Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Bonds were Boring in 2007 -- and Worth Avoiding in 2008

Unless you’re expecting a severe economic recession, high quality government bonds are expensive, provide poor inflation-adjusted yields and should be avoided in 2008. And junk bonds should be avoided like the plague.

That was my advice in 2007 regarding bonds and it’s the same again in 2008.

Government bond yields, especially in the United States, plunged to a three-year low earlier last fall to 3.85% and are heavily overbought – mainly a direct consequence of nervous money heading to Treasury bonds amid a global flight-to-safety panic since August.

The only bonds worth owning remain ultra-short Treasury bonds as an alternative to money-market mutual funds and most bank accounts – many of which still harbour questionable assets invested in mortgage and asset-backed securities. Also, if you think inflation will continue to rise in 2008, then TIPS or Treasury Inflation Protected Securities offer a decent inflation-adjusted return. In 2007, TIPS earned the best return among fixed-income securities, rising almost 12%.

Elsewhere, 2007 was generally unimpressive for bonds with 10-year Treasury bonds rising 9.4% -- not bad nominally, but after inflation and taxes an investor was left with a puny 1.8% total return. With wholesale and retail inflation in the United States now at their highest levels in more than a decade, bonds require a far higher nominal rate of return to beat inflation, which erodes an investor’s purchasing power.

Junk bonds or high-yield debt went into 2007 fetching an expensive price-tag with the tightest credit spreads versus T-bonds in years. Junk bonds gained a paltry 3.4% total return in 2007. And emerging market debt, the best-performing fixed-income sector since 1990, saw a mediocre 6.2% return with credit spreads paying just 247 basis points or 2.47% above T-bonds. That’s not a yield differential that invites me to take risk. Same goes for junk bonds where yields must rise much higher for investors to return en masse.

High risk bonds like distressed debt, junk bonds and emerging market debt are not priced for a global economic slowdown. Junk bonds are the riskiest at this stage with the U.S. economy slowing, implying rising defaults in 2008. Also, the British junk bond market will come apart over the next 12 months as that country’s economy slows further.

The best values among fixed-income securities in 2008 lie in short-term investment-grade corporate bonds. These issues have been hit hard since last August as investors have dumped virtually everything tied to the banking sector. Bonds issued by US Bancorp, which holds virtually zero sub-prime exposure and Britain’s Lloyds TSB plc offer attractive yields compared to T-bonds.

Overall, I’m not bullish on bonds. The only reason why an investor would buy Treasury debt now is because a severe recession lies ahead. The economy will continue to slow into the first half of 2008, but the Fed will print its way out of deflation in housing and bank lending making fixed-income securities a bad deal compared to stocks and most raw materials.
Wishing everyone a happy, healthy and prosperous 2008! See you on Wednesday.

In 2008, Yen will Play on Volatility Hedge

At an absurdly low 0.5%, Japanese interest rates are still near all-time lows. Forecasts for 2008 continue to paint a bearish picture for the Japanese yen as deflation resurfaces again, growth falters since Q2 and capital flows continue to leave the Land of the Rising Sun. That’s not a recipe for yen strength in 2008.

Yet, against a basket of major world currencies, the yen remains the most undervalued. Yen assets are just dirt-cheap as we conclude 2007 and are probably just as cheap as dollar-based assets following a horrendous bear market for the American unit since 2002. Japanese stocks are especially on “sale” and nobody wants them. The Nikkei and the Tokyo 2nd Section, a market I recommended 12 months ago, have declined over the last year and trade at or below book-value. There’s no major stock market in the world cheaper than Japan.

My colleague, Mike Burnick, likes the Japanese market, too. Our currency man, Sean Hyman, also agrees and likes the yen. I can’t remember the last time three investment advisor's at The Sovereign Society were all uniformly wrong on a market. In 2007, we all agreed on the yen recovering at some point, and indeed it did starting in July’s sub-prime crisis. But the Nikkei and 2nd Section are frustrating investors and many are heading for the exits. Mike and I believe 2008 will reward Japanese equity investors, despite being too early on that side of Japan this year.

But there’s one important reason why I still like the yen as a hedge – and that’s because of rising volatility.

I think 2008 will see more global stock-market volatility as U.S. growth cools over the first half, housing continues to unravel, stagflation accelerates and more banks report sub-prime write-downs. From 2003 until March 2007, the VIX or CBOE Volatility Index traded at multi-year lows as volatility was essentially non-existent; but it started to simmer last winter and will rise even higher in 2008 as a host of factors pounce on the markets.

In this environment, you want to own yen because more speculative money will come out of the infamous carry-trade in 2008 as traders unwind risk and buy more yen. The yen against the euro is unbelievably cheap and should be purchased now. Against the dollar, yen at 115 or higher is a great entry point for new investors.

Dogs of the World in 2008

After months of research and more than ten thousand dollars’ worth of expenses paying for statistics and data, I’m thrilled to announce my new Dogs of the World service starting in January. If you like investing but find it takes too much of your time, then you’re going to love this strategy!

The Dogs of the World is predicated on the same strategy revolving around the now famous Dogs of the Dow. This means selecting the top ten highest-yielding Dow 30 stocks at the start of each year and then simply repeating this strategy again 12 months later. Since 1973, the Dogs of the Dow has earned more than 14% per annum, or almost twice as much as the benchmark.

Although still up in 2007, the Dogs of the Dow was weighed down this year by the financials, which now rank as the top-yielders going into 2008 accompanied by big risk as the sub-prime meltdown continues. That’s another story altogether.

But last summer I began to wonder: What if we took a universe of the world’s 500 largest companies and selected stocks the same way? Plus, with the dollar in a bear market returns would be boosted when converted back to dollars.

Well, the strategy proved to be quite successful. We managed to purchase data dating back to 2004 and found amazing results! I’m going to introduce this strategy to Sovereign Society members in a few weeks, so please check-out www.sovereignsociety.com for more information.

The 2008 Dogs of the World, however, will come with a twist.

Since about half of my 2008 list includes banks, including a few that I believe are still vulnerable to more write-downs, I’m pruning my list to include the next highest-yielding multinationals in healthcare, energy and telecommunications. I’ll still have a few Dogs of the World that are banks, but only those with strong insider buying and virtually zero exposure to sub-prime – and they all still yield well above 5.5% right now.

I hope you’ll join me in 2008 for a trip around the world Dogs’ style. Dividends do matter and this strategy includes high income, a low stock price, low p/e multiples, foreign currency-traded shares and best of all, it’ll take about five minutes to execute through an online broker every year.

My Holiday Gift to You...

It’s very rare that I’ll make a specific investment recommendation in these pages. But it’s Christmas and with the New Year upon us, I think it’s time to dish-out a gift to those investors perusing my blog every day. I’m also hoping you’ll become a full member of The Sovereign Society, if you’re not already, where in addition to great global investments like the one you’re learning about today, you’ll also get a world of advice on everything relating to international tax planning, insurance, private banking, privacy and surveys on the best offshore tax havens.

Over the last eight years I’ve invested in a spectacular fund called The First Eagle Global Fund (SGENX), which was originally called The Socgen International Fund. On a risk-adjusted basis called standard deviation, there’s simply nothing like it in the world. She rarely loses money. The fund, remarkably, earned double-digit profits in every year of the bear market from 2000 to 2002 while global benchmarks plunged 50%.

The hallmark of a truly great money-manager isn’t what he can earn in a bull market, but rather, if he can avoid losing capital in a bear market when most advisors typically lose money. It’s an extraordinary talent to make money when everyone else is losing their shirt.

Managed by legendary French money-manager, Jean-Marie Eveillard, First Eagle Global and First Eagle Overseas (SGOVX) are classic Ben Graham/Warren Buffett mutual funds but with a global twist. Since 1979, Eveillard has managed to smash his benchmarks by simply focusing on global values and company cash-flows. And unlike his peers, he’s not shy about buying gold, gold stocks, bonds and raising cash reserves if values become too rich for his liking.

Eveillard, who retired from managing the First Eagle Funds in 2004 after 25-years at the helm, was succeeded by his apprentice, Charles de Vaulx, that same year. But Eveillard came out of retirement earlier this year after de Vaulx’s departure. Both First Eagle Global and Overseas, which closed because of capacity limits in 2004, will now reopen to new investors for the first time in four years starting in January.

Eveillard, however, will not manage both First Eagle funds indefinitely.

The funds’ advisor, Arnhold & S. Bleichroeder, is a 300-year-old asset management firm with enormous experience managing global assets. The venerable firm is carefully assembling a team to replace Eveillard over the next 12-24 months. In fact, a renowned Ben Graham value disciple is already working with Eveillard and will likely succeed the great French money-manager in 2009.

Despite this important caveat, First Eagle did a superb job training Charles de Vaulx and I have no doubt Eveillard’s replacement, under his guidance now, will continue to log impressive returns long after Jean-Marie’s departure.

First Eagle Global Fund and First Eagle Overseas Fund will reopen in mid-January. I don’t expect the funds to stay open for long as investors rush to buy new units. I’ll be anxiously waiting, like a kid for rock concert tickets, to purchase more shares next month.

In this world, nobody does it better than Eveillard and Arnhold & Bleichroeder.

Happy Holidays…

Carry-Trade Strongly Correlated to Commodities Prices

The infamous carry-trade, or borrowing in a low-yielding currency to fund investments in higher-yielding securities, has largely centered on the Japanese yen since 2003. Japan continues to harbour the lowest interest rates in the world this decade, a consequence of its deflationary morass over the last 17 years. And though the Bank of Japan raised interest rates earlier this year, the economy has since stalled making the likelihood of low interest rates a continuing theme over the near-term.

As a result, global speculators continue to flock to the yen hoping to crank more juice from the forbidden carry-trade fruit.

But investors are wrong to assume that just because Japanese short-term interest rates might remain low over the foreseeable future, the yen must decline. That’s not the case. In fact, the yen also shows a strong correlation to commodities prices, in addition to rising stock prices.

In 2008, I think it’ll pay to own Japanese yen versus the euro, natural resource currencies and even against the depressed American dollar. On a trade-weighted basis, the yen remains the cheapest currency among the majors since 2002. It might even outpace gold, which has posted yearly advances since 2001 and since 2005, has outpaced all major currencies.

By now I’m sure you know how the carry-trade works: when the yen rallies on any given day, world stock markets decline, and vice versa. But the yen also rises and declines with the fortunes of commodities prices, including natural resource currencies like Australia, New Zealand and Canada. These three units are heavily overbought as we conclude 2007 and have enjoyed huge gains over the last five years, especially the Canadian dollar, up 52% against the U.S. dollar.

I expect some commodities to decline in 2008, namely crude oil and the base metals. If that forecast comes true, resource currencies will post declines vis-à-vis the yen. I also believe volatility will remain a prevalent theme in world markets next year, which should benefit the Japanese currency as more investors reduce risk exposure and buy yen. The Japanese currency is an optimal hedge in down markets; if you own stocks, the yen serves as a great hedge amid turmoil, plus it’s liquid and cheap to own.

In 2008, some of the most overbought and overvalued assets will likely log the worst absolute returns. Oil, base metals and natural resource currencies look the most vulnerable while the yen the most attractive on a risk-adjusted basis.

From all of us at The Sovereign Society -- have a Merry Christmas! I’ll be back on Wednesday. Have a great holiday!

U.S. and European Governments Mum on SWF Investors

Since November, Asian and Middle Eastern Sovereign Wealth Funds or SWFs, have made numerous investments in mostly American and European banks. Over $30 billion has been invested this month alone as banks struggle to boost their capital base amid the worst credit crunch in decades. The biggest recipients thus far include Union Bank of Switzerland, Morgan Stanley, Citigroup, Barclays plc and this morning, even goliath Merrill Lynch.

Thus far, Western governments have yet to oppose Asian and Pan-Arabian investments.

The fear among global investors hoping for a global “White Knight” to save plunging bank stock-market capitalization is a concerted attack on SWFs to explicitly detail their long-term intentions in these huge entities; will these SWFs demand a seat on the board in the future, becoming more vocal? Will SWFs turn hostile like private equity and demand greater shareholder return on equity? So far, the SWFs appear quite placid and most aren’t even demanding a seat on any board.

The reality of the crisis, however, is that Western governments are now at the mercy of SWFs, especially in the United States and Europe.

In America and Europe, there is a major shortage of capital, which explains why the big banks and brokers are looking for saviours, especially from overseas. International SWFs are not vulture investors looking to take a target company apart, dump management and assert their own corporate agendas. I think that’s why the major banks and brokers are very relieved to have SWFs as investors.

In the future, the United States and other countries might start special committees to investigate SWF investor intentions. This whole process might turn into a major political scandal, especially if countries like Saudi Arabia, already targeted by some officials as an OPEC king-ping refusing to boost supplies, increasingly becomes a major investor in several American or British banks.

Warren Buffett, chairman of Berkshire Hathaway, would be ideal as an American investor taking a major stake in a distressed Western bank; but unlike SWFs, he’s far more active in corporate management and would certainly demand a board seat among other criteria.

This century belongs to Asia and SWFs. Western banks have no choice but to open their doors because many other lending crises and derivative-based fiascos lie ahead over the next decade and beyond. Welcome to the New World.

No Boom, but Maybe a Bust: The Consumer and Sub-prime Hold the Cards to Economic Growth in 2008

As we shortly close out another year in the markets, it’s fair to conclude the best of America’s economic growth cycle lies behind us. Growth peaked in the second quarter along with broader stock market aggregates later on July 19th. On November 21st, Dow Theory triggered a bear market sell signal as more stocks continue to break down and hit new lows.

The next few months will confirm whether the world’s largest economy is now contracting or mired in a slowdown. That’s a key trend-setter because it’ll determine how to position investment portfolios in 2008.

Small is Struggling, Sub-prime Spreading

Smaller companies, the backbone of corporate America, have already peaked since last spring and are cutting back on capital spending. Signs also point to a reduction in hiring as slower growth forces more companies to shed redundant labor. But labor trends, a lagging indicator, typically shows up late after a recession has already started. In late 2007, the unemployment rate is still historically low; as the New Year progresses, however, more job losses will mount as sub-prime spreads to the non-financial economy.

One major source of instability that threatens to delay a recovery in broad economic growth remains housing. And not just in the United States.

Residential investment is falling hard since mid-2006 in America but has only started to decline in ”bubble” markets in Europe, mainly Spain, Ireland and the United Kingdom.

Housing in the United States is still hemorrhaging with no signs of a bottom, bank lending is contracting amid the worst credit crisis since 1998 and with the exception of exports every facet of the economy is now in a downtrend. The economic picture doesn’t look too pretty for the first half of 2008.

Over $1 Trillion – and Counting

In addition to housing, the sub-prime crisis is deepening with over $1 trillion dollars now committed to money-markets by the world’s central banks since August 9th. The European Central Bank (ECB) is responsible for more than half of that total, attacking the inter-bank lending freeze across the euro-zone with $500 billion alone on December 17th. Although Euribor and Libor rates have declined as a result, spreads remain well above central bank targets as banks are reluctant to lend overnight.

To the casual observer, Libor and Euribor might not matter much. Yet, in reality these inter-bank lending rates -- still in a virtual freeze since August, affect global lending rates and trends in institutional and corporate borrowing; even if rates were to normalize tomorrow, the lasting impact has already been felt across the global economy, especially over the last 30 days.

The Consumer and Employment are Wildcards

The United States might escape a severe recession in 2008, defined as two consecutive monthly declines in output. But one more major shock and a real bust might tip the scales into a deeper economic contraction.

With domestic consumption in the United at 70% of gross domestic product and big business providing another serious chunk of change to economic growth, the odds are rising that a soft recession has already started in late 2007. Corporate earnings are too optimistic for 2008 as capital spending stagnates and consumption faces a temporary freeze following the Christmas retail sales jolt. Once the holidays are over, domestic consumption is likely to stall combined with weak GDP data for the fourth quarter denting already fragile consumer confidence.

The Fed Fighting Stagflation and Deflation

Meanwhile, the Fed is fighting a toxic cocktail of rising inflation and growing deflation in housing – a major policy challenge for any central bank. The Europeans also face the same problem as the ECB remains reluctant to cut short-term lending rates amid high inflation, mainly in energy and food prices.

In an environment where global economic growth is slowing, especially in the United States, Japan and the United Kingdom, the time to hedge your investment portfolio is now. It’s not too late to add alternative investments like reverse-index funds, Japanese yen and other Asian currencies, and hedge funds specializing in distressed debt and busted credits. Plus, commodities, though likely to face some downward pressure (oil and the base metals) still offer great hedges in the grains, soft commodities, livestock and the precious metals as supplies continue to tighten.

Join me at the Sovereign Society’s Emergency Money Summit in St. Kitts (February 20-23) to learn how to hedge your global portfolio, access some world-class money-managers for All-Weather markets and protect your wealth ahead of the next bear market.

Scrap Onerous U.S. Listing Rules Now for Companies

The United States is still one of the best countries to market products and services in the world. Its vast borderless size expanding coast to coast, a single currency for transactions and huge 300 million consumer-based economy make it a great free market unlike any other country.

But since 2002, America has been losing its share of foreign listings mainly because of onerous listing requirements and expensive compliance requirements. That’s the word from the Committee on Capital Markets Regulation after conducting a definitive survey on the subject.

The delisting of foreign companies this year in the United States rose to 56 through the end of November from 30 last year – a sizable 87% increase. Ten years ago, that figure was just 12; in the last decade, delistings have surged a cumulative 367%.

The trend to list abroad really gained momentum following the Enron and Worldcom scandals earlier this decade. The SEC subsequently went gangbusters, introducing the complex and mundane Sarbanes-Oxley legislation making it expensive and too burdensome for international companies to list on U.S. exchanges. And many either avoided U.S. listings altogether or delisted and headed to London – a primary beneficiary of lost U.S. business because of less burdensome listing requirements.

To be sure, the United States is still the world’s largest and most liquid stock market.

Despite cumbersome listing requirements and burdensome regulations, many companies still seek a listing on the New York Stock Exchange and view that listing as prestigious. But that’s not the case for smaller companies where London’s AIM or Alternative Investment Market continues to draw a swarm of listings.

In order to make the U.S. an attractive destination for new listings again, especially for smaller companies going public, the government and SEC should work together to scrap or seriously revise current legislation. Otherwise, London, Shanghai, Tokyo and Hong Kong will reap what New York fails to sow.

Dollar Bear Market Rally Might Dent some Commodities in ‘08

If the heavily oversold U.S. dollar musters an unexpected rally next year, some commodities might suffer big declines.

Bull markets are always accompanied by sharp, painful corrections. Already this decade, we’ve seen a major bull market take hold for raw materials. Two leading benchmarks have gained more than 200% since 2001 while virtually every commodity has posted even bigger gains, including the base metals until recently. From its low in 1998, spot West Texas crude oil has skyrocketed 820% or more than eightfold.

The most widely followed commodity indices are the Reuters/Jefferies CRB Index and the GSCI or S&P Goldman Sachs Commodity Index (see below, and left click your mouse for a larger resolution). Like all commodity indices, crude oil and the rest of the energy complex holds the largest constituent weighting; as goes oil, so goes the bull market.

Oil prices were unchanged in 2006 but several commodity benchmarks still declined as other sectors of the market tanked, namely natural gas and some of the soft agricultural commodities.

I think the odds of oil prices declining next year, even modestly, is high. Global economic growth is slowing as the reality of “decoupling” becomes a myth. That’s because the United States is still the world’s largest economy, and when she slows, the rest of the world feels the heat. I don’t think oil prices accurately reflect a slowing economy. Natural gas, on the other hand, looks extremely compelling against oil.

If was betting on indices in 2008, I’d avoid the GSCI and instead concentrate on the grains, the meats and precious metals. The GSCI holds about 70% of its assets in energy futures -- vulnerable to a major correction in crude oil. None of the diversified commodity benchmarks have big positions in these three areas so I’m more inclined to play it individually.

In addition to slowing global growth next year, watch out for a rising dollar.

The buck is heavily oversold at these levels against most currencies and might surprise investors in 2008, if only temporarily. The dollar, after having plunged from 2002 to 2004, enjoyed a short-term cyclical bounce in 2005 as the Fed began raising rates. Yes, the Fed is cutting rates now but if the European Central Bank finally relents and stops fighting yesterday’s war on inflation and cuts rates, the dollar might post a big rally.

A sharply stronger dollar might cut into commodities prices. I’m already very bearish on the base metals (topping out) and would avoid most energy trades, except natural gas. But the fundamentals for the precious metals should defy a dollar counter-rally because of shortages in near delivery for gold and platinum. I also like the grains and other soft commodities, which remain extremely cheap compared to their inflation-adjusted highs in 1980-1981. Plus, the meats, a boring place to diversify this year, should come alive as feed prices continue to rise into next year, boosting cattle and live hog prices.

Wonder Boys at Goldman Sachs Make Bundles as Rest of Wall Street – and America, Bleeds

While investment banking peers Merrill Lynch (NYSE-MER) and Bear Stearns (NYSE-BSC) have lost billions riding sub-prime related securities into the doghouse this year, Goldman Sachs (NYSE-GS) is literally laughing all the way to the bank!

The venerable and extremely savvy Wall Street firm has earned billions in 2007 amid the worst financial disaster since the Savings & Loans debacle in 1989-1990. The group’s big bets that sub-prime securities were headed sharply lower earlier this year generated nearly $4 billion dollars of profits for the year ended November 30. And those profits amazingly erased the $1.5 to $2 billion Goldman lost in mortgage-backed securities leaving the firm with a net profit in the distressed asset class.

Goldman Sachs Envy

The boys at Goldman Sachs that generated sub-prime profits while the rest of the country suffered incredible losses, are expected to earn between $5 to $15 million dollars in 2007, according to a The Wall Street Journal report. That compares to a major shaving in year-end bonuses for most other Wall Street firms as the credit-crunch comes to home to roost affecting everyone from Main Street to Wall Street. But at Goldman Sachs, famous for punching out those big salaries and bonuses, the median bonus later this month will fetch approximately $335,000 in 2007.

The Smartest Money on Wall Street

Goldman Sachs is undoubtedly the smartest money on Wall Street. I’ve been following the investment banks’ progress over the last 17 years with a few of my own school buddies from Montreal landing jobs at the firm in the early 1990s. Completely burnt out, withdrawn and now immensely wealthy, both ex-Montrealers now live in New York and have taken sabbaticals following years of utter exhaustion and long hours. Goldman works its people hard, and pays hard, too.

Goldman Sachs is an interesting dichotomy on Wall Street.

Most of the financial sector typically suffers big losses when a protracted economic crisis hits the markets; but that’s not always the case at Goldman where its multi-layered trading departments are encouraged to take calculated risks against one another, often arbitraging different trading desks to hedge the firms’ exposure. That’s exactly what happened this year as sub-prime exploded.

One proprietary trading desk made bad bets heading into 2007 riding opaque CDOs or Collateralized Mortgage Obligations (losing $2 billion) while another trading desk headed by two top guns, earned about $4 billion in profits, more than offsetting the sector’s trading exposure.

Goldman’s Talent Goes Far

It’s no wonder that Julian Robertson, former hedge fund legend who founded Tiger Management Corporation more than 26 years ago, used to pilfer Goldman’s young trading talent and lured them to his firm for substantially greater salaries.

Many of Roberston’s Cubs, as they were widely coined on Wall Street, or junior apprentices, have since started their own successful hedge funds managing billions for sophisticated investors.

Morals versus Profits

Virtually every bank has suffered big losses in 2007 as write-downs and exceptional items continue to surface on bank balance-sheets, including SIVs or Structured Investment Vehicles. Yet Goldman Sachs earned $2.9 billion dollars in the third quarter while everyone else posted losses – its best three-month period on record.

Morally, however, Goldman Sachs is not exactly a beacon for ethical trading. Of course, neither is the rest of Wall Street.

Goldman Sachs ranked as a major underwriter of mortgage-backed securities over the last several years, helping to grow a market that is now completely shunned by global investors. But at the same time it peddled CDOs, the firm was placing major bets against the same asset class and benefited enormously when CDOs imploded.

Wall Street has No Morals

I’ve always had great respect for Warren Buffett, arguably the world’s greatest investor since the Rothschild’s. Buffett is an investor, not a trader and doesn’t make huge arbitrage bets like other Wall Street firms with skads of leverage. He builds large stakes in great management with solid cash-flows accompanied by brand-name recognition.

Goldman Sachs, on the other hand, represents everything that is truly great and equally pathetic about Wall Street. I don’t like how it pairs its own trading desks against each other while selling billions of mortgage-backed securities (a.k.a. garbage) to the public while making a fortune in the process. But that’s market-based capitalism.

Don’t feel bad for Wall Street this holiday season. They’re already working on the next financial disaster by selling everyone else mostly trash.