Investors might prefer TIPS to T-bills, sift corporate, municipal, and emerging market debt, and start scanning for financial survivors
The dramatic market dive of Sept. 15 reminded many professional investors of the panic- induced selling of Black Monday in 1987 or the worst days of the bear market in 1974. But while those episodes took place before major market turnarounds, that's not the scenario pros lay out today. They see selected opportunities but remain cautious overall, alert to risks that may be buried in teetering financial firms.
Bill Gross, manager of the $132 billion PIMCO Total Return Fund (PTTAX), thinks the unwinding of debt that is roiling the markets is leading investors to dump both good and bad securities without differentiating. Rob Arnott, chairman of Research Affiliates, a money management firm in Pasadena, Calif., describes this as "a target-rich environment." But, he notes, "people have to be careful not to fall for a sucker punch by disregarding the fact that assets are priced low when perceived risk is high."
Gross and Arnott, along with many other market veterans, urge investors to think about safety first. And nothing matches the safety of short-term U.S. government Treasury bills, as well as savings bank deposits and certificates of deposit, which typically are insured up to $100,000 per individual account. Short-term Treasuries are where economist and former money manager Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk, placed proceeds from the sale of his Vermont vacation home. "I wouldn't want to put it anywhere else," he says.
Bernstein wouldn't, for instance, go into long-term Treasuries. Gross—manager of the world's largest bond fund—isn't a fan of the world's biggest long-term bond market, either. In the Sept. 15 stock market rout, investors ran screaming into Treasuries, pushing the yield on the 10-year note down to 3.25%. At that level, says Gross, the yield doesn't compensate for the risk of losses from higher interest rates down the road.
Gross suggests looking at Treasury Inflation Protected Securities (TIPS). Panic selling hit the TIPS market on Sept. 15 as investors who needed to meet margin calls sold whatever was readily saleable, he says. At market rates on Sept. 16, the buyer of a 5-year TIPS would collect a yield of 1.31% plus any increase in the consumer price index. Yields on 20- and 30-year TIPS are over 2%. Investors can buy TIPS from the Treasury Dept.'s Web site or use the iShares Lehman TIPS Bond Fund (TIP), which has fallen more than 5% over the past six months.
Dan Fuss, a 50-year veteran of money management and co-manager of three mutual funds for Loomis Sayles (LSBRX) in Boston, sees bargains among investment-grade corporate and municipal bonds as well. "It's as cheap relative to the rest of the world as I've seen in more than 50 years," he says. Fuss oversees bond funds that can invest across the fixed-income spectrum, from the least risky government securities to the most dangerous junk bonds, but says he's patiently looking to buy in the middle.
Arnott, who manages the PIMCO All Asset Fund (PASAX), along with other money, is looking at emerging markets debt. Emerging markets have been hit just as hard as more developed markets over the past week, but their economies may be on sounder footing, he says. He likes PIMCO's Developing Local Markets Fund (PLMIX). There are also several exchange-traded funds (ETFs) in the sector, including the iShares JPMorgan USD Emerging Markets Bond Fund (EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY).
The market for closed-end funds has also suffered a severe blow. Closed-end funds issue a set number of shares that trade on an exchange, so unlike a mutual fund, the price can vary greatly from the value of a fund's portfolio. Tom Herzfeld, who has invested in closed-end funds for decades as president of Thomas J. Herzfeld Advisors in Miami, says he has never seen discounts to net asset value as big as those he's seeing now. Shares of Western Asset Emerging Markets Debt Fund (ESD), for example, trade at 25% less than the value of the fund's assets. But despite big discounts, he's staying away from some of the newest funds, which rely on complicated trading strategies such as selling call options on a portfolio of stocks. "Most of these strategies have backfired," he says.
On the equity side, the question of the day is whether the financial sector has hit bottom. With major banks and brokerage firms disappearing into the subprime muck, the survivors eventually will find themselves operating with fewer competitors. But early bargain hunters have been badly burned, so most are holding back for now. "I'm not very far from being a bull on financial services stocks," Arnott says. "Once the dust settles, the survivors are going to be stronger than they've ever been." He isn't going near the housing sector yet, though: "Housing prices can't rise until inventories fall, inventories can't fall until foreclosures start to drop, and all of that is months and months away."
The sector that lost the most on Sept. 15 was not financial services, surprisingly, but energy stocks, which were crushed by a $5 drop in the price of oil. After rising more than 50% through the end of June, oil now stands below $95.98 a barrel, where it started the year. But Jerry Jordan of the Jordan Opportunity Fund (JORDX) is buying both energy and materials companies. All of the measures taken by the Federal Reserve and other central banks to shore up the global economy will start to help in 12 to 18 months, he says. "Demand will come back and we'll have another tight environment by the second half of 2009."
Few if any managers recommend full-fledged buying of stock market indexes, though some sense that the bottom for the stock market may be near. To confirm that a bottom has been reached, Michael Avery, co-manager of the Ivy Asset Strategy Fund (WASAX), wants to see the Standard & Poor's (MHP) 500-stock index stay in the 1200 to 1250 range for a couple of months. That would give investors time to evaluate U.S. election results, the state of the credit market, and the strength of the Chinese economy.
The emotions running high have made Avery more optimistic, not less. For now, though, he's maintaining his defensive posture; half of his $15.4 billion fund is in cash. "Just because we are forming a bottom doesn't mean that the market has to go higher," Avery says.
With Christopher Farrell, Amy Feldman, and Lauren Young