It was a stormy week in the market.  The correction I’ve long anticipated, and the biggest one week loss since March 2003, materialized but the sky didn’t fall. The chart below puts the week in perspective.

12 month                                19.5%              15.5%              24.7%

Year-to-Date                             6.4%                2.9%                6.1%

Feb. – Mar. correction               -5.6%              -5.6%               -6.9%

From 2007 high                        -5.3%              -6.1%               -5.8%

Last week                                 -4.2%              -4.9%               -4.7%

 

Any investor should be happy with the twelve month returns of the major indices. If we assume the market was undervalued in 2006 and reached fair value at the beginning of 2007, the year-to-date returns on the Dow and the NASDAQ are respectable. Corporate earnings are expected to grow by approximately 5% in 2007 (see Earnings Matter), so the Dow’s and the NASDAQ’s appreciation is marching in step. The S&P is lagging due to its exposure to homebuilders and financial intuitions. (Those of you who own sector funds, note the risk.)

 

Last week’s correction came about because of widening credit spreads and illiquidity in certain parts of the debt market. The Chrysler LBO debt couldn’t be sold, so the banks were forced to hold it, and securitizations, an offshoot of the subprime mortgage problem, were effected. 

 

Significantly, the market’s psychology shifted. All the issues leading up to the correction have been known for months but the market chose to look at the glass as half full (see The Glass is Half Full and Half Empty) until last week.  Strong Q2 GDP growth of 3.4% and low inflation numbers were ignored. So was the strong 6.4% growth in exports - which shows the competitiveness of US companies and the positive impact of a weak dollar. The market took a bearish position, focusing on the residential housing market – weak new home sales and a rising inventory of existing homes on the market – and consumer spending increasing by just 1.3%.

 

Risk abound. There could be a full-blown credit meltdown. (See The Perfect Storm.) The construction industry accounts for 1 out of 10 jobs. Further weakness in the residential market could lead to more layoffs.   The price of oil could hit a record high this week, leading to further weakness in consumer spending. A declining residential market and increasing oil prices could bring on a recession.

 

I don’t think so. At least not right now.   The circuit breakers worked well last week. Treasury rates fell as investors sought safety. The world is awash in dollars which it has to recycle through the US at some point and the global economy is strong, witness the aforementioned overseas sales growth by US companies. (Many of the largest US companies generate 50% or more of their sales overseas, which is one of the reasons why Big Cap stock funds have performed well).  As a last resort, the Fed could step in and cut rates just as it did during the last credit crisis (Russia and Long Term Capital Management), ten years ago.

 

What do I expect for the upcoming week? A violate market which works its way lower. You’ll note form the chart above that the correction thus far has been less than the Chinese-market induced February – March correction. As painful as they are, the good news about corrections over the past twenty years is that they’ve been swift. The tests will be if the Dow can hold above 13,000 and the S&P above 1,450. These are psychological levels, nothing more, but psychology is a powerful short term driver of the market. I see the markets falling by less than 10% from their high of 2007 (a recessionary market correction would be 20%), so we’re more than halfway through the pain.

 

Whether this is a correction in a bull market or the harbinger of a recession depends upon upcoming economic news. Watch employment data, specifically, new job creation (not unemployment). Job creation is the canary in the coal mine. Negative job creation means a recession is on the way. A second indicator will be a downturn in the commercial real estate market. Either one could turn this correction into a 20% decline. So, ignore the chicken but watch the canary.

Financial leverage is like a land mine. You might be unaware of it until it blows up.   Buying stocks on margin is an obvious form of leverage (the mortgage on your home is another) and all of us understand how risky it is to buy on margin. Simply put, leverage magnifies your gain or loss and, since you’re borrowing money which must be repaid, you can lose more than your entire investment (the investment and the loan amount).   Okay, you say, point made, but I don’t leverage my investments. Are you sure?

 

Did you know that many mutual funds use leverage to enhance their returns?  To illustrate, let’s take a look at two Nuveen municipal bond funds (Nuveen is one of the top municipal bond mutual fund companies): Nuveen Municipal Market Opportunity and Nuveen Municipal Value. Kinda hard to tell how they differ from the names, so let’s look further. Both funds are mostly invested in triple A municipal bonds, the average maturity is approximately 20 yeas for the bonds held in each fund and, for you quants, the duration is 5.5 – 6.0 years. The funds are quite similar. Let’s look at the five year returns (as measured by NAV). Municipal Market returned 6.21% annually; Municipal Value 5.90%. 31 basis points annually for five years is a noticeable difference for municipal bond funds. Why did Municipal Market perform better? There could be a number of reasons but an obvious one is its leverage. 

 

Municipal Market is leveraged 36%. In a period of stable or declining interest rates we’d assume it would outperform Municipal Value, as it did. But, what if interest rates rise? Shouldn’t its leverage reduce its return. And, if you aren’t sure which way interest rates are going, or think they’re going up, you want to avoid funds with leverage.

 

The leverage employed by the Municipal Market fund, and many other funds, is an “auction rate” preferred. Like any preferred stock, the principal does not have to be repaid – that’s good. But the “auction rate” means the dividend rate (think interest) is reset regularly, typically every week or month, depending upon the instrument. If interest rates rise, the cost of the preferred increases. The result of rising interest rates can be a decline in the NAV (due to a decline in price of long term bonds) and an increase in expense (the rising cost of the preferred), which further reduces NAV. A double whammy (not a defined financial term).

 

Leveraged funds aren’t trying to pull anything over on us. They exist because there’s a demand for them. Leveraged funds, like leverage itself, are not inherently good or bad. Leverage increases risk (volatility) and the amount of gain or loss. Whether you should invest in a leveraged fund - whether you should employ leverage and how much -depends upon your risk profile and time horizon.

 

Any fund (municipal bond, corporate bond, Treasury, equity, balanced, international) can have leverage. The key is whether the fund’s covenants allow it. This has to be disclosed in the prospectus. The financial instrument used to create the leverage, i.e., an auction rate preferred, will appear on the balance sheet of the fund. Seek and you shall find. This brings me to my final point.

 

You have to go looking to determine if a mutual fund employs leverage. You can’t tell from the name. Nor can you tell from the typical “snapshot” provided by Morningstar and others. To find out if your mutual fund is leveraged go to the fund’s site and do some research. Nuveen’s website, for example, is easy to use. Find the fund and click on Capital Structure. 

 

Leverage in mutual funds is perhaps the single biggest investment factor overlooked by investors. The reason is that you have to do your homework to learn if a fund uses leverage. So, decide if you want, or don’t want, leverage in your mutual funds, research your funds to see if they are leveraged and make any necessary portfolio adjustments.

The stock market turned down last week, so did the prices of non-investment grade bonds. The “junk” end of the debt market showed falling prices, widening credit spreads and a dramatic decrease in liquidity. (Conditions that often go hand-in-hand, but are troublesome nonetheless.) Subprime mortgage loans are the primary culprit.  The only surprise is how little attention the press is paying to these events.  Sounds like the perfect storm to me. We could be on the cusp of a full blown credit crisis.

 

The stock market did pay attention to earnings, as Caterpillar and Google will attest. Caterpillar’s results are instructive. The preeminent maker of construction equipment in the world reported strong international sales, offset by weak domestic demand. I think you’ll see a slowing U.S. economy and continued strong intentional growth repeated in the earnings of other Big Caps.  Slowing earnings growth will keep the stock market from going higher (see Earnings Matter). Stronger international growth causes me to repeat one of my favorite mantras – diversity your equity portfolio to include international funds (see A Yen to Diversify). 

 

The storm clouds have gathered and the prefect storm is upon us. If you haven’t reviewed the risk level of your portfolio and re-balanced to adjust for the great stock market rally of the past five months, do so quickly. 

Want to structure your mutual fund portfolio to achieve optimal returns for the next twenty years? Read on (or just skip to the last paragraph.).

 

There was a great article in the June CFA Institute publication Expected Rates of Return: Back to the Future by Jim O’Shaughnessy.   Mr. O (I can’t call him Jim because I’ve never met him, although I’d like to.) conducts solid research, writes clearly, and (gasp!) makes recommendations.   This unusual combination of talents first came to my attention when I read What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time.  Although the book discusses stocks, Mr. O’s research and conclusions are applicable to mutual funds.   The article published in by the CFA Institute is a synopsis of his work.

 

Mr. O reminds us that most money mangers lack the discipline to consistently execute strategies. That’s true for us investors - we tend to change our strategies, following the hot idea in the market - as it is for professional money mangers. (Note to self: make sure your fund manger follows their stated investment strategy.) The corollary to disciplined investing is not to expect to outperform the market every quarter. Even Warren Buffett doesn’t. Adhering to these principles alone will make us better investors. Chasing quarterly results and/or changing investment strategies only guarantees one result – bad performance.

 

Mr. O uses rolling 20 year periods (i.e., 1945 to 1965, 1946 to 1966), and went back fifty years to measure performance and draw his conclusions. He first published his work in 1996. Ten years later (as discussed in the article and the newest edition of his book) he looked at the performance of the strategies recommended in 1996. They worked! Investors can find many strategies predicted by historical data but it’s far less frequent to be able to test actual recommendations. (Correlations can change over time and sometimes extrapolations from past data don’t hold up.)

 

One of his more interesting observations is how many times over twenty year periods investors lost money owning long term corporate bonds. Rising interest rates (falling bond prices) from the 1950s into the 1980s had something to do with this, but Mr. O says that the twenty year bond rally (starting in the 1980s) is over and I agree with him.

 

How should we invest for the next twenty years? Drum role, please. Your equity portfolio should be 40% big cap value, 25% big cap growth and 35% small and mid-cap funds. Your fixed income component should be invested in intermediate term bond funds. Sounds like good advice (don’t forget to invest some of your equity money in foreign funds) for any investor with a reasonable time horizon.

Last week was a week of records. The Dow and S&P closed at new highs. The NASDAQ closed at its highest level in six years. Oil closed at $74 a barrel, an 11 month high. The Euro hit an all-time high against the dollar. It now takes over $1.38 to buy one Euro. (My sympathy to all of you vacationing in Europe this summer.) 

 

Twice last week I read/heard commentators saying that rising oil prices are good – they’re a sign of a strong economy. The talking heads glass is half full (and I think it’s filled with something stronger than water). Rising energy prices worry me. They take money out of the consumers pocket, add to inflation and increase our balance of payments deficit, leading to higher interest rates. Sorry, my glass is half empty on this one, but maybe I’m just old school.

 

Something else happened last week, which received almost no press. Credit spreads widened. This means the yield on junk bonds rose, even though the Treasury market was flat. Why did junk bond yields (and the cost of financing with junk bonds) go up? It could be due to ongoing problems in the subprime market and/or the amount of private equity transactions which need financing. Or it could be something more ominous.

 

The bond market has been better at calling turns in the economy than the stock market. The players in the junk bond market are really smart guys (and women). If their glass has gone from half full to half empty we better beware.

 

Here’s how events could play out. Rising interest rates in the junk bond market ripple through all classes of debt. The continuing record trade deficit and the declining value of the dollar cause foreigners to demand higher returns to hold US Treasuries. The result is both rising interest rates and rising credit spreads (making junk debt financing more expensive/driving the price of existing bonds lower).   The tipping point from rising interest rates to a full blown credit crisis is a debacle in the subprime market or the inability for a private equity firm to finance a big transaction (think Chrysler, Hilton, Sallie Mae). 

 

Interest rates will rise and, at some point, the stock market will switch from viewing the glass as half full to half empty. Soon, I think.

There was an excellent article discussing the pros and cons of investing in ETFs in the July 3^rd Wall Street Journal: As ETFs Seek Niches, Risks Rise (unfortunately, The Wall Street Journal doesn’t allow us to link to their articles, perhaps that will change after Rupert Murdoch buys Dow Jones.) There’s over $500 billion invested in ETFs and, I believe, they will either replace open-end index mutual funds or force those funds to lower their expenses. A win for investors. ETFs generally have lower on-going expenses then index mutual funds. You’re charged a commission to buy or sell them, as for a stock, but the commission may be less then the fee charged by your broker, or fund, for buying a mutual fund (consider the share class you’re buying). ETFs are priced, and traded hourly, not at the end of the day as with open-end mutual funds.

 

ETFs are excellent tracking vehicles for many different kinds of investments. Want to invest overseas? In commodities? Buy an ETF. (Not to get carried away, there are index funds that track most of the indices that do ETFs.)

 

So what’s not to like about ETFs? Going back to The Wall Street Journal article, Lipper, which tracks fund performance, reported that a disproportionate number of ETFs showed up on its losers (poor performing) list. For some ETFs it is simply a case of tracking a narrow and volatile index, nanotechnology, for example. The lesson here is that investors need to consider the riskiness of any investment they’re making. An ETF doesn’t diminish the risk of a cutting-edge technology, volatile commodity, or stock market of an emerging country. What a good ETF will do is reflect the performance of whatever index its is designed to track.

 

Like most new products, and ETFs are a new product, there will be some product-specific risks as well. Some ETFs won’t track their underlying index due to design error or too narrow a portfolio. Costs won’t automatically be less, turnover and taxes will be issues for some ETFs. To mitigate these risks stick with ETFs issued by well-known institutions.  

 

Vanguard, the godfather of index funds, has joined the ETF party and is coming out with more. (See When is a Door Not a Door for more information on ETFs and what John Bogle, the founder of Vanguard, thinks of them.) Vanguard’s action is perhaps the best evidence to date of the rise of ETFs.

 

The moral to the story is to consider ETFs whenever you’re considering an index fund or want a low cost and liquid way to obtain exposure to a particular type of investment. Just remember that an ETF doesn’t reduce the risk of the investment class.

The S&P 500 is up about 7.5% thus far this year. That’s a good return for just over six months.   Will it keep going up? Consider this. The earnings of the S&P 500 companies are expected to grow by about 5% in 2007, according to a leading Wall Street brokerage firm.  That means if the market was fairly valued at the beginning of 2007 and there were no big changes as to how investors think about the market, the S&P should only go up by 5% in 2007. Hence, game over.  Come back next year.  

 

But wait! Let’s examine each of the above assumptions. Was the S&P fairly valued at the beginning of 2007? Well, for the 12 months ended June 2007, it’s up 22%, so it had a pretty good run in the second half of last year and considering that 2006 was the fourth year of the current economic expansion, it’s likely the S&P was around fair value at the beginning of 2007. Okay, but doesn’t the market discount the future? And aren’t all the Wall Street analysts talking about 2008 earnings? Yes to both (although December 31, 2008 is 18 months away, so maybe there’s some uncertainty). 2008 S&P earnings are projected to grow by 7.5%. Amazing, the same percentage the S&P is up this year. I could end this report right now but I think it’s a coincidence.

 

I don’t know how far into the future investors look or whether they’re looking at 2007 or 2008 earnings.  Either way, though, there’s not much of a case to be made for further gains in the S&P unless there’s multiple expansion. (The P/E multiple has to expand when stock prices grow faster than earnings.)

 

So, will P/E multiples expand and the S&P continue to go up? Depends upon what makes multiples expand. Common factors include accelerating earnings growth (I don’t think 5% to 7.5% qualifies), an improving economic outlook (balance of trade, energy prices, inflation), or a reduction in interest rates. The last one’s a two edge sword. If interest rates fall (the Fed cuts rates) because of declining inflation expectations, that’s bullish (along with an expanding economy that’s the goldilocks scenario). If the Fed cuts rates because the economy is slowing down, that’s not good. A Fed cut for good reasons appears unlikely.

 

Thus, the S&P is likely to be flat to down over the next few months, until earnings growth is ready to take it higher.

The stock market put in a great performance for the first half of 2007, the Dow is up 7.6%, the S&P 6.0%, the NASDAQ 7.8%. Almost all of these gains were realized in the second quarter, a very impressive quarter given the uncertain economic and geopolitical backdrop.

 

The bond market did not fair nearly as well as the stock market. Treasury yields rose approximately 30 basis points across the yield curve, resulting in falling bond prices and one of the worst quarters for fixed income securities in the past few years.

 

Economic consensus is for continued growth. The housing drag and subprime mortgage problems will be contained, economists say. The consensus is less clear about the outlook for interest rates. The sentiment has shifted in recent weeks from a Fed cut late in the year to an increase, economic strength and inflation containment cited as why. 

 

In the latter stages of an economic cycle interest rates rise and the stock market gets choppy. Given the stock markets performance in Q2, it’s likely we’ll see a down market in Q3. But that’s the short term and we’re long term investors. What to do? 

 

It’s time to repeat our mantra. Review your mutual fund portfolio to see if it is properly aligned with your investment time horizon and goals. Are you comfortable with your overall level of risk? (Your risk tolerance will be tested in the coming months.) Rebalance. Make sure you have significant international exposure (20% - 25%), including to Japan. With money market funds yielding 4.50% +, cash is king right now. If you’re uncomfortable, money market funds are a good place to park some funds until the stock and bond markets make their next moves.