10/15/08   Waiting for the Dust to Settle

Editor’s Corner

Waiting for the Dust to Settle

Ron Rowland

Since our last report, the S&P 500 traded in a range between 839.80 and 1044.31, or about 24% from bottom to top. Clearly this was no ordinary five-day period. After swinging from despair to euphoria and back to despair again, it is understandable if some investors are inclined to throw in the towel. Yet they should not lose hope. By one standard, stocks are actually becoming less risky with every losing day. How can this be? We know that stocks are down about 25% in the last two months. That means there is now 25% less distance to fall before reaching zero. On the other hand, zero is a long way down no matter where you start. Whether you fall from a 200-foot cliff or an airplane at 10,000 feet, you will be equally dead when you hit the ground.

Financial professionals tend to measure risk in terms of volatility. Mathematical calculations of the daily movements obviously show that we are in an extremely risky period. When intraday price swings exceed 5% on a daily basis, every trade execution contains a large amount of risk. Yet the common sense fact remains that the market is substantially less over-valued than it was a few months ago. That means the bottom is getting closer. Now if only we knew where it was…

The political and monetary authorities seem to be getting a grip on the global credit crisis. It is still a huge problem, but the systemic collapse that looked like a real possibility last week appears to have been averted, at least for now. This is allowing investors to turn their attention toward the more fundamental challenge of a worldwide recession. Contrary to popular opinion, the business cycle has not been repealed. Negative growth does happen from time to time, as is becoming evident in corporate earnings, housing prices, and retail sales. Now the question is how deep the recession will be — and what it will do to the markets.

It is no stretch to say that the bond markets were in complete turmoil over the last week. Long-term Treasury securities are under pressure as investors realize that the cost of the U.S. government’s various bank bailout plans will be even more enormous budget deficits. Municipal bonds are being hit hard due to fear of default by state and local governments. High Yield bonds — which typically trade in line with stocks — declined thanks to fear of corporate defaults. The Monday holiday in U.S. bond trading seemed to add to the panic-driven trading on Friday.


Last week we remarked that Materials set a new record for negative RSM readings from a major GIC sector. It went on to break that record and set a new one each succeeding day, culminating in a -214 reading on Friday. When we get the inevitable bear-market oversold bounces, like the one on Monday, it is typically the weakest sectors that bounce the most and the strongest that bounce the least. Energy and Materials acted true-to-form by being the weakest sectors and bouncing the most. Consumer Staples also performed as expected by being one of the strongest sectors and bouncing the least. Health Care was a different story. Being one of the better-performing sectors on a relative basis, we would have expected a below-average bounce on Monday. Instead, Health Care turned in one of the better performances of the day. This combination of above-average relative strength and above average performance on the “bounce” days suggests that Health Care could be the leadership sector of the next bull market. It is too early to say for sure, but it bears watching.


Our relative strength rankings for Style categories are not showing much change, except that everything is weaker across the board. As with sectors, negative momentum in the Style categories is reaching extreme levels that are simply unsustainable. Mega Caps remain on top of the chart while Mid-Cap Growth is still the lowest.


As with Styles, our global relative rankings did not change much in the last five days. Canada lost some ground and China climbed a few notches. Latin America was beaten down so hard that it actually showed improvement this past week and posted the largest percentage gains of the major market segments we follow. Unless entire economies simply disappear from the globe, these scores will have to start improving soon. This kind of accelerating negative momentum is mathematically unsustainable.


The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

“…I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don’t. And I have no idea, really, how this will work out.”

From an interview that appeared in the 10/13/08 edition of Barron’s.

Jeremy Grantham (b 1938)
Board Chairman and Co-Founder of GMO


Introducing Closed-End Funds with: WIW

John Schloegel

Pick of the Week: WIW


After a whiplash week in the stock market, many investors want nothing more than a safe hiding place. Money market funds used to be the preferred place to wait out such storms, but with so many venerable institutions collapsing, it’s hard to have much trust in even the biggest names.

On the other hand, “safety” usually equates to “little or no return” on your capital. This is unacceptable to growth-oriented investors. So what do you do? We may have an answer for you. Imagine safety of principal, decent yield, and a discounted price. Sound like a dream? Read on.

Our investigation brought us to the world of closed-end funds. This column has focused primarily on individual stock and exchange-traded fund (ETF) ideas, but today we will look at closed-end funds. Closed-end funds (CEFs) are similar to ETFs, but there are a fixed number of shares outstanding. This means the market price of a CEF may be higher or lower than the actual net asset value (NAV) of the fund itself. This discrepancy is called a discount or a premium.

You can buy and sell CEFs much like stocks or ETFs, through your discount broker, with a commission on each transaction. There are CEFs for many asset classes, including fixed income (taxable and tax-free), equities (domestic and foreign), and combinations of the two.

CEFs give you an opportunity for excess return if you buy when there is a substantial discount. This happens when a fund’s asset class is out of favor and shareholders just want to sell at any price. In theory, at least, the discount will eventually narrow when the fund’s asset class returns to favor and buyers become willing to pay a premium to own the fund.

Our research turned up a compelling opportunity in Western Asset / Claymore Inflation-Linked Opportunities & Income Fund (WIW). WIW is a government bond CEF that has been in existence since early 2004. It owns mostly Treasury Inflation-Protected Securities (TIPS). It currently pays dividends monthly, typically on the last day of the month, at a rate of 7.55%. As of yesterday’s close, the market price is -13% lower than the actual net asset value of the fund’s holdings combined. That’s called a 13% discount. That is also called an opportunity!
What’s the catch, you might ask? WIW has several risk factors.

1) Credit Quality: 85% of the holdings are AAA rated. Of course, ratings don’t mean a whole lot anymore. But how would you rate a portfolio that contains 85% of TIPS? The remaining components of the portfolio are investment grade corporates, high yield bonds, mortgage-backed securities and less than 2% in emerging market bonds. Over 90% of the portfolio is A rated or better. Perhaps this explains the –13% discount. Let’s assume 1/2 of the bonds rated less than A go bust, then perhaps the upside is “only” 1/2 of the discount.

2) Deflation Risk: These are clearly “Inflation-Protected” bonds, and by definition, TIPS are tied to the Consumer Price Index (CPI). As inflation increases, in theory, CPI should trend up. As inflation decreases, or disinflation if you will, CPI should trend lower. Interest payments on TIPS adjust every six months based on CPI. Therefore, buyers of TIPS get higher interest payments in inflationary times as opposed to straight U.S. Government bonds that pay a set interest rate for the life of the bond, no matter what CPI is doing.

Thanks for the long explanation, but what about deflation? Straight from the TreasuryDirect.gov website:

“At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation.”

Note the key point: AT MATURITY. So, we have a unique fixed income instrument here. You get the higher interest payments if inflation climbs (which is a good bet with Helicopter Ben pumping cash into every bank he can find). However, as leverage unwinds and real estate and stock prices fall, one has to be mindful of the potential for a deflationary crash. Fortunately, the TIPS you get inside of WIW offer protection from deflation, too.

Bottom line: WIW is by no means risk-free and should not be regarded as a cash alternative. But for those who want to stay out of stocks but still have potential for growth and current income, WIW is a great choice.

All the best.


Keep in mind, the Pick of the Week is usually intended for aggressive investors. Don’t risk money you can’t afford to lose. You will need to decide when (and if) it is time to sell.

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