Investment Outlook as of Novemver 2007, Part II

Indexes and Prices
1 Dec 2007
DJIA: 13,371.72
S & P: 1,481.14
NASDAQ: 2,660.96
oil: $88.71
gold: $789.10
euro: $1.466

Part I of this essay argues that US goverment borrowing to finance bank bailouts and foreign colonial wars will lead to inflationary devaluation of the dollar and probably higher-than-expected overall price increases for consumers. Furthermore, the CPI will systematically understate the actual cost-of-living to consumers. In this section I explore some options available to the individual investor seeking preservation of capital in the anticipated economic environment of the next ten years.

First, consider the yield curves shown in the table below. Also, be aware that at present the interest rate trend is down, as the Fed continues to lower rates as part of its bank bailout and also to immunize the economy against a dreaded recession.

Interest Rates 1 Dec 2007

3 mo6 mo2 yr5 yr7 yr10 yr15 yr20 yr30 yr
Treasury3.153.363.013.393.94 4.38
AAA Corp Bonds4.575.36
Muni Bonds3.373.503.683.964.394.594.63
Implied CPI2.282.352.57


Treasury - US Treasury bills, notes and bonds. Interest taxable by Feds, not by state.
TIP - Treasury Inflation Protected bonds. Interest is fixed percentage of face value and face value increases with the CPI. Interest taxable to Feds, not to state.
AAA Corp - Top rated corporate bonds. Interest taxable to Feds and state.
Muni Bonds - Top rated municipal bonds. Interest not taxable to Feds, maybe not to state.
CDs - Bank certificates of deposit.
Implied CPI - Treasury rate minus TIP rate for given maturity.

(Data from

No doubt these rates bring joy to the hearts of borrowers. They bring something else to the hearts of investors. The interest rates do not compensate for inflation risk and the investor is further insulted that the government will tax what paltry interest payments he gets. Let's assume--reasonably in my opionion--that actual consumer prices rise at 6%/year over the next ten years and the CPI increases by 3%/year. Then the investor will suffer real capital loss over that period regardless of whether he puts his money in treasuries, TIPs, corporates, munis or CDs.

The treasury yield curve is basically flat--at about 3.2%--out to five years. Then it rises slowly to 4.38% at thirty years. Where's the demand for these low-paying securities coming from? From foreigners mostly, who can't find a better place to put the dollars they've gotten in exchange for their exports. Also from flight-to-safety investors bailing out of investments in financial services firms that are facing danger from the subprime crisis. Personal investment in treasuries is an investment guaranteed by the government to give you a net loss-of-capital in inflation-adjusted terms.

As for TIPs, the 1.59% rate for ten years is also an insult. If the CPI increases by 2.35%, your return will be the same as with the ten-year T-note. I'm inclined to think the CPI will rise faster than 2.35%, but still not as fast as consumer prices actually rise.

Corporate bonds give a higher return than treasuries, but are dangerous to hold now because of likely credit quality downgrades. The best way for a personal investor to own corporates, in my opinion, is to (1) build a ladder of individual bonds that seem especially unlikely to default and (2) hold them to maturity. Avoid corporate bond funds, especially now, when massive downgrades seem imminent.

The situation with municipals is unusual. I can not remember another time when the entire municipal yield curve was higher than the treasury yield curve. Also, I point out that the municipal yield curve over the past ten years has always remained normal (i.e. rising monotonically with increasing maturities) while the treasury yield curve has frequently inverted. My interpretation is that the foreigners and speculators who dominate the market for treasuries are simply not buying municipals. The municipals market is made up almost entirely of US investors, who buy them to benefit from their tax advantages. The American investors, naturally, demand a higher yield for longer maturities to compensate for inflation risk. Foreigners do not pay taxes on treasury interest income, as Americans do, so municipals give them no advantage when treasury yields are higher than municipal yields, as they usually are.

As with corporates, the best way to own municipals is to build a ladder of individual bonds and hold them to maturity. The market for municipals is less liquid than for corporates and selling a municipal bond will involve greater transaction cost. If you must invest in municipal bond funds it is important to choose funds with low expense rations, 0.2% or less. Vanguard offers such funds. Also, beware that if you put a fixed amount of money into a municipal bond fund, do not add to it, and take out the income distributions rather than reinvest them, then your yearly income will probably gradually decrease over the years as the overall yield curve drops. Significant defaults of municipal debt seem unlikely anytime in the next ten years.

What's the future of interest rates?

In the immediate future, it seems the Fed will continue lowering the Fed funds rate to bail out Wall Street. In the somewhat more distant future, maybe a year from now, they might commence another rate-lowering campaign to avert a recession. If they start from an already low rate, then they face the likelihood of bringing the short term rate down to zero, at which time the Fed will be out of ammunition. What will happen when this occurs is unknowable, but there is the possibility that the US economy will respond as the Japanese economy responded to zero interest rates in the 1990's. That means a long period of economic stagnation. It's also possible that the Fed will lose all credibility for either controlling inflation or preventing recession and a worldwide dumping of dollars will result in runaway inflation.

The most likely scenario, in my opinion, is that interest rates available to investors will gradually decline toward zero over the next ten years. All the while,
  1. real consumer prices will rise more rapidly than the treasury bill interest rate,
  2. the CPI will remain less than the real rate of consumer price increases,
  3. the "core CPI" will remain less than 2%, and
  4. the Fed chairman will announce at each meeting, "Inflation is well under control."

Also, during this era, the dollar will be declining steadily in value relative to the currencies of developed countries that choose not to bear the expense of colonizing hostile regions in the middle east.

Substitute high yielding stocks for bonds

It is traditional that investment portfolios contain a significant portion of bonds. Bonds provide a stable income stream and their prices in the past have been less volatile than stocks. Nowadays, however, bonds provide almost no income and they are vulnerable to price declines as a result of credit quality downgrades. So I suggest the substitution of high yielding stocks to provide the portfolio with the income stream and value stabilty formerly provided by bonds.

In this new way of thinking, the dividend becomes the most important quality in the selection of a stock for inclusion in the porfolio. We must consider the stock's dividend yield, what fraction of its income it pays out, its record of dividend payments, its likelihood of increasing its dividend and whether there is a possibility the dividend will be suspended or reduced. We must recognize that a dividend is solid, tangible evidence that the company is making money and that it respects its shareholders. And we must acknowledge that the management of a company will likely be reluctant to lower a dividend payment because that always causes a big drop in stock price, and nowadays management bonuses are generally tied to stock price.

In our evaluation of stocks, we must think of them as investments which will (if carefully selected), on average, increase in nominal value (and possibly in real value) in an environment of moderate inflation. A bond's real value, on the other hand, is guaranteed to decrease in a similar environment.

Stock dividends are now taxed quite favorably--no more than 15%--as a result of the Bush administration's tax breaks for the rich. So it's good to take your income as dividends rather than as more highly taxed interest (or wages, for that matter).

Suggested allocation for financial investments

The contents of the portfolio suggested below include (1) capitalization-weighted index funds, (2) individual stocks and (3) a small segment containing inflation hedge investments.

Capitalization-weighted index funds are called "tax efficient" because they generate few of those pesky capital gains dividends, which are of no value to the investor yet require tax payments to the IRS. At the same time they give the protection of a disciplined and broadly diverse selection of stocks.

Individual stocks chosen for the portfolio are large caps with strong monopolies and good records of increasing their dividends.

#1: 30% in international stock index funds

Such funds provide a degree of protection against a falling dollar. Two suggestions: Vanguard Developed Markets Index Fund (VDMIX), which tracks the MSCI-EAFE (Europe, Autralasia and Far East) index and Vanguard International Stock Index Fund (VGTSX), which is the same as VDMIX, except that it includes emerging markets. Both yield about 1.9%.

#2: 40% in domestic stock index funds

For this category I like the Vanguard Value ETF (VTV), which is based on the MSCI US Prime Market Value Index. This fund has been beaten down lately due to its heavy weighting in financials, which are getting clobbered by the subprime crisis. Yield is now 2.6%.

#3: 20% in high-yielding, large-cap, value stocks

Individual stocks in this category must have strong monopolies and good records of increasing their dividends. Some candidates: Altria (MO), which has a monopoly on an addictive drug (the Marlboro cigarette); Abbott Labs (ABT), Johnson & Johnson (JNJ), and Merck (MRK), which have patents on pharmaceuticals and medical devices; Duke Energy (DUK), which has exclusive rights to sell electricity to thousands of homeowners who need air conditioning in a planet experiencing global warming; Chevron (CVX), Exxon-Mobil (XOM), Conoco Phillips (COP), because competitors can't raise the capital needed to compete in the Big Oil arena. To be avoided are sectors where competition keeps profits down: examples, grocery stores, restaurant chains and clothing retailers. Also avoided are sectors where companies never seem to make much money: examples, airlines and forest products. Don't buy stocks of single-product companies whose prospects can be destroyed by an unexpected technology development: example, most high tech companies on the NASDAQ. Such avoided sectors and companies are for speculators, not investors. And never buy a stock selling for 100 times earnings.

Now is a buying opportunity for the beaten-down banks, particularly those with minimal exposure to toxic debt. Remember, the Fed is going to bail them out! Bank of America (BAC), yielding 5.5%, seems attractive. It has a very low PE and probably won't reduce its dividend as a result of the current crisis.

#4: 10% in gold, gold mining stock funds, and other funds whose value correlates with prices of internationally traded commodities

The easiest way to buy gold for speculation is to purchase shares in Streettracks Gold Trust (GLD). Each share tracks the price of one tenth of an ounce of gold less the accumulated management fee of .4%/year. One disadvantage is that GLD is considered a collectible when it comes time to pay capital gains tax. That means a 28% rate.

Fidelity Select Gold (FSAGX) and Fidelity Select Natural Resources (FNARX) are suitable investments in this category, but caution is advised: they have run up so far in the past few years that a correction might be due.

What about rebalancing?

Dividend yield of this allocation should be about 2.3%, assuming a yield of 3% for the segment containing individual stocks. Do not reinvest this income in the stocks or funds where the distributions came from. Instead, use the income generated, plus any capital gain distributions, to shift the balance of the portfolio towards the original allocation.

Note that the dividend payment from the portfolio should increase 5 - 10% per year. If it increases at 7.5% per year, then after five years, it will exceed the present-day interest generated by T-bills and five-year notes.