon equity preferred, when its yield jumped to about 12.9% at my $18.4 purchase. Bought 30 ZBPRC at 18.4/ In effect, given my exposure already at close to $1800, I did not want to risk more than another $500 even at that 13% tax advantaged yield. And each investor has to make that assessment for themselves, no one can make it for you.

Bary also mentions the recommendation of Bill Gross to buy utility stocks, which I have previously discussed. I already owned several utility stocks, and decided to buy a couple of utility ETFs after reading Bill's commentary. One was XLU mentioned by Bary in his column, which is the low cost ETF containing all of the utility stocks in the S & P 500. Bought 100 XLU For How Long Will Cash Be Trash? A few days later I bought 100 of DBU, which contains international utility stocks: Bought 100 DBU at 22.37 I would add this caveat. Most of the electric utility stocks that I own yield anywhere from 5% to 7% at the current prices, with a couple of exceptions. If interest rates start to move up again, and they will, those 5% yields will not look so good. And the utility companies have to borrow money and their costs for capital will be going up. Many are already paying a large percentage of their income out in dividends, and do not have that much room left for dividend increases, usually modest ones at best. So, I am mindful of all of that, and will start selling when interest rates start to rise appreciably from the current abnormally low levels. My first sell will probably be the ETF XLU.

I do not recall Bary or anyone else at Barron's ever discussing the dividend generation of the European hybrids, which are bonds that pay qualified dividends. The hybrids from Aegon and ING have been discussed throughout this blog, and I wrote a gateway post on Sunday for the Aegon hybrids: Aegon Hybrids: Gateway Post The same is true for the Trust Certificates, a subject almost totally ignored by financial publications. Trust Certificates Links in One Post

Most of the securities mentioned by Bary are generally known to the more active individual investors. I suspect that most individuals are not aware of Trust Certificates, and many other types of exchange traded bonds that Baron's never mentions, even though a discussion of them would have been very helpful to individual investors back in October when I started to write this blog, partly to fill the void left by financial journalists. I view these posts by me to be financial journalism revolving around my daily activities as an investor as the source material.

2. Strategy after Classifying Long Term Trend in Market as Being a Secular Bull or Bear: The S & P 500 closed Friday at 1,105.98, about where it was a few days after the Lehman bankruptcy and before the VIX moved into what I call Phase II of the Unstable VIX Pattern. While the rally has been huge off the intraday low on March 6, 2009 of 666.79, there has been a more modest gain from the closing number of 903.28 on 12/31/2008: ^GSPC: Historical Prices for S&P 500 INDEX,RTH This is roughly a 22.5% gain year to date after the plunge in 2008. It seems like that we have come a long way, but not really. The S & P 500 index was higher in May 1998 than now: ^GSPC: Historical Prices for S&P 500 So this is turning out to be a typical long term secular bear market pattern. You look back 15 years and have gone nowhere. During that period, there will be at least one really nasty bear market, like the one just experienced or the first one in my adult life which occurred in 1973 to 1974. Then, they will be a number of cyclical bear and bull cycles of relatively short duration (2 years would be close to the norm but four years is possible, e.g. 2003 to 10/2007), with the gains during the bull cycle lost in the bear cycle. When it is over, the long term bull starts, and the chart will look a lot different after 15 years compared to the long term bear market chart, where you end up running up and down and in circles arriving at the same spot after all of that effort and time. LONG TERM SECULAR BULL PATTERN 1950 TO 1966/ Long Term Secular Bear Pattern from The Great Depression
More on 1982 or 1974/ Just looking at a long term chart, it is not difficult spotting these long term bull and bear cycles.

We are currently in a long term bear market. Some will start this current cycle in 2000 and I start it in 1997 for several reasons. The long term bear is defined by me as generally being a 13 to 17 year cycle of going nowhere. Frequently, the market will just come back to a a level that is in the distant past, meanders around that point and then proceeds to go up again. I narrowed the time frame on a YF chart for the S & P 500 to start it on 1/2/1997. If this link works, the picture will show why I start this bear market in 1997, so that means I would say the bear is 12 years old now, and will soon be moving into year 13. S&P 500 INDEX,RTH Index Chart - Yahoo! Finance If that link does not work, anyone can set the time period for the chart at the YF site.

When I look at that chart, it is hard to get excited about the recent run up in stock prices. Taking a guess at the future course of events, I would give this cyclical bull more life, well into next year, before it falters with a 20% or greater correction. I would view it more as similar to the 1974 to 1976 cyclical bull move after the devastating 1973 to 1974 bear market. I would hasten to add that the turning point into a long term secular bull market can not be known with any degree of certainty. Many thought that the upturn starting in August 1982 was just another cyclical move of a temporary nature, and it turned out to be in retrospect the start of a long term bull market that I date as starting in August 1982 and ending in 1997.

So, since my investing philosophy requires me to make macro type calls, all guesses of course, I am currently predicting another three years in the long term bear market. For most of 2010, the U.S. market will trend upward, possibly another 20% in the S & P 500 average, with several small pullbacks along the way. The cyclical bull will last about 18 months starting in March 2009. By late 2010, concerns will mount about interest rate hikes and the inability of developed nations to borrow more money to continue their stimulus programs which will largely expire next year. GDP will grow nicely for the first 3 quarters of 2010 and then start to tail off, possibly turning negative again by the 2nd quarter of 2011. The next major dip in the market may then occur taking the averages back to close to where they are now. Emerging nations will continue to grow rapidly however, with their middle classes expanding at a substantial rate. By 2013, the American consumers will have largely repaired their over leveraged balance sheets, there will be considerable, mostly unexpected and unpredictable technological progress, and growth will resume led by consumer demand in non-developed countries with considerable support in the developed nations. Thus by 2013 the market will anticipate that many changes have occurred which have laid the foundation for the birth of a long term secular bull market. It may start at around the current level or possibly as high as 1200 on the S & P 500. In this next bull market, it will be clear that the U.S. is far less important to the upturn than at anytime in the past fifty years.

Of what I just mentioned, the only really important influence on my activity now is the classification of the current market as a long term secular bear market. This classification requires a different and far more active trading strategy and constant changes in the asset allocation mix. As a consequence, I have done several major allocation shifts for example since 2007 and I doubt that I still own 5% of the securities bought prior to 2007. Some of these issues are discussed in these posts:

With a long term bull market, trading is de-emphasized. Changes in the asset allocation mix are less frequent and more subdued, leaning more toward factors important in the target funds glide path which are fundamentally flawed and ineffective asset allocations tools in a long term bear market, with a few important caveats (the major caveat to those glide path criteria in a long term stock bull market is whether the other major asset class, bonds, is likely to be in a secular bull market at the same time or will it diverge into a long term bear market). More on Failures of Standard Asset Allocation Models and Target Funds/Use of Volatility in an Asset Class to Make Adjustments to an Asset Allocation Broad based stock ETFs can be held for 10 to 15 years without selling much, mostly just buying on the periodic corrections which could be deep but relatively short in duration. Buy the dips and do not sell the rips in the long term secular bull market. Some stock trading is permitted primarily based on factors unique to a specific company. Another important factor is whether both bonds and stocks will have a bull market at the same time or will there be divergence. I suspect that the next long term bull market in stocks will be joined by a long term bear market in bonds, somewhat similar to the 1949 to 1969 period.

3. HISTORY of Closed End and Mutual Funds: This article from Investopedia contains a history of the CEFs and the Mutual Funds. I knew that the closed end funds came first, and most of them were wiped out during the Great Depression since they used leverage. A few survived that crash and can be bought today such as the Adams Express Company (ADX) (owned), General American Investors, Central Securities Corporation, and Tri-Continental (TY). Tri-Continental Corporation was formed just in time for the crash, dating its history to January 1929. Central was formed just before the crash on 10/1/1929. These older CEFs would be listed under "General Equity Funds" in the closed end section of the WSJ data center: Closed-End Funds by Category - Markets Data Center - As I said most of those 700 CEF collapsed in the big GD.

The origins of the CEF goes back to the Netherlands and a Dutch merchant by the name of Adriaan van Ketwich who started an investment trust in 1774 called for my Dutch readers- Eendragt Maakt Magt (Unity Creates Strength). Before the 1929 crash, there were close to 700 CEFs in the U.S. and only 12 mutual funds. The first modern mutual fund was the Massachusetts Investor's Trust formed in 1924 and is now know as MFS, a mutual fund family owned by the Canadian life insurance company Sun Life. Most details about Ketwich's fund can be found at The Origins of Mutual Funds. The next fund established in 1776 by Uthrecht bankers was called Voordeelig en Voorsigtig ("Profitable and Prudent", or so I am told).

4. Unemployment Rates 1948 to Date: For future reference, I wanted to make a note of a link to the BLS rate of unemployment data:

5. Volatility: The DJIA Volatility index is the only major volatility index currently below 20. VXD Index Charts - Cboe Djia Volatility Index The VIX closed Friday at 21.25 VIX Index Charts Both the Nasdaq and Russell 200 volatility indexes are at higher levels than the VIX: VXN Index Charts - Cboe Nasdaq-100 Volatility Index As expected the Russell 2000 remains at the highest level of the four. The expected order is lowest to highest: DJIA, S & P 500, Nasdaq 100, and Russell 2000. A three month move of below 20 for three months in the VXD or VIX would establish a stable VIX pattern, reflecting the formation of an investable bull market lasting generally more than 3 years based on past historical patterns in these volatility indexes.

6. Aegon: I mentioned in my weekend post (Aegon Hybrids) that I was unaware of any action taken by the European Commission on Aegon's restructuring plan. The latest story that I have found referencing the status is from three days ago in the WSJ which states that the EC has not yet acted on Aegon's plan. The primary focus of that article is the Dutch government's willingness to discuss with Aegon the repayment premium, but Aegon apparently does not want to enter that negotiation with its host government until after the EC acts on its restructuring plan.

7. Trust Preferreds and European Hybrids: Confusion of Nomenclature: I wanted to discuss the reasons why Americans refer to the ING and Aegon hybrids as "preferred stocks" when they are in fact bonds. I would start with a brief discussion of another confusing term, Trust Preferred. We call the security issued by the U.S. banks, which are similar to the European hybrids, Trust Preferred stocks just to add to our confusion. Just from my viewpoint, I would have to say most individual investors have varying degrees of confusion about those securities. At least the Trust Preferred stock is in fact a preferred stock, a preferred stock that is also really a bond rather than a traditional preferred stock. The typical bank TP is a preferred stock sold by a Trust to the public, whose common shares are owned by the bank, and the proceeds are used to buy a junior bond from the bank. The TP is not a traditional preferred stock, but actually a piece of paper that indicates an undivided beneficial interest in those junior bonds owned by the Trust and the owners of the TPs receive distributions taxed as interest. Those junior bonds will be the most junior bonds issued by the bank, subordinated to all other bonds issued by it.

The European hybrids are called preferred stocks in the U.S. even though they are in fact bonds like those trust preferred stocks. One reason for this designation is that the distributions are treated as qualified dividends under U.S. tax law. Bonds do not pay qualified dividend. Bonds pay interest. Common and non-REIT equity preferred stocks do pay qualified dividends. So, it is natural for a U.S. investor to call any security a preferred stock which (1) is traded on the stock exchange, (2) bought in shares, (3) pays qualified dividends, and (4) is not a common stock. I can not think of another class of securities that pay qualified dividends that are really bonds. I can not explain why this is apparently the case. I can only say that all of the European hybrids that I owned in 2008, which included AEB, IND, and INZ, were classified as paying qualified dividends in my 2008 1099, just like the non-REIT equity preferred issues like METPRA and GSPRA from U.S. financial institutions. It may have something to do with the fact that the "hybrids" are considered equity for regulatory purposes in Europe. This would make them like equity preferred stocks in the U.S. Also, like our equity preferred issues, the hybrids are perpetual, a characteristic of equity issues rather than bonds.

I have also seen in the prospectus for IGK, an ING hybrid, one of the few issued after Congress adopted the qualified dividend rules, that expressly states that distributions should qualify: see page S-11 424B5

8. Tidbits: There are several news reports that suggest that "professionals" are selling stocks because of a fear that the FED may at some point start to raise the federal funds rate from the 0 to .25% level. (e.g. MarketWatch ) Anyone doing that of course needs to be fired instantly by their client.

I do have a double short position in the Euro. If I was sitting in Europe, with a bunch of Euros, I would be looking to buy some securities in the U.S. market now, and to convert my Euros into dollars at the current exchange rate. The same would be true for virtual all other developed nations. Maybe not for those holding Zimbabwe dollars. There was a NYT story a few months ago that collectors were snapping up a few trillion Zimbabwe dollars on Ebay for say $25, which is a great deal more than they were worth in Zimbabwe.

Since RB is the Head Trader now, we will have to wait until it decides whether it feels like working before a trade can be made today. The Headknocker just said that, while the RB is a bit wild and crazy at times, it can accomplish more in 2 minutes than the LB can in one year. Still, the HK is worried about sleeping under a bridge if the RB is given to much slack. The LB replied that it could accomplish more if it actually had some help at HQ and the HK would be sleeping under a bridge without the LB Deep Thinker, Chief of the Caution Police, Focus Machine extraordinaire.

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