Investing Daily

Is the recession over?

On Thursday the US Dept of Commerce’s Bureau of Economic Analysis announced that gross domestic product (GDP) rose at an annualized rate of 3.5 percent in the third quarter, a vast improvement from the 0.7 decline in the second quarter, and particularly the 6.3 percent drop in the first.

The number also topped Wall Street expectations, sending stocks surging and at least partially reversing four days of declines.

What’s in debate is whether this marks the end of the worst US economic debacle in decades. The Obama administration immediately released a report crediting the president’s signature $787 billion stimulus package with creating/saving between 650,000 and 1 million jobs, and forecasting that number would rise to 3.5 million “by the time this program winds down.”

Critics, meanwhile, warn any good news will prove fleeting as short-term programs like “cash for clunkers” come to an end.

Investor worries about a “Big W” recession and another major market collapse are still clearly front and center. And they’re certain to stoke up selling of stocks whenever there’s worse than expected news on the economy.

Friday’s sharp reversal of Thursday’s gain is a pretty stark reminder of how little (if any) conviction investors have about things getting better, and how willing they are to sell at any provocation. That kind of sentiment is usually a bullish sign for stocks in the longer term. But it also means potential for jagged short-term declines is still substantial.

Consumers and businesses alike are in the midst of a great deleveraging. That’s the inevitable backlash from last year’s credit crunch, and it may continue for months or even years. Unemployment, meanwhile, is at a generation high and is expected to grow further.

As far as we investors are concerned, corporate earnings are where the rubber meets the road. Since the tough times began in mid-2007, my benchmark for holding onto stocks has been that the underlying businesses stay healthy. Those that have measured up, I’ve stuck with. Those where the business has faltered, I’ve unloaded.

We’re now in middle of third quarter earnings season and will be for the next couple of weeks. Given the economy’s dramatic decline over the past 12 months, it’s hardly a surprise that third quarter 2009 comparisons for most companies are coming up short versus year-ago levels.

Equally, however, companies that have weathered the downturn thus far are avoiding real negative surprises. Those that covered distributions comfortably through the second quarter of 2009 did do again in the third quarter--and in fact appear poised to do so going forward.

Balance sheets continue to strengthen, thanks to ongoing refinancings at record low borrowing rates. Meanwhile, guidance for full-year 2009 and 2010 earnings made earlier in the year appears to be holding. Some companies--such as Utility Forecaster Portfolio holding MDU Resources (NYSE: MDU)--have actually raised projections as business conditions have improved.

Electricity sales to industry are considered a key benchmark of future economic health because this measure indicates utilization of the nation’s job-intensive factories. Not surprisingly, they’re down steeply from mid-2008 levels. Duke Energy (NYSE: DUK), for example, reports industrial demand in its Carolinas service territory is down 15 percent from third quarter 2008 and 14 in its Ohio, Indiana and Kentucky territory.

On the other hand, however, the utility serving the Carolinas and parts of the Midwest also reported an 11 percent increase in industrial sales sequentially, i.e. in the third quarter 2009 over the second.

Duke posted earnings of 40 cents per share versus 33 cents a year ago, not including a one-time $400 million non-cash charge to write down the value of certain assets. That was despite the impact of a mild summer, and it beat analyst estimates of 38 cents. Duke CEO Jim Rogers affirmed the company remains on track to meet its 2009 earnings target of $1.20 a share.

As one of the power industry’s strongest companies, Duke’s third quarter results are likely to prove a cut above those of most other utilities. But based on what we’ve seen to date, they appear to represent a pattern of gathering strength for this industry that has generally weathered the recession well.

That performance has been in large part thanks in part to the dramatic and still ongoing industry-wide deleveraging that’s taken place since the fall of Enron in late 2001. But it also reflects positive trends in the economy as a whole that have little or nothing to do with direct government spending, and that’s encouraging for power utilities as well as other sectors.

From an investor point of view, Duke stock currently sells for slightly less than book value, roughly 20 percent below its mid-2008 level, and yields more than 6 percent. As is the case with many utilities, that implies considerable upside as the US economy cycles out of recession.

Like most income investments, the shares are still trading in lock-step with the rest of the stock market, rallying on days when the economic news is good, slipping on days when it’s bad. That’s the opposite of utilities’ traditional bond-following ways. But it’s certain to persist until the US economy definitively recovers and inflation again becomes a worry.

Just what sort of risk inflation is now, of course, is another subject for debate. At least one major bond trading house has declared the biggest long-term risk to fixed income investors has now shifted to inflation from the credit concerns of the past couple years. Bond traders are a notoriously pessimistic bunch. And as yet inflation is basically non-existent, either in the US or globally.

Meanwhile, the negative reaction in the stock market to a drop in October consumer sentiment is a pretty clear sign most don’t really see it that way, at least not yet. Rather, it’s still all about credit risk, and particularly what could happen if the US economy has a relapse.

The US dollar has fallen sharply since early March against every major currency, and particularly those tied to commodity exporters, such as the Australian dollar. That’s hardly a surprise, considering the fact that the Federal Reserve has held interest rates near zero for months. Moreover, the US Treasury has stated its desire to keep the dollar weak to boost US exports, a strategy that’s likely helped US industry start to bounce back.

Nonetheless, every time the US economy seems to falter investors come running for the dollar, specifically US Treasury paper that continues to sell at record-low yields. Yield spreads between investment-grade bonds and Treasuries have shrunk remarkably since early 2009, with Southern Company (NYSE: SO) borrowing two-year money last month at a premium of just 40 basis points.

Yet the benchmark 10-year Treasury yield at 3.45 percent is still near a record low versus yields of other popular income investments, including utility stocks and US-based master limited partnerships (MLP). In other words, the market is still building in some pretty massive spreads to compensate for real or perceived credit risks.

For income investors, the implications are these. As the US economy does recover, real and perceived credit risks will diminish. As that happens, the hefty spreads between benchmark interest rates and yields on utilities, et al., will decline.

If inflation remains low, declining credit risk spreads will translate into huge capital gains for income investments across the board. If, on the other hand, inflation roars to life, declining credit risk spreads will provide substantial downside protection and almost certainly upside as well. This has always been the case for income investments with higher credit risk, such as junk bonds.

It will no doubt also surprise many investors to learn that this was also the case for utility stocks during the latter 1970s. The sector took a big hit along with the rest of the market in the 1972-74 bear market. But in terms of total return, it largely held its own for the rest of the decade, mainly because prices were so low and risk spreads commensurately high.

Of course, no matter how much history rhymes, it never repeats itself exactly. And the performance of industry averages can and does mask very real differences between the companies within. For example, the absolutely horrendous performance of certain nuclear power utilities after Three Mile Island in 1978 was a stark contrast to the much steadier showing of their non-nuclear counterparts.

What sort of inflation we see and how it affects individual companies is still a major unknown. And in fact it’s still not nearly as important a concern for income investors as the basic safety of distributions in a still shaky economy.

The bottom line, however, is expectations are still very low, for utilities as well as virtually every other income investment this side of Treasury bonds. And as long as that’s the case, we’ve got great potential to build on the gains since March 2009 as well as substantial downside protection in a worst-case, should either the economy falter again or inflation pick up unexpectedly.

That’s the main reason to stick with positions in good companies--at least those that continue to perform well as businesses. And it means there are still bargains to be had for those serious about building long-term wealth.

Question of the Week

Here’s my answer to a question I received frequently from readers this week. I hope you find it useful.

• I’ve been having trouble buying the individual bonds you’ve recommended in the Utility Forecaster Income Portfolio Conservative Holdings. My broker tells me they’re not traded, and that even if they were they’d be impossible to sell. I like the high yields and safety, but are they still worth buying? And if so, how can I get what I want?

Intermediate-term bonds issued by investment-grade utilities are among the absolute safest investments for any environment. The intermediate-term maturity (three to seven years) protects principal against inflation as well as credit risk. And regulated utilities have the best track record of any industry coming back from financial problems.

My selections actually gained ground 2008, holding the UF Income Portfolio’s overall performance roughly level in one of the worst environments ever.

And they also held up against the interest rate spikes of spring/summer 2003, 2004, 2005, 2006 and 2007, a good portent should we see more inflation in future years.

Back in the January 2009 UF I recommended a basket of eight investment-grade utility and energy infrastructure bonds, with maturities ranging from 2013 to 2016. Since then, the average total return has been on the order of 25 to 30 percent. That, unfortunately, has pushed several of them out of buying range for now.

My advice for those who got in at lower levels is to stick with them. The best thing about quality utility bonds is they’re as close to a one-decision investment as you can get. Once you’re in, your return is locked in until maturity. At that point, you get your principal back ($1,000 per bond) and you can move on to something else.

The only real risk is that the company goes out of business. But consider this: Even when utilities have filed bankruptcy, bondholders were eventually paid off in full. That’s principal plus any back interest.

And all of the companies represented in my Portfolio are getting stronger. That means credit ratings are much more likely to be raised than cut before maturity. And rising credit ratings mean higher bond prices.

As for new buyers, there are still some selected intermediate-term utility bonds priced at levels that would lock in very generous returns. That’s where you want to concentrate you fire power.

As I’ve written in Utility Forecaster, buying individual bonds doesn’t work quite the same way as buying common stocks. A company will generally issue only one brand of equity or common stock. But it will typically have several different issues of bonds, in large part to spread out the maturity of its debt to make it easier and more reliable to finance.

That means that individual bond issues are not as liquid as common stocks. All of the bonds I’ve recommended are certainly traded and any broker with access to a Bloomberg terminal can get a current quote. The problem is the individual brokerages may or may not have a special issue in inventory. And because investors generally buy and hold to maturity, they may not come up in a specific company’s inventory for days, weeks or even months.

Here’s how I recommend you get around this. If your broker can’t find a particular issue I recommend, see what else they have in inventory from that company with a similar time to maturity. In other words, if they don’t have the Sierra Pacific Resources 7.803 Percent Note of June 15, 2012 (CUSIP: 826428AJ3), have them look for other issues of parent NV Energy (NYSE: NVE) that mature between 2012 and 2015.

Note the coupon yield matters very little when it comes to buying individual bonds. Rather, it’s the yield to maturity (YTM)--which takes into account the fact that bonds always mature at par--that’s important. That’s the annualized return you’ll lock in when you buy. YTM will be generally the same for all of a company’s bonds maturing in roughly the same time frame.

As you can see, I’ve focused on more near-term maturities, given my long-term concern about inflation. But all bonds of a company move together. One issue is literally as good as any other, again with the caveat that longer maturities are more affected by interest rate swings.