Indeed, the whole world is skittish about Europe; there are no easy answers. Investors seem to be exiting all assets save for U.S. Treasuries and Germany sovereign debt. Both are at record low yields with 10-year Treasuries dropping to 1.43% and German bunds to 1.18%. Even gold has failed to hold up, down for the year following a 6% drop in May.
The outlook isn’t good; in the near term what’s to change the skepticism about the southern European countries’ debt? With the “fire” out of control, investors fear a domino effect; if one country falls or is ejected from the Euro zone then suspicion grows about the next country, producing a run on that country’s debt and economy. That run becomes self-fulfilling, and the contagion spreads. Will it affect our shores? If uncontrolled, why wouldn’t it?
Some Silver Linings
However, there are some salutary effects from the present state of affairs. Gas prices are falling, down 10% nationally since March; given the oil price’s 17% decline in May to an eight-month low, prices at the pump should continue to fall. This is like a tax cut for consumers and should spur spending and the economy.
The U.S. dollar’s value has risen significantly, up 10% in the last year versus a basket of other currencies, reducing our import costs and making American financial markets more desirable. Inflation risks are reduced; commodity prices have fallen 22% in the last 12 months, further helping consumers.
While uncertainty looms over the fate of the Bush tax cuts, scheduled to expire at the end of this year, a weak economy and increased acceptance of anti-austerity arguments would increase the likelihood of shelving the tax increases. This would further boost consumer spending.
Finally, mortgage rates continue to fall, indeed to the lowest levels since long-dated mortgages started post-World War II, boosting housing affordability. That’s a big positive for real estate markets and the economy.
Will We See the Political Will?
The good news about the problem is that it can be solved by political action. The problem isn’t a natural disaster or immutable force, like an uncontrolled plague, asteroid from outer space, or nuclear meltdown. All the debts are denominated in paper euros.
With the appropriate political will, debts can be guaranteed, depositors and creditors paid off. At this point no one wants to do that, because things aren’t that bad. But, if things worsen, well, politicians and regulators’ jobs will be on the line.
So, how to play it? If you’re long term oriented, you use this as a buying opportunity. Low prices spell opportunity today just as they did after past frightening periods, like October 1987, 9/11, March 2003 (the onset of the Iraq war), and March 2009, amid discussion of nationalizing our banks.
What if this time is different? That’s the case for diversification, holding lots of fixed income, to hedge on that. But, due to the risk long term of inflation and higher interest rates, you don’t want to overdo that allocation. Remember, with interest rates so low the price for using fixed income as “insurance” on the equity portion of your portfolio has never been higher.
To be short-term oriented is quite risky. For every stock being sold today, someone else is buying it. So, the short-term outlook is never clear. Too much certainty gave rise to the speculative bets that caused MF Global’s downfall and JPMorgan’s losses.
Ideally, you’d move to the sidelines near term and move back in “when the present uncertainties clear up.” Unfortunately, the odds of anyone doing that on a sustained, repeatable basis are low. Hedge fund guru John Paulson, who made a bundle shorting just before the sub-prime crisis, has recently given much of it back by making wrong-headed bets on banks and gold. So, was he lucky or smart during the sub-prime crisis?
Energy Stocks Look Cheap
Crude oil prices have slid by nearly a fifth in the last six weeks amid concerns over recessionary conditions in Europe, slowing growth in China, and a rising U.S. dollar. But, if the situation worsens, expect monetary authorities to launch new forms of monetary accommodation, under such names as advanced TWIST or QE3 on these shores, or Long-Term Refinancing Operations 3 on the other side of the pond. Commodities, especially oil, are especially sensitive to any effort by policymakers to reflate the economy.
While you could buy crude oil futures, we like interests in energy businesses. Consider that the market value of energy companies relative to the overall market is at a five-year low, just 10.5%, but is responsible for 20% of all companies’ profits. So, the sector looks undervalued.
But, which name stands out? The gold standard is Exxon (XOM), the largest energy player in the world. It boasts very low debt and diversified operations, ranging from upstream exploration to downstream refining and marketing. With its global operations, the impact of a hostile political environment in any one region is reduced.
Exxon seems attractively priced here; the current quote of just $78 is nearly 12% less than it was as recently as January. The stock has rewarded investors handsomely over the last 10 years, returning nearly 9% annually, almost 5% more per year than the overall market. While you wait for the European travails to abate, enjoy the near 3% yield, nearly 2.5 times more than the 10-year Treasury and nearly 1% more than the average stock.
Exxon’s dividend has historically protected you from inflation; it’s grown 4.3% annually over the last five years. Finally, Exxon has returned $130 billion to shareholders via stock buybacks during the same period.
An energy stock like Exxon should serve well a conservative investor wishing to hedge the risk of inflation on a fixed income portfolio.
Given some recent signs that the worst may be behind domestic residential real estate, it may be time to take another look at banks and related financial stocks. After all, write downs on non-performing mortgages that were at the heart of the 2008 financial crisis. Continued family formation, a dearth of new construction, and record low mortgage rates have slowed the rate of home price descent and even helped boost them in some areas.
Meanwhile, such blue chips as Citigroup (C) and AIG (AIG) are trading at just half of tangible book value – the theoretical proceeds should they be liquidated. Goldman (GS) is 25% of its tangible book value.
Special mention should also be made of JPMorgan (JPM). This preeminent banking concern came out of the financial crisis with high praise for its leadership and risk management prowess. More recently it confessed to a $2 billion trading loss, causing many to lose confidence. Yet, since the beginning of May the stock has lost over $50 billion in market cap, suggesting the sell-off was a gross overreaction. Here, too, enjoy an above-average dividend of 3.8% while you wait for the dust to settle.
We know that European stocks have been pounded. For example, for the 12 months ending May 31, the Fidelity European Capital Appreciation Fund (FECAX) has lost over 23%. Some European companies undoubtedly will not survive but others will.
The trick is to look through the rubble for the sure survivors, the best long-term franchises. The legendary Warren Buffett did just that in late February, investing in eight European companies. His rationale was simple: “These companies will do fine regardless of what happens in Europe… And in the end, those eight companies I bought are going to be there 5, 10, 20, 50 years from now.”
There has been no public announcement of what those companies are. However, analysts have speculated that they include Swiss consumer products company Nestle (NSGRY). It’s grown by double digits annually for the past decade, and 40% of its franchise is in the fast-growing developing world.
Also speculated as a Buffett Euro buy is French yogurt maker Danone (DANOY). Trading at 15 times next year’s earnings it boasts a near 3% dividend. While based in Europe, it, too, offers global exposure.
David G. Dietze, JD, CFA, CFP™ is the founder, president and chief investment strategist of
Point View Wealth Management Inc., Summit, N.J.
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