One Man’s Junk is Another Man’s Treasure

John Mauldin | Thoughts from the Frontline
February 13, 2001

This is an important e-letter. Not only does it suggest things may get better sooner than I had previously thought, it will also be important in understanding the new Income Investment Model I will be introducing within a very short time.

One Man's Junk is Another Man's Treasure

Everyone recognizes there will be investment opportunities when the economy turns around. The question, of course, is when will the economy turn around and where will the opportunities be? I have been writing about the yield curve and its success in predicting downturns/recessions. Today I will discuss a single indicator that is very useful for telling us the economy is getting ready to turn around. It also represents a significant investment opportunity if we get in at the right time.

Today I am going to make the contrarian case for junk bonds or, in more polite company, high yield bonds. The last three years have been terrible for junk bonds, with many funds showing very real losses for the total three year period. But at the bottom of the last recession in 1990-91, junk bond funds turned around, signaling a recovery, and the total return for high yield bonds for the three years of 1991-93 was a handsome 79.4% (source: First Boston).

I want to describe these investment instruments, examine some of their future potential and see what they are telling us about the economy.

First, a quick primer. High Yield bonds are debt instruments from companies with ratings of "BBB" or less. Higher rated bonds are described as investment grade. When the lower rated bonds sell or trade at par value (the price for which they were originally sold) and pay a high rate, they are politely called "high yield." When investors are worried about the ability of the company to actually pay their debt (say Amazon.com, for instance) they sell for less than par value and become "junk."

As an example, if a $1,000 bond paying 10% is issued and no one doubts the ability of the company to pay the debt-holders, the bond maintains its value, and investors get 10% income or $100 annually. But let's say investors begin to seriously doubt the ability of a company to make their bond payments. If the person or fund who originally bought those bonds decided to sell them because of that concern, they might only get 50 cents on the dollar. (Less or more depending upon how "serious" the company's problems are thought to be.) The new investor buys the bond for $500 but still gets $100 interest, as long as the company can pay. The effective interest rate to the new investor is 20%, which he demands for taking the perceived future debt risk.

Junk bonds trade a great deal more like stocks than highly rated bonds. And therein is the current opportunity. Typically, high yield funds pay about 4% more than treasury funds. Today, the spread is closer to 8%; so if rates come back to their average, there is the nice potential for capital gains as well as interest. The capital gains are what boosted the 1991-93 returns to 79% .

When the economy is slowing down, an announcement by one or two companies in an industry that they are missing debt payments can send the value of every "junk" bond in that industry tumbling, even though the rest of the companies may be well managed. If you own a junk bond fund, that means the interest your fund is paying may get quite high, but the value of your shares could be taking a tumble. That has been the case for the past few years.

The reverse happens, however, when investors perceive the risks are less. Then the investor who bought that "risky" bond for $500 may now get much more for it, assuming the company shows improving ability to pay its debt. Not only is he getting high interest, his bond is worth more.

Many investors are attracted to high yield bonds because of the higher interest. A case can be made for a well managed high yield bond fund, but the reason junk bond funds pay higher interest that is there is more perceived risk. I generally suggest avoiding junk bonds as interest investments. I only recommend them when my systems tell me there is capital gain potential as well.

The play that interests me in junk bonds is not the interest, but the increase in the value of the bonds. And what is even more interesting is that when high yield bond funds turn up they may be telling us the economy is getting better.

Now comes the tricky part. What do I mean by "turning up"? Rising 2%? 5%? 10%? How high is "up'?

Remember I said junk bonds act much more like stocks than regular bonds? That means they can be volatile, so using an absolute percentage number like 3% or 5% or 7% can be quite deceiving. Junk bond funds took a steep and quick dive at the end of last year, and have rebounded since then. Depending on the quality of the portfolio of bonds in the funds, the rebound could be anywhere from 3% to 7%.

Better rated junk bond funds have one very good characteristic, in my view. They trend very well. You don't typically see precipitous 5% drops in 3 days. The moves may be dramatic, but they are slower.

For the purposes of predicting the bottom of a recession, I like to use a series of moving averages over a variety of funds. I use a powerful mutual fund analysis program called Monocle. You can set up this program to analyze historical trends of moving averages on a variety of funds. I use a number of different combinations of moving averages.

Typically, this consists of a "fast" moving average combined with a "slow" moving average. An example would be a "fast" 15 day moving average combined with a "slow" 60 day moving average, or a "fast" 40 day moving average combined with a "slow" 120 day moving average. When the trend line of the "fast" moving average is above the "slower" moving average, that is a positive sign.

Choosing moving average combinations is tricky. The shorter the time span of the two averages, the more likely you are to get "whip-sawed". The longer the time span, the more likely you are to miss out on the profit potential at the beginning of a real trend change. But for economy predicting directions, I like to see an entire series of moving averages (short, medium and long) turn positive and stay positive for at least a few months before we blow the all-clear whistle.

Where Are We Now?

Last month, I noticed that junk bond funds were just beginning to turn back up, but they had fallen so far that I was not surprised that they would bounce some. But in the past month, junk bond funds are starting to surprise me with the intensity of their rise. The faster moving average combinations have turned positive, as well as those of the medium term averages. The longer term, slower moving averages are not far from showing us a positive number as well. Could they be signaling to us that the economy is getting ready to turn around, as they did in early 1991, in the midst of all the gloom and worry?

In 1991, the upturn in junk bonds did not pick the end of the recession, but preceded it by a quarter or so. While other current signs seem to predict more pain, just like the yield curve being an early predictor of downturns, junk bonds may be an early predictor of recovery.

Tony Dorsett or Earl Campbell?

In Texas, we have had two great professional running backs. Tony Dorsett of the Dallas Cowboys used to move his head one way but his body went another. Defenders ended up looking foolish as they grabbed at air.

Earl Campbell of the Houston Oilers had no use for such deceit. He simply ran over anyone who got in front of him. Defenders ended up being bruised and sore.

Are junk bonds acting like Dorsett, giving us a head fake before the economy takes a nose dive, or is the American economy like Earl Campbell, getting ready to roll over the bears?

I will give you both arguments, because it is important you understand them. Either way, our high yield investment strategy will be essentially the same.

The bulls like Dr. Yardeni would argue that because of new computerized management information systems, companies today are much quicker to respond to poor economic performance and "pull in their horns" than they were 10 or 20 years ago (which is true). But they also argue they will be quicker to respond to an upturn. Further, we are just simply more productive than we have been in past recessions, helping us to recover more quickly.

In the last recession, Greenspan also cut 100 points, but it took him six months. He has done that in just one month, and many argue he will do another 50 basis points before the first quarter is over, with more to follow this year, as inflation is no longer a primary worry. There is also the likelihood of a stimulating tax cut as well. In short, the recession cycle is going to be shorter than it has been in the past.

They would argue that since investors typically look 12 months out, and the average 12 month market return after a third Fed rate cut is 17%, it is time to invest, because the economy and the market are going to turn around faster than they have in the past. 2002 earnings forecasts are bullish, so even if we see a profits recession this year, in 12 months the stimulus from rate and tax cuts will be showing up in the earnings. Besides, they opine, we are investors for the long term.

Finally, they will note the very upbeat congressional report by Alan Greenspan on Tuesday. The Fed is predicting a quick rebound to growth and one could imagine that we even avoid the classic definition of a recession as being "two down quarters."

Bears would point out that earnings estimates get cut every quarter. Analysts are notorious for being optimistic. How can we believe any analyst proclaiming a bottom when, as a group, they are nearly always wrong? Further, consumer confidence shows no sign of rebounding and until we see an upturn in consumer confidence, calling any type of bottom is premature. There is a great deal of personal and corporate debt which needs to be restructured. Manufacturing is slowing down to levels not seen in years. The rate cuts are great, but take 9-12 months to have any real effect. Unemployment is rising and massive new layoffs are announced every day.

What do I think? I am actually leaning to the bullish side. Betting against the Earl Campbell American economy is usually a losing wager. But I want to see the long term moving averages in junk bonds turn positive and stay positive for a few months before I move into a total bullish position. And as I will point out below, that does not mean I think the NASDAQ is going back to 5000. The NASDAQ is a bubble, and the air is leaking out. We will stick with value when the time to get completely back in is here.

So What Do We Do?

First, there is some real potential for profits in junk bonds when this economy turns around. I am a big believer in using systematic approaches to investing. We can use some basic tools to help us find the potential in junk bonds.

As I pointed out earlier, the typical spread between junk bonds and money market funds is 4%. It is closer to 8% today. These spreads will narrow in a recovery, and that is why we will see capital gains in the high yield bonds. Also, if short term money market rates drop, as I believe they will, then that will produce even more opportunity for capital gains in high yield bonds.

I do not think we will see as big a gain as in the 1991-93 period because the spreads back then were larger. The key to our future gains is how low the money market rates will go. Barry Evans, chief fixed income officer of the John Hancock funds, thinks it is likely we will see 20% gains in 2001 and good gains for the two years after that. He calculates that 20% by adding the 13% interest rates many bond funds are currently paying, and the gains an investor might make if the difference between the treasury and high yields funds only goes halfway back to "normal" this year. That seems reasonable to me. (Past performance is not indicative of future results.) That still leaves some more room for the next year and the following years.

First, historically using a medium term combination moving average (like 15 days versus 60 days) would let us catch a great deal of the upside in high yield bonds while avoiding the bad periods. For the model I use for clients, I use a few extra bells and whistles, but the essential part is the moving average. That model is telling me it is time to invest a portion of our income portfolios in junk bonds. Conservative investors should use a very tight trailing 2% stop, as I do. Call me a Nervous Nellie, but I am concerned about the Tony Dorsett economy. If we lose 2% on this trade, then so be it. We will exit and wait for the model to turn around, because when it does, the potential, as you can see from the last 1990 recession, is quite nice.

As I write this, Greg Weldon just sent me notice of a report just released by Moody's that predicts continued erosion in the junk bond market. Much of this was already priced into the current prices, so there may be no effect. If things are worse than they say, we could see this initial trade hit its stop point. As you all know, I am a big believer in following whatever system we use, because in the long run, that is the best way to invest. Because the system I use tells me to invest in junk bonds today, that is what I am doing. But as systems go, it is relatively conservative with tight stops and medium term moving averages.

Actually, from a profit point of view, if junk bonds do go back down and hit the 2% stop, the further they go down, the more potential for later profits when the economy and junk bond funds do rebound. Since I am now long, I certainly do not hope that happens, but I try to look for the silver lining. I should note that many sophisticated investors, like Warren Buffett, are beginning to buy junk bonds.

You can go to my web site at http://www.2000wave.com and on the home page will be a box entitled "Income Model". It will tell you when we are in high yield bond funds. I will send you an alert if we should exit these bonds and go into another fund in the income model (more info in a later e-letter).

Which high yield funds should you choose?

It can make a big difference. "Safer" high yield bond funds probably will actually not do as well, because they have better quality bonds in them now. But low rated funds may well deserve their low ratings. For safer investors, choose among Morningstar favorites Columbia High Yield (CMHYX) , the Strong High Yield Bond (STHBX) or the Vanguard High Yield fund (VWEHX). If you are in the American Century or Fidelity family of funds, they also have good high yield bond funds.

For the more aggressive investor, you can look at "three-star-rated" Invesco (FHYPX) or the Federated High Yield funds (FHIIX). (I am personally in one of the latter.) Stay away from lower rated funds. One of them will be the big winner next year, but it is better to be safe than try to get lucky. I have never had much luck picking the future swan out of the ugly ducks, and I bet you haven't either.

Do NOT invest in high yield bond funds because you read about it here and then forget about them. They can be very volatile. They are invested in risky instruments. You have to watch them, at least weekly. We do it daily. At the end of this e-letter is a copy of the risk factors of high yield bonds I got from a prospectus for a high yield bond fund. I was surprised to see it was relatively short. I am used to much longer risk disclosures, as those of you who have read any material I have sent prospective clients can attest. I wanted you to at least see these points; but I suggest you read the complete prospectus of any fund before you invest.

Within a week or so, I will show you how you can use high yield bond funds combined with a very special type of index fund to create an income fund with the potential for better than money market returns without having to take the large risks associated with stock market funds. The system is something I am excited about and I think holds great promise for those of you who have large cash positions, and want more potential for return, but do not feel safe investing in the stock market.

What About Stocks?

I keep getting asked, "If the economy is going into recession, shouldn't we steer clear of stocks?" In general, that is the safest approach. But maybe Yardeni and others are right, and the economy is going to turn around soon. I think you are relatively safe if you stick with genuine value stocks. A year ago, 20% of the S&P had Price to Earnings (P/E) multiples of 5 to 10. Now only 7% do. A year ago, 46% of the S&P 500 tech stocks had P/E multiples in excess of 50. Today only 20% do, and the percentage is dropping each week. (Source: Yardeni.com) There is a clear shift going on to value stocks. Value stocks are going up in price as investors go back to tried and true investment principles.

I have been telling you about this shift since last April. I only wish I could be as right in every prediction I have made. It was clear in our investor sentiment data, and is now clear in a variety of reports. This move will continue. Dodd and Graham, the original (1930's) proponents of value investing are once again the kings of the market. Warren Buffett wins. Last year, the non-tech portion of the S&P 500 was up 8%. I think much of that was due to the value stocks in the index moving up in value.

The message to value investors is clear. It does not matter whether the economy is going to act like Tony Dorsett or Earl Campbell. Over-priced stocks like Cisco and Sun, which cannot sustain 20%-30% growth rates, are going to go down in price, especially if the economy gets weaker. The NASDAQ 100 still has an average P/E ratio of 54, even after last week's drop. The growth of these stocks were not rationally related to the previous good economic years. It was a classic greed-based bubble. The bubble is bursting, and it is not yet finished. The future value of tech stocks will be based upon more classic definitions of value and realistic growth models. That means that no matter when the economy picks up, most tech stocks still have a lot of room to drop. If they do not drop, their growth will be limited as their profits grow to give them realistic P/E ratios.

Investors are clearly changing the valuation models. If you are holding on to high-priced tech stocks waiting for them to come back, you may have a very long time to wait.

Real core value stocks will hold their value in the rough times and benefit greatly from the boom, whether the boom is next quarter, as the junk bonds might be telling us, or next year as the yield curve would suggest.

How much is $1.6 trillion?

I was driving in the car with my 12 year old son, listening to talk radio talk about the proposed tax cuts. Chad asked me how many pounds would $1.6 trillion be? After I realized he was talking about weight and not British currency, and seeing a good opportunity to teach him the importance of math, I began to do the calculations in my head, explaining the process to him. I asked him whether he wanted to know in $100 bills or $1 bills. Being a practical son, he decided $100 bills sounded better.

After bouncing a few zeros around in my head, and noticing that we were passing a train (I used to buy paper by the train carload and back then it was 40,000 pounds of paper per carload), I came to the conclusion that it would take approximately 13,333 train cars to move 533,320,000 pounds of $100 bills. That would be 1,333,300 train car loads of $1 bills.

He thought about that for a moment and then said, "Boy, wouldn't that make us late for school if we had to wait for a train that long." (Confession: I have displayed a certain lack of patience being caught by trains taking my kids to school.)

"Yes," I sighed, "about as long as I will have to wait to actually see my taxes cut."

Investor Sentiment

Investor sentiment is about the same, except that last week the largest investors pulled back some, and in my opinion that is what has caused the recent drop. I expect that will reverse, as our numbers showed a short term bottom yesterday morning when we analyzed them. Sentiment Percentage Uptrends is still rising rapidly, so I am not too worried about a large drop any time soon in the NYSE or S&P 500, and expect them to rise from here.

For those following the sector rotation model, we are still in energy services, and are actually showing a profit of about 3%, although the energy services fund has slipped to third in our model and that could mean a change soon.

It was nice to get some emails from some of you worried because I did not write last week. Busy week, and I promised my bride I would take her away for the weekend.

Your patiently waiting for his tax cut analyst,

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