Which Dividend Stocks Are Worth Looking At?

The market has been defying gravity this summer, with the S&P500 up 49% since March. But most of the appreciation has been in what I consider lower quality stocks. Many homebuilders with doubtful prospects have doubled from their recent lows, while stocks that are somewhat recession proof like McDonalds, Walmart, Coca-Cola and Procter & Gamble have bounced a mere 15-20%.

According to Bloomberg, “companies with the worst earnings led the 45 percent gain in the Standard & Poor’s 500 Index since it fell to a 12-year low five months ago”. It might be a good time to sell some of your winners that have exceptionally well and either wait for a pull-back, or if you’re trigger happy, buy solid investment-grade companies.

Given the current economic environment with the US Dollar likely to devalue against foreign currencies and the high probability of inflation, you want to invest in a company with exposure to foreign markets, a stable business model that is non-cyclical and a history of growing dividends. You also want to avoid luxury brands or businesses that sell expensive goods.

Here are a few of the companies that I would consider looking at, along with their dividend yields.

  • Verizon Communications (VZ): 5.87%
  • Johnson & Johnson (JNJ): 3.21%
  • Procter & Gamble (PG): 3.28%
  • Colgate-Palmolive (CL): 2.41%
  • Unilever (UL): 4.39%
  • Altria Group (MO): 7.10%
  • Philip Morris International (PM): 4.61%
  • McDonalds (MCD): 3.55%
  • Walmart (WMT): 2.51%
  • Enerplus Resources Fund (ERF): 9.56%

While I don’t own any of these yet (except ERF), I do own some ETFs that hedge against dollar devaluation and inflation:

  • CurrencyShares Australian Dollar Trust (FXA): 2.04%
  • Morgan Stanley Emerging Markets Domestic Debt Fund (EDD): 7.45%
  • Market Vectors TR Gold Miners (GDX): 1.90%

If you are going to buy currency ETFs or currencies you might want to also check out some of the risk-free currency CDs offered by Everbank. At the very least, definitely subscribe to their free newsletter, the Daily Pfennig. It’s quite informative and very interesting.

ETFconnect.com is a great site to find out more information about ETFs.  Having some exposure to foreign currency and gold miners isn’t a bad idea. I’ve been worrying about the effects of the Federal Reserve printing money like its going out of style and the CEO of Coeur d’Alene (CDE), a silver mining company that I happen to own, predicts that Silver will jump 29% by the end of the year because of this.

Demand from investors seeking a store of wealth accounts for more than half of silver’s 23 percent price jump this year before today, Wheeler said in an interview in New York. The metal will reach $18 an ounce with supplies little changed and demand buoyed by purchases from exchange-traded funds, he said.

“We have this crushing new debt and dollar weakness,” Wheeler said today. “The outlook for precious metals is very positive, and silver will be No. 1.”

The U.S. government has pledged $12.8 trillion, an amount that approaches U.S. gross domestic product, in a bid to stem the longest recession since the 1930s. The spending will erode the value of the dollar and boost the appeal of silver and gold as alternative assets, Wheeler said.

“There’s a lot of anxiety out there over this debt,” Wheeler said. “Around the world, there are a growing number of investors who want protection. They’re going to want silver as part of their portfolio.”

If you believe any of this, you might want to increase your exposure to silver miners like CDE, SSRI or SLW, although these don’t pay any dividends.

Disclosure: I own ERF, CDE, FXA, GDX, EDD, physical gold and silver.

Protecting Yourself Against Inflation

While the debate between inflation and deflation keeps on going, I’m firmly in the camp of inflation. And so is Warren Buffett, as are many other investment advisors. So how do you protect yourself and your investments from the effects of inflation?

Investment newsletter editor, Keith Fitz-Gerald, recently had a post on his blog regarding the 4 ways to protect your investments against inflation. Here’s an excerpt:

What’s interesting is that many investors holding large cash positions view their money as an asset, when, ironically, it’s really more of a liability at this stage of the game.
Some might take issue with that statement. After all, even we at Money Morning have counseled readers that cash – correctly deployed – can allow an investor to sidestep the worst stretches of a financial crisis, like the one from which we’re currently attempting to extricate ourselves.

But when the markets are as beat up as they as they have been, history suggests there’s probably more upside than downside – even if we haven’t bottomed out yet.
And there’s a broad body of research to support that contention – including our own newly created “LSV (LIBOR/Sentiment/Value) Index” (published as a part of The Money Map Report, the monthly investment newsletter that’s affiliated with Money Morning).

There’s also data sets widely published by others, such as Yale Economics Professor Robert J. Shiller. Shiller has found that when you look at 10-year periods of Price/Earnings (P/E) data dating all the way back to 1871, the markets tend to rise when the average P/E is low, as it is right now. Conversely, when the average Price/Earnings values are high – as they were in late 1999, and again in 2007 – a decline in stock prices is much more likely.

There are obviously no guarantees that history will repeat itself. But if it does, the same data implies we could see real returns of 10% a year or more “for years to come,” as Shiller noted in a recent interview with Kiplinger’s Personal Finance.

My own research seconds the general-market-increase theory, but I’m much more conservative in my expectations of returns and think that returns of 7% are more likely.

Perhaps what’s more important right now is that inflation typically accompanies growth – and with a vengeance. And that means that investors who are sitting on cash “until the time is right” may have their hearts in the right place but are relying on the wrong protection strategy.

My recommendation is a four-part plan that can help lock in the expected returns you want, while also protecting your cash from the ravages of inflation. Let’s take a close look at each of the four elements of this strategy:

  • First, protect your cash with Treasury Inflation Protected Securities (TIPs). Even though the trillions of dollars the Fed has injected into the system seem to be having some effect on the critically ill patient the U.S. central bank is trying to fix, we’re likely to pay a terrible price in the future. Forget the hyperinflation scenario so many people are hyping at the moment. While that’s certainly possible, it’s not probable. However, what is likely is a dramatic realignment of the dollar and a general increase in worldwide living expenses.

If you’re based in the United States and have mostly U.S. assets, you may want to consider something as simple as the iShares Barclays TIPS Bond Fund (NYSE: TIP) to offset this risk. The TIP portfolio is chocked full of inflation-indexed securities, but it also offers a healthy 7.46% yield. If you’ve got international exposure, you may also want to consider the SPDR DB International Government Inflation Protected Bond ETF (NYSE: WIP). It’s a collection of internationally diversified government inflation indexed bonds that provides similar protection. Make sure you talk with your tax advisor about both, though. Depending on your tax situation, you may find that because of the tax liability on inflation-related accretion, these are generally best held in tax-exempt accounts.

  • Buy gold but don’t go crazy. Despite widespread belief to the contrary, gold has never been statistically proven as an inflation hedge. But the yellow metal has proven to be a great crisis hedge because of the 10:1 relationship between gold prices and bond coupon rates – which obviously are directly related to inflation. Over time, the two move in such a way that having $1 for every $9 in bond principal can help immunize the value of your bond portfolio.

So to the extent that you own gold, do so not because you expect it to rise sharply, but because it will offset the inflationary damage to your bonds. A good place to start is the SPDR Gold Trust (NYSE: GLD) because it’s tied directly to the underlying asset without the hassles or risks of direct personal storage associated with bullion.

  • Consider commodities. It’s too early to tell if the so-called “green shoots” that everybody is so excited about are little more than weeds. Therefore, it makes sense to concentrate on picking up resource-based investments. History shows that these things are less susceptible to downturns, but more importantly, rise at rates that far exceed inflation when a recovery begins in earnest.

I prefer companies like Kinder Morgan Energy Partners LP (NYSE: KMP) that are less dependent on the underlying cost of energy than they are on actual growth in demand. That way, if energy prices don’t take off immediately for reasons related to deflation or stagflation, those still will benefit from demand growth. It’s a fine point, but one that merits attention for serious investors. KMP, incidentally, yields an appealing 8.68% at the moment.

  • Short the dollar to hedge your bets still further. Not only is the government going to borrow nearly four times more than it did last year, but when you add the complete federal fiscal obligations into the picture, our government owes nearly $14 trillion. This makes the dollar, as legendary investor Jim Rogers put it, “a terribly flawed currency” that could fail at any time.

To ensure you’re at least partially protected, consider the PowerShares DB U.S. Dollar Index Bearish Fund (NYSE: UDN), which will rise as the dollar falls. It’s essentially one big dollar short against the European euro, the Japanese yen, the British pound sterling and the Norwegian kroner, among other currencies.
In closing, there is one additional point to consider. You rarely get a second chance to do anything, especially when it comes to investing. So act now before the markets make it cost-prohibitive to protect yourself. When the economic recovery gets here, you’ll be glad you did.

Pretty sound advice. I was just thinking about converting my 401k into TIPS today when I came across this article. The rest of the advice I’ve followed in some form or another. Instead of directly shorting the dollar, I’m long FXA, which is the CurrencyShares Australian Dollar ETF and EDD which is an ETF of short-term foreign government and corporate bonds.

Another way to SHORT the dollar is buy going LONG foreign currencies. Everbank has multiple CDs you can open in various currencies. They also have some neat products where the principle is guaranteed against loss – there is no free lunch – the interest is used to hedge against loss – but you do get any upside appreciation of the currency. Check out their Marketsafe BRIC CD. Also check out their free newsletter, the Daily Pfennig, which is a good source of unbiased global macroeconomic/monetary and currency information.

Mobs, Messiahs & Markets: Book Review

The publishers of Mobs, Messiahs, and Markets: Surviving the Public Spectacle in Finance and Politics, were kind enough to send me a free copy to review.

I’m glad they did. It was an excellent read, similar in some respects to one of my all-time favorite investment books: Extraordinary Popular Delusions and the Madness of Crowds delves into human psychology and crowd behavior. Mobs, Messiahs & Markets is like a modern-day version with emphasis on investing and explores popular delusions like “real estate never goes down”, “stocks always go up”, “deficits don’t matter”, “you are either with us or against us”. When rational, intelligent human beings become part of a group, they are fine. However, as soon as they become part of a crowd, they lose all rationality and turn into blockheads! I found the book quite entertaining, with great wit and sarcasm to keep me amused.

The book talks about people who were determined to make the world a better place by making it conform to their delusions. People like Hitler for example! The authors also talk about how crowd think leads to wars and how wars are futile and never worth the cost. There’s also a complete chapter making fun of Thomas Freedman and his banal book “The World is Flat”. I never liked that book and apparently neither did the authors. There’s also a full chapter devoted to Alan Greenspan which was particularly eye-opening. It describes how his cowardice was responsible for the mess we’re in today. He exchanged his ideals when he went to Washington for fame and fortune. In his younger years, Greenspan apparently once said “In absence of the gold standard, there is no way to protect savings from the confiscation of inflation…The financial policy of the welfare state requires that there be no way for owners of wealth to protect themselves“. But once in Washington, he turned on the credit spigot and inflated the money supply 10-fold!

The end of the book explains how you should ignore the popular beliefs and learn to think for yourselves if you want to invest profitably. They also caution against buy and hold investing. There is no such thing as buy-and-hold, you are either long or short an investment. If you are in cash, then you are long currency and short stocks and vice-versa. In the current economic climate they encourage going long Gold and short the US Dollar, which they think will fail like all fiat currencies before it (there’s actually a pretty extensive list of defunct currencies on page 256). As they say, gold isn’t a typical investment but its more of a store of value. Since the value of the dollar is about to be destroyed, it makes sense to load up on gold.

Overall, it was a very interesting read. The first half was a little excessive in its mockery of public figures and events. But the later half more than made up for this by explaining how the government and various financial institutions swindle the common public. I plan on re-reading it for the sheer entertainment value alone!

Leaking your Way to the Poorhouse

Today’s guest post is by Wade W. Slome, CFA, CFP® (www.Sidoxia.com), author of How I Managed $20,000,000,000.00 by Age 32

We are living through unprecedented times in our economic history and the urge to give into the all-consuming panic spreading across the airwaves is very tempting. Unfortunately, succumbing to the pressures of following the herd produces suboptimal investment returns over the long run. The appropriate tactic is to invest objectively and independently, not emotionally. Or in other words, buy fear and sell greed. Most people understand the concept of buying low and selling high, but their thought processes at peaks and troughs somehow regress to the belief that circumstances are “different this time.” Stocks are definitely not for everyone; however history shows that recessions are the absolute best times to buy, for long term investors.

The eventual outcomes of emotional buying or selling are self evident in the regrettable data. John Bogle, the very successful founder of The Vanguard Group, did an eighteen year study (1984-2002) showing that individual investors underperformed the “do-nothing” index strategy by more than 10%…PER YEAR. It really astonishes me how much trading, fees, and emotions can impact long-run investment returns.
Paying fees on your investment portfolio is somewhat like a car leaking oil. A few oil drops leaking out of your engine is no big deal. But if your car is leaving behind large puddles and the engine cannot maintain the adequate level of lubricant, eventually the engine will simply stop running – leaving behind a messy situation that precludes one from reaching the desired destination. The same principle applies to investing, when considering fees, transactions costs, and taxes.

If the last decade hasn’t been challenging enough for equity investors, some brokers have added insult to injury by charging excessive fees – not a healthy recipe for individuals’ retirement plans. I am actually very optimistic about the investment opportunities available in today’s marketplace, however less sanguine about the sucking sounds coming from some of the aggressive fee-sucking brokers (a.k.a., Hoover vacuums). I’m making every effort I can to educate investors to better arm themselves against unscrupulous behavior and augment their knowledgebase regarding fees, transaction costs and taxes.

And when it comes to the investment industry, fees come in all shapes and sizes. There are explicit fees, such as, management fees, 12-b1 fees, administrative fees, load fees, and surrender charges, among others. Unfortunately there are indirect costs that drag down returns such as excessive transactions costs and taxes, and most investors don’t consider these impact. It does no good for the investor if a gargantuan pre-tax return is achieved and then evaporated away with fees, transactions costs, and taxes. Even if you exclude taxes, the average investor is paying 2.5% annually according to Bogle (1% in management fees, 1% in sales/load fees, and .5% for transactions costs).

Consider a $150,000 investment account earning an after-tax (net of fees) return of 5% over 20 years. That portfolio would grow to nearly $398,000. Let’s assume the efficiency of a portfolio could be improved with lower-cost, tax- efficient products and strategies, resulting in a net after-tax return of 7%. What do you think that innocent 2% improvement is worth? ANSWER: Over $182,000! That’s not chump change, and that money could buy a lot of vacations, medical bills, tuition for grandchildren, or many other niceties and necessities. Most people don’t fully appreciate how direct and indirect costs impact the timing of when AND how you will retire.

Now that you have recognized the leaking oil in your engine, don’t let fees, transaction costs, and taxes seize-up your investment engine!

Wade W. Slome, CFA, CFP® (www.Sidoxia.com)

Plan. Invest. Prosper.

Long-Short Bond Trade: Now With Reduced Volatility!

In a previous post on Deleveraging, I promised I’d talk about an interesting long-short bond trade that I entered last week.

If you believe that US Treasuries are over-valued, or foreigners will lose their appetite for US debt thus forcing up the interest rates, you’re probably looking to short treasuries.  Ok, maybe you haven’t looked in to shorting anything.  In that case, may be you should read this link on Barrons and then come back. (Barron’s thinks that investors are buying gold as an alternative to near-zero yielding treasuries.)

One of the ways to short the Treasuries is buying the UltraShort Lehman 20+ Treasury ProShares (TBT).  This ETF returns twice the inverse of the daily movement in the 20 year T-bill. However, these things never move in a straight line and can be extremely volatile.

Instead, I decided to do something a little esoteric.

I shorted the iShares Barclays 20+ Year Treasury Bond (TLT) and netted $112.10 per share.  I used that money to buy an equivalent dollar amount  of the Alliance Bernstein Global High Income Fund, Inc. (AWF) at $8.29 (that’s buying about 13.52 shares of AWF for every share shorted of TLT).  Unlike the TBT position however, this position yields a dividend! AWF has a yield of ~13.4% while the short TLT position had a negative yield of 3.5% (since I shorted the ETF I need to pay this dividend), which results in a positive net dividend yield of ~9.9%.

Since TLT and AWF might sometimes move in sync, you’d think this portfolio would have a lower volatility than just TBT. Just to be sure, I also calculated the standard deviation of this portfolio on a bloomberg terminal at school and the resulting standard deviation was about 30% lower than for each individual ETF. (The standard deviation is often used by investors to measure the risk of a stock or a stock portfolio. The basic idea is that the standard deviation is a measure of volatility: the more a stock’s returns vary from the stock’s average return, the more volatile the stock. In short, less volatility is better).

Check out the graphs of TLT, AWF and TBT. Remember, TLT is a short position so you need to multiply the returns by -1 and add it to AWF.

long corporate bonds - short US treasuries

From the chart you can see that yesterday both TLT and AWF trended higher and predictably TBT lost value.  However the combined portfolio was slightly positive.

After last years volatile returns, anything that reduces volatility in your portfolio is a good thing!

Note that AWF is mainly comprised of short-term US corporate debt and some soverign bonds. There is a some foreign currency risk involved but with the US Dollar being a lot higher than it was a year ago, I’m willing to take this risk.

[Disclaimer: In case it wasn’t obvious, I’m long AWF (short-term corporate bonds) and short TLT (long-term government bonds).]

Sam Zell Imparts His Wisdom

One of the advantages of going to a top-tier MBA program is that you get to meet a lot of succesful, well-known people. Last week, billionaire real estate investor Sam Zell was on campus and gave an hour long speech about his views on the economy.

He made an analogy that the economy was like a bus being run by a monkey who let everyone drink, smoke weed and fornicate like crazy and then crashed it!  There’s no free lunch.  We’re going to have to pay for the past excesses.

sam_zell_equity_properties

Over the past 40 years, there’s only one true metric for real estate – and that’s the replacement cost of a building. Costs cannot stay much higher than that for extended periods of time. During the past few years, real estate was selling at astronomical levels. People were buying long-term with short-term financing, which has always ended in disaster. The value was not based on its intrinsic value, but on how much they could borrow against it. And the people making the loans just sold them off to unsuspecting pension funds and sovereign wealth funds. There was a huge disconnect between the borrower and the actual lender. There was also a disconnect between risk, reward and responsibility.

A lot of the current mess was caused by long held beliefs just being plain wrong. People believed that real estate always goes up, that companies like GM and Merill Lynch were too big too fail.  They also came up with a new belief system that didn’t include paying back loans – instead they just refinanced them! A rolling loan, carries no loss.

Instead of throwing people with bad credit out of homes they couldn’t afford in the first place, the government lamented on the victimization of the borrowers. Zell isn’t impressed with the government’s handling of this situation. In an effort to get the bail-out bill passed, there was a lot of fear-mongering and even a bait-and-switch to get the bill passed.  Apparently a $700 billion bailout got passed with a 3 page memo which no mention of how to spend the money.

He also commented on the recession. He sees consumer consumption going down, but the government will step in replace it. He thinks that government spending will increase from the current 18% of GDP to being more like France, where it is around 50%. This is a structural change caused by the deleveraging effects of and this recession is going to felt around the world.

But this doesn’t mean there won’t be opportunities to make money! Opportunities exist, but for those with access to capital. Capital is as scare as ever and you need to recognizing that capital will be the key to make money in this environment.  Asset pricing has started to become out of whack with reality.  We are starting to see deep discount below the intrinsic value.  We can buy assets below their replacement cost.  This will essentially create a floor at some point, since buyers will step in below the replacement cost.

But right now he see the best opportunities in debt. Right now we can get unlevered returns of 15-20% on performing loans, which is unheard of.   This is a function of liquidity risk, not of default risk!

In the 80s and 90s, Zell was a buyer of the last resort. He’s proud of the fact that everyone calls him the grave dancer, since he buys properties at fire-sale prices and resells them for a profit.He recommends waiting until the equity holders have no equity left in the assets before buying them.  He mentioned the story about a bank who came to him with a property they said was worth $32 million. He offered $16 million. The bank said they’d do the deal at $18 million or else they’d take it to the market. Zell called their bluff and eventually bought it for $9.5 million! Patience is a good thing to have in this market! (Check out this link to see cheap commercial real estate).

Zell thinks there will be a demand recession. You never want to invest where there is no demand for your product. He recommends buying where demand is still strong. He’s currently building low-income housing in places like Mexico, where there is a strong pent-up demand for that product.

He also spoke about investing in BRIC (thats Brazil, Russia, India and China). He strongly cautions against Russia because there is no law. However, he thinks positively of the other countries since they have embedded demand. If you can service that demand, you will do well. But doing business with honest and ethical people is very important. He recently passed on a proposal to do business with an Indian company because he didn’t think they were ethical. As it turns out, they weren’t and they’re now facing bankrupcy. That company was Satyam, India’s Enron!

He isn’t a fan of investing in Europe. With it’s shrinking population, he sees no demand.

However, if you can find demand in the US, you will do well here too. The US will somehow spend its way to recovery, although he later mentions that this will come at a cost of a severe inflation. But he still likes the US. We’re special. The US is the only place on the planet where you’re allowed a do-over if you mess up. It’s called Chapter 11!

Housing in the US is getting better. While there is a standing inventory of 1 million households, the creation of new households keeps on increasing. Housing will come back, but slowly.

He thinks there will be no instant gratification this time around. The medicine being put into the system will slowly impact the economy. He thinks the economy will start to turn around by the beginning of 2010 but the risk of inflation is very high. He didn’t really elaborate on the inflation or economy part but the only thing I know is that you should buy gold ;-).

The US is a unique society with a lot of opportunity. However, he sees the current government interference hindering the growth that has made us the greatest country on earth. This sounds a bit contradictory to me. First he says the government spending will pull us out of recession but it will also hinder our growth? Again, he didn’t really explain this.

After this he took a few questions:

He doesn’t think the US will lose it’s place as the world’s reserve currency.  There isn’t really any other replacement. In the very long term maybe it might happen, but right now he doesn’t see any alternative. Currently no central bank wants to bet against the dollar.  He also mentioned that the “beggar thy neighbor” mentality of European countries would disappear and interest rates would drop all across the developed rates to match the pathetically low rates of the US.

He also explained how he managed to sell Equity Properties at the very peak of the real estate cycle to Blackstone group. (Speaking of Blackstone, check out this post on How Capitalism Really Works). He does a quarterly valuation of all his holdings. Blackstone made him a $39 Billion offer that was 20% higher than what he thought it was worth, so he sold it.

He also mentioned that he didn’t think the government programs would stem foreclosures. There has been massive fraud going on. He gave the example of an entire subdivision of  homes in Stockton being sold to migrant Mexican workers. People who made $8/hour were somehow approved for $350,000 loans! Only people who can really afford them to get to keep them. He cites the example of Japan. The government/lenders allowed people to stay in the homes rent and mortgage free. Since there was no incentive for people to pay, property prices stayed depressed a lot longer than they should have. So the biggest risk right now is lenders not cleaning up and making poeple pay for there mistakes.

Zell also spoke about his Tribune purchase. He says the newspaper model is broken. It costs more money to have papers home-delivered but you pay less for that service. He explained he would change that model and that would increase the revenues. Let’s see if that’s true.

In all, it was very interesting.  But it was over quickly and the $5  billion man literally ran out the door before anyone could stop him for photographs or autographs.

Super-Hero Investments

Just thought I’d share an interesting email:

Jim Grant noted in his recent Interest Rate Observer that eight blue-chip companies now meet or exceed Ben Graham’s strictest criteria for defensive investors: Pfizer, Nucor, Cooper Industries, Cintas, Tiffany, Archer Daniels Midland, Molex, and RadioShack.

These are like superhero investments. Each has

  • 10 consecutive years of net profits
  • 20 consecutive years of uninterrupted dividend payments
  • earnings growth in the past decade of at least 33%
  • price-to-earnings and price-to-book multiples of less than 15

For perspective, Grant notes that at the bottom of the Nasdaq bust in 2003, only two stocks met all those criteria. At the bottom of the market in 1991, only six qualified. (Since 1991, those six produced average annual returns of almost 19%.) If you bought just these eight stocks and forgot about them for a decade, chances are better than 90% you’ll make a substantial return and beat the market. Usually, that’s a lot harder to do.

Note: These, are not my personal recommendations to buy. Do your own Due Diligence.

Is It Safe To Buy California Munis?

In my last post, I mentioned that about California was running out of cash.  Because of these concerns, yields on California Municipal Bonds are pretty high right now. But is it safe to buy them?

According to the Wall Street Journal, it would appear that it is. They asked the California state treasurer Bill Lockyer whether  the California public debt was completely safe. “Absolutely, the only way we’re going to default is if there’s a thermonuclear war.”

David Blair, the head of municipal credit research at bond giant Pimco, agrees. “They clearly have the ability to pay,” he said. But he added that the main risk is headline risk, where bad news smacks prices.

The ten-year Treasurys currently yield about 2.5%. California’s bonds yield about 4.2%. And that’s also exempt from federal income tax.

According to Vanguard’s Mr. Smith, the gap between the two has never been so high. The picture is similar for municipals across the country. Panicked investors have dumped everything – and blindly jumped into Treasurys, driving yields down to incredibly low levels. Meanwhile munis are also under pressure because so many states and cities will have to borrow more.

So there’s no doubt that California will pay back the debt. In the worst case, the Federal Reserve would just bail the state out. If they’re willing to bail out car companies, I’m sure they’ll step in for California.

But if there’s more bad news, the yields could go higher still, and the prices of the bonds could fall in value.

Will 2009 Be A Good Year For Stocks?

Prof. Jeremy Siegel, author of the excellent book The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New, seems to think 2009 will be a good year for the stock market:

All of this means that, although the first quarter of 2009 will see negative growth, GDP should stabilize in the second quarter, earlier than most economists now anticipate. In real terms, housing prices have already retraced most of their gains from 2000, and by midyear prices should stabilize in this low-interest-rate environment. Year-over-year inflation should sink to zero, especially in the first half of 2009.

This year, as the economic slide abates and investors realize a catastrophe has been avoided, stock prices should enjoy a 20 percent or higher return. All equity sectors should recover.

The financial stocks will still be burdened by bad loans and government obligations. Nevertheless, new lending will prove extremely profitable to the banks whose cost of funds is now essentially zero. The Fed might find that it will be forced to raise rates during the summer, earlier than planned. And I believe long-term Treasuries are in a giant bubble and their prices will fall to earth once the economy improves.

All of this doesn’t mean there are no risks to stocks. The Fed must do more to encourage banks to lend to credit-worthy, non-delinquent customers. And the Obama administration must carefully structure its recovery plan so as not to bail out those that have been profligate and penalize those who have been thrifty.

Still, just as 2008 disappointed us on the downside, 2009 might surprise with better numbers than most are expecting.

Of course, just like everyone else, he didn’t exactly predict the worst bear market since the Great Depression! In fact, he thought the market would be led higher by financial stocks.

One of the few people who got it write was Nassim Nicholas Taleb or NNT for short. NNT was an options trader who achieved public fame after his awesome 2001 book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets became a best-seller. His hedge fund actually did very well last year returning in excess of 50%.  Check out his video:

Also check out this great NYT article on how misunderstanding of risk management tools caused the financial mess.

Common Sense Advice For Investing In The Stock Market

Given the poor performance of the stock market in 2008, its time to go back to the investment basics and make sure you don’t forget the important stuff.

1. Only invest in companies that pay a decent dividend (at least 3%) and that have a long history of increasing their dividend.

You should consider share buybacks when measuring the dividend yield. This criteria achieves several goals. Its narrows your possible choices substantially, providing you an investment “universe” that’s more manageable.

It also automatically prevents you from buying stocks that are speculative or overpriced. If the company is cooking the books, it cannot maintain its dividend. Companies like AOL or MCI Worldcomm were reporting record profits during the Tech bubble (and so was Enron during a later period) when in fact, they were booking large losses. Since they weren’t paying out any dividends they were able to get away with the fraud for a lot longer than otherwise possible.

Investing in dividend-paying companies greatly reduces the odds that your account will ever show a loss. Earning 3% a year isn’t much, but it adds up, especially if the company continues to increase its dividend. After a year or two, even if the share price dips, you’ll probably still show a gain, thanks to the dividend.

2. Out of the companies that are paying a good dividend, only buy companies whose businesses you’re able to easily understand and that you judge to have a solid competitive advantage.

To increase your understanding, read the company’s 10K (annual report) filed with the SEC. You can get a copy online for free at the companies website or the SEC’s website. If you’re not willing to spend an hour or two reading a company’s 10K, are you really ready to invest 4%-6% of your life savings in its stock? It’s surprising that investors will readily pile money into companies that they don’t understand, and that they make no effort to understand.

Note, I’m not talking about trading here. I’m talking about investing – buying a position and keeping it for years.

3. Only buy stocks when they are very attractively priced, i.e. when there’s a substantial margin of safety in the stock.

Benjamin Graham (The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel) was a huge proponent of Margin of Safety (Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor), which means you should buy a stock when it is worth more than its market price.

This step makes it nearly impossible for you to lose money investing and will ensure you garner the benefits of compounding, because your entry price will be small relative to the company’s assets and future earnings.

It’s very hard for anyone to beat the compound returns of high-quality common stocks held for the long term. If you will follow these three simple rules – good dividends, understandable businesses with competitive advantages, and buying only at very safe prices – you can achieve world-class investment results.

Now if I could only follow this advice!