A spending trap to lure investors
Low interest rates encourage the public to borrow and spend, says this U.S. advisory, but investors should be managing risk, not adding to it.
Spend, spend, spend.
This is the route to recovery, as far as the powers-that-be are concerned.
But it’s also the road to ruin if individual investors aren’t careful, says one U.S. commentator.
“The Federal Reserve and the government want you to spend, borrow and take risk. They hope to motivate you with low interest rates and enough liquidity to stabilize the economy. Are you going to fall into this trap?
“The ride from here won’t be as smooth as the markets seem to think. We’re in for a bumpy stretch, and I want you to be prepared.”
That’s the warning sent out this month to readers of Bob Carlson’s Retirement Watch. This advisory is invariably cautious when it comes to assessing the economy and the markets.
We’ll take a look at several of Mr. Carlson’s recommendations, which indicate where conservative investors might find security.
Then we’ll see why he believes the spectre of risk should be uppermost in every investor’s mind in the months ahead.
No longer bargains
Many of the investments in Mr. Carlson’s portfolio will not translate into Canadian portfolios since they are American funds of various kinds. But the nature of those investments is revealing.
For over a year, this editor has held a fund devoted to treasury inflation protected securities (TIPS). A Canadian equivalent would be real return bonds.
When he purchased this fund in late 2008, TIPS were selling at deep discounts due to the deflation scare. They were priced to indicate 0 per cent inflation for 10 years.
Subsequently, the fund brought “strong, steady gains” as fear of inflation grew along with the Federal Reserve’s actions to stimulate growth. They are now priced to forecast 2 per cent inflation over 10 years.
Then the fund began to slip, partly in response to the financial flap ignited by the debt crisis at Dubai World. Yields from TIPS fell off.
“TIPS no longer are the bargains of a year ago,” reports Mr. Carlson. It is time to sell and move on to higher-yielding opportunities.
Time to add utility stocks
Mr. Carlson also likes a closed-end fund that is 94 per cent invested in mortgages and mortgage securities bought at good discounts. Even if defaults are high, it is expected to earn double-digit returns over time as the economy recovers and refinancing picks up.
The fund is run by a manager this editor respects and it needn’t sell assets to meet redemptions since it trades on the exchange. For the record, it is TCW Strategic Income (NYSE-TSI) and it trades at $4.34.
He also thinks it is time to add utility stocks. Here, too, he avoids individual stocks and turns to a closed-end fund that is traded on the exchange. This fund is 75 per cent invested in stocks, with the rest in bonds and preferred shares.
It is Cohen & Steers Select Utilities (NYSE-UTF) and it is trading at $15.93. These two recently purchased funds make up 35 per cent of Mr. Carlson’s Balanced Portfolio, giving us some idea as to where the conservative American investor might be turning these days.
No growth in jobs
The rough ride is not over, Mr. Carlson insists. The economy stopped sliding because government spending and debt replaced household spending and debt.
But the level of government spending cannot be sustained. How will markets react when it cools down?
What’s more, while economic indicators may be positive, growth is not impressive. Employment is around the 2000 level — in short, there has been no real growth in jobs for 10 years.
Consumer confidence is low and that will not promote the spending needed to stimulate the economy. Growth is stabilizing rather than accelerating, which means we could easily face another downturn, says this editor.
And yet stocks and other risky investments have been rising. There are four reasons for this, says Mr. Carlson — and none of them are sound.
Don’t want to miss the boat
The first reason for the market’s movement is simply the low level of interest rates. Short-term rates near zero force investors to take more risk for good returns. “Keeping rates low is one way the Fed is trying to induce you to take more risk,” says Mr. Carlson.
Second, investors are expecting a sharp recovery. Analysts keep repeating the chant that steep downturns are always followed by sharp recoveries. But this is not a normal cycle, the editor insists. The credit crisis has had a deep and corrosive effect.
The third reason is the misuse of resources. When the Fed injected liquidity into the system by buying mortgages and treasury bonds in the market. This money was supposed to increase lending. Instead, it has been channeled into stocks, commodities and other investments.
Lastly, there is motivating force of momentum. As prices rise, more investors buy into the stock market. They assume the future will be just like the recent past and don’t want to miss the boat, says Mr. Carlson. This is how assets become overvalued.
“The stock market momentum can continue into early 2010 before investors rethink what they are paying for stocks.”
The basic problem has not been solved. Private credit has not recovered. There is low demand for loans from households and businesses. The government is spending, but its citizens are not.
“We are waiting for signs the private level of activity will increase as government stimulus is withdrawn,” concludes Mr. Carlson.
Until those signs appear, there’s a spending trap waiting to swallow up unsuspecting investors.
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