(June, 2004)
ANOTHER CONTRARY INDICATOR—THIS TIME, IT’S OIL
As a general rule, once everyone and his brother has determined that a particular asset class is a “can’t miss,” the easy money has been made; at least, for the time being. Further, with everyone on pretty much one side of a particular market—especially if this has been fostered by leveraged bets to accentuate the move in question—odds favor some near-term danger for those arriving at a party too late.
Such now appears the case where crude oil is concerned.
There has been no shortage of pitches in recent weeks and months extolling the virtues of betting the farm on “the new energy crisis.” As I wrote myself back in the April issue, we do indeed face what by all appearances is a major demand problem with oil and natural gas both going out several years into the future. It is one which will be exacerbated as time goes on, and many undeveloped/developing regions of the world—India, China and Eastern Europe—slowly begin to catch up with the rest of us.
Yet nothing goes up forever in a straight line, as oil prices have pretty much done now for over a year. Sooner or later the music stops; and, led by the most leveraged players, traders scurry out before their profits evaporate.
The trouble with hot markets such as energy has been recently is that the novice ends up getting hurt the worst. On a daily basis recently, various companies have been particularly pushing oil price futures as a sure-fire way to get rich on oil. They use recent statistics—which are often true enough—to show how much money would have been made if YOU had but some contracts mere weeks ago. Many well-meaning but greedy investors, believing that oil will continue powering higher just as it has in recent months, have piled in. Now they are getting whipsawed.
As I discussed earlier amid my overall market comments, I have no doubt that a year or two from now—barring a major downturn for the global economy—that oil prices may well see $50 per barrel or higher. Between now and then, however, it’s quite possible that they will move significantly lower, making a shambles of those investors’ who came to the party late and too aggressively. A short term fate not unlike that suffered recently by those too heavily invested in metals and metals stocks could be just ahead.
In March’s “Caveat Emptor” column I discussed how the same thing was then happening where the U.S. dollar was concerned. Many investors nevertheless piled in to dollar contrary investors—again, often via futures contracts on competing currencies—based in part on the notion that if Warren Buffett was bearish on the greenback, they should be also. As we saw afterwards, the dollar rallied by some 10%.
Don’t think that oil prices can’t decline; at least, for a while.
MARKET VALUE ADJUSTMENTS ON ANNUITIES
With long term market interest rates having risen significantly of late, those insurance companies competing for your savings have been able to increase the rates they pay you for fixed annuities. Many companies are now paying first-year yields of 5-7% now; attractive, considering most of the competition and especially since taxes on annuity interest are deferred until you actually make withdrawals.
These kinds of products typically charge you a withdrawal fee of one kind or another if you were to take out anything more than a modest amount from your account. Besides this, however, some companies have an additional “hit” in store for you if for some reason you cash out early; it’s referred to as a market value adjustment, or MVA for short.
Remember that insurance companies predominantly invest premiums they receive for annuities in fixed-income instruments such as Treasury bonds, mortgage-backed securities, corporate debt and the like. In an environment of rising interest rates, the underlying principal value of such securities generally declines. Thus, were these types of things to be sold prior to their maturity, the owner (i.e., the insurance company) would have suffered a loss on the investment due to the declining market value.
Those insurers who have an MVA as a provision of their contract want to pass this loss on to you; and again, this can often be a charge you’re hit with in the event of an early withdrawal that is in addition to the usual descending back-end surrender charge.
So, make sure that if you are in the market for a fixed annuity for part of your portfolio that you 1) never invest money you can’t afford to keep pretty much tied up for an extended period, and 2) that you avoid those contracts with an MVA.
PARTY’S OVER FOR JUNK BONDS
As has already been well chronicled in these pages and elsewhere, 2003 was a year when virtually everything benefited from the unprecedented monetary inflation engendered by the Fed. Rock bottom interest rates, plenty of liquidity and all the rest made just about everything rise in price, even when such moves were inherently contradictory (for example, with bonds rising in price along side stocks and commodities.)
In the bond area, the best performers among domestic issues were so-called “junk” bonds. Not only did their prices benefit from the overall decline in interest rates, but also from improving economic prospects. Unlike Treasury securities, corporate bonds can benefit somewhat from improving economic prospects; it’s not uncommon for their values to rise together with stocks during periods of a growing economy. During such times the “spread” between Treasury yields and corporate bond yields tends to narrow, with the latter outperforming government obligations by a wide margin as a result. In 2003, this was especially true with junk bonds, whose previously sky-high yields following the economic mess we seemed to face in 2001-2002 plunged. Many of the most depressed junk bonds—in areas like telecommunications, technology and energy trading—doubled or better last year as the underlying companies came back from the dead.
Now, with the Fed set to at least gently apply the brakes, a few voices are warning that we can no longer expect the kind of strong double-digit returns we were treated to for nearly the last two years (in 2003, the average junk bond-oriented mutual fund achieved a total return of about 26%.) Yield spreads have already started to widen anew, in part due to the huge new supply of corporate debt that’s been issued recently to try to take advantage of present interest rate levels. Further, as Jim Grant (Editor of Grant’s Interest Rate Observer) wrote in a piece back in the February 2 issue of Forbes, the waves of investment dollars moving back into this area last year has already driven prices to, he suggests, unsustainable levels. Back then he wrote that 80% of junk debt was trading above par, or its face value. Further, he pointed out, 63% of junk bonds were trading even above their call price; meaning that at any moment the issuer could force redemption at less than the market currently values the paper at.
So far in 2004, most such funds’ performance has been pretty much flat. Though some small gains might still be eked out if the stock market manages significant further gains this summer, the salad days for this move are clearly over. After their strong run since the latter part of 2002, the other moniker for these securities—“high yield” bonds—doesn’t fit any more, as yields have generally fallen to the 6-8% range.
The risk from this point forward is that they will again earn the title of “high yield,” as rising interest rates generally followed by signs—especially as we move toward 2005—that the economy is showing some cracks provide a one-two punch to such bonds. You don’t want to be owning them while they get back there.
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