Review & Outlook

Our take on the investing, financial, & economic themes of the day

First Quarter

12 April, 2010 by Mark O'Brien in Quarterly Letters

At about this time last year we urged clients to avert their eyes from gyrating stock prices and focus instead on their portfolio’s cash flow (dollars and cents paid out as stock dividends, bond interest and money market interest). The latter were a sea of tranquility compared to stock prices. While stocks were falling about 40% from October 08 to March 09, portfolio cash flow barely budged. To be sure, a few high profile companies cut their dividends (GE cut its dividend 67%, its first cut since 1938), but the vast majority of stocks did not. And of course bond and money market interest continued uninterrupted. This re-focus from price change to cash flow was good advice, if I do say so myself, and it may even have contributed enough peace of mind to keep more than one client in stocks long enough to participate in the remarkable rebound we have been enjoying. As I write, the Dow pushes 11,000, up from 6,500 last March.

Should one continue to avert his eyes from changing stock prices, even though now they are rising, and stay focused on the portfolio cash flow? It might be a good idea. Cash flow of 3 or 4% may not sound like much, but given the climate, it’s not bad. And it is getting better.

Assuming one has a well-balanced and diversified portfolio of stocks and bonds (and our portfolios do), one is nearly certain of receiving more interest and dividends today than one received last year. And next year is likely to be even better. Why? Corporations are sitting on more cash than ever before. These cash-rich corporations have only so many things they can do with the money: they can buy other companies, they can invest in more plant and equipment, they can pay down debt, and they can increase dividends. To date it looks like corporations are taking the last course, they are increasing dividends. Already in 2010, 70 companies in the S&P 500 have increased their dividends, and only two have decreased them. Analysts expect the rate of dividend increases to accelerate in the balance of the year.

Bond yields are on the march too. At the beginning of 2009 a new issue 10-year Treasury note paid about 2%; today a new issue 10- year Treasury note pays twice that. The last component of portfolio cash flow, money market funds, remains shamefully low, the distortion of misguided central bank policy, in our opinion. But, on the brighter side, money market rates are so low (presently in the range of 0.1%) that they cannot go lower. They can only go up, as surely they will in the face of what appears to be a slowly recovering economy. In sum, then, portfolio cash flow – – what my kids used to call “cash money” – – is heading higher in at least the next year. I would call it a near-certainty that your portfolio a year from today will pay you more cash than it pays today.

Against this near-certainty is a variety of highly unstable situations, any one of which could blow up and send stock prices sharply lower. Let me cite a few. The European Union (EU) appears poised to unravel. The history of federations, especially ones with a weak central authority like that in the EU, is not encouraging. But quite apart from the sad history of federations, Greece, Italy, Spain, Portugal, and Ireland have run out of money, and rich EU members Germany and France are not in a position or of a frame of mind to give them more. Thus we expect a lot more bad news from Europe. To date the troubles in the EU have made the USA look like a safe haven, and this has strengthened the dollar and helped our economy. But longer term, a weaker trading partner never helps an economy.

Closer to home is the commercial real estate sector, where big trouble brews. About $3.4 trillion in commercial real estate loans are coming due in the next several years. Insofar as prices in the sector are down as much as 40% since 2007, the value of many of these loans exceeds the value of the underlying property. Will owners just mail in the keys to the banks and insurance companies that loaned them the money? Commercial banks hold roughly 45% of the debt, the preponderance of which is concentrated among small to midsize banks. Is the federal government going to bail them out too?

Residential real estate still has its own problems. To support it last year the Federal Reserve (Fed) bought $1.4 trillion in residential mortgages. I use the word “bought” loosely, since the Fed printed the money. But what is the Fed going to do with all the mortgages? I could go on about excessive levels of state and local debt, but will conclude with a few worries about the unprecedented peacetime expansion of the national debt. Having put all this money out, how is the government going to get it back, without pitching the nation into inflation or recession? Washington policy-makers say they know how, but we see little reason to believe them. In the last year or so the burden of debt has shifted from the private sector to the public sector. We do not see that this reduces the risk of accident to the system.

So where does this leave us? In the business of managing money, one is often managing oneself as much as one is managing assets. We have found that a good way to keep one’s mind when others are losing theirs is to focus on maintaining constant cash flows, and let prices, in the fullness of time, take care of themselves. To do otherwise, that is, to follow each and every turn in stock prices, can lead to ill-timed bearishness in bad markets, as occurred in the first quarter 2009 when people sold at precisely the wrong time, or ill-timed bullishness, as occurred in the late 1990s when people bought at precisely the wrong time.


Mark O’Brien