AB Analytical Services

Interest Rates: Not as Scary as Headlines Suggest

Alan Greenspan, the long-time Chairman of Federal Reserve Board who just can't fade away quietly, grabbed headlines late this week calling rising Treasury rates the "canary in a coal mine".  Talk about kicking a guy when he is down, given that the Treasury auctioned a ton of debt this week!  Mr. Bubblemaker's observations aside, should we be concerned?  Take a look at this chart, and you just might:

Holy cow!  Look, the 10yr Treasury has almost doubled.  Surely, the world must be coming to an end.  Yet, when we take a longer-term perspective, it is quite clear that rates are returning to a somewhat normalized range from panic extremes:

We can debate the implications of this rise and what constitutes a "normal" rate for the environment we are in (which is probably an even greater source of debate!), but I will answer that this doesn't really matter.  How can rates not matter?  How preposterous!  Well, I didn't say that RATES don't matter, I tried to say that TREASURY RATES don't matter.  That is, unless they impact other borrowing rates.  Take a look at the Moody's index of Long-term Corporate Bond yields, and you get a much more sanguine view of the current rise:

Taking an even longer-term view, long-term corporate bond yields remain extremely low:

It used to be that 7% yield on this index was low, and I will call that now high.  We are currently below 6%, so, in my view, we have some wiggle room here even if rates were to rise.

The bear story, being portrayed in black and white all over the place, is that our government borrowing needs are so great that there will be a buyers strike.  I doubt that, but I do acknowledge that there might be some "crowding out" where traditional buyers of corporate and mortgage debt decide that the spreads above the "risk-free" Treasuries don't merit continued investment and dump them.

Why is the rate at which corporations borrow so important?  As long as rates remain low and capital available to credit-worthy borrowers, companies can continue to roll over their maturing debt at perhaps even lower costs than historically (especially considering the steepness of the yield curve).  A year ago, I was concerned that companies might get hit with more expensive borrowing costs.

The rate is important to the valuation of stocks as well.  What should the PE be for our stock market?  I would argue that it is a function of two things:  Expected growth in earnings (higher PE for higher expected long-term growth) and alternative investments like Corporate bonds (higher PE for lower rates).

There is a lot of argument now about the future pace of earnings growth, which isn't surprising after the sharp moves in earnings over the past couple of years (from plunging to soaring).  I am in the slow recovery camp (no double-dip), and I am cognizant about a number of potential impediments to growth though also appreciative that there is tremendous operating leverage (meaning that if there is extra top-line, it will drop to the bottom-line).  But, what about the market PE?  As long as rates remain well-behaved, it is too low from what I can tell. 

As my clients and I have considered large-cap multinationals or other slower-growth non-cyclicals, we find that the market seems to be missing something (but maybe we are!).  Let me offer a simple example of JNJ.  The company is currently trading at 13X 2010 EPS, a pretty low ratio historically.  Sure, it's not going to grow too rapidly most likely, but let's say that the analysts are right in their long-term projections of 6% per year.  The current dividend yield is 3%, and the company, which pays out less than 50% of its earnings in dividends, has been growing that dividend at something like 11% for the past several years.   I estimate that over the next five years, JNJ investors can expect that their stock will go up 35% (as long as the PE doesn't drop from 13 and earnings do compound by 6%).  They will also pick up another 18% or so in dividends.  Adding it all up, I think that over the next five years, an investor in JNJ can earn 9-10% compounded total returns assuming very little earnings growth and no PE expansion.  This seems pretty good compared to investing in long-term corporate bonds, which are more likely to return close to the current yield of 6%.  I would argue that the market PE based on current rates should be closer to 20 rather than lower than 15.  I think it's that fear of the double-dip.

The point wasn't to call out JNJ (or the plethora of other large and relatively stable companies with reasonably strong balance sheets and PE ratios below 16 like KO, MCD, WAG or many others), but to illustrate how rising yields might impact our view of stocks.  IF corporate rates were to shoot up, it would make us want to pay less for stocks.

This whole interest rate thing can actually be a little confusing.  I have already pointed out that the Treasury rate isn't the thing to watch but rather corporate rates, which impact the earnings of companies to some degree and represent an alternative for investors.  Still, I must point out that rising corporate rates may or may not be harmful to equity values.  This simple diagram illustrates the point:

In an environment where rates are rising and growth is strong, the outlook for stocks can be quite favorable, especially for those companies whose growth is very strong.  Maybe the market PE takes a hit from the rise in rates, but it can be offset by higher earnings expectations.  This assumes rates don't choke off that growth.  The scenario of rising rates and fading growth is an investor's worst nightmare.  Conversely, the great Bull Market (from 1982-2000 let's say) was fueled by that rare combination of falling rates and strong growth.  The current environment (i.e. the past year) has seen falling corporate bond rates and improving growth (or at least not as bad as feared).  The final box - falling growth but falling rates is not one that is too likely these days given how low rates already are.  So,  higher rates aren't always bad for stocks.  If they are accompanied by strong growth in earnings, stocks can do ok.  If the economy turns out to be stronger than we expect this year, rates will indeed rise.  Fortunately, it looks like we have quite a substantial buffer in place currently, as the JNJ example suggests. 

My expectation is that interest rates aren't likely to be a major factor this year, so react to the headlines at your own peril.  With that said, I believe that a shakeout in Treasuries here could be the catalyst that sparks the correction to which I have been alluding.  If the dollar surge continues, no one wants to be left holding the bag of low-yielding Treasuries at the end of the move.  My call from January remains that we see an interim peak in the late March to Mid-April time-frame (now here) at S&P 500 <1230 (we are close - within 5%).  That's the game we find ourselves in.  I wish I had a lot of conviction regarding how deep the correction might be or how long it lasts, but I want to see it start before I make that call. 

Disclosure:  Sadly (for one who likes to fish in smaller ponds), I find JNJ and WAG to be very attractive and hold them in a foundation I manage as well as in both model portfolios.

Short-Covering Boosting the Broad Market

File this in the "silver lining" category, as I now have a new data field for screening:  Short-interest.  While I am extremely saddened by Thomson Reuters' decision to kill StockVal later this month, I know that as I transition to Baseline I will encounter some improved data and functionality.  For a decade, I have been unable to screen on short-interest, but that is no longer the case.

As I was running through my watchlist, where I knew that there were some good companies with very high short-interest, it dawned on me that the broader market might be seeing some of the same thing that I have enjoyed in some of the stocks in the Top 20 Model Portfolio like Allegiant (ALGT), Buckle (BKE) or Family Dollar (FDO).  Massive moves in heavily shorted names has been one of the factors that accounts for the strong double-digit return year-to-date.

Anyone that follows my views knows that I am not surprised by the move to new highs this past week.  I detailed my outlook in January that the bear market rally should continue into late March or early April.  This weekend, I updated my views to subscribers to Invest By Model that I am beginning to become a bit more vigilant for a near-term peak. 

Back to the task at hand, I screened the S&P 500 for stocks with more than 10% of the float short - not an easy task for these large companies.  In fact, though, 46 companies met the criterion.  In the table below, sorted in descending order by sector, you can see that the shorted companies come from all over the place:

The S&P 500 price return is about 4% year-to-date.  While short-covering surely isn't the primary reason, the heavy concentration of names in the Consumer Discretionary and Financial sectors highlights the potential relevance of this factor.  While the Industrials sector leads the way for the market so far in 2010, these two other strong-performing sectors which comprise 25% of the index are chock full of exploding over-shorted names.  The Consumer Discretionary names are up 14.1%, while the Financial names are up 13.5%.  The sectors were the worst in 2008 and middle-of-the-pack in 2009. In every sector, the average return of the shorted names exceeds the sector average, except for Industrials (thanks to First Solar (FSLR)).

While this is interesting to me, I don't know that it gives us too much insight into what the future holds.  It just tells us that one of the reasons the market is doing better is that there has most likely been some short-covering.  If you are skeptical, consider the S&P 400 Mid-Cap index, which is up 8%, or double the S&P 500.  As I explained (or didn't explain!) at the end of February when I reviewed returns, there isn't a structural or compositional difference that would explain the radically superior performance.  I suggested that it could be the improved M&A environment, but might it be that 25% of the Mid-Cap index is shorted in excess of 10%?  The S&P 600 Small-Cap index, which is also up about 8%, has 27% of its constituents shorted in excess of 10%.  Now I know!

Disclosure:  Long ALGT and BKE in a portfolio I manage and long ALGT, BKE and FDO in one or more model portfolios. 

21% of the Russell 2000 is up over 20%

The Ides of March is upon us, but it seems like there is no reason to beware.  Bears have been head-faked and otherwise bullied about by a market that just won't quit.  I continue to expect that the objective I laid out earlier this year of the S&P 500 testing 1200-1230 is likely to be achieved in the next few weeks. It's not that heroic a call, as it represents just another 5-7%. 

For anyone who looks at just the big stocks, you are missing the story of the year:  Small-caps are on fire!  I count 419 stocks in the Russell 2000 that are up more than 20%.  I am happy to say that this is where I have been hunting this year.  Almost all of the sectors are well represented, with even a Utility making the cut.  This frothiness isn't a sell signal, but it does tell us that there are lots of folks throwing in the towel.  The median return of this bunch is 31%, and that's on top of the 27% median return for these stocks in 2009.

While the S&P 500 is up about 3.6% on a total-return basis this year, the Russell 2000 has soared 8.4%.  The stars have lined up, with the calendar turn inducing risk-taking by hedge funds and the investment of cash by long-only guys.  Additionally, the strength of the dollar most likely has contributed to investors favoring the more domestic-oriented smaller companies.  I am on the record as calling 2010 a year to "seek Alpha" and certainly it is playing out that way, with investors willing to look at perhaps obscure stories.  In 2008, it didn't matter the story, it was going down.  In 2009, it didn't matter the story, it was going up.  I expect to see this small-cap bias, which kicked in mid-November, to persist all year.  Here is how IWM, the ETF for the Russell 2000, has done over the past year, with the relative strength line beneath the price line:

In case it is hard to see, I based it to the beginning of 2009.  The small-caps bottomed relatively in early March and then ran into September.  An ugly correction knocked them down to underperforming on a year-to-date basis in early Q4, but they recovered into year-end and are now the best they have been on a relative basis since late 2008.  Here is a longer-term perspective:

 
This chart looks like a triple-top on relative performance, with the peak in 2006 and 2008 now being tested.  I think that the trend persists.  I have been arguing since 2008 that smaller companies tend to have better balance sheets and to be more nimble than their larger peers.  The dynamics of a slow-growth economy will continue to favor smaller companies with the added kicker that M&A is heating up. 

While I continue to like Small-Caps, the market's run is most likely nearing an end or at least is ready for a big pause.  I expect that the end of March to the beginning of April will represent a near-term peak in stocks, though I am not willing to say how bad things get because I don't have a clue (hint:  watch the 10yr Treasury).  My best guess is that we get a 10% retreat after just missing in the last test.  It smells to me like the buying isn't out of conviction but rather out of necessity.  It has been painful to fight, and I am very glad not to have been doing so, as I succumbed to that loser's game last summer.  My Top 20 Model Portfolio is performing quite well due to being focused on smaller names, but I have begun to make the portfolio a bit more conservative with the recent addition of a utility and taking some profits in extended smaller names.  With that said, though, I am having no problem finding names that meet my criteria of offering potential returns in excess of 20% over the next year.  Smells like a stock-picker's market!

Disclosure:  No stocks mentioned

Utilities Poised to Become Market Leaders

Utilities are a corner of the market that I normally avoid, but I believe that the opportunities are too great to ignore.  I am no expert in the area, but I have been spending some time learning about some of the big-picture drivers as well as the details about a few of the names.  I shared my interest initially in December as I focused on higher-yielding Utilities and have reposted it to my blog.  I subsequently made two purchases in February, which I disclose below, but this is really a sector call.

Utilities are generally regulated, though many participate in unregulated activities and some are totally unregulated.  The sector is typically low-beta and higher dividend yield than stocks in general.  Capital structures tend to be significantly more leveraged than other industries.  While one of my goals when I invest is to find good management (or at least be fully aware when management is inferior), it's hard to find stand-outs in the sector.  Even when one does identify strong management, other factors dominate the earnings outcomes, like regulatory or even weather.  So, for someone who typically likes to invest in companies with strong balance sheets and superior management, I can't be blamed for not spending a lot of time on Utilities.

In the Russell 3000, just 95 companies are classified as Utilities.  The S&P GICS system breaks down the sectors into various industries, including pure Electric Utilities, Gas Utilties, Multi-Utilities, Water Utilities and Independent Power Producers.  Here are the definitions according to Standard & Poors:

Electric Utilities

Companies that produce or distribute electricity. Includes both nuclear and non-nuclear facilities.

Gas Utilities

Companies whose main charter is to distribute and transmit natural and manufactured gas. Excludes companies primarily involved in gas exploration or production classified in the Oil & Gas Exploration & Production Sub-Industry.   Also excludes diversified midstream natural gas companies classified in the Oil & Gas Storage & Transportation Sub-Industry.

Multi-Utilities

Utility companies with significantly diversified activities in addition to core Electric Utility, Gas Utility and/or Water Utility operations.

Water Utilities

Companies that purchase and redistribute water to the end-consumer. Includes large-scale water treatment systems.

Independent Power Producers & Energy Traders

Companies that operate as Independent Power Producers (IPPs), Gas & Power Marketing & Trading Specialists and/or Integrated Energy Merchants. Excludes electric transmission companies and utility distribution companies classified in the Electric Utilities Sub-Industry.

If you would like to see the entire universe, sorted by industry and then yield:  Download Utilities Sorted By Industry on DivYld

Here are some observations that encourage me:

• Many companies, especially electricity or gas providers, were crushed in 2009 by the plunge in industrial demand, but there should be a recovery in demand
• Fears abound about "Cap and Trade" and emissions controls, but those risks seem to be abating and investors forget that some or all of the costs will be passed on
• A few high-profile rate cases with negative or less-than-expected outcomes have concerned investors, helping to create an attractive entry
• The majority of Utilities yield more than 4%, many more than 5%
• It's not difficult to find regulated utilities trading below tangible book value
• These stocks went down hard in 2008, barely rallied in 2009 and are down a bit in 2010, meaning that they have underperformed the market.
• M&A is a strong possibility - note the recent deal (FE for AYE)
• Everyone knows about the sector, but not very much - it's just 4% of the market, meaning that it could be as mispriced as I suggest.

I believe that Utilities are poised to rally this year by 20% or so as the dividend yields come down.  My forecast is dependent upon a slow economy in which we see some growth that allows industrial demand to pick up compared to its implosion last year, but not too much growth.  If the economy booms, my call will be horribly wrong.  First, other stocks will be a better place to be, as they are more leveraged to earnings growth.  Second, and perhaps more significantly, very strong economic growth means higher interest rates, the anathema of yield investors.

The best easiest way to play the sector is through an ETF.  SPDR Utilities Trust (XLU) represents the S&P 500 names only. iShares offers its version (IDU), but it is an odd-lot in comparison and tracks XLU extremely closely despite having more names.  I have chosen to invest in two electric utilities, Portland General (POR) and Allete (ALE).  POR is Oregon's regulated electricity provider.  It has been hit by the the weak industrial demand, but it has its own set of stumbling blocks including warm weather and low hydroelectric availability.  The stock was handed out to Enron investors a few years ago as a settlement, so not surprisingly it was dumped, though that is well behind them now.  I like the valuation and the yield (5.4%), and the stock trades well below tangible book despite having D/E ratio lower than typical for the industry (<100%).  A catalyst that many fail to appreciate is that it could be added to the S&P 400 Mid-Cap index.  Allete, which is basically Minnesota P&L, is covered by only 2 analysts as is also outside of the S&P indices.  The yield of 5.3% and a Debt to Equity of just 75% make me comfortable waiting for that Midwest Industrial recovery!  These may not be the very best ways to play, but I wanted to share what I had done.  Both of these names are in the Conservative Growth/Balanced Model Portfolio, which isn't too surprising, but I also put them in the Top 20 Model Portfolio because I think that they can return 20-30% over the next year.

The chart below for the market-weighted composite of S&P 500 Electric Utilities highlights the attractiveness of the group.  The equal-weighted numbers are very similar:

Note that dividends have grown and continue to grow (albeit slowly), that the dividend yield is well above the median for the past decade and that the yield relative to the 10yr Treasury is still quite higher than normal. 

Here is the same set of charts for S&P 500 Utilities overall:

It's the same story, but with lower numbers due to lower yields in some of the other sectors.  For a final thought, consider how the sector looks relative to another large yield sector, REITs.

 
Yes, the Utilities and REITs are back to their beginning of 2008 price relationship.  Yes, the P/B ratio relative to the REITs is well below its traditional relationship and very close to its lows (1.4X vs. 2.0X). Yes, you get more yield in the Utilities (4.50 vs. 3.60). Yes, the PE ratio is at an extreme (11.7 for Utilities, 15.5 for REITs - and sorry, this is not FFO or AFFO.  REITs are the expensive yield play that factors in a strong economy.  Utilities are the cheap one that doesn't need that at all.

I think that XLU can get to 36 or so based upon the yield dropping to 3.60.  That's more than 20% upside before the dividend.  To me, the regulated electric utilities look like the real bargains.  I think that buying the large-caps works quite well, but there may be some opportunities in smaller names that provide even more upside.

Disclosure:  Long ALE and POR