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Contents » Bond discussion » Reporter roundtable

KAREN GIBBS: Without being too alarmist, it's hard to overstate the fallout in the bond market in recent weeks. So let me try to put it in perspective for you.

As the sun was coming up the morning of July 31, traders at the Chicago Board of Trade began frantically unloading bond futures contracts. By the time the closing bell rang, bond futures had moved 3 3/4 points, the biggest one-day move in 26 years. To paint you a picture, that selloff in bonds would be equal to an 800-point drop in the Dow. Careers, retirements, and lots more have been ruined by much smaller losses.

So what's the fallout, and how do we make money in this environment? Randall Eley, of the Edgar Lomax Co., says when handed a lemon, make lemonade. Chuck Tennes, of the Rydex Funds, says when the sky is falling, sell sky. And Jim Bianco, of Bianco Research, says look for sectors that will benefit from the recovery that rising rates are signaling. Jim joins us from Chicago.

Gentlemen, welcome.

Jim, let me ask you -- I used to work on the Chicago Board of Trade floor and I know the energy that’s behind that type of one-day move -- but what was the message investors were supposed to get out of that?

JIM BIANCO: Oh, I think the broad message is, is that the economy is recovering. Rising interest rates are not a bad thing. They are a sign the economy is recovering. And so in some respects it should be greeted with open arms that rates are rising.

On the other hand, that type of move, over that short a period of time, should also be a warning to investors that the market has too much leverage in it and that may not be over with. You don't usually end with those kind of moves in the bond market, at least. There's usually more to come.

GIBBS:: Well, investors, Jim, have been told to diversify their portfolio by adding bonds. Now what are they supposed to do?

BIANCO: Well, that's worked very well for them for the last three years or so, but I think that the bull market in bonds has about run its course and they should be looking for other avenues in the marketplace. (If) the economy is picking up like I think it is, they should be looking back towards stock market or corporate bonds or high yield bonds, and in particular be looking towards, say, cyclical stocks which which would benefit from a recovery in the economy.

GIBBS:: Chuck, let's talk about this bond sell-off some more. A lot of people were caught offguard by the rapid descent. Do you think they could have been or should have been better prepared?

CHUCK TENNES: I'm not sure about better prepared, but I think people should be aware that there were a few external shocks that helped to trigger those events. If you remember, it was just a few weeks ago that the Freddie Mac scandal came out. Subsequent to that the European bank advised its clients, its members to sell U.S. mortgage-backed securities. Last week we had a very large issuance from the Treasury; this increased the supply of bonds which lowered prices and increased yields. So one thing we have to be careful of is not to assume that this is the beginning of a long upward trend -- which I think we are expecting for the long term. (But) it's entirely plausible that the next move could be down, however, in interest rates.

GIBBS: Randall, what are you telling investors that are holding bonds now?

RANDALL ELEY: Remember, we are value investors when it comes to stocks and so we look at the bond market in a similar vein. The fact of life is, history tells us a lot about where securities ought to be valued. So I never thought the 10-year bonds should have been yielding 3.1 percent, at least not for the long term. When you look back, the historic average is somewhere in the 5-percent-plus area. Sooner or later it's got to go back there. Plus the U.S. government is borrowing more than any other government in the world, to my knowledge, so you have a supply/demand situation too. Yield’s got to go up in order to move the supply of bonds.

GIBBS: Jim, let me come back to you and talk about corporate bonds. Why should they be any better than treasuries?

BIANCO: Well, corporate bonds have another little wrinkle to them in that they are a lot like stocks. They're starting to kind of gravitate from just pure interest rates into the holdings of corporates. If the economy is going to recover, that should reduce the credit risk with corporate bonds. And that we've seen happening throughout most of this year, as credit spreads have been narrowing, suggesting investors are gaining more confidence that corporations are going to be able to repay their debt, and those bonds have been doing very well for that reason, more so than interest rate movements.

GIBBS: And we asked Morningstar to give us a list of their top corporate bonds funds and they came up with the Calvert Income Fund, the Nations Bond and the Bond Fund of America. Now Chuck, let me talk to you about getting out of bonds and going into the stock market. Where do you see some areas of value?

TENNES: There are a couple of areas that our models prefer right now at Rydex. We do like the small cap growth stocks. We feel that that sector is most typically financed by equity rather than by debt and so could have a little bit of insulation from the impact of rising rates. We also find that food industries, the consumer noncyclicals, are looking good right now. These are defensive areas that did very well through the bear market of ‘01 and ’02. As tech had its good run earlier this year…

GIBBS: Can you give me some names?

TENNES: ...these stocks got built up. Yeah, right now, names like Colgate, a very good brand of consumer products. We also favor at this time Dean foods, (whose) brand names are Borden’s and Meadow Gold, (and) often dairy and soy products. And finally our quantitative models are overweighting Interstate Bakeries.

GIBBS: I’m overweighting those Hostess Twinkies too. (laughs)

TENNES: Yeah, exactly. Our models show regardless of the direction of interest rates there is a demand for Twinkies and Interstate Bakeries.

GIBBS: It might be because of this market.

TENNES: Could be.

GIBBS: Randall, how about you, what are you looking at?

ELEY: We're looking at large companies, and not just because that’s we normally invest in. When you look at the greatest performance over the last two or three years, first you had large cap growth up until 2000. Then you had small cap value. Much of the move has been made in those areas. I think large cap value's term is here and that's going to be names like Exxon Mobil, for example, with a P/E ratio somewhere in the neighborhood of 14; that’s Eastman Kodak; Chevron Texaco. The fact of life is, you're also seeing high dividend yields here anywhere from 3 percent to 6.5 percent, with the S&P 500 not even yielding 2 percent. So you have stocks that ought to return something normal, somewhere between 7 percent and 9 percent a year in a market where over the next five to 10 years, I don't expect the S&P 500 to return more than 5 to 5 1/2 percent a year.

GIBBS: Jim, the most recent numbers from money market flows are showing that whatever is going into the stock funds are actually finding their way into financials, and not the health care and biotechs. Is that the right move for investors right now?

BIANCO: I would be very cautious about the financials right now. In history we’ve seen when the bond market had the kind of month like it had in July, and the 30-year Treasury had its worst total-return month in history in July, that it usually causes a lot of pain and stress in the market. All one has to do is look back to 1994, where it was a similar, but less of a period that we saw. We eventually saw major brokerage houses in Orange County go bankrupt in the wake of that kind of interest rate move. This type of interest rate move, while it may not lead to bankruptcies, is probably leading to some pain and stress in the financial sector, and until we see some kind of stabilization in interest rates and a reporting of numbers through this rise in the third quarter, I would probably, would underweight or shy away from the financials.

GIBBS: How about the utilities? A lot of investors like them even though they’re considered stodgy. But they do pay dividends. Would utilities be a haven?

BIANCO: Well, utilities would be a haven only if we thought we were in a bear market or only if you thought that the rest of the market was shaky. But if you're a bull like I am on the stock market, and you think interest rates are going to go up, I also think utilities would be a place that you would want to probably rotate out of and play a little bit more aggressively in the stock market. So utilities would be an underweight.

GIBBS: Now chuck, we're talking about (how) rising rates would signal an economic recovery. Why shouldn't we be in those cyclicals, those companies that do well when the economy is recovering?

TENNES: Well, I think the theory of noncyclicals is simply that if we're in a rough patch right now -- especially for equities, slower-than-expected growth, rising interest rates -- that this may be a time to get a little more conservative. You know, we joke about Twinkies, but there are a lot of household products that people buy in any economic cycle, and especially because those stocks were particularly forgotten a few months ago when tech was on a roar, this may be a good time for those noncyclicals.

GIBBS: And where do you weigh in on this, Randall?

ELEY: I think cyclicals can in fact, can do very well in this sort of environment where again they've been priced lower. We are, in fact, putting more money in the industrials, in general, than we are in most of the rest of the market. Dow Chemical, DuPont, for example, are names that I think will fit the bill here. Let me just mention, even though being a stock specialist, I also think there is one particular bond area that does hold pretty good values after the sharp fall in July, and that's the intermediate term high grade -- I mean very high grade -- sector like government guaranteed. The 15-year Ginny Mae right in through here, I think, is going to offer…

GIBBS: That’s the government national mortgage association.

ELEY: That's right. And that's very comparable to a 5-to-6-year Treasury note. So I think it’s going to offer relatively good value over the next five or six years.

GIBBS: Randall, you’ve got the last word on it. Randall, Chuck, and Jim Bianco, thank you for joining us.

Reporter roundtable

GEOFF COLVIN: Well, a political earthquake in the world's fifth-largest economy, California. Heads rolling on Wall Street. Important changes at the world's most valuable company, GE. And what's up with tech stocks, anyway?

For insight into all that and much more, we've brought together some of the sharpest minds in journalism, who just happen to be my FORTUNE colleagues: senior writer Adam Lashinsky joins us from Silicon Valley; editor-at-large Patty Sellers is in New York City; and Jeff Birnbaum is our Washington bureau chief.

Jeff, before anything else I gather you have a significant announcement to
Make.

JEFF BIRNBAUM: Yes, I do, Geoff. I would like to announce publicly here that I am seriously considering making a run for governor of California.

BIRNBAUM: I was thinking everyone else has, so why not?

ADAM LASHINSKY: Geoff, if you run, you've got my vote, since I'm the only one -- including you -- on this panel who can vote for you in California.

BIRNBAUM: That’s right, that is a drawback. another one would have been the $3,500 registration fee but I have a rich uncle who says he’s going to front me the money.

COLVIN: And you've got until the end of tomorrow to file.

BIRNBAUM: Yeah, it’s going to be a tough decision tonight.

COLVIN: By the end of tomorrow, how many candidates will have filed?

BIRNBAUM: Hundreds. I think there’ll be hundreds, and I think it will be a tough choice, although I think Arnold Schwarzenegger is muscling his way to the top of that list.

COLVIN: Well, it does look that way and he has tried to make the economy of california a big issue. Lots of jobs have been lost in that state over the last couple of years. If he wins do you think he can really change things?

BIRNBAUM: Well, I don't know if he can change things. It's not exactly clear what he would do, although he has mentioned the workman's compensation problem in California is very expensive and difficult there. Usually taxes are cut in order to attract more businesses and that's not an option for a state with as large a budget deficit as it has.

COLVIN: Adam, Silicon Valley is virtually an independent republic within California. What's your observation of how it is observing this whole governor's race carnival?

LASHINSKY: At a distance. Silicon Valley has no, as you know, no particular affinity either for Democrats or Republicans. If it has any of those, it's Libertarian and this seems to be very much of a political spat. So Silicon Valley is sitting back and undoubtedly will get involved as it gets closer to being a real race instead of the carnival that it is this week.

COLVIN: And when they do, it's unlikely that they're going to support the current governor, right?

LASHINSKY: It's unlikely that anybody is going to support the current governor. That's right.

COLVIN: Patty, another big story that we've been following –- well, look some of the greatest drama in business lately has involved Wall Street firms. Just this week and last Stan O'neal of Merrill Lynch very publicly pushed out two top-level executives. Before that sandy weil at citigroup announced a successor which a lot of people thought he never, ever would. Now lately you've been paying a lot of attention to John Mack, CEO of Credit Suisse First Boston. How come?

SELLERS: I have, Geoff. You know, John Mack lost a bitter power struggle at morgan stanley to his merger partner, Phil Purcell, and left Morgan Stanley, went off to CSFB, which really was the most troubled firm on Wall Street a couple of years ago. He went in there, he's doing a big turnaround, he's brought in a lot of straight arrows and we saw in earnings, Credit Suisse group earnings that came out this week, that the guy is really turning -- is pulling off a very impressive turnaround. So it's a real impressive story. The company is actually in the news in the coming month, because the Frank Quattrone trial is coming up September 29 and Quattrone happens to be one of the few Wall Street executives that has been criminally charged, and by far the biggest gun on Wall Street who’s been indicted.

COLVIN: And the trial coming up with remarkable speed really considering all things that have happened. What should we look for when that happens?

SELLERS: Well, you know, it's kind of a shame for John Mack because he's really done a good job of doing the right thing, trying to bring an ethical culture to a company that really had major ethical lapses. And what we're going to see in September and October is this company's name dragged through the mud again, we're going to hear about this sort of casino culture, it's going to -– you know, what we saw at Merrill Lynch this week was sort of like the casino culture in terms of Stan O'Neal moving people like chips around a casino table. And, you know, what we're going to see at CSFB in a few weeks is kind of the old drum beat about the loose, free-wheeling casino culture cowboy ways on Wall Street.

LASHINSKY: By the way, Patty, it’s going to be a shame for Silicon Valley as well because the Valley will be on trial in Frank Quattrone's trial in New York at the end of September and it’s going to be yet another pounding for tech stocks, at least looking back at what happened during the bubble era.

SELLERS: It will be, it will be. And there’ll be all sorts of new questions raised about the separation of research and banking, and investors I think will begin to question once again whether, you know, analysts are just hyping stocks that they're getting paid to hype.

COLVIN: Hey, Adam, let me ask you about tech stocks a little bit. They're up 24 percent year-to-date, Nasdaq 100 is trading at a multiple of 90. It seems crazy to ask, but could it be that tech stocks are yet again getting to insane heights?

LASHINSKY: It's not at all crazy to ask. It seems fairly clear that they have been, which begs the next question, “So what?” The trend line seems to be going up and that's all that matters to investors, although let's be realistic: They were tempered no doubt by Cisco's really meager earnings report this week. Everyone wanted Cisco to say, you know, to ring a bell, if you will, and say “It's all better.” And they didn't ring that bell, it's not all better. It’s not any worse, but it hasn't gotten any better.

COLVIN: Let me ask you about another big company in the news that you have been paying a lot of attention to, General Electric. What's going on?

SELLERS: I have a bold proposal, and that is that General Electric change its name to General Financial. It should be known as GF, not GE. Because already, about 36 percent of its operating earnings are related to financial services. That's going up. The company says it's going to be a little bit north of 40 percent for 2003, and some think it's even higher. It's interesting, GE started off as an industrial company with a financial component supporting it. Now it's almost as if GE is a financial company with an industrial component supporting it.

COLVIN: Well, and the logical question is, “What's wrong with that?”

LASHINSKY: Nothing wrong with it, except in terms of how it's positioned, how much risk it's taking on. The risk profile of a financial company is different from the risk profile of a maker of aircraft engines and so on. Nothing wrong with it at all.

COLVIN: Except it sounds like you're suggesting the stock could suffer as investors realize the transition that's going on.

LASHINSKY: Different kinds of investors might want to be involved in a different kind of a company, you bet.

COLVIN: Jeff, let me ask you about this. It's not too often that you see a feature story in TIME and NEWSWEEK that’s the same story in the same week, but Howard Dean has achieved that status this time. He has risen suddenly within 10 days to being tied for second place along Democratic voters, (in terms of) who they prefer right after Joe Lieberman. Is he (Dean) for real?

BIRNBAUM: I think he's definitely for real, and it is amazing that a month ago most people wouldn't know the difference between Howard Dean and Jimmy Dean. But they do now. And it shows, I think, the thinness of the field in general, the hunger of the Democratic base for someone who will excite them. And I think Howard Dean, the former governor of Vermont -- we should remind people who he is, because not everyone knows who he is …

COLVIN: Not everyone. In fact, most don't know.

BIRNBAUM: I think he really has captured the imagination by bashing Bush in a really scorching sort of way, and that pleases the Democratic base, and that's what you have to please if you’re going to win the Democratic nomination. Now I think what's interesting about Dean is that like another former governor of a small state, let's say Arkansas, for example, he's a very intelligent fellow, an adept politician, an experienced executive of that state. And he could pivot, I think, better than most people think from the very left-leaning rhetoric he has now, to something more centrist. He ran his state in a fiscally conservative way in a way that could make him more of a viable general election candidate than most people -- especially Republicans -- now expect.

COLVIN: And that's a pirouette that every successful candidate apparently has to make.

BIRNBAUM: Must make. And the rap on Dean is that he's too far to the left, he can't come back to the center. That may not be true and if he proves that that could be true, he may actually win this nomination.

COLVIN: Patty, there’s something I wanted to ask you about. We don't have a whole lot of time left, but you have made an observation about changes you saw in the Wall Street culture, that I don't think most people have observed yet. The days of rampant aren't what they used to be, right?

SELLERS: They aren't. And one thing that John Mack did which amazed everyone was that he got hundreds of executives at Credit Suisse First Boston to give back -- by coaxing and cajoling -- he got them to give back $421 million in guaranteed cash pay packages. Yes, these are investment bankers giving back bonuses. Can you imagine?

COLVIN: No, I almost can't imagine.

SELLERS: Gave them equity instead and you know what, Wall Street stocks are going up and equity is valued. So these guys --

COLVIN: They may be willing to take it. We have to leave it there. But we'll see you soon.