These Markets are Bonkers and Living on the Edge

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We don’t know about you, but as we observe the global economic picture we have gone from somewhat confused to downright negative. Again we have reached that point where we look around, north, south, east and west and find nothing that gives us hope that the equity markets are going to fly higher anytime soon. Now as income investors you might think–why do you really care? We care because we almost have to maintain a diversified portfolio which includes common stocks, REITs and other securities that are sensitive to how the equity markets act. Additionally, we have to include the soft equity markets into a more global outlook. Firm stock markets help to lift consumer confidence and thus spending (although that sure isn’t true at the retail level lately). As we have noted before we hate to go ultra negative on the economic news–we don’t want to be Zero Hedge or David Stockmans Contra Corner–we can only guess that they have their money in a coffee can buried in the backyard–at least if they actually ‘walk the talk’. We know from over 40 years of investing that the coffee can pays damned little interest so one doesn’t really want to go there.

So we have the S&P500 down about 5% from the 52 week high.  No problem. In normal times we would expect corrections and in fact welcome them, so 5% is no big deal. The problem is that corrections happen in the course of either a upward trending market or a downward trending market when there have been no changes to the underlying fundamentals and we think that may not be the case here. Recall that we have been in a market that has trended upward for about 3 years with hardly a breather taken on the way. Is it possible that we may now be entering a downward trend that will last a number of years without a breather being taken.

Let’s take stock of the current situation on a global basis. Europe is a no growth arena. Only Greece and Portugal have 10 year interest rates above our 10 year rate.  France is at .67%, the Netherlands at .49%, Germany at .47%. Sickly Spain and Italy are at 1.58% and 1.73%. We don’t believe that Spain with a unemployment rate of 23% is going to rise from the ashs anytime soon, nor is Portugal or Italy with their 13.9% and 13.4% unemployment rates. Unemployed people don’t (can’t) borrow money and go on spending sprees. Additionally every single country has more government debt than a year ago, except for Germany meaning that more stimulus justs makes the problem worse.

Now for Japan. First off we simply need to realize that Japan is a demographic basketcase as far as growing an economy. In many ways they are not unlike the United States.  1/3 of their government budget goes to social programs and 1/4 of it goes toward debt repayment. Amazingly the government budget of $812 billion requires borrowing of about $300 billion!!! These are crazy numbers.  Japans public debt is twice the size of its GDP!! This government has actually moved the country in the right direction, but we shouldn’t hold our breath waiting for much help from Japan in lifting the global economy.

Now focusing on China. For decades now we have depended up China to provide huge global demand for all sorts of materials–cement, steel, copper, gold, oil, natural gas–you name it they bought it, and lots of it. As the Chinese economy matures the domestic demand for all these materials has fallen sharply and many of their industries have huge overcapacities moving the country to a less competitive position in the global markets. China also has had a sharp slowing in their currency surpluses as the new middle class has demanded (and received) more finished consumer goods that are imported from around the world. Additionally China has lagged in technological innovation meaning they are importing large quantities of product from elsewhere. Although China’s growth and consumption has slowed markedly they remain in a growth mode, but is it adequate growth to power the world? We think not.

This brings us to the new global growth engines. India, Malaysia, Viet Nam and Mexico would appear to be the engines that will power global consumption higher. The problem with these companies is they can’t consume at rates high enough to counter a global slowdown. As time goes by they will contribute more and more, but these things don’t happen overnight and for the coming potential slowdown they won’t be of much help.

Bringing us to the United States. By many measures the U.S. economy is just fine, but as we have asked many times-can the U.S. lift the world up? We don’t think so. Our plunging interest rates have been warning of pending issues for months. We believe at a minimum we are on the verge of a substantial slowdown.  This idea is being furthered by the collapse of crude oil prices.  We strongly believe that this collapse will have serious implications far and wide and maybe we have now touched the tip of the iceberg with jobless claims today taking a huge 19,000 person jump. We think before the year is out we will lose hundreds of thousands of jobs because of the low crude oil prices and these will not be replaced with jobs of quality bringing the nations employment growth to a halt (or near halt).

How do we address our thoughts in our investing

While in the last 7 years falling interest rates have treated the income investor in a very friendly way we don’t believe that will universally be true this time around.

Investment grade income securities will perform the best in the months ahead.  This isn’t a new trend–investment grade issues have been outperforming junk grade since last August (primarily because of energy and related issues). If you follow our static portfolios (in the portfolio menu above) you will see that the account value of the investment grade portfolio is above ‘par’ while the junk grade portfolio is 4% below ‘par’ (although the junk grade model has tossed off much high income over the last 2 years making it the better choice over the 2 year period–in a shorter 6 month period it has under performed the investment grade). This leads us to the conclusion that we need to continue to upgrade the older 2014 Model Portfolio – Blended Income by selling more perpetual preferreds and purchasing more short duration exchange traded debt issues. We have already made most of this move, but we have to force ourselves to go further.

This tells us that we need to concentrate on quality for the next 6-9 months.  Given that we believe that common stocks will have little success in moving higher we will not be able to count on the ‘rising water lifts all boats’ method of stock choice. We will have to scrutinize all common shares held more closely.

As one reader mentioned to us in a note earlier today ‘BDC’s have been my worse sector’–we agree. Even in a good economy they have been poor performers. Again we need to scrutinize these carefully and weed out those we deem higher risk.

This leaves us with the REIT sector.  REITs have performed in a stellar fashion and our 2014 Model Portfolio – Blended Income has some issues with huge gains. Should we harvest these gains–or should we let them ride?  We think for now we should harvest a portion of these profits, while letting 75% of them ride for now. We will be watching for a sentiment change in the REIT sector as nothing grows to the sky forever and these are just about there now.

To summarize, the first few weeks of model performance have been acceptable, but acceptable is never good enough. The S&P500 is off 3.2% YTD. The 2014 Model Portfolio – Blended Income is up .49% while the 2015 Model Portfolio – Blended Income is off .8%

The 2014/2015 Short/Medium Duration Income Model just keeps chugging along–exactly as it is designed. Current yield is 6.66% and it has a small $522 capital gain.  Remember the design of this Model is set up to pay good income with little volatility.  Most days the $85,000 model moves  up or down only $100 to $200. We love it.

Let’s face it–reaching our 7% target this year will be a substantial challenge.

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