Time to wake up Canadian investors and do some foreign diversification. Shake off the cobwebs of inertia and go shopping for U.S. assets with your much enhanced purchasing power! 

But the $64,000 question is (in U.S. dollars, of course): which U.S. assets to buy? 

Stocks are a bit scary at the moment because they have run up so far so fast. Halloween might be more trick than treat this year murmur the goblins — one being Gluskin Sheff strategist David Rosenberg. He has the DNA of a bear but we still might want to take note of his point that stocks typically haven’t gone up by this much until the second or third year of the business upturn.  

Still, there may be some pockets of undervaluation in the U.S. stock market. It might take awhile, but I can see the SPDR S&P Homebuilders ETF (XHB) being much higher. The U.S. housing market was ground zero and still looks like it. There remains a big wall of worry to scale and a lot more recovering to do.

U.S. stocks in health care, technology, consumer products and other areas underrepresented on the Toronto Stock Exchange, can add diversification to a portfolio of Canadian stocks. A recent John Heinzl article mentioned some picks in this regard. We could add some ETFs such as the PowerShares Dynamic Pharmaceuticals (PJP) and iShares Dow Jones U.S. Healthcare Providers (IHF) funds. They are in health sectors that should emerge as winners once the overhaul of the U.S. healthcare system is complete, according to Reuters.

Bonds might not be such a steal anymore either but with stocks having run up so much and now likely exceeding chosen allocations in portfolios everywhere, it might be more prudent to go with bonds at this stage. Indeed, the year-end rebalancing is coming up for many investors and allocating toward bonds will be the path they have to go if they are to stay disciplined. And, of course, if you are near retirement or have trips/sojourns planned in the U.S., fixed-interest investments are the way to go.

High-yield bond ETFs are still offering yields in the vicinity of 10%. Examples are SPDR Barclays Capital High Yield Bond (JNK) and iBoxx $ High Yield Corporate Bond Fund (HYG). High-yield bond ETFs are not available in Canada, so they would be a welcome addition for investors reaching for more yield in their fixed-income allocations.

Many other, more conservative, bond ETFs are available. The ones tracking short-term bonds, such as the Vanguard Short-Term Bond ETF (BVS), are less exposed to capital loss and their interest rates will move up more quickly if market rates rise. A U.S.-dollar savings account has no price fluctuations to worry about; rates are low (ING Direct pays 0.75%) but should move up as the economy recovers.

Some other ideas for buying U.S. assets that I have posted on before: 

- Probably the cheapest of U.S. assets to buy right now is real property — unlike other assets, prices still haven’t gone up much (although the work involved in carrying out a transaction is onerous) 

- Another idea is to buy Canadian assets in line to benefit from the soaring loonie, such as shares in Canada’s largest travel-tour operator, Transat A.T. The high loonie means it’s more affordable for Canadians to visit and/or stay in the U.S., which plays to Transat core business of arranging foreign travel and accommodations.

A final note: the loonie could even go past the peak of $1.10 (U.S.) attained in 2007, say some forecasters. Spacing of asset purchases over time would average out the timing risk.

Bonds are currently bought and sold over-the-counter (OTC), mainly through the desks of the six big banks. No explicit commissions are charged; they are embedded in the bid-ask spreads. But those implicit commissions are not always easy to assess – which presents opportunities for gouging.

A central exchange, as exists for stocks, may be better. The bid-ask spreads will be clearly visible; investors will know what it exactly costs to buy and sell bonds.

Moreover, it’s possible the rather large bid-ask spreads that presently exist may come down through greater awareness and competition from other providers. Greater transparency may also invite greater participation, and, in turn, generate the kind of liquidity that can help reduce the spreads, says FAIR.

Falkenblog had a post making this argument with more than the usual gusto. Main points:

Arithmetic vs. geometric averages: when an index goes from 100 to 200 and back again, the average annual return on an arithmetic basis is 25% (200/2 + 50/2 = 125). The geometric average, which shows 0% change, would seem to be more relevant to the long-term investor.

Survivorship bias: the U.S. had the best stock market in the 20th century –it’s not a good benchmark for what to expect going forward on average.

After-tax returns: taxes applicable to the equity premium reduce the margin (even in RRSPs since they just defer taxes).

Market timing: dollar-weighted returns, reflecting high inflows at peaks and outflows at troughs, are lower than time-weighted returns.

Transactions costs: “commissions were about 60 cents/share until the 1975 deregulation and are currently about 2 cents a share (about 0.1%) on average. Plus, mutual funds often had 8.5% fees. …. the bid-ask spread will cost you about 0.25% on average….”

Add up all these factors, and the equity premium shrinks to zero or worse for the average investor, says Falkenblog.

Food for thought, as they say. Personally, one issue I am wrestling with is: even if the equity premium does exist, how can it be expected to persist? To rephrase, how can one reconcile a positive equity premium with the efficient market theorem.

The latter says a systemic opportunity to profit doesn’t persist in the stock market because market participants capture such profit opportunities by biding stock prices up or down until the anomaly is eliminated. Yet, the equity premium says there is a systematic opportunity to profit in stocks by buying and holding over the long run.

Ten or fifteen years ago, there weren’t many books or studies alerting investors to the premium, so not many were responding to it. But now everyone knows about it, so we might expect many investors to have incorporated it into their strategies (or be in the process of doing so). Just look, for example, at how much pension funds and other institutional investors have shifted out of bonds toward equities over the past 10 to 15 years.

The end result may be that stock prices have been bid up relative to long-term fundamentals such that the equity premium will turn out to be close to zero or negative (at least more so for investors who buy during the mature  bullish phases).

Getting back to the low “would be consistent with over $5.0 trillion of debt elimination,” says Rosenberg. This is too much for even the U.S. government to absorb, he declares: “A goodly chunk of this excess debt — bringing credit into realignment with the permanently new and lower level of household net worth — is going to have to be paid down (or defaulted on).” Hence, Rosenberg’s bullish stance on government bonds and bearish stance on stocks.

No doubt some of the debt will be extinguished, as it should be. But there is also a denominator in the debt-to-asset ratio. It can move up and take the ratio lower too. Indeed, the previous declines and cyclical lows in the series may mostly reflect, it seems to me, periods of asset inflation brought on by Fed monetary expansion. Something similar could happen again this time around.

Just as I’m not sold on the view we are heading for a raging inflation problem, neither am I personally sold on the debt-deflation thesis. Never underestimate the power of policymakers to pull rabbits out of the air or do whatever it takes to save the system. The bears are right about the system being in need of a great purge but the government is the “house” in this great casino.

Pro:

1. Oil is rising because investors see a recovery.

2. Government bond yields in the U.S. are rising because people are moving money out of the bond to riskier assets to take advantage of said recovery.

Con:

1. Oil is rising not because times are good but because the U.S. dollar is falling and investors are looking for real, hard assets as a place to hedge that rise.

2. Bond yields are rising because bond buyers are worried about the future ability of the U.S. government to deal with rising government deficits.

What’s the correct interpretation? I’m going to go with Con on this one. Check out the U.S. dollar. It lost more than six percent of its value in May, the biggest monthly fall since 1985, while gold just hit $980 last week, a three-month high. That is, the price of other “worry” assets suggests oil and bond yields are moving for all the wrong reasons. If these were positive developments you’d think gold would be falling. It’s not.

The liabilities piling up on the U.S. government—stimulus spending, retiring boomers—are mounting and bond buyers are demanding a higher yield to hold government debt. The Wall Street Journal called this emerging dynamic the return of the bond vigilantes. The U.S. government has made a lot of promises, but whether it will be able to borrow enough money to fulfill all the promises is now being questioned a little more by the bond market. This sort of market discipline wasn’t a factor in the lower deficit boom years of the late ’90s. But as the macro situation shifts from the golden age to…whatever comes next…bond buyers are beginning to get a little nervous. Who can blame them? Now that we’re into an era of unsure energy supply, broke retirees and damaged consumer spending, private capital would be remiss not to apply a little vigilantism to its investing.

His February report to unit holders augments some points I was making in my column last week on the U.S. government deficit. Specifically, he warns that the U.S. budget is addressing too many issues at once.

Washington is attempting to deal with “the aftermath of the crisis while at the same time attempting to build a framework for sustainable growth through investments in alternative energy, healthcare and the like.” This will push the U.S. into a deficit-spending cycle “which could backfire badly,” Narayanan says.

At a projected $1.75 trillion, the U.S. deficit for 2009 far exceeds the U.S. domestic savings rate and is larger than the combined surplus savings of the rest of the world. Along with previous requirements for bond issuance, the U.S. is expected to float well over $2 trillion in Treasury securities in 2009.

“If the world balks at purchasing the huge quantity of Treasuries issued, we could have a bond market crisis with U.S. yields spiking dramatically. If the Federal Reserve were to step in to monetize the debt by printing U.S. dollars, it would be a Zimbabwe-style response to the problem and could trigger a currency-market crisis,” adds Narayanan.

To minimize this risk, U.S. politicians should get agreement from rest of the world on how to finance the huge expenditures that are planned. But such support does not seem likely. Indeed, both Europeans and the Chinese are sounding rather unforgiving in their pronouncements on the situation in the U.S.

“Such dissent does not bode well for financial stability going forward,” concludes Narayanan. “We are very likely setting the stage for a significant bond market crisis this year.”

This reminds me of the time I was following the macroeconomic commentary of a bank economist during the 1990s. As the economy recovered from the recession earlier in the decade, he kept warning about inflation reappearing. His warnings went on for a couple years – yet inflation remained well behaved. Then came news his reports were no longer available. He had been let go by the bank.

I wonder if the inflationists this time around will similarly discover that their fears were misplaced. In March, the U.S. consumer price index (CPI) fell 0.4% year-over-year, the first decline in half a century. The core CPI was up 1.8% — mostly due to an increase in cigarette prices.

But what really makes one question the inflationary thesis is the amount of slack in the economy. As the Financial Times of London reports, the Congressional Budget Office calculates the “output gap” will be 7% in 2009 and 2010. They don’t expect it to be closed before 2015. Prices don’t normally start going up until the “output gap” is a lot smaller.

Many people, including several well-known investors, have been calling for a bursting of the bubble in U.S. government bonds. I have been looking at going short with the ProShares Ultra-Short 7-10 Year Treasury (PST) or ProShares Ultra-Short 20+ year Treasury (TBT) exchange-traded funds. However, until there is a resurgence of inflationary pressures, the decline could be less dramatic that what might initially be expected.

I hadn’t quite finished deploying my cash balances when he began singing happy days are here again, taking the indexes up 20% in two weeks. He’s snatching away all my buying opportunities. Give that guy a Qualude, already.

Being constitutionally averse to buying while buying panics are in full flight, I am left asking: what, then, can one buy right now? Are there any asset groups with the prospect of good returns  — that haven’t had a sharp run-up and become overbought?

There may actually be one: inverse bonds funds – specifically those tracking government bonds such as the ProShares Ultra-Short 7-10 Year Treasury exchange traded fund.

The prices of inverse government-bond funds should be climbing too because of the inflation expectations unleashed by the Federal Reserve’s unprecedented creation of new money. Then there is the oversupply arising from massive fiscal deficits caused by more than a trillion dollars of government spending on bailouts, fiscal stimulus, and so forth.

But the rally has been delayed by the Federal Reserve announcing plans to buy several hundred billion dollars of long-term U.S. government bonds. In fact, they were set back sharply by the announcement. This was what I was waiting for and now that it’s out in the open, it’s time to look seriously at taking action.

At some point, the Fed will have to stop buying the bonds and their prices – now artificially held near their historic highs – should trend back down to more natural levels. The tsunami of new money should eventually goose the economy. Indeed, it may be like the stuck door that springs open suddenly after much hard pushing. A side-effect will be higher inflationary pressures and expectations. So, the Fed will in time lay off buying government bonds.

Another reason for do-it-yourself investing. And a second reason. And a third.

 A clear winner in the RRSP vs. TFSA debate.

Shopping for corporate bonds like going into a candy store.

More love for bonds.

Special report on self-directed investing.

Eliot Spitzer’s thoughts on salary caps for CEOs

Unfortunately, during the bull market that ran to early 2008, many people thought they were diversified if they spread their 70% to 90% equity allocation by geography, industry, and market cap. So now diversification is taking a bit of an unwarranted rap on the knuckles.

Activa also has a calculator showing the impact of diversification over bear/bull cycles in the stock market since 1968. For the most recent cycle, from September, 2000 to May, 2008, Activa’s diversified portfolio finished 53% higher, while the all-stock portfolio finished 48% higher. The all-stock portfolio may have raced ahead during the bullish phase but wasn’t able to compensate for the huge losses incurred during the bearish phase.

However, during the previous six bear/bull market cycles back to 1969, the all-stock portfolio ended up higher in four of them. So, being diversified doesn’t always win. Whether you go with a stock-intensive or diversified portfolio would seem to be more a matter for risk preference. And of course time period is important too: it is generally believed stock-intensive portfolios would be suitable for young persons saving for retirement. Endnote: Activa’s calculator used total return U.S. indexes (and 10-year government bonds).

This is a breakthrough in making ETFs more convenient. Until now, index mutual funds were the only way for index investors to reinvest dividends without charge. Now they can DRiP with Claymore ETFs, which have much lower annual expense ratios.

Claymore will also be offering commission-free, dollar-cost averaging through its Pre-Authorized Cash Contribution Plan (PACC Plan), as well as commission-free, systematic withdrawals through its Systematic Withdrawal Plan (SWP). Those features will be quite convenient too.

Yet, the federal government has taken on spending commitments that entail gargantuan budget deficits for some time and a tsunami in bond issuance. Current spending commitments include trillions of dollars for existing commitments such as Social Security, Medicare, etc. and the Iraq war — as well as trillions more for bailing out the financial system, propping up ailing industrial sectors, and massive fiscal stimulus package promised by the Obama administration.

At the same time, the Federal Reserve is creating credit at rates never seen before. As Northern Trust economist Paul Kasriel noted, the year-over-year increase (to November of 2008) in bank reserves is about ten times the previous high, which occurred in 1934. Deflationary forces are ascendant right now but one wonders for how much longer given the massive stimulus unleashed.

Shorting government bonds would thus appear to be a no brainer as risk appetite responds to signs of an upturn in economic growth and inflation worries arise anew. But what might not be so obvious is the timing of the trade.

Lags in the impact of stimulus measures could mean deflationary news will linger for awhile yet. More importantly, the Federal Reserve has stated it is committed to buying Treasuries to keep interest rates low until the crisis and economy stabilizes. China too will likely be a buyer of U.S. Treasuries as part of its strategy of suppressing the yuan to enhance the competitiveness of its exports.

So watching from the sidelines may be the strategy for now. Ways to short the bond bubble include going long on the ProShares Ultra-Short 20+ Treasury and ProShares Ultra-Short 7-10 Year Treasury Fund ETFs (but understand the constant leverage trap first) and short selling the iShares Lehman 20+ Year Treasure Bond ETF

Market Decline to Dec. 31

China – 65.8%
India – 52.1%
Hong Kong – 48.3%
France – 42.7%
Japan – 42.1%
Brazil – 40.3%
Germany – 40.4%
Nasdaq – 40.5%
S&P 500 – 38.5%
Toronto – 35.0%
Dow Jones – 33.8%
UK – 31.3%
Mexico – 21.6%

More generally, as Bernstein believes, it may be better to estimate expected returns for stocks according to the dividend discount model rather than extrapolate them from the past. After all, one of the cardinal rules of finance is that the value of an asset lies in its stream of discounted income. Specifically, investors are advised to use the Gordon model whereby:

Market Return = Dividend Yield + Dividend Growth

Taking the market’s historical annual average dividend yield of 4.5% and historical average dividend growth rate of 5%, one gets a total annual return close to 9% for the long run. But if dividends at a particular point in time yield 1.5%, the expected long-run return will be 6% (assuming 5% growth rate in dividends). A lower weight for equities may then be justified.

With dividend yields in North America presently averaging close to 3%, now would seem to be a better time to have increased exposure to equities. The settings for the Lazy Portfolios may now be more appropriate. Dividend yields in Europe are above 4.5%, suggesting it might be better to tilt more toward foreign markets where yields are so high. Caveats would be i) currency risk and ii) assumed dividend growth rates (which may turn out to be different than 5% per year). Also, other factors, such as small caps and undervalued stocks, have in the past been worth emphasizing.

Drilling down on asset allocations, we see they all had high exposures for stocks. The designers, as has been popular this decade, appear to have been influenced by the empirical studies showing stocks historically have averaged about 9% annually over the long run, better than bonds (5%) and cash (3%).

However, during the recent bull market, dividend yields got down to the 1.5% to 2% range. That was not a good omen because about half of the long-run return on stocks derives from dividend yields of 4.5% earned during the historical periods.

Lazy Portfolios constructed during the bull market were thus destined to earn about 6% annually on their stock exposure (ceteris paribus). The recent crash digs a deep hole for them but the impact may be just to lower long-run equity returns by a third or so (assuming dividends hold up reasonably well during the recession).

In retrospect, by taking valuation levels into account, the boom-era Lazy Portfolios may have captured a better risk-reward ratio by allocating less to stocks and more to investment-grade bonds.

Sensitivity to market valuations is what William Bernstein urged in Chapter Two of The Four Pillars of Investing when he recommended the dividend discount model (DDM) as an alternative to extrapolating expected returns from the past (more on this in next post). Another approach, which also takes valuations into account, adjusts allocations to stocks according to departures from their historical average return (see the One-Minute Portfolio).

i) predetermined shift into bonds according to calendar dates, as done by lifecycle mutual funds
ii) a dynamic shift into bonds that takes into account bear/bull phases in the stock market
iii) constant all-stock portfolio
iv) constant balanced portfolio (60% stocks, 30% bonds, 10% treasury bills)

The authors found that the dynamic strategy provided more wealth than the predetermined strategy in most cases, and more than the all-stock strategy in a “significant number” of cases. The balanced strategy provided the least wealth.

Buffett wrote a New York Times article explaining his reasons for buying stocks. It has his usual clearheaded explanation for why now is a good time to buy stocks. Everyone is fearful so it’s time to be greedy. But there wasn’t any explanation why he was ignoring a basic precept of financial planning.

Is he buying out of force of habit? Markets are down, so he buys stocks just like he always has for half a century? Could it be the emperor doesn’t have any clothes on?

More likely there are some caveats to the conventional approach to portfolio management over the lifecycle. Maybe an all-stock portfolio is OK for a 78 year old when they have a modest lifestyle and a nest egg large enough to live for decades off dividends and draw downs of principal regardless of market conditions? Or maybe his personal estate is to be passed on to his beneficiaries with the stipulation that it be disbursed in stages over the long run?

Note: Apologies to commentors whose comments to a previous version of this post were inadvertently lost. You are wlecome to resubmit them.

Meanwhile, as the Financial Times of London reports, jewelry demand, comprising about 70% of gold end use, is tumbling. High prices and slowing economies are causing jewelry buyers to cut back. Also, scrap supplies are surging in response to higher prices.

Gold bugs anticipate galloping inflation from monetarization of the government’s debt load, which is to be substantially increased by the requirement to rescue the financial sector. Admittedly, it’s possible the Fed may resort to the printing press but the forces of de-leveraging are way out front now, spreading ever stronger deflationary impulses. Expansion in the money supply won’t accelerate inflation when the economy is moving away from full employment.

Gold bugs anticipate a tumble in the U.S. dollar. Yet, government borrowing is destined to escalate because, as mentioned, of the imperative to rescue the financial sector; the higher borrowing in turn creates upward pressures on interest rates and, in turn, draws capital into the U.S. Besides, other currencies are not looking all that attractive either as the world economy sinks further into recession.

It could be a warning not to expect a sustained rally in stocks if and when policymakers stabilize the financial crisis. There may be no need to rush back into equities, just yet.

The silver lining might be that a weaker world economy could considerably reduce the odds of the tumble in the U.S. dollar, upward spike in interest rates, and/or galloping inflation that many fear will be the consequence of the U.S. government taking on an estimated $1 trillion (U.S.) in debt to rescue the U.S. financial sector.

As the Chinese economy ratchets down, the authorities will likely want to keep the yuan from rising even more so than before — so they should remain willing buyers of U.S. dollars and treasuries. They won’t want to flee U.S. assets when it will cause the U.S. dollar to fall against the yuan and undermine their export-led, industrial development strategy. A preliminary signal of their willingness to continue supporting the U.S. dollar was the recent decision to cut interest rates.

Commodity-based economies like Canada and Australia will see weakness in their currencies against the U.S. dollar as the commodity boom fades further. And Europe’s regional differences are likely to be exacerbated, raising political conflicts that could undermine the euro – on top of the region’s more restrictive monetary policy that seems destined to produce a greater and/or longer lasting economic slump in the region.

And don’t forget, the U.S. dollar’s status is not just about economics. For many countries, political considerations are paramount. Countries like Japan, South Korea, Taiwan and Saudi Arabia would not want to dump the U.S dollar and assets because of their security relationships with the U.S.

During recessions, lower risk appetite and flight to safety favors government bonds. Although the supply of treasuries will be rising in the U.S., so will portfolio demand – especially considering how underweight many investors are. A Merrill Lynch study noted households currently have less than 0.7% of their financial assets in government bonds, about $1 trillion (U.S.) less than the peak of 4% in 1993. Public pension bond holdings are close to two-decade lows. Bond yields are low right now, even negative after adjusting for inflation, but as the economy winds down, inflation should be subsiding.

Admittedly, the debt obligations arising from the financial crisis — along with ongoing debt requirements for other government programs — are substantial and there should be upward pressures on interest rates. However, like in the 1980s, higher rates should be bullish for the U.S. dollar as foreign capital flows in, attracted by the higher yields. And slack in the U.S. economy may also allow the Federal Reserve to buy some of the debt without inflationary consequences, which offers some assurance the rise in bond rates should not be extensive.

History is an imperfect guide, but when the Resolution Trust Corporation began to buy bad assets during the savings and loan crisis in 1989, U.S. economic growth, house prices and equity markets did not bottom out for another 12 to 18 months. The dollar, however, traded sideways during the period