Grow Your Portfolio the Intelligent Way

October 2005 Issue

By Richard C. Young

125 Miles of Levees…

In 2004, four major hurricanes made landfall in Florida—each a mini disaster. And how did Florida’s economy fare last year? Florida’s economy roared ahead with a 5% gain.

What can occur with a disaster such as a hurricane is a teeter-totter effect. Although wealth takes a downside hit, economic activity shoots up as the rebuilding process takes hold. For every roof that blows off taking value out of the homeowner’s pocket, a builder sees his fortunes improve as materials are needed and a repair crew gets put to work.

Jeb Bush Took Action

Unfortunately, Hurricane Katrina is quite another kettle of fish. The four 2004 Florida hurricanes were roof-rippers and mobile-home reconfigures for sure. Florida quickly became the state of blue roof tarps. But unlike with Katrina, water-related issues, civil disobedience, and health concerns were minimal. And the Florida hurricanes did little to foul up energy and shipping. Finally, Florida had highly focused and efficient Governor Jeb Bush, not the deer-in-the-headlights Louisiana Governor Kathleen Blanco.

New Orleans Structurally Compromised

New Orleans sits below sea level in a saucer wedged between giant Lake Pontchartrain and the Mississippi River. The lake is 40 miles wide, about double the size of New Orleans. Only an aging 125-mile system of levees prevents Lake Pontchartrain from engulfing the city. A big part of the levee system was built and built well by the Army Corp of Engineers back in the late 1920s and early 1930s. Some of the levees, however, were built by private industry, and politics in New Orleans has never allowed much comfort regarding integrity, whether personal or structural. Over the decades I have spent a great deal of time in this unique city and not much has changed in all the years I’ve been visiting New Orleans. The old city is still old and largely free of so much of the updating visible in progressive cities like Boston and Providence. Wind damage is one thing. Water damage is quite another. New Orleans is going to suffer mightily, as a big percentage of the old city’s buildings are now structurally compromised.

I’ve been writing to you recently about Chaos Theory and the butterfly effect. Katrina will act as a catalyst to a series of events, both big and small, many unforeseen and unpredictable today.

Supply-Side Shock

Katrina is kicking off a supply-side oil and gas shock that may be in line with what occurred in the 1970s. Eight Louisiana and Mississippi refineries are already shut down. Perhaps 10% of U.S. refining capacity (already super tight) has already been knocked out. Louisiana itself is not a big factor in the U.S. economy, accounting for maybe 1% of U.S. GDP. But to knock out refineries is a big deal, as is the crippling shipments of agricultural products. Pipeline systems from New Orleans traverse America from Denver to New England. The Gulf Coast is the key entry port and refining location for much of the U.S. refining industry.

On a national basis, it is clear that, in the next couple of quarters, GDP growth will not be as strong as the perhaps 4% growth pre Katrina. It is even possible that the Fed would put its program of interest rate hikes on hold until next year. In a worst-case scenario, theoretically the U.S. could fall into recession before year end. Consumer confidence is the key here.

Counterbalancing Saves the Day

Your investment strategy need not be altered from current, as I have been guiding you in the direction of a fully counterbalanced portfolio capable of riding out even catastrophic events like Katrina. I don’t expect Katrina to affect your flow of cash payments. Stock and bond prices may or may not be temporarily adversely affected by Katrina. No matter the outlook, at this point, there is no action to take keyed to expectations for portfolio price fluctuations. As noted, Katrina is going to kick in an economic teeter-totter effect. Real estate and various commercial businesses will lose value, and businesses associated with rebuilding will make money. There will be big winners, as well as big losers.

X-Zone Mandated

I have been advising that when looking to reside in hurricane country, you follow my policy of X-Zone, or non-flood locations. Dade County, Florida, has a construction code good for 150-mph winds. And I have written to you to exit St. Joe (NYSE: JOE) for the summer hurricane season if your tolerance for hurricane season volatility is low. St. Joe is since down 15 points. You have indeed avoided the seasonal weather skirmish (and the potential of a shattering hit). There will be plenty of time to return to St. Joe when the weather turns cooler.

Conservative Investing Wins

In the new century, an aggressive stock portfolio invested 50% in the S&P 500 and 50% in the NASDAQ would be down 33%. By contrast, conservative stock market investors invested 50% in the Dow Jones Transportation and 50% in the Dow Jones Utilities would be ahead by about 32%. I regularly advise you to adopt a conservative income-oriented approach, and nothing that has occurred in the new century has diminished my enthusiasm, and I hope yours, for such an approach.

Looking ahead, what should you expect from your portfolio? Here’s a simple back-of-the-envelope approach you can update any day of the week with section C of the WSJ. Drop down to the bottom of page C1 “Bonds & Interest,” and seek out the yield on 10-year T-notes (today 4.11%). Now turn to C2 under the chart on the Dow. Under the “Yearly Range” display, you will find “P/E Ratios and Yields.” Divide the P/E ratio into one to get the Dow’s earnings yield (i.e., 1/17.90 = 5.59%). Add this number to the dividend yield (recently 2.51%) to get your total projected annual return from a diversified portfolio of dividend-paying blue-chip stocks. In my example, 5.59% + 2.51% gives a projected average annual total return from your stock portfolio of 8.10%.

As a conservative target for retired investors, I like a 50/50 mix of stocks and bonds. In my Charts #47 and #52 (Economic Supplement), I show what a 50/50 mix of stocks and bonds historically can do for you. Note the consistency of returns. Now turn to Chart #51 on Vanguard Wellington Fund to get a longer-term perspective on what balance can do for you. Note the paucity of disaster years. Chart #50 shows how bonds act as a counterbalancer to stocks.

Best Stock Market Chart

Finally, turn to Chart #45. It’s the most useful chart on the stock market you will ever come upon. Instead of setting up the Dow in terms of points, I’ve set it up in semi-log form, where percent change is measured rather than change in points. I’ve included a trend line and upside and downside barrier lines for two standard deviations. I write to you a lot about standard deviations because, in a normalized series of data, the empirical (based on experiences) rule is that 95.5% of observations should fall within two standard deviations of the mean. Today, stock prices are well above trend, an indication that you must adopt a conservative approach. And if you need reinforcement for a conservative take on stocks, eyeball Chart #46 on the S&P 500’s dividend yield. Hard to make a value case for stocks today, isn’t it?

6.10% Portfolio Return

Setting up a 50/50 formula based on the 10-year T-note yield (a good proxy) in the WSJ and your earnings-yield/dividend-yield duo, you arrive at a projected total annual average 50/50 portfolio return of 6.10% (4.11% + 8.10% ÷ 2). Remember here, we’re looking at a dividend/interest-based blue-chip portfolio invested 50/50 in stocks and bonds ideal for a retired investor. You could draw 3% per year comfortably on this portfolio and have little worry of seeing your living standard cut due to inflation or running out of money during your lifetime. With modest tinkering, you could likely improve your projected portfolio yield by perhaps 1% per year, but not much more than that without taking on a level of risk I would personally find uncomfortable. You would draw 4% annually.

Let’s briefly focus on fixed income. It looks as if there will be a revival of the 30-year Treasury. No, I don’t like investing in long bonds for a conservative income flow, but I do like long zero-coupon Treasuries at the right time in the interest rate cycle. It will be nice to have some extra ammo to fire at the next peak in the interest rate cycle.

Often I have a subhead or paragraph lead, “TIPS & STRIPS.” My interest in STRIPS is as above and in shorter maturities for regular core investing. TIPS appeal to me when the yield on long TIPS is 4% (far from the case today). With 4% yielding TIPS, you would take on no stock market risk, no credit market risk, and no inflation risk. And you could draw 4% in a retirement portfolio.

Until the unwelcome arrival of Katrina, I had expected the Fed to continue to hike rates well into next year. As such, one decent play was to simply ride up Vanguard Short-Term Investment-Grade as rates rose. With its short duration, a good strategy was in place. I still like the fund, but we’re going to ride steady with today’s 3.95% yield until the impact of Katrina passes.

Vanguard GNMA #1

I’ve written first and foremost on the fixed-income front of Vanguard GNMA Fund with its short duration (3.0 years) and OK yield of 4.45%. Most of your fixed-income mutual fund investing should be done with Vanguard due to the group’s industry-leading low costs. Remember, GNMAs carry the federal government’s full-faith-and-credit pledge, unlike other agency securities.

Preferred stocks should be one-third of your fixed-income holdings. Look for cash flow only. If you’re thinking cap gains, you’re setting yourself up for trouble. Today, investment-grade preferreds offer an average yield of about 6%. You want investment-grade preferreds only. Stick to “A” and better. I like JPM Chase Capital XIV (A1/A-) with a current 6.15% yield.

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