Commentary for the week ending 3-26-10

The markets continued their run this week, reaching new highs for the year. The major indices trended modestly higher for most of the week but sold off late Thursday and into Friday. For the week, the Dow closed up 1.01%, the S&P 500 gained 0.58%, and the Nasdaq rose 0.87%.

Source: MSN Moneycentral

Even though the stock market reached new highs last seen in late 2008, the interesting story of the week came from the bond market. Several issues in the news are forcing yields higher on bonds. Bond investors are very concerned at the amount of debt on the U.S. government’s balance sheet, and the news this week only increased these concerns. First, we found out that companies like Berkshire Hathaway (Warren Buffett’s company) can borrow at a lower rate than the U.S. government. That implies that there is less chance of default for these companies than for the U.S. government, a rare feat.

Next, it was reported that we will be paying out more in Social Security this year than collected in taxes. It was believed that we would reach this milestone in 2016, so this troubling statistic adds fuel to the fire for the deficit reduction hawks.

Finally, dominating the news this week was the healthcare bill. With its passing, new concerns have arisen on its cost. Despite the CBO report indicating a reduction in the deficit, further examination of the details actually reveals a substantial increase in debt.

These growing entitlements and the lack of fiscal restraint came to a head this week in the latest debt auctions. Fewer people (or foreign governments) are showing interest in purchasing more U.S. debt, so yields are rising. That impacted the entire bond market as the prices of bonds dropped (price and yield are inversely related, so when the yields rise, the price of the bond falls). So if, for example, you own a bond mutual fund or ETF, you saw a drop in the value of the fund this week. But with interest rates rising, the payments you receive from the bond fund will increase over time.

While bonds can be boring, it is important to note the trends in this market. Let’s get back to some stocks now. With the healthcare bill now requiring all Americans to purchase insurance, this is seen as a boon to healthcare stocks. This sector has had a nice run recently due to this fact. Digging deeper into the healthcare bill, though, reveals some very damaging items for this sector. A little reported new law will require insurers to pay out 85% of each dollar collected to claims, while the remaining 15% goes to administrative and other miscellaneous expenses. That doesn’t look bad on the surface. The problem is, that ratio currently stands at 65/35. So for every dollar you pay now, 65 cents pays for claims and 35 cents covers those admin costs.

Do you see the problem there?

Insurers must cut their administrative costs by more than half (from the current 35% to the new 15%). In order for insurers to meet the new 85/15 threshold, they will either have to dramatically cut admin costs (i.e.-fire people) or dramatically raise premiums - which won’t be allowed. If this daunting new 85/15 threshold can’t be met, the insurer will be out of business.

Also in the bill is a new 40% tax on “Cadillac” health packages beginning in 2018. This tax will not be paid by the person receiving the benefits, though. For some reason it will be paid by the insurer. Margins will have already been squeezed from the 85/15 mandate, and this new cost may be the final nail in the coffin for private health insurers.

While the bill may look like a boon to the healthcare sector, it is actually just the opposite. The government opted to not include the public option in the bill, but these new mandates provide them with the back-door takeover they desired. We believe healthcare stocks should be avoided at all costs, and more adventurous investors might profit by shorting (profit when the value falls) these stocks.

Next week marks the end of the first quarter and will have several economic reports we will be watching. Personal income, consumer confidence, factory orders, and manufacturing reports will all be released. The most important report will come on Friday (although the stock market will be closed for Good Friday) with the release of the unemployment rate. We have seen estimates as low as 20,000 job gains and as high as 300,000. The market is pricing in a pretty large gain here, so a poor number will likely cause a sell-off (on the following Monday).

Where are we investing now?

For the overall market, we remain optimistic in the short term, but cautious. As we have said in past reports, the easy money and stimulative measures currently in place will help the markets higher. Higher interest rates, higher taxes, increasing government involvement in the private sector, and high unemployment have us worried for the longer term.

In equities, we are focusing on higher-quality and multi-national stocks. We are still bullish (optimistic) on commodities and believe that government policies will weaken the dollar in the long term. TIPs continue to be a favorite, as we expect inflation to increase in the future, despite being tame at the moment. U.S. treasuries are a sector we are very bearish (pessimistic) on. Finally, we are optimistic about international stocks, as emerging markets (excluding China) are areas we favor.