“It’s not always easy to do what’s not popular, but that’s where you make your money. Buy stocks that look bad to less careful investors and hang on until their real value is recognized.”
John Neff, retired Vanguard Windsor portfolio manager
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”
Robert G Allen, author and real estate investor
Last fall I gave client seminars in Scottsdale and San Diego. The second hour was called Zero-bound. The gist of my presentation was that we were headed back to zero percent interest rates during the next recession. It was our belief at the time that the economy would continue to expand with central banks around the globe applying monetary stimulus through interest rate cuts, including the U.S. Federal Reserve. I knew that eventually there would be another recession, which is why the Fed cut the federal funds rate three times last year. They don’t cut rates unless they see signs of economic weakness as GDP growth was slowing down.
As recent as late February of this year, the stock market was at record levels, the unemployment rate was the lowest in six decades and the futures market was predicting several more rate cuts this year by the Fed. The economic indicators from the ISM service sector and the job numbers for February were close to record highs.
That was then and this is now. As of this writing (March 26, 2020), 10-year Treasury notes are at 0.88%, 30-year bonds are yielding only 1.45%, and short-term Treasury bills are offering negative interest rates on three and six months. To keep money in short-term bills, you now have to pay the U.S. government to loan them money.
The government is throwing in everything but the kitchen sink to keep the economy from descending into a recession. Second-quarter GDP is expected to contract anywhere from 12-24% and unemployment could be back over 10%.
As dismal as this all seems, it will not remain there for long. Listed below are the measures the Fed is now implementing on steroids:
- Dropping fed funds rate to 0.0-0.25%
- Discount rate reduced to 0.25% from 1.75% so banks can borrow from the Fed and loan money
- QE infinity: Initially $700 billion; now infinite
- Fed buying investment-grade corporate bonds and ETFs
- Dollar swap arrangements with all major central banks (trade is done in dollars so the Fed is loaning dollars to other central banks to facilitate trade)
- Backstopping money market funds
- Backstopping the commercial paper markets (where corporations go to handle short-term funding needs)
- Congress is considering giving the Fed the power to set up digital dollar accounts whereby the Fed would transfer dollars into your bank account as a direct injection of cash. Much faster than going through the Treasury to issue you checks. Can you say helicopter drops?
The country is now at war with the president invoking several war-time power measures, such as ordering companies to shift production to medical necessities like masks and respirators. What you are witnessing in monetary and fiscal terms is equivalent to what we call in war times “shock and awe”. This includes MOAB (the Mother of All fiscal Bombs). Round one of fiscal stimulus will be $2 trillion. On the day I’m writing, Congress is talking about additional rounds of fiscal stimulus to follow this as added assurance they will do “whatever it takes.”
As discussed previously, we will get stimulus one, two and three before this is all done. The U.S. is approaching $24 trillion in national debt and will be at $27 trillion or more by the end of fiscal 2021, which ends in September of next year. We are now looking at fiscal deficits that could approach $3 trillion annually over the next few years, raising the national debt to $30 trillion.
We simply don’t have the tax revenue to pay for all of this spending so it will be financed mainly with Federal Reserve money printing. In order to keep interest rates low to meet debt payments, the Fed will suppress interest rates and keep them artificially low as they are now. It is my view by the time this is all over, we will see negative interest rates on U.S. debt instruments as you see in Europe and Japan today. It may get to the point where banks charge you interest to keep your money on deposit as they did with institutions in 2008-2009, and as they are now doing in Europe and in Japan.
This brings me back to what I wrote previously: Why we set up the income account. We foresaw this day coming, albeit not this soon. The account was set up to provide an increasing stream of income that offered yields far above regular stock index funds and ETFs as well as bonds. As a hedge, we invested a portion in gold which, in my opinion, given the level of fiscal and monetary largesse, will eventually exceed its former highs.
We have roughly 15% invested in preferred stocks with yields as high as 7%, with several of our stocks now yielding over 9% as a result of the correction. I have not tried to time moving in and out of stocks nor have I used hedges like reverse income funds mainly because political headlines are driving this market. Recently, the Dow advanced nearly 12%, its biggest one day gain since 1933. The following day it was up another 6%; a gain of 18% in just two days.
It is impossible to predict daily moves when markets change this quickly. This is why instead of selling or hedging outside of gold, I have held on (the investment objective of this account). I cannot produce income levels that increase each year if I try to time the market nor do I feel I am smart enough to predict the daily moves of the markets when they move at warp speed daily.
A good example is Chevron, who announced on Tuesday they were suspending their $5 billion stock buyback program and pairing back capital expenditures in order to maintain and increase their dividend. The president of the company told analysts maintaining and increasing dividends was one of the company’s top priorities. The stock rose 23% after that announcement and is up 38% in just two days. Despite the run-up these last two days, the dividend yield is still high at 7.75%.
Our income portfolio includes many high-quality Dow stocks that all have a history of increasing dividends, which is why I chose them to begin with. I have not chosen to sell or hedge these stocks with reverse index funds or puts, simply because this market moves too fast. How could anyone know that the president of Chevron would make this announcement sending the company stock price up 38% in just two days?
As interest rates remain at zero, or go negative as they are in short-term Treasury yields, high quality blue-chip stocks will be sought out by pensions, institutions, insurance companies, and income investors and is why we continue to hold them. They are paying consistent dividends that increase over time, exactly as I expected.
I would like to end by sharing two personal stories. I have been a life-long student of Benjamin Graham, (Warren Buffett’s mentor) after reading Graham’s book The Intelligent Investor. I read that book in graduate school where I fell in love with the financial markets. I have also read everything about Warren Buffett — perhaps the most successful investor in history. If you want to understand Buffett, you need to understand cash flow. Buffett is all about owning companies that generate large amounts of cash. This makes sense as he runs an insurance company that makes money off the float between the premiums he takes in and the claims he pays out. The only difference between Buffett and the rest of us is that he has become so wealthy with this philosophy that he is able to buy whole companies instead of just shares. Even the stocks he owns like Wells Fargo, Coca-Cola, and Apple, many of which we also own, generate large amounts of cash and have strong profitability. Apple is still sitting on $100 billion in cash.
But the story I really want to share with you is an interview I did with famed technical analyst Ralph Acampora, which had a profound impact on me. Ralph is a legend in the industry for the numerous prescient market calls he has made throughout his long, successful career working on Wall Street. Once again, Ralph made a prescient call in my interview with him in August of 2018, where he predicted a major market correction within a bull market trend. The Fed was raising interest rates at the time and asset markets crashed in the fourth quarter and the S&P 500 fell just shy of 20% — not quite a bear market.
What he told me after he called for a major market correction left a profound impact on me.
I asked him, “What do you do Ralph if you are retired and need income?” He said, “My wife Rosemary was a financial advisor, specializing in retirement planning on Wall Street her entire career. Her specialty was putting her clients in dividend-paying stocks: blue-chip companies in the Dow and S&P 500, all of which paid increasing dividends every year.” We call these stocks dividend aristocrats, which populate our income portfolio.
When Ralph was predicting the bursting of the tech bubble in early 1999, he went to his wife and said they should consider selling out of their stock holdings. She told him to go away. When he persisted she explained her logic, “If we sell, we end up paying 40% in federal and state income taxes. There is your bear market. If we hold on, we owe no taxes, the dividends are taxed at a lower rate, they go up each year, and the stocks will come back when the recovery in the economy and next bull market begins.” That is exactly what happened.
He tried the same approach with his wife in 2007, when he again predicted a bear market ahead of time. He knew the drill and she told him the same story. They held on during the downturn and captured the entire market’s return which consisted of 339% in appreciation and 479% including dividends. Their dividend income more than doubled during the bull market.
He ended the story and said, “My wife told me, ‘if you sell, you have to sell at the right time and then buy at the right time. Then you have to pay the taxes.’ So we rode it on the way down and all the way back up….thank God Rosemary was adamant about it and didn’t listen to me. Because now I am lucky enough to buy the family farm, if not, I would be a cow on the farm.”
His story left a deep impression on me. Here was one of the greatest technicians I have ever known, who has made one prescient call after another on market tops and bottoms heeding his wife’s advice rather than following his instincts and that created great wealth for them both.
One approach I have incorporated and employed in the income account was something I learned from studying Ben Graham. That was to have 25% of your portfolio outside of stocks so you can take advantage of opportunities as we are doing now. The income portfolio maintains a 40% position, which includes T-bills we bought when interest rates were higher, preferred stocks and gold.
One of the greatest investors in history and one of the greatest technicians in the markets both bought and held dividend-paying stocks. This reinforces my own views of what I learned studying and following Graham and Buffett. This is what prompted me to create and launch the income account following the same Graham and Buffett principles.
We have been deploying cash and doubling down on many of the great companies we own and picking up incredible yields. I believe this will eventually gain traction as institutions and individual investors scramble to find returns in a world of zero and negative interest rates.
As mentioned in my previous letter, this too shall pass.
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