Income Security Recommendations

BondsOnline Advisor – February 2008

By Stephen Taub

Equity Strategies

Let's face it. Most investors want to know two things—Was the recent market rally a bear market bounce or the start of the next bull market? If it is the latter, should they jump in now or wait longer?

Wachovia Securities warns clients not to be fooled. It believes the recent run-up was just a head fake. "During a bear market, especially one that is falling rapidly, strong counter-cyclical rallies are normal as traders cover short positions or buy opportunistically for a bounce," it recently told clients.

It acknowledged that some nimble investors might make some money. But, it recommended investors use these rallies as opportunities to position portfolios for what it expects to be a difficult year.

Its model portfolio's equity allocation is currently about four percentage points below benchmark levels, Wachovia pointed out. "If we are right, the rally will fail somewhere between 1370 (the first level of resistance) and 1440 on the S&P 500," it told clients.

In fact, Wachovia believes the daily percentage swings resemble bear markets. This said, the investment bank stressed it does not currently expect the bear market to be severe by historical standards.

In addition, it thinks Treasury bond yields at current depressed levels are an unattractive alternative to stocks on a medium term time frame. However, it does think they provide a good opportunity to refinance debt.

Deutsche Bank is decidedly more upbeat than Wachovia. It believes the US equity markets are far along in pricing a complete recession cycle. It notes that equity markets, on average, have corrected by 25% in the run up to and during recessions.

So, when the current market's decline amounted to 20%, as implied by S&P futures, the market was 80% of the way towards an entire recession-cycle, it recently told clients. "A complete average cycle would take the S&P to 1175," it added.

DB does believe there is further downside given that the average duration of recessions is 11 months and the lead time is four months before equity markets discount their end. "With markets pricing the beginning of a recession in January, the average 11 month duration of recessions suggests an end in November, with equity markets on average reaching a trough four months earlier, so July," Deutsche added.

Near term, it expects equities to fall further. So, what does DB recommend that investors do?

The investment bank has moved equities to underweight, given what it deems to be the likelihood of further drops in stock. However, it is retaining its sector allocations. "Our sector allocations for this year were designed to perform in 'both worlds,'" it added, "particularly as the market perceptions of the probabilities of two polar outcomes shifted."

As a result, it is retaining its longs in healthcare and staples, which it says have been the two best performing sectors year-to-data.

On the short side, it is sticking with consumer discretionary and energy because it believes oil prices are too high to be justified by global growth or the dollar.

It remains neutral on the financials, but long the diversified financials.

Lord Abbett says there are four reasons it can see as longer-term opportunities in equities and in credit-sensitive products, despite all the setbacks and losses of the past few weeks and months.

1. Until very recently, the S&P 500 Index was nearly 20% below its highs from 2000. If stocks were to remain where they are now, this would be the worst decade since data has been available, the mutual fund company points out. This includes the Great Depression of the 1930s. "As bad as things might seem at the moment, few would argue that the nation faces the same troubles now that it did then," the money manager states. "Since these fundamental differences suggest that the market should do better, not worse, than those very difficult times, equity gains on balance seem much more likely over the next few years than either stagnation or further declines."

2. It is better to be invested in stocks rather than waiting to jump in, Lord Abbett reminds investors. Few people can market time and once the market makes its move, it will be too late. Consider that in the past 10 years, when the market gained on average around 7 percent a year, an investor who missed the 10 best days would have missed two-thirds of the entire gain. If he missed the 20 best days, he would actually have realized a loss.

3. Think the economy is in a recession? A market correction typically lasts about eight months, Lord Abbett points out. "On that basis, the current correction is largely done," it adds.

4. The money manager maintains that even doubters would want some equity exposure. It asserts that even nervous investors could get into large cap stocks without taking any undue risk.

Bear Stearns upgraded financials to market weight from market underweight. "Our upgrade is primarily based on our view that stock prices now reflect likely write-downs and weaker trend-line earnings," it explained to clients.

This is critical, given that investors hate uncertainty. So, even if write-downs come in greater than expected, Bear says the increased clarity surrounding the ultimate amount of losses, and how losses are distributed on a company-by-company basis, may prove to be a turning point for the sector.

Bear also believes that expectations now reflect realistic outcomes. "Earnings expectations have fallen precipitously over the past several months," it added. "Also, financial stocks have begun to exhibit signs of capitulation."

So, why doesn't the investment bank move financials to Overweight? It says the current credit environment continues to contain significant uncertainties. "Negative trends in mortgage- and consumer-related lines of business are likely to continue, and we fully expect loss and delinquency trends to continue to worsen," it added. "While we believe that the reward-to-risk picture is skewed towards a positive outcome, we also expect significant choppiness."

It even singles out two high profile banks with Outperform ratings—Citigroup and US Bancorp.

Electric Utilities and Energy

Citi recently told clients now is a good time to get back into certain electric utilities. So, it upgraded nine companies to Buy from Hold.

Three are deemed to be defensive stocks-- American Electric Power, Westar Energy and DTE Energy. The other six are called integrated stocks-- Firstenergy Corp., PNM Resources, FPL Group, Entergy Corp., Exelon Corp. and Edison International. "We believe current valuations offer very attractive entry points," Citi said.

Citi noted that defensive stocks and bond yields typically have a strong correlation. So, this would generally mean now is actually a bad time to get into utilities, given the Fed's recent aggressive rate cutting. "But our dividend risk premium and dividend discount models show that this relationship has decoupled to an extent not seen since the early part of this decade following the California energy crisis and Enron scandal," Citi asserted. "As this relationship reverts to more a more normal level, we believe these stocks will trade up."

Master Limited Partnerships (Energy)

Lehman states that while most broad stock market averages posted losses in the fourth quarter of 2007, MLPs were able to generate a 3.3% total return. Lehman said it expects a 9% total return for the Alerian MLP Index in 2008. This estimate is predicated on 10% distribution growth and a closing yield of 6.5%.

"Upside to this forecast appears potentially considerable if the credit market headwinds dissipate," the investment bank told clients. It calculated that a 6% terminal yield would imply an 18% total return.

Conversely, distribution growth of only 8% capitalized at 7% would result in a still positive 1.2% total return for the year, it noted.

Lehman explained that in a yield-oriented product, growth is undervalued. So, in order of preference, it believes general partners, energy and pipeline, and gas and pipeline subsectors are the most undervalued constituents in its universe. "We would caution that the E&P segment has been hit hard by private placement registration and is not out of the woods on this exposure," it warned.

It added that propane and refined products areas look most overvalued.

For details of the six energy midstream master limited partnerships reviewed this month, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.

REITs/Deutsche Bank

With most REITs stocks suffering through their biggest downturns in years, the investment bank recently told clients the sell-off has created some great entry points into select retail REITs. It estimates that the shares are trading at 20% to 40% discounts to their net asset values. And, although retail sales have been soft and there is concern that there will be a big increase in store closures, DB asserted: "We think store closures may tick up from its lows last year, but they should remain within the historic range." Still it conceded that until REIT mutual fund outflows abate and/or the credit markets come back to life, the stocks will remain volatile. DB lists four favorite retail issues, which can be found in the February issue of Yield and Income Newsletter.

Preferred Stocks

UBS explained that when considering preferred securities to add to portfolios, investors should be mindful the security's tax treatment. It noted that when purchasing preferreds in fully taxable accounts, the two types of preferreds that pay tax-advantaged income are DRD-eligible (dividends-received deduction) US preferreds and non-US QDI (qualified dividend income) preferreds. Due to the recently large volume of issuance, DRD-eligible preferred yields have increased relative to non-US QDI preferreds, it added.

"Their corporate tax benefit has historically tended to compress the yields of DRD-eligible preferreds," UBS noted. "However, higher yields now make this segment more appealing."

As a result, it recently upgraded several DRD-eligible preferreds from Marketperform to Outperform, where yields have risen relative to non-tax-advantaged issues and credit quality is stable. It also initiated coverage of the BAC prI and BAC prJ, DRD-eligible preferreds with Outperform ratings.

"When purchasing tax-advantaged preferreds, we remind investors to review the pertinent features of the tax law," it warned.

For complete coverage, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.

Fixed-Income

Citi notes that the rally in Treasuries, driven by market turmoil and heightened concerns about an economic slowdown, has caused credit spreads to widen out to multiyear highs.

It warned bond investors to expect elevated market volatility to persist in the near term. "While valuations in the lower-quality sectors have become more attractive, we are still wary of veering away from focusing on high-quality portfolio positions," it added.

It stressed that the Treasury market appears rich, but high-quality (investment-grade) credit in the short- to intermediate-maturity range is attractive. "Moreover, there are opportunities in the more volatile high-quality bank and broker-dealer issuers for investors with a longer horizon," it added.

For example, it pointed to preferred stock securities. Citi said current yield pickup compared with other long-term instruments is compelling. It asserted that the 300 basis points spread of preferred stock yields to 30-year Treasury bonds more than offsets potential credit and duration risks, particularly in the new issue market.

In municipals, Citi said many bonds appear already to be pricing in a worst-case scenario for the insurers, or nearly so. For example, medium-quality long municipals, which it said are equivalent quality to double-A corporate, are trading to yield 100% or more as 30-year Libor swaps, which it said represent double-A bank credit strength.

"The muni market appears to be at or near a bottom, given that most issues insured by one of the perceived weaker insurers are already priced at yields in line with those on the underlying credits," Citi's muni analysts recently told clients. "Demand has strengthened from performance-oriented institutional investors and high net worth individuals."

It pointed out that n the negative side, the market has not yet been tested by heavy supply, with volume in January down 47% from last year.

However, on the plus side, it noted that muni yields are at or near all-time highs versus taxable benchmarks, "and the slope of the yield curve is already quite steep and likely to steepen further."

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