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The Curve in the Road

John Mauldin — Mon, 06 Oct 2008 14:53:08 +0000

The “Bailout Plan” was passed. Will it work? The answer depends on what your definition of “work” is. If by work you mean no more government intervention and no further costly programs and a functioning market, then the answer is no. But there are things it will do.

This week I try to help you see what might lie ahead around the Curve in the Road. We look at how the rescue plan will function, see what is happening in the economy, and finally muse as to whether Muddle Through is really in our future. It will make for an interesting, if not very upbeat, letter, so strap in. I would like your promise to not shoot the messenger. I am just trying to give you some of my thoughts as to what may lie in our future. And remember, as you read this, we will get through it. There are better days “a’coming.”

The Curve in the Road

When you are out driving on a strange new road, you can’t see around the curve ahead. But you can read the warning signs to get an idea of what might be coming. And while we can’t really know how the developments in the economic world will actually unfold, there are some signs we can point to that might give us a few ideas.

First, let’s look at the “rescue plan” as passed by Congress. As I pointed out last week, this is a bad bill. But it was necessary to pass something, and soon. Earlier this week I sent out a report that reviewed a study of 42 major baking crises. The conclusion: navigating them successfully depended upon quick action.

As everyone should know, the credit markets are almost completely frozen. LIBOR is bid only, no offers. Commercial paper markets are imploding. And what is trading is often at rates that are much higher than they were a few months ago. Corporations are being strangled on high rates. Corporations have little or no access to normal credit markets, and they will face massive problems when it comes time for them to roll over short-term debt.

LIBOR has gone crazy. This is not an orderly market.

Look at the following chart from friend Greg Weldon. For most readers, the commercial paper market is something you don’t think about. But it is the lifeblood of business. We have seen this market drop by almost 30% in a year and by 10% in just the last three weeks! I simply cannot overstate how serious this is. Left unchecked, business activity in the US would soon slow enough to bring thoughts of the Great Depression. It will not be left unchecked.

The credit crisis is not simply a Wall Street issue. It has fast become a Main Street issue. And Main Street is where jobs are created and maintained.

As I have said repeatedly for months, the problem is that financial institutions are having to deleverage. They have massive losses and simply have to raise capital in order to survive. If you can’t raise equity capital (and most can’t), one of the ways you do that is to make fewer loans and to take less risk. You also charge more for the loans you do make.

Larger institutions cannot raise capital on competitive terms. GE is an AAA-rated company. Yet they had to pay Warren Buffett 10% to get $5 billion, plus in-the-money warrants worth at least another 10%. Buffett is likely to double his money on this deal over 4-5 years. A short while ago, GE could get short-term commercial paper for a few percentage points. That difference is going to significantly impact GE’s bottom line. But they had no real choice. They took the money.

As did Goldman Sachs. Yet another Buffett $5 billion preferred-share purchase (with more warrants) at a rate that even Goldman will find it hard to make money on. But they had to raise capital quickly, and they had little choice.

I had lunch with Michael Lewitt and Joe Harch yesterday. They were in town to meet with a client, and we took the opportunity to get together and share notes. They run (among other things) a collateralized loan obligation fund. They buy bank and corporate debt. They now have the opportunity buy well-collateralized loans from rated companies at prices well below par. They related story after story of debt from quality, highly rated companies selling below $.90 on the dollar, and some much lower.

If GE and Goldman are paying 10%, what do you think it costs a firm with “only” a B rating? 15%? More? Junk bond yields have simply gone ballistic. Firms which used the credit market to access capital now are simply shut out. If they are a small public company, they can go to what are known as PIPE hedge funds (Private Investment in Public Equity) and sell equity at usurious rates (which is what Buffett does but on a larger scale). But a small or medium-sized private company? It is a hard time to go looking for money.

Left alone for the markets to work out, the economy of the US and the world would be in a depression within two quarters and would need years to recover. Think Japan.

FOMC Minutes Will Get The Most Attention, Earnings Are Upon Us Again

Christian Hill — Mon, 06 Oct 2008 13:36:54 +0000

The economic calendar this week isn’t particularly exciting, but coming off the pain inflicted on the markets last week, that could be a good thing. The market will have its hands full with earnings season starting up again, so a full week of reports could have been dangerous.

The FOMC Minutes from the September 16 meeting come out tomorrow afternoon at 2:00 P.M. and will provide an interesting read. Going into the weekend before the meeting, the odds that the Fed would cut rates stood at ten percent. By that Monday the chances the Fed would cut rates jumped to 90 percent. The next day, the Fed didn’t cut rates, and the market reeled. Many on Wall Street will be reading the minutes to try to determine why the Fed left rates untouched. In an interesting side note, the probabilities for the October Meeting are all over the board. Currently the probability of the Fed leaving rates unchanged stands at 20 percent, a one-quarter percent cut stands at 20 percent, a half-percent cut stands at 30 percent, and a full one percent cut stands at 30 percent. Or, another way of looking at it, there is an 80 percent chance of a rate cut of some sort.

On Tuesday, the Consumer Credit report for August is released, and the number is expected to grow significantly versus July. An increase of almost $1 billion is what the market expects. How the amount of credit extended to American consumers has grown in the face of the current credit fiasco is unknown, but it could also mean that Americans are more desperate than ever to pay bills and are maxing out their credit cards.

The Trade Balance report comes out on Friday, and the market expects a drop in the trade balance of almost $2 billion. This is most likely due to the strengthening dollar over the last five to six weeks. A smaller part could be due to a decrease in demand due to slowing consumer spending.

Earnings Reports:
Tues: AA, YUM
Wed: COST, MON
Thurs: CVX
Fri: GE

Source: The FOMC Minutes Will Get The Most Attention, Earnings Are Upon Us Again

Dollar Shoots Higher, Fed Leaves Interest Rates Alone

Doug Casey — Wed, 17 Sep 2008 13:08:13 +0000

In the currency market, the dollar notched big gains against the euro. Late Tuesday, the euro was trading at $1.4162 vs. $1.4305 on Monday. The buck was already upward bound before the results of yesterday’s FOMC meeting.

The Fed, apparently trying to project an appearance of calm and stability as financial markets are ripped apart, left its benchmark fed funds rate unchanged at 2.0%.

“At the end of the day the Fed has refused to bow to pressure to save the system above and beyond what it’s already done,” said Andrew Wilkinson, of Interactive Brokers.

“The winner today may well be the greenback whose multi-year downtrend appears to have run its course. The fact that the currency went into the meeting rallying hard against all units except the yen points to the fact that investors have invested in the policies at both the US treasury as well as at the Fed,” Wilkinson added.

The dollar received its initial boost from a Labor Department report showing that consumer prices dipped 0.1% in August, the first decline in nearly two years. Core CPI, excluding food and energy, rose 0.2%, however. Both numbers were right in line with economists’ expectations.

Many market watchers were expecting a quarter-point rate cut yesterday and, not getting it, still feel it may be in the cards next time. But there is apparently a significant difference of opinion in the FOMC, with a vocal minority warning that inflation remains the most serious threat to the economy, while the others say the focus should remain on the weak economy.

But, “Growing economic slack and sagging commodity prices suggest inflation will drop quickly in the months ahead,” said Sal Guatieri, an economist for BMO Capital.

Source: Dollar shoots higher - Fed leaves interest rates alone.

Alt-A Is the New Subprime

John Mauldin — Mon, 15 Sep 2008 19:18:22 +0000

All eyes are on the drama being played out on Wall Street today. But the cause of all the bloodshed was the downturn in the US housing market. This left banks and financial institutions with exposure to toxic subprime loans with a load of worthless securities on their books. This led to writedowns and losses. And the rest is history. Shockingly, given the scale of the crisis, John Maudlin says the housing crisis has a ways to run yet. Alt-A mortgages may the next to fall…

The short answer is no, but let’s look at the data from one of the most knowledgeable sources on that topic. John Burns of John Burns Real Estate Consulting consults with over 2000 of the largest banks and homebuilders in the country (his client list is a who’s who of banks, builders, and hedge funds). He has a reputation for solid research and pulling no punches. Some of his hedge fund clients were the ones you read about who made billions. (He wishes he had negotiated a percentage!) He is deeply involved in analyzing trends in the housing market. His web site is www.realestateconsulting.com. He has graciously sent me the executive summary of his latest posting (a 27 page executive summary) that we will be looking at for the next few pages.

Let’s start with a quote from John at the beginning of his report: “The prospects for the U.S. housing market have changed for the worse. It has become increasingly clear that the U.S. economy is on the brink of recession, as overall job growth has slowed to zero and retailers are reporting abysmal results. New home sales, traffic and pricing are all heading down according to the results of our survey of over 300 builder executives. Resale [existing home] sales are starting to plateau in some markets, but pricing continues to fall as distressed sales dominate the market. The new housing bill will help in some ways, but will first serve a devastating blow to homebuilders, with the elimination of seller-funded down payment assistance, which accounts for 17% of new home demand by one estimate.”

How far along are we? Burns thinks that home prices will drop by 22%, 12% which has already occurred. His analysis differs from that of the Case-Shiller Indices, which suggests a much steeper decline. Note in the graph below that the Case-Shiller Index shows home prices rising more than does Burn’s work. Part of it is different methodology and part of it is the CS index focuses on major markets and Burns work is more broadly based.

However you slice it, there has been a lot of pain. Shiller’s work shows home prices in the areas he measure to be down about 17%. He said last week that he does not think it unlikely that we sill see home prices drop by as much as 30%, or about the same as during the Depression of the 30s. Burns see less of a drop, but from not as high a point, so they both end up close to the same end point.

The graph above shows Burns’ projection for the next few years. He thinks it will be 2011 before housing prices begin to turn back up on a nationwide basis, with national prices continuing to fall into 2010. That will not sit well with the pundits who keep telling us each month that we have seen the bottom.

For the difference in his numbers with Case-Shiller, he offers the following explanation: “The Case-Shiller national number, which is a “paired sales” analysis, showed much more price appreciation than other indices based on median prices. We suspect that there was a shift in the mix of homes sold to lower priced homes in 2006 due to subprime lending, which depressed the median value and showed large % increases in the paired sales index.”

Sales volumes are suffering. “We believe sales volumes have already fallen back to 1995 levels and will hit 1992 levels sometime next year, when they will begin to slowly rebound later in the year. We are already seeing rebounds in some of the hardest hit markets, such as Southern California, where sales fell to below the levels of the early 1990s. The rebound in sales will be driven by foreclosure buying activity and demand from real households that need to move for personal reasons and have been delaying their purchase for fear of further price corrections. Our 8% per year projected [starting in 2010] increase doesn’t get us back to normal sales volumes until after 2012, and that is because the tremendous excesses of this cycle moved many renters into homeownership earlier than usual, and allowed existing homeowners to “move up” to their dream home earlier than usual. Conservative mortgage lending will also prevent a sharp turnaround.”

Jim Rogers: Fannie and Freddie Bailout ‘Madness’, ‘Insanity’

Contrarian Profits — Tue, 09 Sep 2008 13:26:13 +0000

The government’s bailout of mortgage giants Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) has Wall Street on a roll. After yesterday’s rally, US stock futures are pointing up again today.

For legendary investor Jim Rogers, however, the government’s intervention is “socialism for the rich.”

One big issue is the Treasury Department’s agreement to make secured loans to the companies if needed and even buy some mortgage-backed securities itself.

This from Jason Simpkins in Money Morning, writing about Rogers’ reaction to the bailout:

This is the biggest point of contention, as it puts taxpayer money at risk while at the same time boosting the value of Fannie and Freddie’s mortgage backed securities and bonds.

“This is madness, this is insanity, they have more than doubled the American national debt in one weekend for a bunch of crooks and incompetents,” Rogers said. “I’m not quite sure why I or anybody else should be paying for this.”

Fannie and Freddie will broaden their operations to support the shaky housing market until 2010. At that point, however, the two will be forced to unwind their portfolios by 10% a year, until they reach $250 billion, to reduce the risk to the taxpayer.

Though, according to Rogers that plan could backfire as well.

“That’s going to also ensure that house prices continue to go down. It’s going to be harder and harder to get a mortgage,” Rogers told CNBC’s Squawk Box Europe.

Simpkins says Rogers is at odds with Berkshire Hathaway’s (NYSE:BRK.A, BRK.B) Warren Buffett :

Of course, the Oracle of Omaha sees things differently. He praised the plan as a wise move for Treasury Secretary Paulson, who Buffett said “did exactly the right thing.”

“I wouldn’t change anything in the plan myself,” Buffett said in his own interview with CNBC. “It’s the best deal and the most sensible deal available now.”

While he admitted the Treasury is officially “on the hook” for the depth of the housing downturn, Buffett argued that the government had no choice but to bail out Fannie and Freddie.

“Whatever they lose from this plan, if they hadn’t acted there were going to be greater losses down the road,” Buffett said. He also pointed out that the arrangement between the two insurers and the Federal government, from the point of inception, is truly to blame for current troubles and nothing can be done now to erase that.

“They got into this position many, many decades ago when they got into, sort of, half-slave, half-free position where they said, ‘We don’t guarantee Freddie and Fannie’s obligations,’ and wink-wink.

“You can argue that there should have been some different rules put in decades ago in terms of what these companies have done, and it wouldn’t have come to this,” Buffett went on, “but those rules weren’t put in by this administration, or this Congress or this Treasury Secretary, and they face the problem of, in effect, $5 trillion plus of a combination of portfolio and insurance out there, and, really, chaos in the housing and mortgage markets.”

Dollar Posts Small Gain vs. Euro, Eurozone Weakness now seen as a Primary Currency Driver

Doug Casey — Thu, 21 Aug 2008 15:20:14 +0000

In the currency market, the dollar wound up higher against the euro. Late Wednesday, the euro was trading at $1.4745 vs. $1.4785 on Tuesday. Traders’ focus returned yesterday to concerns about the economic health of the eurozone.

“Technical indicators on [euro/U.S. dollar] suggest that there is potential for a further rise towards $1.4875-1.4900 in the short term,” wrote strategists at Jyske Bank.

“However looking a bit further ahead, there is no doubt that the trend [for the euro/dollar cross] is down,” they said.

Meg Browne, a senior currency strategist at Brown Brothers Harriman & Co., put forth the case for a stronger dollar, saying that, “In the long term, the tectonic plates of the market have shifted. The markets are coming around to the idea that the U.S. is weak but Europe is weaker.”

But sentiment that the Fed might raise interest rates soon, to combat inflation, appears to be receding.

The futures market on the Chicago Board of Trade now shows only a 21% chance that the Fed will raise its target rate for overnight lending between banks by at least a quarter-point by its December 16 meeting. That’s down from 35% odds a week earlier.

Source: Dollar Posts Small Gain vs. Euro, Eurozone Weakness now seen as a Primary Currency Driver

Jim Rogers Says Bigger Financial Shocks Loom

Keith Fitz-Gerald — Tue, 19 Aug 2008 15:16:57 +0000

The U.S. financial crisis has cut so deep – and the government has taken on so much debt in misguided attempts to bail out companies such as Fannie Mae (FNM) and Freddie Mac (FRE) – that even larger financial shocks are still to come, global investing guru Jim Rogers said in an exclusive interview with Money Morning.

Indeed, the U.S. financial debacle is now so ingrained – and a so-called “Super Crash” so likely – that most Americans alive today won’t be around by the time the last of this credit-market mess is finally cleared away – if it ever is, Rogers said.

The end of this crisis “is a long way away,” Rogers said. “In fact, it may not be in our lifetimes.”

During a 40-minute interview during a wealth-management conference in this West Coast Canadian city last month, Rogers also said that:

U.S. Federal Reserve Chairman Ben S. Bernanke should “resign” for the bailout deals he’s handed out as he’s tried to battle this credit crisis.
That the U.S. national debt – the roughly $5 trillion held by the public– essentially doubled in the course of a single weekend because of the Fed-led credit crisis bailout deals.
That U.S. consumers and investors can expect much-higher interest rates – noting that if the Fed doesn’t raise borrowing costs, market forces will make that happen.
And that the average American has no idea just how bad this financial crisis is going to get.

“The next shock is going to be bigger and bigger, still,” Rogers said. “The shocks keep getting bigger because we keep propping things up … [and] bailing everyone out.”

Rogers first made a name for himself with The Quantum Fund, a hedge fund that’s often described as the first real global investment fund, which he and partner George Soros founded in 1970. Over the next decade, Quantum gained 4,200%, while the Standard & Poor’s 500 Index climbed about 50%.

It was after Rogers “retired” in 1980 that the investing masses got to see him in action. Rogers traveled the world (several times), and penned such bestsellers as “Investment Biker” and the recently released “A Bull in China.” And he made some historic market calls: Rogers predicted China’s meteoric growth a good decade before it became apparent and he subsequently foretold of the powerful updraft in global commodities prices that’s fueled a year-long bull market in the agriculture, energy and mining sectors.

Rogers’ candor has made him a popular figure with individual investors, meaning his pronouncements are always closely watched. Here are some of the highlights from the exclusive interview we had with the author and investor, who now makes his home in Singapore:

Keith Fitz-Gerald (Q): Looks like the financial train wreck we talked about earlier this year is happening.

Jim Rogers: There was a train wreck, yes. Two or three – more than one, as you know. [U.S. Federal Reserve Chairman Ben S.] Bernanke and his boys both came to the rescue. Which is going to cover things up for a while. And then I don’t know how long the rally will last and then we’ll be off to the races again. Whether the rally lasts six days or six weeks, I don’t know. I wish I did know that sort of thing, but I never do.

(Q):What would Chairman Bernanke have to do to “get it right?”

Rogers: Resign.

(Q): Is there anything else that you think he could do that would be correct other than let these things fail?

Rogers: Well, at this stage, it doesn’t seem like he can do it. He could raise interest rates – which he should do, anyway. Somebody should. The market’s going to do it whether he does it or not, eventually.

The problem is that he’s got all that garbage on his balance sheet now. He has $400 billion of questionable assets owing to the feds on his balance sheet. I mean, he could try to reverse that. He could raise interest rates. Yeah, that’s what he could do. That would help. It would cause a shock to the system, but if we don’t have the shock now, the shock’s going to be much worse later on. Every shock, so far, has been worse than the last shock. Bear-Stearns [now part of JP Morgan Chase & Co. (JPM)] was one thing and then it’s Fannie Mae (FNM), you know, and now Freddie Mac (FRE).

The next shock’s going to be even bigger still. So the shocks keep getting bigger because we kept propping things up and this has been going on at least since Long-Term Capital Management. They’ve been bailing everyone out and [former Fed Chairman Alan] Greenspan took interest rates down and then he took them down again after the “dot-com bubble” shock, so I guess Bernanke could try to start reversing some of this stuff.

But he has to not just reverse it – he’d have to increase interest rates a lot to make up for it and that’s not going to solve the problem either, because the basic problems are that America’s got a horrible tax system, it’s got litigation right, left, and center, it’s got horrible education system, you know, and it’s got many, many, many [other] problems that are going to take a while to resolve. If he did at least turn things around – turn some of these policies around – we would have a sharp drop, but at least it would clean out some of the excesses and the system could turn around and start doing better.

But this is academic – he’s not going to do it. But again the best thing for him would be to abolish the Federal Reserve and resign. That’ll be the best solution. Is he going to do that? No, of course not. He still thinks he knows what he’s doing.

(Q): Earlier this year, when we talked in Singapore, you made the observation that the average American still doesn’t know anything’s wrong – that anything’s happening. Is that still the case?

Rogers:Yes.

(Q): What would you tell the “Average Joe” in no-nonsense terms?

Rogers: I would say that for the last 200 years, America’s elected politicians and scoundrels have built up $5 trillion in debt. In the last few weekends, some un-elected officials added another $5 trillion to America’s national debt.

Suddenly we’re on the hook for another $5 trillion. There have been attempts to explain this to the public, about what’s happening with the debt, and with the fact that America’s situation is deteriorating in the world.

I don’t know why it doesn’t sink in. People have other things on their minds, or don’t want to be bothered. Too complicated, or whatever.

I’m sure when the [British Empire] declined there were many people who rang the bell and said: “Guys, we’re making too many mistakes here in the U.K.” And nobody listened until it was too late.

When Spain was in decline, when Rome was in decline, I’m sure there were people who noticed that things were going wrong.

(Q): Many experts don’t agree with – at the very least don’t understand – the Fed’s current strategies. How can our leaders think they’re making the right choices? What do you think?

Rogers: Bernanke is a very-narrow-gauged guy. He’s spent his whole intellectual career studying the printing of money and we have now given him the keys to the printing presses. All he knows how to do is run them.

Bernanke was [on the record as saying] that there is no problem with housing in America. There’s no problem in housing finance. I mean this was like in 2006 or 2005.

(Q): Right.

Rogers: He is the Federal Reserve and the Federal Reserve more than anybody is supposed to be regulating these [financial institutions], so they should have the inside scoop, if nothing else.

Dollar Shows Strength, Traders Banking on Fed Reversing Rate Policy

Doug Casey — Thu, 17 Jul 2008 16:16:10 +0000

In the currency market, the dollar rallied against the euro. Late Wednesday, the euro was trading at $1.5823 vs. $1.5899 on Tuesday.

Traders were scrutinizing the release of the minutes from the last Fed meeting, searching for the future direction of interest rates, and apparently decided from the mixed signals that the Fed is about to turn hawkish on inflation.

As Dow Jones Marketwatch reported: “Some members said the Fed had aggressively cut rates to 2% to guard against downside risks to growth and now that these risks had ‘diminished’ that ‘some firming in policy would be appropriate very soon.’

“But other FOMC members said financial conditions were still too fragile and borrowing costs were higher for consumers than before the Fed starting cutting rates last fall.

“The minutes show a clear divide and intense debate between one camp that favored rate hikes sooner rather than later and others who believed the outlook was still uncertain at best.”

Those who think the Fed will have to raise rates got support from the day’s most important numbers. The Labor Department reported that the consumer price index rose by 1.1% in June. It was the biggest monthly increase since Hurricane Katrina nearly three years ago, and well above economists’ expectations for a 0.8% gain.

CPI was led higher by a 6.6% jump in energy prices and a 0.8% increase in food prices.

“The Fed will face an ongoing inflation threat that will eventually require a policy response that we continue to expect before year-end,” wrote Michael Englund, chief economist for Action Economics.

Source: Dollar Shows Strength, Traders Banking on Fed Reversing Rate Policy

Dollar Hits All-time low vs Euro before Rallying; Bernanke gives Ambivalent Testimony to Congress

Doug Casey — Wed, 16 Jul 2008 19:53:39 +0000

In the currency market, the dollar rallied from $1.6036, a new alltime low against the euro, clawing its way just back into positive territory. Late Tuesday, the euro was trading at $1.5899 vs. $1.5904 on Monday. Traders were carefully watching Fed Chair Ben Bernanke’s testimony to Congress on the state of the economy.

Big Ben continued to bounce his rhetoric between an “increase in upside inflation risks” and “significant downside risks to growth,” with most analysts seeing his words, on balance, as backing off a bit from the recent inflation hawkishness Fed spokespeople have been displaying.

That sent the federal funds futures market lower, reflecting only a 26% chance of an interest-rate increase of a quarter of a percentage point as soon as September — down from a 52% likelihood on Monday.

Meanwhile, a lot of economic data rolled in, none of it particularly good. The Commerce Department reported that, despite some $50 billion in stimulus checks, retail sales rose a paltry 0.1% in June, with auto sales experiencing their biggest drop in more than two years, at -3.3%. Expectation had been for a 0.4% bump in retail sales.

Then the Labor Department said that wholesale prices rose 1.8% last month, after seasonal adjustments, with energy prices shooting up by 6% and food prices increasing by 1.5%. Economists had been looking for a considerably more modest rise of 1.4%.

Source: Dollar Hits All-time low vs Euro before Rallying; Bernanke gives Ambivalent Testimony to Congress. Economic data Disappoint

Insights on Income: Foreign Markets are a Necessary Profit Play for Today’s Income Investor

Martin Hutchinson — Mon, 14 Jul 2008 20:01:38 +0000

Back in the middle 1980s, income investing for U.S. investors was pretty simple. Inflation was around 5% – roughly the same as now – but U.S. government bonds were paying close to 8%, and without going into high-risk debt issues you could find 9% with very little difficulty.

If you were an income investor, to balance those high yields, you also had to have capital appreciation, so about half your portfolio would be invested in U.S. common stocks – which, thanks to their dividend payouts, yielded a good 3%-4% themselves. Even after you paid Uncle Sam, a portfolio such as this one would have easily thrown off 5% of its value in income, and allowed you to keep up with inflation as stock prices generally rose.

Clearly, those were the halcyon days for income investing.

More than two decades later, income investors face a much bigger challenge. U.S. stocks have posted mediocre results since 2000, while bonds and cash have provided truly lousy returns after inflation and taxes are taken into account. Stocks pay lower dividends than they used to, especially since top corporate executives now are loaded up with stock options, and those decline in value every time a dividend payout extracts a big slug of cash from the corporate coffers.

The bottom line: While stock prices, interest rates, and inflation are at current levels, and U.S. economic growth remains sluggish, income investors who focus only on domestic income investments will be lucky to break even in cash terms after they have attempted to live on 5% of their capital.

There is a solution, however. In fact, this particular income strategy can offer much better returns than anything a domestic income investor can ever hope to find. We’re talking, of course, about investing internationally. Most investors think of the international markets only as another place to seek out stocks. But overseas financial markets are a great option for income investing, as well. And here’s why.

The Overseas Option for Income Investors

The United States continues to run an annual balance-of-payments deficit of $700 billion. As long as that persists, the dollar will tend to be weak against other currencies. Sometimes, even low-risk investments in the right foreign currency can provide substantial capital gains – and it’s not always the obvious currencies. Did you know you could have made more than 30% in dollar terms during the past year from a bank deposit in Czech crowns? And that wasn’t some wild investing gambit: These days, the Czech Republic is a perfectly solid middle-income democratic European Union member with an admirable free-market president, Vaclav Klaus.

Because U.S. interest rates are so low, many countries have higher interest rates – with lower rates of inflation. Australian, Brazilian, and New Zealand bank deposits all pay more than 5%. All three currencies have recently been strong against the dollar and will likely continue to perform so. And all three of those economies have inflation rates that are comparable to, or lower than, the United States’ rate of inflation (South Africa also has 8% deposit rates, but there inflation is too high for safety).

While the U.S. economy scuffles along at a 1% pace – and even if it were to recover to 3% – there are a number of countries with growth rates of 5% or greater, not all of which have overvalued stock markets. China and India famously have growth rates of 9%-10%, but what about South Korea and Taiwan? Both are richer countries with growth rates consistently in the 5%-6% range. By definition, if stocks in those countries are no more expensive than in the United States, they are likely to offer better value.

Many stocks outside the United States pay generous dividends, often because they are still controlled by the original founding families who want the income, or because these firms are based in companies with are located in countries with good-value stock markets.

International Income Investing: The Secrets of Success

For income investors seeking dividends from international investments, the secret is to find companies with high dividend yields, but which aren’t operating in the kind of risky or highly cyclical business sectors that will make those dividends vulnerable.

In other words, what you don’t want to see is a situation where you buy into a stock for its hefty dividend yield – only to have the board of directors of that company suddenly decide that it needs to conserve cash. For instance, Telecomunicacoes de Sao Paulo SA (ADR: TSP), the fixed-line telephone system in Sao Paulo, Brazil, has a dividend yield of no less than 14%. However the company’s profit margins are under attack by the aggressive cellphone operators in the country and its earnings seem likely to decline. Indeed, the consensus forecast for TSP’s 2008 earnings is about 30% less than the dividend payout, suggesting that dividends will be forced downward – unless the company starts liquidating itself.

Some current recommendations that have good dividend payouts that are also securely covered by earnings:

Kookmin Bank (ADR: KB): The largest bank in South Korea, Kookmin has a dividend yield of 4.6% and a Price/Earnings (P/E) ratio of less than 8.0. Kookmin has avoided an entanglement in the U.S. subprime-mortgage mess, but has nevertheless been dragged down by investor disillusionment with the financial services sector.
Acer Inc.: Based in Taiwan, Acer is now the world’s third-largest manufacturer of PCs, with a global market share that reached 10% since its 2007 purchase of Gateway. Although there are several ways to invest in this company, this is best bought through its Global Depositary Receipts, which are listed on the London stock exchange (ACID). Acer has a dividend yield of 6.4% and a P/E ratio of only 11.0 – pretty alluring numbers for a leader in a major growth sector.
Tele Norte Leste Participacoes SA (ADR: TNE): Also known as TNE, Brazil’s cellphone compay has a yield of 4.8% and is trading at about seven times earnings.

One final note: Income investing is all too often viewed as a stodgy, no-growth strategy for the total risk-averse. But as Acer and TNE demonstrate, you don’t need to confine yourself to stodgy, low-growth sectors to get a juicy dividend yield with good security. You just have to look globally.

[Editor’s Note: When it comes to global income issues, Money Morning Contributing Editor Martin Hutchinson knows his stuff. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. In February 2000, as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians, who had been stripped of nearly $1 billion by the breakup of Yugoslavia - and then the Kosovo War. Hutchinson’s "Insights on Income" column will now be a regular feature in Money Morning].

Source: Insights on Income: Foreign Markets are a Necessary Profit Play for Today’s Income Investor