Reality Check on Markets and the Economy

By Lee Bellinger / October 28, 2014

The U.S. stock market finally got a dose of economic reality last month. In October, stocks broke lower in the face of weakening economic data and Ebola fears.

The Dow Jones Industrials slid into negative territory for the year. So far, it’s just an overdue correction. Whether it turns into a more protracted bear market remains to be seen.

This newsletter has been cautioning against buying stocks at elevated levels all year. Those cautions still remain in place for areas of the market still beset by overvaluations, including the broad indexes themselves. However, the recent slide in global equities markets has created some attractive long-term buying opportunities in certain beaten-down areas.

My September lead story specifically urged you to brace for an outbreak of volatility. I highlighted low-volatility investments you could own and hedges you could put on. Is now the time to think about getting more aggressive in some areas?

At this juncture, investors would still be wise to favor dividends over growth stocks. Market averages still have room to fall further. At the same time, dividend yields in many sectors still beat the pants off bonds and cash. So long-term income investors should continue to focus on dividends from equities that are in favorable sectors and countries.

Many of the recent high flyers in the Nasdaq and smallcap spaces pay no dividends. These types of stocks are speculations. Now isn’t an ideal time to speculate in areas that could be expected to come down the hardest if volatile market conditions persist.

Harvest Rich Dividends from the SEA

Earlier this year, we highlighted lower-risk, highdividend sectors such as utilities. The October pullback has created attractive value propositions in a lesser-known high-dividend sector I’d like to bring to your attention: the global shipping industry.

The Guggenheim Shipping ETF (SEA) tracks an index of shippers involved in the transport of bulk goods and materials via freight ships. SEA’s portfolio of 26 stocks delivers an estimated yield of 3.5%. The vast bulk of its investments are in the United States, Denmark, Bermuda, Greece, Japan, and Hong Kong.

The fund’s top ten holdings by portfolio weighting are:

  • Moeller-Maersk (18.9%)
  • Nippon Yusen (6.6 %)
  • Teekay Corp (5.3%)
  • Sembcorp Marine Ltd . (4.9%)
  • Cosco Pacific Ltd. (4.8%)
  • Teekay LNG Partners (4.3%)
  • Teekay Offshore Partners (4.3%)
  • Kawasaki Kisen Kaisha Ltd. (4.3%)
  • Matson Inc. (3.6%)
  • Navios Maritime Partners (3.5%)

The global bulk shipping industry is more cyclical than other high-income sectors such as utilities. That’s why it’s prudent to wait for cyclical downturns to play out before buying into shippers. Then, be patient while you collect dividends and wait for the sector to recover into the next up cycle.

From these levels, the sector should prove rewarding over time, especially compared to bonds and other income instruments with inferior yields. But it will give you a more volatile ride than conventional fixed income instruments.

If you are prone to emotional “sea sickness” after experiencing ups and downs in your investments, then SEA shouldn’t occupy a large area in your retirement account and may not be suitable for you at all.

Oil Prices Tumble…
But May Soon Find a Floor

Shipping, transportation, and consumer stocks stand to benefit from the recent drop in crude oil prices. (Unless the oil market is serving as a harbinger of a global recession.) In that case, beaten-up precious metals mining stocks could be the prime beneficiaries as they see lower input
costs and stabilize to rising gold and silver prices.

Oil has taken a huge decline from the summer highs of $107 per barrel back toward $80 per barrel. The oil market moved on weakening global economic reports and Saudi Arabia’s vow to ramp up production.

If it weren’t for the U.S. oil and gas fracking boom, we would have surely been looking at record high oil prices north of $150 this summer. Along with a lower dollar and a much worse economy under the weight of Obamanomics.

A surge in supply from hydraulic fracturing has enabled domestic oil production to grow the most since 1970 (source: U.S. Energy Information
Administration). Consequently, U.S. oil imports have been plummeting. That’s why OPEC now feels compelled to undercut U.S. shale oil by bringing more lower-cost crude to the market.

At first glance, it seems like the fundamentals are in place for much lower oil prices. But the reality of shale oil is that its costs of production are fundamentally high. Oil from shale formations costs an average of around $80 per barrel to produce – compared with only $20 a barrel for
conventional oil drilling.

If oil dips below $80 and stays there, the fracking boom will start going bust. And domestic supplies will start dwindling. There seems to be a fundamental floor somewhere around $80 per barrel. The EIA forecasts that West Texas Intermediate Crude will average $94.58 next year. It could go significantly higher on a spike.

Energy investments look attractive, as do precious metals and natural resources in general. Over the past couple of years, the fracking boom has taken pressure off the government and the Fed to provide inflationary stimulus.

That’s allowed the dollar to strengthen temporarily. Which in turn has put downward pressure on commodity prices. But the months ahead could see a big rebound in the resource space as economic realities set in.

U.S. No Longer Tops Economic Freedom List – But See Who Does

Cheaper fuel prices at the pump act like a broad, major tax cut. The United States economy has been spared from suffering the worst consequences of Washington’s misguided policies – so far. But the debt obligations keep piling up. The high corporate taxes keep driving capital flight. And the excess regulations keep stunting small businesses, medical breakthroughs and broader employment.

Once considered the world’s bastion of free enterprise, the U.S. now ranks 12th in the world for economic freedom, tied with its former imperial master, the United Kingdom. That’s according to the Fraser Institute’s 2014 Economic Freedom of the World report.

As Fraser Institute senior fellow Michael Walker remarked, “The United States has suffered from a weakened rule of law, the ramifications of wars on terrorism and drugs, and a confused regulatory environment. Consequently, it’s dropped from second place in the world rankings in 2000 to 12th place this year…”

The U.S. is still in many respects freer than most other parts of the world. But in other ways, the U.S. is among the most over-regulated and over-taxed places. Take the corporate tax, for example. At 35%, the American corporate tax rate is the highest in the industrialized world. Over-taxation and overregulation threaten to undo the economic boon we’ve enjoyed from the oil and gas fracking boom.

Unless the U.S. tax system is reformed in a meaningful way to make it more pro-growth, we risk accelerating capital flight in the years ahead.

Some in Washington, D.C. have taken to bashing corporate “inversions” (wherein a company acquires a smaller firm in a more tax-friendly country so that it can repatriate its earnings there). What’s really inverted is our rank in corporate tax rates. The Land of the Free should be near the bottom, not at the top! The corporate tax rate in the United Kingdom of all places is set to fall to 20% in 2015.

Entrepreneur Nigel Green predicts that our uncompetitive 35% corporate tax will start hurting the economy, big time: “My prediction that 2015 will be the year that the U.S economy could be defined by this phenomenon is based on deVere Group’s U.S. business-owning client base. The number of requests that we are receiving from them for more information about moving their registered business headquarters overseas is steadily
growing.”

Hong Kong remains the world’s freest economy. Yet it has never been a fully independent, fully democratic society. Concerns that mainland China’s control over Hong Kong would squelch freedom there have been voiced since it passed from British to Chinese stewardship in 1997. But political freedom and economic freedom appear to be two separate concepts so far.

Recently, student protestors in Hong Kong took to the streets to demand more political freedom. Regardless of the merits of their complaints, they have it pretty good there compared to most mainland Chinese and most of the rest of the world.

More economic freedom means more capital inflows, more wealth creation, and over time more robust equity markets. You can invest in the stock markets of the world’s freest economies by constructing a portfolio of country ETFs. A World’s Freest Countries portfolio could look something like this:

  • iShares Hong Kong (EWH)
  • iShares Singapore (EWS)
  • iShares New Zealand (ENZL)
  • iShares Australia (EWA)
  • iShares Switzerland (EWL)
  • iShares Canada (EWC)
  • iShares Chile (ECH)

The portfolio gives you diversification into Asia, Oceania, North America, South America, and Europe – but with a focus on freedom! Where things stand now, the World’s Freest Countries (and most other countries in the world) trade at more attractive valuations than the U.S. Their stock markets give you more earnings for the price you pay for the shares and pack bigger dividend yields.

Some of the single country exchange-traded funds are more thinly traded than the big, broad international indexes. This includes examples such as Vanguard All-World ex-US (VEU). Exercise caution and use limit orders to make sure that you aren’t toyed with by market makers.

Lower Mortgage Rates = Buyer’s Market?

What about real estate? Recent data on housing starts suggest the recovery is stalling. The nation’s homeownership rate has fallen officially to 64.7%, according to the U.S. Census Bureau. That’s the lowest level in 19 years. The real homeownership rate is probably lower after accounting for the more than one million homes with delinquent mortgages or in foreclosure.

The good news is that there’s no housing bubble! The bad news is that the market may still need more time to recover from the last one.

Meanwhile, mortgage rates are heading back down toward enticing levels for people in the market to buy. The average rate on 30-year home loans tracked by Freddie Mac fell to 4.12% in October. That’s down from 4.53% in January.

Some analysts now believe rates could dip back below 4%. If so, they likely wouldn’t remain there long-term. Eventually, interest rates will rise back up toward historic norms. Interest rates have been manipulated by the Federal Reserve over the past few years.

With the Fed now telling the public that it will stop buying mortgage securities, perhaps more normal rates of interest will start to set in.

The smart money seems to think that rates will head higher over time as the value of the dollar heads lower. Owning real estate financed at a low fixed rate is one way to gain from inflation – if you’re in it for the long term.

Get A Fixed Rate Home Loan

Mega investor Warren Buffett is on board with this wealth-building strategy. He said at an October 7th conference hosted by Fortune magazine, “You would think that people would be lining up now to get mortgages to buy a home…It’s a good way to go short the dollar, short interest rates. It is a no-brainer.”

Buying a home or refinancing an existing one is worth considering if your financial and lifestyle situation can support a major long-term commitment to property. Don’t expect immediate benefits.

But if Warren Buffett is right that interest rates will head higher and the dollar lower in the coming years, then now is a good time to acquire tangible contra-dollar assets using low, fixed-rate financing.