By LAUREN R. RUBLINDON'T LET THESE MOSTLY SMILING FACES fool you. We just as easily could have called the opening installment of the 2008 Roundtable "Before the Deluge"-that is, before the great unwinding of a quarter-century of excesses that our panelists, to a one, predict will set the investment tone for much of this year. Their forecasts for the U.S. economy are particularly sobering: a recession, or growth so tepid it will feel like one. Fortunately, their expectations for the U.S. stock market are considerably more upbeat, especially for the second half of the year.
This year's Roundtable met Jan. 7 in lower Manhattan, amid unseasonably balmy weather -- except for the blizzard of sell orders that morning, just down the Street. Drilled and grilled 'til well past dark by Barron's editors, our latest crew of 11 money managers and market seers shed copious light on subjects that ranged from inflation to interest rates to sovereign wealth funds and the price of breakfast in Paris. (Did we mention the Giants-Cowboys game?) One minute we were all in the 1960s, debating Kennedy-style tax cuts to help the middle class. Then it was on to the '70s; predictions of stagflation tend to do weird things like that. A year ago, you read nary a word about that eight-letter word "subprime." This year, you'll read lots about the nation's mortgage mess, and the folks who brought it to you.
![[one]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_us9GF1pri6jXs7ISnexv1aTm8wdj9lEldM6NDU2U9OHxQxbRph0p7M81vH3cHuBb9uN7ps3u8lvN51kbXpd7vaYIwuEcDuOg502x76X1rw-6JqsxKj_wy_X37g0vfEgmw911RfJlO3s_9kZ7sN=s0-d) |
| Samberg (L) sees the market flat to down 5% in '08. Gabelli sees it up about 5% |
You'll also get the chance, in this first installment of three, to study Oscar Schafer's latest investment picks -- in utilities, drilling, lodging, biotech and credit services. The captain of O.S.S. Capital Management in New York, Oscar has much to say about markets, too, even though he owes his abundant investment success to an exquisite grasp of company fundamentals.
DOW JONES REPRINTS
This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit: www.djreprints.com. • See a sample reprint in PDF format • Order a reprint of this article now.
Bill Gross, founder and bond boss of Pimco, the Newport Beach, Calif., fixed-income specialist, likewise gets his close-up in this issue. He uses it to maximum advantage, to highlight a trio of closed-end bond funds with snappy yields, and a pair of Ford Motor and General Motors issues that should reward investors as -- better brace yourself -- the outlook for the U.S. auto sector improves. If the Roundtable members' big-picture views are correct, the total returns Bill expects from these securities might make investors think the bull market is still alive, and even well.
For smart talk and good ideas, it is. Please read on.
Barron's: It looks like we'll have a few things to talk about this year. Let's start with Bill, the only person in the room who mentioned last January the possibility of a credit disturbance. Bravo, Bill.
Gross: So, I'm the first of the grim reapers. I'll start with the economy. It's important to distinguish between the U.S. economy and the global economy; the U.S. economy is much worse, and is nearing an inflection point. We're looking at slow growth, and maybe, in a quarter or two, negative growth. Risk markets are at risk, and without the ability to pump up consumption through asset inflation, we're going to have a difficult time in 2008 and beyond. For years the economy's growth has been predicated on asset inflation -- stocks in the 1990s, then housing. There are no large, classic asset categories left to inflate, and as some assets deflate -- namely housing -- credit contracts. Economic growth will be below zero or mildly above it for a long time, and nothing like what we've grown used to in the past 10 to 15 years. Get used to anemic growth or a mild recession in terms of the economy, job creation and wealth creation. It's not a favorable forecast.
Abby, we trust you disagree..
Cohen: I agree we haven't seen the full shakeout yet. The housing problems, particularly in some regions, will take many quarters to resolve, which will create a significant impediment to overall economic growth. Goldman Sachs' official forecast is that we avoid a recession, though it will feel like one in some sectors and perhaps some regions. [Goldman changed its official forecast two days later, saying it expects the economy to contract by 1% on an annualized basis in both the second and third quarters.] Things will start looking better toward the end of '08. That's because the corporate sector is in much better condition than usual heading into a period of weak growth. Inventories are under control, and corporate balance sheets are healthy. While many households have borrowed too much, that's not true for most companies in the U.S.
![[two]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_vd6lGcZLLWpgdlmc5KA0Da5dNplEp-d9k02qqYdPL4ixzZPfpHbmk79zOSz3EtPfgaQawb1fwNXfUCqB5CXLPVfZnWWX5lacKpJdOhb5ABDWlbHMZ0177J-SdMnLR7Mwz0SdlP3rUl-dv5iRBw=s0-d) |
| Witmer (l.) and Zulauf both worry about excessive housing inventories in the U.S. |
Profit margins are under pressure and corporate earnings power is starting to shrink. As operations come apart, so will balance sheets.
Cohen: We said in the midyear Roundtable ["Room to Run," June 18, 2007] that margins were at a peak. Returns on equity, which have been at record highs, also will come under pressure. The question is how bad it will get, and how long it will last. By the end of 2008, things will start to improve.
As we have written before, consensus earnings estimates for 2008 aren't credible. Our own Standard & Poor's 500 profit numbers will be at least $10 below analysts' numbers. A dichotomy exists between what industry analysts say and what portfolio managers believe may be priced into the market. In the past three months, when the economic data were far weaker than many people expected, and third-quarter earnings came in well below consensus expectations, Wall Street analysts cut their 2007 estimates but barely touched their '08 numbers. Portfolio managers have adjusted their '08 expectations.
MacAllaster: What is your S&P earnings estimate?
Cohen: At year end the consensus estimate was approaching $105. A more likely expectation is $90 to $95 for 2008. When fourth-quarter results come out, we'll look to see whether companies have used what wiggle room they have to keep the '07 numbers as low as possible. It may be a good tactic to push up reserves or defer good news because '08 comparisons will matter more than fourth-quarter results.
Felix, how do things look to you?
Zulauf: The world economy is slowing, and the U.S. has the biggest problem. You have underestimated in the U.S. how much asset-price changes impact gross domestic product. It is underestimated on the upside as well as the downside. Home values probably are five to six times the size of GDP, and if home prices rise by 10%, that creates new assets and borrowing power equal to 50% of GDP. Asset prices have a dramatic multiplier effect on the economy, something that has worked extremely well for a long time and now is reversing. Home prices are down around 10% on average, and there may be another 15% to 20% to go.
The excesses in the U.S. aren't as big as they were in Japan, but the same process is at work. First, you have an event that surprises the markets, which think it will end quickly. When that doesn't happen, households and financial institutions become more cautious. In Stage 3, the corporate and household sectors begin to repair their balance sheets. At the end, the government gets involved, usually through fiscal help. The U.S. is between Stages 2 and 3. Monetary policy -- cutting interest rates -- won't be as effective as it was on the way up, when asset prices were rising. In 2008 and '09, the Fed may be pushing on a string. They will cut rates and the markets will rally, but over time they'll realize it isn't enough. Economic growth will be on surprisingly low. Whether the economy technically is in recession I can't say.
Could the U.S. decouple from the global economy, or was that just a fiction?
Zulauf: It has never happened and it won't happen this time. Several emerging economies are in a different life cycle and won't be affected as much as they might have been 10 years ago, but they will slow. China's growth rate will come down 2% or 3%.
Gabelli: It is still 7% to 9%.
Hickey: Felix, there are housing bubbles all over the world. The credit markets have blown up all over the world.
Zulauf: The biggest problems will occur in the Anglo-Saxon world, which had the biggest housing booms, plus Spain. But the slowdown is a global phenomenon.
Gabelli: Why won't Japan rally 1% or 2% in '08 and '09?
Zulauf: Japan has been struggling for a long time. The most positive factor in Japan in the past year or two has been exports. With the yen rising, exports won't contribute a lot this year.
Gabelli: The yen has strengthened but the euro is stronger. In competing against the Germans, the Japanese are at parity.
Gross: Japan's problem has always been consumption. Demographics will continue to move in the wrong direction.
Zulauf: Also, real income has declined for a number of years. That's why the domestic economy has never come back to life.
Hickey: Asian markets that export a lot of electronics have started to get hit. We hear it from Singapore, Malaysia and Japan.
Zulauf: Basically, the industrialized world has exported the most cyclical parts of its economy to the developing world. It's not surprising those countries would be hurt.
Gabelli: Gross world product is around $40 trillion. The U.S. is $12 trillion, and you see 1% to 2% growth. Japan is $5 trillion. The CRIB countries -- China, Russia, India and Brazil -- are almost 10%, and they are growing at 8% or 9%. For the next 12 to 18 months, there's enough momentum to keep global growth going.
Hickey: But the U.S. consumer is 19% of the world economy.
Gross: If U.S. growth drops toward zero, the rest of the world will be affected. But the most affected economies are the finance-based economies -- the ones that depended upon financial engineering. The U.S. is the prime culprit, and the U.K. is close in terms of its problems. These economies are paying the price as the so-called shadow banking system contracts. A normal bank reserves 15% against deposits. The shadow banking system of SIVs [structured investment vehicles] and financial conduits has no reserves. Financial engineering has run amok. This isn't going to be a normal cyclical downturn in which inventories are addressed, paving the way for the economy to be rebuilt. The contraction in the shadow banking system will probably be with us for a number of years. It is a unique situation the world hasn't faced in modern times.
Samberg: There are some positives, such as a huge, developing middle class in emerging markets that could surge to 50% of the population from 10% in the next 30 years. In China alone, the middle class is going to triple in five to 10 years. These countries are developing indigenous economies. Their people are going to buy more automobiles. The numbers are staggering. I'm with Bill and Felix: The global economy slows but doesn't stop growing.
![[four]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_tww6ZhHfL4dKAuWLtnXhT5ME3-tG41_YrFw_gYW1tsGqwyxQ2yxFQMxHwRKiX4HtctlZuISeXcu0fXWiibk1RipusnwfPq0nTQPRxZgU4TE8ifbR5Z-DH6vcRpCq5O5MoMo1Ed-yrBLTo60uWWew=s0-d) |
| Cohen:"Things will start looking better toward the end of '08" |
Cohen: The U.S. imports more from Europe than from China, so economic growth in Europe will be dependent on circumstances in the U.S. Also, much of the domestic revival within Europe is coming from the expansion of the euro zone itself. It's not that the household sector has improved significantly. The euro has been very strong relative to the dollar. Everyone has his own version of purchasing-power parity -- how much it costs to have breakfast in a hotel in Paris or New York, for example. In Paris, it costs quite a lot. Now European corporations are starting to complain about slowing growth within their domestic economies. They feel they are losing out to the U.S. and others because of the currency. If we're looking for some non-consensus views, one might be that European growth lags expectations. Art, what do you think?
Samberg: The economy stinks. The subprime mess and the leveraging up of financial-company products and balance sheets are unwinding. And with energy and food costs rising, the U.S. consumer is under pressure. The U.S. will have a recession, but it's going to take one hell of a recession here to slow global growth.
Hickey: It will be one hell of a recession.
Samberg: The excesses in the U.S. have to be flushed out, and we're not close to finished. Actual mortgage defaults are just starting to accelerate in the next few months. In addition, companies like Citigroup (ticker: C), Merrill Lynch (MER) and others have to re-equitize their balance sheets, and that process is just beginning. People are way underestimating the dilution this will cause financial-services companies. They are in an awkward position. The faster they take writeoffs, the less capital they have and the less lending they can do. The market has not fully appreciated how much more equity will have to be raised. The first half looks awful, but it doesn't mean the whole year will be awful. I'm a big believer in not trying to anticipate the end of the world.
Hickey: Only home mortgages have blown up. There are problems in auto loans, student loans, leveraged-buyout and junk-bond loans. Wherever people were lending, they were lending stupidly. Delinquencies have risen across the board, but defaults haven't come yet. That process lies ahead.
![[five]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_uadEeHzhRcf84ID72Sl9dseFl3Glq8QudjfbQHmgLqROvBY0_riMJDereTKMXdEjMrNG5ihjpx6a_gMriaz6lc1KlKAa59h0XZmk0cVFLjX5CWRUT0WzZjCVmZUyua7obxQ7y-v-PzWpMsNSkRxQ=s0-d) |
| Black: "For '08 S&P profits will be flat to down 5% to $83.50." |
What will this mean for credit-card debt, which has been a sustaining influence?
Samberg: This cycle is different. People usually pay their mortgages and go late on their credit card and car payments. This time they're giving up their houses and keeping their last line of credit -- their cards. That's one reason the downturn will last longer.
Gross: Many people today have no equity in their homes.
Schafer: It's a big margin call. It happens to be a margin call in mortgages. I agree with Art that it's going to continue.
Cohen: The economic effect will vary widely based on the borrowers. While there has been a great deal of focus on lower- and middle-income families that made mistakes and borrowed poorly, there was also a lot of speculative fervor in housing.
Schafer: There's got to be something wrong here. We all agree! We agree there will be a lengthy credit unwinding.
Gabelli: Let's say you're now in charge of the Federal Reserve, Treasury and the White House. And, it's a political year. The consumer is suffering from rising costs, and the automatic cash machine -- the housing market -- is broken. What is your fiscal and monetary policy?
Samberg: Mother Washington is going to come to the rescue?
![[six]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_ub3xfxdLghGPrbGfdmgtzmtEb1BXnxQpadNrbstNHNjKNd1FDd3UbN3et0c81brLr4gJXIJtzPnIqZsyLPmK7InUw8fpD_XcodNNT7pu4jBRDs-YEYeip3_jow3TuJ1GijStZvlLf5qhgtzqPjXA=s0-d) |
| Gross: "There are no large classic asset categories left to inflate" |
Gross: Fiscal policy is locked because of the election. The Democrats don't want to give and the Republicans don't want to change their orthodoxy on a balanced budget and permanent tax cuts. So the possibility of a fiscal package is small. Monetary policy has borne the brunt of the rescue effort, and it is relatively ineffective in this type of market. Both parties are fixated on "pay-as-you-go." That orthodoxy has to be given up. Both Republicans and Democrats have to sense that fiscal deficits must expand by 2%, 3% and perhaps 4% in 2009. This is a very poor year to have a recession.
Gabelli: You'll get sunlight in 2009 because there won't be a choice. The consumer went off the cliff without even tapping on the brakes.
Cohen: Normally I would agree with Bill's scenario, but this may turn out to be a peculiar political year if the fiscal policy proposed by the Democrats is geared specifically to middle-income families. One of the arguments between the parties in the general election may be about income distribution, and how wealth has become more concentrated. If the Democrats make this an election issue, they could promote fiscal stimulus that would work primarily for middle-income to lower-middle-income families. The Republicans in Congress then could fall into the trap, if you will, of opposing it, and hurt the Republican candidate.
Another negative consequence of a weaker economy is the impact on state- and local-government revenues. They have been flush in the past few years, due to a strong economy and rising property taxes. There are many local communities whose primary source of revenue is related to property taxes. One thing to be wary of in '08 and '09, as property is reappraised downward, is a diminution in state and local property-tax revenue, at the same time states and localities are dealing with long-term infrastructure requirements. Also, a new accounting measure for state and local governments finally will bring government accounting up to the level of corporate accounting on pensions and retiree benefits. We're just getting information as to how large those liabilities are. These issues could create concerns not only for governments, but bond holders.
Zulauf: State and local governments have to cut spending and jobs.
Cohen: Many have collective bargaining agreements that assure pension and retiree benefits for workers and former workers. There isn't a lot of flexibility to cut.
Gabelli: General Motors [GM] had the same problem. They got relief from collective-bargaining agreements.
Let's talk about interest rates. Marc, you've been uncharacteristically quiet. Aren't you feeling well?
Faber: I am well and happy because I talked about many of these issues a year ago and recommended shorting the brokers. Subprime is a symptom of a much wider problem: the huge credit bubble built over the past 25 years. It is just the appetizer to something bigger, which will lead to relative illiquidity in the world. I travel around the world regularly, and every place I've gone has had a boom. The U.S. already would be in recession if government statistics were correct. The rest of the world will see a meaningful slowdown because global financial connectivity is greater than ever before.
The Fed brought about the latest boom by cutting the federal-funds rate from 6.5% in January 2001 to 1%. It kept fed funds at 1% until June 2004, even though the recovery in the U.S. began in November 2001. In other words, almost three years into a recovery [then-Fed Chairman] Alan Greenspan still had the fed-funds rate at 1%. This led to huge liquidity in the system -- asset bubbles, debt growth and growth in the trade and current-account deficits. Now those deficits are shrinking. This is an unfriendly environment for economic growth, financial markets and even industrial commodities. But it is friendly for the U.S. dollar.
Gabelli: Why is that?
Hickey: Money supplies are growing, but credit isn't.
Faber: I took a taxi from Times Square to lower Manhattan this morning and paid $14. In Europe the ride would have cost me three times as much. Prices in the U.S. are relatively inexpensive, as Abby learned at breakfast in Paris. This reminds me of other economies in which prices became low and inflation picked up. The taxi driver will increase his price massively sooner or later. Let me stress that weak currencies don't produce inflation. Inflation in the system produces a weak currency.
Cohen: The U.S. trade deficit is shrinking not so much because our imports are shrinking, but because exports are growing more quickly. Some of that may be due to demand for what the U.S. sells, such as technology and other high-value-added items, and some is related to the more competitive dollar. Dollar-based assets are attractively priced for investors based in other currencies, just as Rockefeller Center -- my euphemism for shopping in Manhattan -- was attractive to foreign tourists during the holiday season.
Faber: U.S. exports have gone up a bit, especially because of price increases in agricultural commodities and some capital goods. But the number of inbound and arriving containers at U.S. ports is down year on year, as are rail-car loadings. The trucking index is down. These statistics point to a recession in the U.S.
Black: Let's go back to the limitations of Fed policy. Core inflation is well in excess of the 1% or 2% barrier that Mr. Bernanke [Federal Reserve Chairman Ben Bernanke] thinks is judicious in terms of lowering rates. He is in a bind. He is probably going to cut interest rates in the short term by another 25 basis points [a fourth of a percentage point], but there's a problem with inflation. Remember the stagflation of the Carter administration? We are looking at stagflation again, with a low-growth economy and harbingers of inflation on the horizon. We need a 1962, Kennedy-type, neo-Keynesian tax cut. It should go to the middle class. You have to compensate for the loss of disposable income created by higher food and energy prices. It's a political year and Republicans and Democrats don't want to act as if they are slovenly in managing the budget deficit. But we may need a one-off tax cut to resuscitate the economy.
Rate cuts create a vicious cycle: All things being equal, the dollar goes down when rates come down. Commodities and metals prices, which are denominated in dollars, go up. If you cut interest rates, gasoline prices eventually go up, eating into the consumer's disposable income. It is less efficacious to cut interest rates than it used to be, because of cross-border inflation.
Zulauf: There is no easy way out. You can't wash your skin without getting wet.
![[nine]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_vrFTwblZMR4-B1SrzXBWqKKWFKcp-6VBCM7cLY4rYWdlBaTWIwn7TuXMP9Qv3s0yjeg1WXEOW6V-4dc_okjFHEliuUz_RAJ_AQ1_PDkdwX0ZktBm4AJZzhH5F5pIaifetDkkQY0sgO4a-Cj3NT-A=s0-d) |
| Hickey: "If we don't have a bear market now, I don't know when we will." |
Hickey: My concern is that everyone will cut rates. In New Hampshire we don't have Rockefeller Center. We have food banks that are empty already, and the recession has just begun. People are being killed by $100 oil and $3 gas and massive price increases in health insurance. Bernanke has studied the Great Depression, and his response was to flood the system with money. If we continue to do that we'll debase the $53 trillion of debt we have, which will cause even more harm to the 95% of the population that can't benefit from asset inflation, unlike the people in this room.
Faber: Scott, your fiscal policy will be another disaster superimposed on a disastrous monetary policy.
Black: The housing bubble was a case of unintended consequences from Alan Greenspan's actions. At this point, we're not going to let the country sink into a recession. Maybe you think a recession is good because it wrings out the speculative excesses. But for the average American citizen whose family income is $46,600 -- the median family income -- it is not good.
Faber: The average citizen will be in a recession anyway, because inflation will be higher than the benefits he gets from the tax cuts you propose. I also see a stagflation scenario similar to the 1970s, with high volatility in financial markets. Corporate earnings get squeezed nicely, with S&P earnings falling to $70 to $80. That will knock down share prices. But it will create opportunities.
Black: I'm talking about a one-time attempt to kick-start the economy -- a $210 billion to $250 billion tax stimulus. Consumption is still 70% of the GDP, so it would help.
Faber: U.S. policy is misguided in targeting consumption, not investments.
Gross: You're all arguing about how many angels fit on the head of a pin. In 2008 Republicans will go for a tax cut for the middle class only if they can get some type of permanency for tax cuts for the rich. The Democrats won't do it. This year is going to be a dead one for fiscal policy.
Let's get Meryl's view.
Witmer: Returning to housing, it's a tale of two markets. There are houses that people want, which have come down in value, and houses nobody wants that should be bulldozed. Housing inventory may stay large for a long time because some homes will never sell. Some years ago I recommended Countrywide, a real-estate broker in the U.K. At one point the U.K. raised interest rates five times, and transactions stopped. House sales fell to World War II levels. A few years later, lo and behold, it was off to the races again. These things work their way through. Home building will be slow for a number of years, but with population growth there are new household formations. The good stuff eventually will trade and clear, and the bad stuff won't. A lot of banks and other lenders will lose 50, 70, 80 cents on the dollar, because they were financing "trading sardines" -- something someone bought to sell to the next guy. On the other hand, there are a lot of good housing assets out there.
Zulauf: Within former hot spots there's about four years' inventory supply. It's unbelievable.
Not only has it become more difficult to afford a house, but borrowing has become constricted.
Witmer: The recovery will be slow, but when we come out the other side there will be people who can afford to buy homes and other things. A cleansing process is good.
Schafer: Banks have stopped lending to people with questionable credit. The banks have to increase their capital and become less liberal. But that's going to change. The banks are in the business of lending money.
Samberg: Return on assets in the banking system has gone up in the past five decades from 59 basis points in the 1950s to 125 basis points today. That's because of all the nonsense we're discussing here. Eventually returns will fall because leveraging up the system is over. Archie is shaking his head "no," but I believe it. Return on equity has been ramped up because of all the incentives to put together big, sloppy, poorly run financial institutions. Everyone got rich from that, and it takes a long time to correct. I'm not talking about financial stocks merely going back to a 10% premium to book value, because book is overstated at every one of these institutions.
![[seven]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_tc0Rri9cZ8iDNHEFZVolEu4tlUcmudaZmxl5H4cQgaxVF6e2FqRp1Icy7OPxP0Pinpvnrdcn6HlgsdK_agtZOBYXUVG9pHOcUNKD6tK9NFqpwCIoD1harz7k-CzPb7_c5e6GAVX--7KbfXKcqFLQ=s0-d) |
| Schafer:"At 22, Wyndham sells for less than the sum of its parts." |
Schafer: Warren Buffett recently quoted a banker who said, "I don't know why the banks had to find new ways to lose money when the old ones were working so well."
Since no one seems to disagree about the economy, let's move on to stocks. Archie?
MacAllaster: I've been an optimist all my life, and I won't change now. I like financial stocks, even the banks. A lot of them are reasonably priced. However, I have quite a lot of cash and I'm not going to spend it for at least a quarter.
I thought the market would finish about even last year, and after some tough times, it did that because some technology stocks doubled and tripled. A lot of other things are a half or a fourth or a third of what they once were. Financial stocks are near a bottom. If you can buy banks with 6.5% yields -- the ones that aren't going to cut their dividends -- you'll do OK. But I wouldn't be in a hurry. The market itself is fairly priced. If nobody likes it, it's at least fairly priced.
Mario, what is your view?
Gabelli: Knowing I'd be here today, a client sent me this e-mail. It says, "The S&P 500 was at 1409 a year ago, and it's at 1411 today. You guys are in a very dull business." Yet 2007 was a volatile year, and volatility will be higher in 2008. The quants and algos [people who trade based on quantitative measures and algorithms] have been able to take their commodity-trading programs and drive them into the equity market, which has increased investors' expectations of higher returns.
The Securities and Exchange Commission has to reestablish the uptick rule. Its elimination last year was a disgrace. [The rule, which was eliminated in July, required short sales to occur at a price higher than the price of the previous trade, thus preventing short sellers from adding to a security's downward momentum.] Something is needed to buffer the market when it's down so sharply. Without the uptick rule, a computerized trading program can short, short and short, which has exacerbated the normal return of volatility. Over time, long-term investors will need higher returns to compensate for the higher volatility. That's not good for the system. The situation should be examined and fixed.
Gross: You're in favor of more regulation?
Gabelli: I'm in favor of the uptick rule. With regard to the market, earnings will be materially higher in the second half of '08, in part because financials are such a large part of the S&P and the banks will have made their true confessions. Risk was mispriced and is quickly being repriced. No chief financial officer is going to go to his board now and say, "I bought asset-backed commercial paper to get 20 more basis points of return." Debt ratings have been challenged. New accounting rules, such as FASB 157, force the banks to mark to market. There have been many changes. By year end a combination of good earnings outside the U.S., when translated into dollars, and an improvement in financials suggest S&P earnings will be much higher. The market probably will finish up 5% from here.
Hickey: I'm having a hard time believing this. You all say we're having a recession, yet the stock market will be up.
Gabelli: Yields on 10-year Treasuries are at 3.90%. Let's assume they go to 4.40%. You're still discounting future expectations at a much lower present-value rate.
Gross: The stock market's value is predicated on three things: the level of corporate profits, the volatility of those profits and the level of real interest rates. Mario dealt with that, though he didn't mention real rates. Although profits may be vulnerable and much more volatile now, the fact is real rates [adjusted for inflation] have come down from 2% to just barely above 1% on the five-year bond. Some say the 10-year is the basic monitor for stock prices, but 10-year yields are down substantially, too. Whether profits are lower or more volatile, they are discounted at a much lower rate. That adds to stocks' future potential value.
Gabelli: Financials were down how much in '07?
Black: The S&P financials were down 20.8% for the year.
Gabelli: Isn't that a bear market for what deserves to be a bear market?
Hickey: The Nasdaq 100 increased by nearly 20%, the Nasdaq Composite by 10%. The Dow industrials were up 6%. That's not a bear market. When the financials were killed, people shifted into the "horsemen" stocks -- Research In Motion [RIMM], Google [GOOG], Apple [AAPL] and Amazon.com [AMZN]. If we don't have a bear market this year, under these conditions, I don't know when we will.
Faber: Equity prices have increased in dollar terms, but in euros the S&P 500 is down about 45% from its peak in 2000 and the Nasdaq is down 60%. Measured in gold, the markets have done horribly and the economy has been in a recession for a long time. I'm not bullish about U.S. stocks, but everything is so bad on a global basis that they might do better on a relative basis. That doesn't mean they go up, but the U.S. market might go down less than China, India, Vietnam and some of the other markets that are in cuckoo land. These markets have gone up because people believe in decoupling. Economically we could see a decoupling, whereby the U.S. is in a recession and China still grows by 5% or 10%. The financial markets won't decouple. Unless, Mario, they reintroduce that uptick rule.
Five years ago I visited family offices and financial institutions that had practically no exposure to international stocks. Today the same people have 50% of their money in emerging markets. Valuations in these markets aren't compelling any more, except for real estate in emerging economies.
Hickey: The only way we might avoid a bear market is if the Fed keeps printing money. That's why you ought to have a big position in gold, which should do even better this year.
Oscar, what do you see?
Schafer: Last year felt like a bear market. We made three-quarters of our performance on the short side. If you were short credit you did well, and if you were long credit you did badly. If you were in RIM, Apple and Google it didn't feel like a bear market. This year, because investor-sentiment figures are so bearish, the stock market probably won't do much again, but on balance will end higher. We will make more money on our longs than our shorts.
Also, whereas leveraged buyouts provided a lot of support for stocks in early 2007, sovereign wealth funds could do the same in '08. Last year these funds invested about $60 billion in the U.S., mostly in financial companies. After all, money is a worldwide commodity. This year such liquidity will provide support to industrial companies. I am optimistic for the year, although the first half will be tough.
![[nine]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_sGkrF0-tkudnYShx4d_Bfn7W9C16Ce9ciCj63stGHQ3AN2fAb3A2cTgchfKe88XQlI-lAZLFyDMp5fg0FoTdca1dkjLeALPIvOjeASzoUyv1eoZcBAYThOmynjv5-HHo8D5Ms6AFFluJwGVWqLGQ=s0-d) |
| Faber: "Subprime is just the appetizer to something bigger." |
Faber: Oscar, how much have sovereign wealth funds earned so far by buying Citi and Blackstone Group [BX]?
Schafer: Just because they have a lot of money doesn't mean they are smart.
Meryl, what do you make of stocks?
Witmer: A year ago I was negative on the market. In my small- and mid-caps that was a relatively accurate call. In the midyear Roundtable, I had only one stock to recommend, Heineken Holding [HEIO.Netherlands]. I couldn't find a second. Today I can talk about eight or 10 stocks. We look at what a company is worth versus where it is trading. Where there's a spread we buy the stock. The market looks relatively cheap. I could see stocks up 10% to 15% this year based on valuations.
Scott?
Black: I, too, use the dividend-discount valuation model. It is driven by the growth in earnings, which is a proxy for growth in dividends and interest rates. Corporate profits will be down this year. We're at about $87.50 in S&P 500 operating earnings for 2007. For '08 we'll be flat to down 5%, or to $83.50. Earnings peaked in the second quarter at 11.6% of nominal GDP, an all-time high for that ratio since economists began keeping score in 1946. That puts the market at a price/earnings multiple of about 16. It's not overpriced, not underpriced. We do a lot of mathematical screening before we call companies. We are finding more small- and mid-cap names than we've found in the past six months -- companies with real returns on equity, decent balance sheets, prospectively good earnings. And they're not busted financials selling at close to ostensible book or seven times some fictitious earnings number.
The market will rally this year, but the first half will be sluggish. Real GDP will grow 1.5%, with monetary stimulus and maybe fiscal stimulus. The economy will do better in the second half, and equity investors will start looking to '09 earnings. Many credit problems will be behind us. The market won't be a runaway freight train, but it's conceivable the S&P 500 will return 5% to 10%, with dividends reinvested. Small- and mid-cap value stocks peaked June 4 and are down 21%-22% since. It has been a true bear market. I don't know if these stocks will outperform large-caps this year, but they'll move in lockstep. Also, for the first time in a long time, you can buy good-quality large-caps for 15, 16, 17 times earnings -- companies with sustainable growth and high returns on equity.
Mario, you didn't give us a precise figure.
Gabelli: The Giants beat the Dallas Cowboys, 14-10 [in the Jan. 13 playoff game]. As for the market, it will be up around 5% by year end. Last year saw $4.5 trillion of mergers and acquisitions, up from about $3.7 trillion the year before. This year, in addition to strategic buyers, sovereign wealth funds and SPACs, or special-purpose acquisition companies, LBOs will come back in the second half as bridge loans are working through the pipeline. The deals in this cycle will be a lot smarter, and more will be financed. M&A, spinoffs and liquidations all will contribute to that 5%-plus gain.
Also, a year ago a lot of "Wall Street" guys -- hedge funds -- went around telling companies to lever up their balance sheets and buy back their shares. Don't worry about the debt. That's another concept that was defrocked in 2007.
Gross' Picks
| | 1/4/08 |
| Closed-end Funds | Ticker | Price/Yield |
| Van Kampen Select Sector Muni Trust | VKL | $12.37/5.5% |
| Pimco Corporate Income Fund | PCN | 13.61/9.3 |
| Pimco Corporate Opportunity Fund | PTY | 14.18/9.7 |
| Automotive Bonds |
| General Motors 8.375%, due July 2033 | | $74.50/11.5% |
| Ford Motor 8.90%, due January 2032 | | 72.50/12.5 |
Source: Bloomberg
Art, what do you see for stocks?
Samberg: Investors are capitulating now. The market is terrible again today. [The Dow had a rough session Monday, but closed up 27 points, to 12,827.] The market could decline 10% or 15% quickly from year-end levels. You'll be able to discount the end of the mortgage mess quickly; it will be clear as soon as some of the large banks start taking additional write-offs. The first half is going to be awful. Can the second half recover enough so that the market is down 5% for the year? Stocks will fall 10%-15% in the first half, and then rally 10%.
Felix?
Zulauf: In the first half, the market will have to digest waves of bad news. If the economy gets weaker, the junk-bond default rate could rise. That would trigger another wave of credit defaults in the swap market, and so on. The first half will be pretty awful, and stocks probably will make a good low in the second quarter, down about 15% from current levels. Then, if the government offers some fiscal stimulus and interest rates are much lower, we could have a decent third-quarter rally. I don't know where the market ends the year.
Abby, do you?
Cohen: Unlike others at this table, I have to publish price targets. It is part of my day job. We've forecast the S&P 500 will be at 1675 at the end of 2008, and the Dow at 14,750. In '07 we hit our price targets for the year in June. Of course, the market performed poorly thereafter.
The stock market is a discounting mechanism, and by the end of 2008 investors will be looking at somewhat better economic data. They likely will conclude that '09 will be a year of economic growth and also some profit recovery. There is a significant difference, however, between target and path. My target is based on a risk-adjusted discounted cash-flow model, where our earnings expectations are below historical trend. We assume real interest rates, which are low, rise. Investors' risk aversion stays at significant levels. The path is going to be sloppy. We'll see enormous disparities within the market. Until mid-'07 many sectors moved together, creating a convergence in P/E ratios that we rarely see. In the past six months there has been a sharp divergence. Small-caps, financials and deep cyclicals have been hard hit.
There are questions about how bad the economy will be this year. We'll be watching the labor markets for clues. Second, inflation is gaining, though not galloping ahead. Prices have risen most notably on the commodities side, but that's less than 10% of business costs in the U.S. Labor costs are a more important factor. Unit labor costs are moving moderately higher in most industries. For all but lower-income and lower-middle-income families household income is keeping ahead of inflation. Finally, there's the matter of a catalyst. Even if our inputs are correct, how do we get to that price target?
Good question. Now you can answer it.
Cohen: Right now, stock prices are where they were at the end of 1999, but GDP is up 50%, corporate profits are up 75%, and so on. Granted, markets were overpriced at the end of '99, but we have to look at them relative to the underlying fundamentals. The S&P currently is selling at less than 15 times earnings, which is below the historical norm. Another catalyst could relate to the dollar, which looks cheap and could attract some natural holders of other currencies. If investors are looking at the German or British or Japanese equivalent of U.S. companies, they might find they'd rather own operating assets here. The U.S. market is cheaper than most equity markets. It might start to see improved investment flows. We're seeing more direct investments from non-U.S. companies. Returns on equity are higher here, and our regulatory and tax structure is a little friendlier. History has shown that foreign direct investment tends to precede portfolio flows, though once portfolio flows from outside the U.S. become distinctly positive, that may be a warning sign.
Schafer: Abby, are sovereign wealth funds shifting their interest to industrial acquisitions?
Cohen: They come in many varieties and have been around a long time. For example, the Government of Singapore Investment Corporation buys primarily financial assets. But Temasek, another Singapore fund, has been a significant private-equity investor. Many countries are using the Singapore model -- that is, the idea of having at least two separate entities. One would look at financial investments the way any large investor might. The others would take long-term positions, in private equity and such. There are some constraints on these funds. The China Investment Corporation, which is currently seeded with about $200 billion, has a note back to the Chinese government. It has to return about 5% annually. This means it will be looking at things as a portfolio manager does, and worrying about its performance on an annualized basis as well as its cost of capital.
A word about bonds: Last January I was concerned about lower-quality bonds, because the [yield] spreads [relative to Treasuries] were too narrow. Spreads have re-widened dramatically in recent months. Corporate bonds look more appealing that Treasuries because of the spread. In the short term, while the Fed might continue to lower rates, Treasury securities might perform well. Looking out a year, we'd rather own high-quality bonds. Even so, corporate equities will outperform corporate bonds.
Do you agree, Bill?
Gross: Yes. There is more value in corporate bonds and high-yield than there used to be. When we met last year high-yield bonds were yielding 2.5-to-3 percentage points over Treasuries. Today the spread is 5.5 points or more. High-yield defaults could approach 5% in '08 and '09. When you recover an average of 35 or 40 cents on the buck, you're talking about a loss of 3% or so in the principal value. If you're compensated at a spread of 550, and you lose three points on the other side, it is still an attractive return. Fears about liquidity and defaults have spooked investors out of the high-yield market.
Samberg: Have spreads completely reverted to the mean?
Gross: Prior peaks have been about 10 percentage points
over Treasuries. If that's the potential spread, you could be talking about another 25% price decline, although that's an extreme, and not our forecast. Nevertheless, we're not investing in high-yields now. We're looking at the second half.
![[eight]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_vSm2umK6X-HVhZ9x6OdBH6toktvGhfQ8wJDLrLHjExH38cd1UwTL1akyJTXzfwqpsMGoMddLnVB4g4PoVOSISJFnUdoiZiIFQYWWSS3Nhntu0JKjys4QnjDAazK_Lrx0wzpcCvEQ81Y2PQl2k9sQ=s0-d) |
| MacAllaster:"A lot of financial stocks are reasonably priced." |
MacAllaster: Why not corporates?
Gross: Some are very attractive. We have been heavy investors in the double-A- and triple-A-rated debt of the Goldmans and Bank of Americas and Merrill Lynchs of the world. In some cases, a double-B bond and a double-A bond have the same yield.
Let's switch to what may be a more congenial subject -- your investment picks. Oscar, let's start with you.
Schafer: Experian Group is the largest credit bureau in the U.S., U.K. and Western Europe. It owns credit data on more than 450 million consumers and 35 million businesses. It also has files on motor-vehicle histories, insurance policies, household purchasing trends and consumer Internet traffic. There are substantial regulatory and economic moats protecting its core business. Experian helps organizations find new customers and develop and manage relationships. It also helps consumers understand, manage and protect personal information, and make more informed purchasing decisions. The stock fell sharply on fears regarding slowing mortgage activity and consumer spending. These fears are overblown.
Schafer's Picks
| | 1/4/08 |
| Company | Ticker | Price |
| Experian Group | EXPN.UK | 395 pence |
| Medivation | MDVN | $13.37 |
| Ocean Rig | OCR.Norway | Nok38.80 |
| TransAlta | TA.Canada | C$33.60 |
| Wyndham Worldwide | WYN $ | 21.93 |
Source: Bloomberg
Really?
Schafer: In tough times, Experian customers place a greater emphasis on risk management, collection and segmentation. In past recessions, Experian's business prevented credit-service revenues from declining. This division represents 45% of Ebitda [earnings before interest, taxes, depreciation and amortization]. Three things could alleviate the impact of a business slowdown and prolonged credit crisis. Experian is invested for growth through its income statement. It could dial back on discretionary expenditures to meet its earnings objective. Growth in eastern Europe and Asia has been strong. And the company has a lot of built-in growth from past acquisitions, which will accelerate its organic growth rate in coming years. It acquired Brazil's leading credit bureau in June.
Tell us about earnings.
Schafer: Despite tough marketing conditions in the U.S. and U.K., the top line could grow by about 8% organically, and earnings by 12% to 15% in the next few years. Longer term, the company should benefit from the growth of the Indian, Russian and Chinese credit markets. It is rare to find a business of this caliber trading for a 9% forward free-cash-flow yield. One factor hurting the multiple has been management's reluctance to buy back stock. With Ebitda interest coverage of approximately nine times, and the cost of debt at 6%, the balance sheet would allow for a meaningful buyback program. Also, Experian could divest some of the Internet businesses it acquired in recent years at lofty multiples, and use the proceeds to do a massive share repurchase. When it emerges from this soft period, investors will again gain appreciation for the resiliency and strength of the company's business model. The stock could trade up to at least 735 pence from a current 394p, or 17 times free cash flow for the March '10 fiscal year. It trades in London. Earnings will be 33.5p this year, 39p next.
Gabelli: So this company trades at 10 times next year's estimate, is growing at 12% to 14% and generates a lot of free cash flow?
MacAllaster: It has a lot of leverage.
Schafer: But the earnings are all cash flow. The stock is down from 639p in July. My second company is Medivation. Its market capitalization is only about $400 million. It is a bio-pharmaceutical company focused on acquiring and developing small-molecule drugs. Its lead compound, Dimebon, is designed to treat Alzheimer's and Huntington's disease. Its other product is a once-daily oral treatment for prostate cancer. Alzheimer's affects about five million elderly people in the U.S. and the incidence is expected to grow as the population ages. The current market for Alzheimer's treatments is estimated at about $4 billion. There are a four primary drugs for treating Alzheimer's, from Pfizer [PFE], Forest Laboratories [FRX], Novartis [NVS] and Johnson & Johnson [JNJ]. All have limited efficacy and will be going off-patent in the next few years. Is Dimebon in clinical trials?
Schafer: The Phase II data are spectacular, showing a statistically significant improvement over the placebo in all five of its endpoints, including measurements used by the Food and Drug Administration for approval of other Alzheimer's drugs. Side effects were minimal. The primary concern has been that the compound was discovered in Russia and the Phase II trials were done there, where the drug already was approved as an antihistamine. The trials were designed by two of the leading U.S. experts in Alzheimer's who were involved in pivotal studies of the two largest FDA-approved Alzheimer's drugs. These experts trained the investigators of the trial, and the study itself was conducted by a U.S.-based contract-research organization. The Phase II study has been accepted for publication by a leading peer-reviewed medical journal. Medivation also is conducting a Phase II trial of Dimebon in the U.S. for treatment of Huntington's. As for its other drug, more than 200,000 new cases of prostate cancer are diagnosed in the U.S. each year. In November 2007 the company released early data from its ongoing Phase I/II study of patients who had failed standard hormonal therapies. Its drug showed significant reductions in PSA, the marker for potential prostate cancer. While the reports are from a small sample, they are encouraging. The stock is 14 and could rally five or six times in the next two to three years.
Does the company earn money?
Schafer: No, but it has enough cash to get through Phase III. It could also partner with a larger company. The large drug companies have lots of cash and no big, new products. My third company, Ocean Rig, is a Norwegian ultra-deep-water-driller; it makes rigs that drill 7,500 to 10,000 feet in water, and send the drill bit down to 30,000 feet. This market is likely to remain tight for the next five years, in part because of the discovery of a new field offshore in Brazil. New rigs are being built to meet demand, but it is difficult to attract rig crews, and there are delays. Contracts are getting longer. Also, the big oil companies are having difficulties with complex deep-water wells. Ocean Rig is well poised to capitalize on the strength of the market this year and next. There are only three active rigs available to satisfy demand over the next two years, and the company owns two of them. The CEO envisioned this situation and has been waiting until contracts roll off to set higher prices.
Black: Where are day rates now and where are they going?
Schafer: They are currently in the low-$500,000 range, and we think they will move to the high-$500,000 range. In the next six months the company will contract its rigs at day rates that should enable it to generate 7.15 kroner of free cash flow exiting 2009, for three to five years. That translates into an 18% free-cash-flow yield at today's stock price of NOK39. The company is strongly committed to maximizing shareholder value. It recently restructured its credit facility to be able to pay out an annual dividend of between NOK4.95 and NOK6.50 for the next five years. Place a 10% yield on the low end of this rate and the stock could go to NOK50. Dry-bulk and tanker companies have a lot more volatility and trade at an 8% dividend yield. It isn't unreasonable for Ocean Rig to trade at a similar yield.
Gabelli: What is the market cap?
Schafer: At six kroner to the dollar, it is about $1.2 billion. In December DryShips [DRYS], a dry-bulk carrier, purchased a 30% stake in the company, and its chairman bought 4.5% of the stock for NOK43 a share. The chairman of DryShips is constructing two rigs and there are concerns Ocean Rig will acquire them instead of paying out its free cash flow to shareholders. A creative deal may be structured allowing it to acquire the rigs and still pay a large percentage of free cash as dividends.
My next stock is TransAlta, a Canadian power company with assets in North America and Australia. It trades for 34 Canadian dollars. It has a C$10 billion enterprise value, but it would cost C$20 billion to replace the assets. Part of the disconnect is due to unfavorable long-term contracts on some of its assets, which account for 50% of the company's power generation and are due to be repriced between 2017 and 2020. Were the company to find a way to reprice these assets, they would add about C$1.5 billion to Ebitda.
Investors underestimate TransAlta's exposure to rising power prices. In the next four years, the company will realize about C$400 million of increased profitability primarily from repricing its merchant Alberta and Pacific Northwest power plants. This should drive Ebitda to about C$1.5 billion in 2011. Earnings of C$1.40 a share in '07 should improve to more than C$3 in '11. Normalized discretionary free cash flow is about C$1 a share more than earnings, due to high depreciation and amortization, so the stock is cheaper than its P/E would suggest. The story really gets interesting when you consider the possibility of strategic changes.
How so?
Schafer: TransAlta has been undermanaged for many years under its current CEO and board of directors. The shares have done well recently, but that's due to the company's presence in improving markets, not the shrewdness of management's business decisions. Adding leverage to the balance sheet to buy back shares would significantly enhance returns near and long term. But the company has been resistant to taking on more debt and doesn't appear to understand how to weigh investing in its own stock against investing in the construction of new assets. It should divest noncore assets in Mexico and Australia, issue additional debt, buy back a significant amount of stock and utilize project financing for future asset construction. The asset sales would net it about C$500 million after taxes. Recently a prominent utility fund became an activist investor in TransAlta. Its views appear to be similar to ours with respect to the balance sheet, leverage and buybacks.
Which fund is it?
Schafer: Luminus Management. It now owns about 8% of TransAlta and recently indicated its intent to nominate up to five directors at either the next board meeting or beforehand. If no strategic changes are made at TransAlta, shareholders could realize 20% returns for the next four years. If the company takes on significantly more debt and buys back shares, equity returns could be 40% over the same span. This valuation doesn't take into account the repricing of long-term assets at the end of the next decade. If there is some clever way to reprice them sooner, it could add a lot of share value, with only 202 million shares outstanding.
My last stock is Wyndham Worldwide, one of the world's leading hospitality companies. It operates in three segments. The lodging segment is the largest hotel franchiser in the world, operating Wyndham, Ramada, Days Inn and other properties. The vacation-ownership business is the world's leading provider of time shares. RCI includes the largest vacation-exchange network, as well the leading European vacation-rental group. Wyndham's brands range from economy to upscale, with most rooms in the economy and mid-scale markets.
Won't this business be hurt in a weak economy?
Schafer: While there has been a lot of concern about the slowing economy and its impact on the consumer, Wyndham's lodging business has remained strong and continues to generate significant cash flows. In past recessions, the economy and mid-scale segments of the U.S. lodging sector were fairly resilient as customers traded down. Also, independent hotel operators have recognized the value of associating with a national brand.
The supply of new hotels has run below historical levels for the past seven years, suggesting favorable supply/demand characteristics. Wyndham also is expanding internationally, and is the leading franchiser of hotels in markets such as China and India. Super 8 is the largest U.S. hotel brand in China, driven partly by the Chinese belief that 8 is a lucky number. The target demographics for Wyndham's time shares are upper-income baby boomers. During the past few economic recessions, time-share sales grew every year. Penetration still is at only 5% of the population. The RCI business competes in a virtual duopoly with IACI/nterActive [IACI]. It offers access to more than 4,000 resorts worldwide. This business generates strong cash flow from annual membership fees as well as transaction fees. The European vacation-rental-exchange business benefits from secular growth trends, significant barriers to entry due to its large network, and strong cash flow from its fee-for-service model.
Tell us about the stock.
Schafer: Wyndham trades for 22 a share with a market cap of about $4 billion. It sells for less than 10 times this year's estimates and under six times Ebidta, or more than a 40% discount to its peers. It also sells for less than the sum of its parts. The company has a strong and deep management team and the stock could be worth 40.
Thanks, Oscar. Your turn, Bill.
Gross: The Treasury market currently offers little value, with two-year Treasuries yielding 2.75%. Even if interest rates come down another percentage point and the two-year yield goes to 1.75%, the total return will be 4.5% to 4.75%. That market is bounded no matter how low the Fed goes, simply because everyone wants to be there. There is more value in the high-yield market than there used to be, but there still is substantial price downside. That leaves the middle, which is occupied by municipal bonds, investment-grade corporates and such. But it's best to ease into the corporate market, not rush. Most of my bond recommendations focus on the middle, and hopefully take into consideration the need for both yield and safety.
For years I've been an advocate of closed-end funds, especially on the municipal side. Both closed-ends and municipals have been trashed recently, because investors don't know what is inside these funds. It's the same fear factor that exists with SIVs. As for municipals, they're trading at yields equal to or higher than those of Treasuries and even high-quality corporates, which is remarkable, as the municipal default rate in the past 50 to 100 years has been much lower than that in the corporate sector. Yields are high because a lot of SIVs and conduits have been liquidating munis, and investors are skeptical about the insurance provided for municipal bonds to bring them up to double-A and in many cases triple-A ratings. But most of these bonds have little risk.
Which closed-end muni funds do you like?
Gross: My first suggestion is really a prototype. Typically readers rush in and bid up these recommendations right after publication, and all the value disappears in a day or two. So, be careful of your timing, and check out the closed-end-funds section of Barron's for other potential values. Look for funds that trade at a discount of at least 10% to net asset value, and yield 5% or more. With that build-up, my pick is Van Kampen Select Sector Municipal Trust. It has a 5.5% yield and sells at a 10% discount to net asset value. When you can get a 5.5% municipal yield relative to 4.3%-4.4% Treasuries, that tells you something. Most of these funds are leveraged, as is this one. They're dependent on cheap financing. To the extent that the Fed lowers interest rates from 5.25% to 3.25% or lower, these funds have the potential to raise their dividends. I'm not forecasting what Van Kampen will do, but generically lower rates create the potential for higher yields.
MacAllaster: They pay out 100% of what they earn?
Gross: They pay out everything and then some, because of the leverage.
If Congress raises the tax rate on dividends and capital gains, won't that benefit munis?
Gross: The higher the tax rate, the more attractive the tax-free advantage. To the extent that '09 is a year of higher tax rates, especially for the wealthy, municipals bonds will hold their value.
Two of my other ideas are in the junk category, which flies in the face of what I said earlier. The yields on General Motors [GM] and Ford [F] bonds are attractive, as is the potential for these bonds to be re-rated higher. In the past year or so, macro changes have occurred in the U.S. auto industry that are going to favor these companies for the next five to 10 to 15 years. One is the dollar's decline, which makes American cars cheaper relative to vehicles produced overseas.
Schafer: A lot of foreign companies are producing in the U.S., and the quality of U.S. car makers isn't up to standards.
Gross: I understand the criticisms, but the lower dollar helps U.S. manufacturing, including auto manufacturing. The second beneficial structural change is the industry's recent agreement with the United Auto Workers to transfer most health-care obligations off corporate balance sheets. Now that health care has been offloaded, there is tremendous potential for improvement in these companies' credit quality. Third, health-care reform is in our future, like it or not. A new national health-care plan would benefit auto manufacturing, and relieve a big burden for the industry. Lastly, GM's Rick Wagoner was quoted this morning as saying 75% of the company's production will come from overseas in the next 10 years. Yes, it's 10 years, but I'm talking about a 25-year bond. To the extent that many of us are enamored of overseas growth, these companies are moving in the right direction.
For these reasons, and with the admission that these bonds are rated single-B, I'm recommending the General Motors 8[frac38]s of July 2033 -- a 26.5-year bond -- and the Ford 8.90% of January 2032. These bonds yield 11% to 11.5%, much more than the high-yield average of 550 basis points over Libor [the London interbank offered rate]. They start with a 250-basis-point advantage. Also, the bonds' price is 73-74 cents on the dollar. Say GM and Ford don't make it -- and some of you might think that's the case -- the recovery value on these bonds would be at least 50 cents on the dollar. The downside in terms of default is limited.
What are your other ideas?
Gross: Two Pimco closed-end funds. I have the advantage of knowing exactly what's in these funds. Here's 10 pages of their holdings, item by item [holds up papers]. There are no subprime assets. The funds -- Pimco Corporate Income Fund and Pimco Corporate Opportunity Fund -- are trading at levels that reflect junk-bond status, when in fact 75% of their holdings on a duration-weighted basis are investment-grade or higher. Corporate Income has a 9.4% yield. It trades at a 1% premium to net asset value. Fifteen percent of the portfolio is in Treasuries. In effect, 15% of the portfolio yields 3.50%, and you're getting a 9.4% yield.
MacAllaster: What is the leverage?
Gross: It is 50% levered, and again, it will benefit from lower interest rates in its ability to maintain the dividend. If rates rise, there's a risk. You don't get everything for free.
Schafer: Can an outside investor find out what is in these funds?
Gross: They can get the top 10 holdings daily on a Bloomberg machine, and all holdings are listed in the quarterly statement, though it is typically filed 45 days after the quarter. But most closed-end funds aren't actively traded. What you see for the most part is what you get. Corporate Opportunity has a 9.75% yield and trades at a 1% discount to net asset value. You can buy it on the New York Stock Exchange. Corporate Opportunity sells for 14.33 and Corporate Income for 13.51.
Don't pay a quarter of a percentage point more than these prices. If people rush in, wait a week or two or three until the price settles. That's it for me.
Thank you, Bill.
![[BA_QA_photo.jpg]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_tOJG0yowFQztPHyLlKLmTIGUAvDc5_3TEwFVAy3x0QXO2MM2czrzW7rSjZO_g3t2Y9M3BqywYCCovQs0mSjBqbbSGecEHfArdAlcY9ZrED7wxhN8YU2EVbI-DpJBXte-EJMmdzl5NauU4NLz1p4Q=s0-d)
![[BA_BUBBLE_ENABLER.gif]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_t-mqff3yjZFJjSG-OlweSaNJnt__yvAyyvLqinpuCFFzaPr9urcM6LyLnUKdkGZVk66nFu-1u5t1xTJQyC5ozGevjg67cGNrfYd-EprA6_upGtAv4yjiOPlz_NTyNmK2kW4m_plYr41FvF1vNQ=s0-d)
![[jessica]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_u2QARSdBzOY4HHYWbOxT0zLpmLuHvfNKwDwA47H4KXKOW17xs2YLKbzZ6BIBPnTSE8Ud2t7ZzvwjiL_uvzd-5WfxeIBYuXH_LhA7CfhBrsKJ_n41BdwnqgLJcYCF6p9wILH6vpJok-Wddl2gxUoA=s0-d)
![[part_nfp_chart]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_toTMecAVZtSDM2y5rOaqHP8ia7hzZol_kXR6IcyMpxFe2p9X9NnUtOE7V7FHs9B-DFzhUF37IiNFtytEbOdIJSxvprv_oNA8U7UCLCo-jBnBikCMMoBPILC3rzLO1Hs_BWjDg5k8TJrRIbTohdLg=s0-d)
![[BA_ANTHR_ROLLUP.gif]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_vGT8x7ilR-umeXVXZbuqreavcQQQXnXk8uKTfSoAW7_WudWnHBpnr2Xgs22SXP60FbvFCpn0_aeRiMwWjj6e5uAZbGFI7RE8BduYw3GodMKfC31LROmmA2Nl93QnXe6t8MBOFlyyw89h9wkHFTGg=s0-d)