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VTI: Who Cares About The Middle Class?

Summary New legislation that may curtail unpaid overtime has been introduced. The P/E ratio of the market is at moderately high levels but the E (earnings) relative to GDP is extremely high. A shift to higher income for labor would be a negative short term catalyst but may be necessary for long term economic health. I’m preparing for the shift by buying less broad/total market funds and more equity REITs. While the turmoil in Greece has been capturing the headlines, there are other issues that may hit much closer to home. I’ve been a fan of indexing the market and riding out the bumps through dollar cost averaging. I believe American investors can be served well by using a diversified index like the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). Even as an analyst, I combine VTI with equity REIT ETFs as the major source of value in my portfolio. I believe in using the index as the main holding and attempting to build around it rather than attempting to individually pick every stock. While VTI is delivering an excellent expense ratio (.05) and excellent diversification (3827 holdings), it is still subject to market risk. I am concerned that we may be nearing a market top for the broad equity market and I am shifting my portfolio to a heavier concentration of equity REITs. Because I believe shorting the market is the game of fools, I would never recommend it. However, I do think the risk/return proposition favors equity REITs. The Middle Class There is a common refrain about the disappearing middle class. I must admit that I do believe over the next decade we may see a further increase in the gap between the “Haves” and the “Have Nots”. In my opinion, the market is far less attractive without consumers to buy the crap on the shelves. Background It helps to remember that the market can still be viewed by running numbers on the S&P 500 which makes up a very substantial portion of VTI. The following chart, built with data from multpl.com, shows the P/E ratios for the S&P 500 over a very long time frame. (click to enlarge) You might notice that we are currently right around the trend, but that is a very serious problem when we consider that earnings are exceptionally high as seen in the chart below: (click to enlarge) Corporate profits after taxes are hitting staggering values by historical measures. I believe a major factor in the high corporate profits is the introduction of more automation and a lack of intense competition in some sectors. One sign for weaker competition is buybacks. When companies are spending their cash on repurchasing shares there is an improvement in the P/E ratio and there is a fundamental increase in the shareholders ownership of the assets, but there is no increase in productivity capacity. A lack of new capacity leads to weaker competition which protects profit margins. If you need to see what high capacity and intense competition looks like, simply research companies in the mining sector. Earnings, ore prices, and share prices have fallen dramatically due to the intense competition. If corporate profits after tax were to revert to a more historically normal level as a percentage of GDP without enormous growth in GDP, it would lead to much lower earnings. Those lower earnings in turn would lead to lower share prices unless the P/E multiples increased significantly. The Headwind for Earnings The White House recently released a fact sheet on some proposed new legislation that would significantly expand the number of workers eligible for overtime pay. Nearly five million workers would be covered and this could set up quite a bit of political sparring. If nothing else changed and the companies simply paid the overtime that is currently avoided through “salaried” compensation, the simple result would be increases in labor expenses and compressed profit margins. At the same time, I would expect increased levels of sales as more money would go to middle class and lower class workers with a high propensity to consume . In short, the money would go into their pockets and then into the cash register at another establishment. Companies Won’t Agree I expect to see some fairly substantial lobbying efforts spend to fight or minimize this bill because the cost of purchasing congressmen and senators is cheaper than the cost of paying overtime to low-wage salaried employees. Was that too blunt? I’d rather get the point across clearly. The legislation is designed to raise the level of salary required to keep an employee exempt. The reason it is important for the long term health of the economy is that the current level is at less than $24,000 per year. By labeling employees as exempt, companies are able to work the employees for overtime that can drive their effective wage rate below minimum wage laws while claiming that the employees are “managers”. To the extent that this encourages companies to simply hire more employees for regular schedules, the change could be positive by improving employment rates and revitalizing a struggling middle class. However, it wouldn’t happen without pain. While the sales would be expected to increase, the weaker margins would compress earnings and I would expect share prices to fall. For VTI, that could mean share prices dropping as low as $90 in a bearish scenario (about a 15% pull back). Long Term I believe the long term implications would be very positive as it would improve employment prospects for many struggling families so a significant pull back would become a great buying opportunity. Without growth in the middle class, I think the growth in EPS from repurchasing shares may become unsustainable because earnings still depend on sales and sales still require consumers that can afford the products. In the short term, growth by repurchasing sales is fine. Over the long term, it fails to provide new productive (physical) assets that generate the wealth that we consume as humans. Seeing an end to unpaid overtime through the guise of “salaried” work would be a short term negative catalyst for stock prices, but it may be necessary for a healthy economy. I’m preparing by shifting more of my purchases into the REIT sector where I expect strong income to translate into higher average rents. I’m reducing my purchases of the broad U.S. market, to the acquisitions made by my dollar cost averaging in an automatic retirement account. How will you prepare? Disclosure: I am/we are long VTI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

PIMCO Expands Presence In Equity Space With 6 New Funds

By DailyAlts Staff After the tumult that followed the high-profile departure of co-founder and former “bond king” Bill Gross, PIMCO has bled assets from its fixed-income business, its traditional stronghold. The outflows have been so severe that CEO Douglas Hodge sent a recent 27-page letter to the Financial Stability Board to let them know that the $50 billion in redemptions did not pose a systemic risk to the economy. Now, with global debt markets in flux and most investors looking ahead to a Federal Reserve rate hike, PIMCO is expanding its presence in the equities space with six strategies designed to outperform market indexes. “In a low return world, investors are looking for approaches that provide meaningful return on top of what the market delivers, which can make a big difference over the long term,” said PIMCO managing director and equity product manager Sabrina Callin, in a recent statement. “PIMCO’s Enhanced Equity strategies provide investors with a range of equity offerings that are designed to achieve this goal.” The new funds are designed to provide exposure to U.S. large caps, U.S. small caps, international (ex-U.S.) stocks, global (including U.S.) stocks, and emerging markets. The six new RAE Fundamental funds include: RAE Fundamental U.S. Fund (MUTF: PKAIX ) RAE Fundamental U.S. Small Fund (MUTF: PMJIX ) RAE Fundamental International Fund (MUTF: PPYIX ) RAE Fundamental Global Fund (MUTF: PFQIX ) RAE Fundamental Global Ex-U.S. Fund (MUTF: PZRIX ) RAE Fundamental Emerging Markets Fund (MUTF: PEIFX ) Each is available in A, C, institutional, and P-class shares. Ms. Callin and John West of Research Affiliates explain how the new funds build on smart beta in a new white paper published by PIMCO. ( Editor’s Note : While these new funds are marketed as smart beta products, they are more closely aligned with a category of products described as “Enhanced Indexing” due to the fact that they will likely have a high correlation to their cap-weighted benchmarks, and a beta close to 1.) The holdings of each fund are weighted according to non-market cap measures, such as sales, cash flow, book value, or dividend payments. The objective of the funds is to capitalize on market inefficiencies and systematically capture returns when prices deviate from the fundamentals of the underlying companies, thereby allowing the funds to outperform market cap-based benchmarks. Furthermore, each of the RAE Fundamental funds’ holdings are augmented by “active insights” based on proprietary research and designed to further enhance risk-adjusted returns. The new funds are part of PIMCO’s Enhanced Equity Suite, which also includes the StocksPLUS and RAE Fundamental PLUS funds. In all, fixed-income specialist PIMCO manages more than $50 billion in equity-related investments.

IGR Vs. AWP: What’s A Yield Worth?

CBRE Clarion Global Real Estate Income Fund and Alpine Global Premier Properties Fund both provide access to global real estate. However a comparison between the two brings up an interesting distinction on the distribution front. Do you want yield at the expense of NAV growth or yield and NAV growth? I was recently asked to take a look at the CBRE Clarion Global Real Estate Income Fund (NYSE: IGR ). IGR is a CEF that focuses, as its name implies, on real estate across the globe. This, inevitably brings with it a comparison to a fund like the Alpine Global Premier Properties Fund (NYSE: AWP ). At the core, they both do similar things and could, arguably, be interchangeable. However, income seekers might be drawn to AWP’s nearly 9% yield over IGR’s lower 6.5% yield. And why not, since they do about the same thing? A lot alike In fact, both have similar discounts right now, with each floating around a mid-teens discount to net asset value. So either one would be cheap. Performance is a bit of mixed bag, however, with IGR outdistancing AWP over the trailing five years through May on an NAV total return basis, which includes reinvested dividends. But AWP beating IGR over the trailing three years. More recently, AWP has handily outperformed, posting a year to date gain of nearly 7% versus a 1.5% decline at IGR’s (both including distributions). Looking at standard deviation, a measure of price volatility, IGR was less volatile over the trailing five years and roughly equally volatile over the trailing three years. So it’s hard to make much of a distinction on this point between the two. That said, both make use of leverage , but they have each kept that to a relatively low level recently at around 6% of assets. Cost wise, IGR has a slight edge . It’s expense ratio is roughly around 1.15%. AWP’s expense ratio is a little higher at around 1.3% or so. Neither, however, is so high that they stand out. So here are two funds with roughly similar objectives. Both are trading at steep discounts. But AWP has a notably higher yield and has been performing better of late. The easy answer is buy AWP. That said, you wouldn’t be buying a bad fund if you chose IGR. Pick your poison? Things aren’t that simple, however. And a quick look at the distributions helps explain why. Since it’s IPO in 2004 , IGR has paid investors over $13 worth of distributions. The IPO NAV of the CEF was $14.10. True, the shares currently trade below that level, with an NAV of close to $9.50, but for income investors the benefit has been fairly large despite the NAV decline. Alpine, meanwhile, started life in 2007 with an NAV of around $19 a share. It’s net asset value is roughly $7.50 a share more recently. It’s distributions over that span have been around $6.50 a share. I’m rounding in both cases, but the point should be pretty clear. But just for fun, if you add the current NAV to the total distributions received for both funds you get around $23 for IGR and nearly $16 for AWP. Since IGR had an NAV at IPO of around $14 and AWP’s NAV at IPO was a touch over $19, which one has been the better option? Since 2007 was a pretty awful time to open a fund that may not be a completely fair comparison. But the same trend holds true over shorter periods, too. Let’s look since 2010 instead (using fiscal years for AWP). Over that span, AWP’s NAV has gone from roughly $7.25 a share in October of 2009 (the end of its fiscal year) to $7.50 a share. It’s paid out around $3.75 in distributions. IGR, meanwhile, has seen its NAV go from about $7.50 at the start of 2010 (it’s fiscal year ends in December) to about $9.50. Meanwhile it’s paid out about $2.90 a share in distributions. If all you are looking for is income, yes, AWP paid out more in distributions. But at the cost of NAV growth, since the NAV rose only about 3% over the span. With IGR, there was less income, but your principal grew by around 25%. In other words, if you buy AWP, your return is almost all in the distribution. That’s fine during good times, but when there’s a bad market it makes building back the NAV that much harder to achieve and can result in distribution cuts if the downturn is long enough. Your call, but I like conservative At the end of the day, which option is better for you really depends on your situation and temperament. If you only care about income, AWP is the clear winner. For me, I’d prefer a fund with a lower yield and net asset value growth. So, there’s reasons to like AWP over IGR, but I’d go with the more conservative distribution if I were making the choice. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.