How to Invest in the Current Market

People regularly ask me how I am investing.  So, I thought I would write a post.


First and foremost, I am an investor, not a trader.  Markets can go up and down over short periods, but I think about the longer term direction/trend in shaping my investments.  It’s very difficult to predict the short term swings up and down, but I feel much more confident about determining the longer-term direction of markets.


The fundamental issue that over-rides everything is as follows:  the developed world demands and has grown to believe they are entitled to levels of consumption that are inconsistent with their level of productivity.  Thus, in order to fund this consumption, they borrow, whether directly or indirectly via their governments' borrowing to provide social benefits.


As a result, the developed world’s economy is a quasi ponzi scheme, where economic activity (consumption) is based on borrowed money.  As we are seeing in Europe and we will see in the US in the future, there is a limit to the amount of debt that can be incurred, and as debt is reduced consumption must fall.  So, what does this mean for investing:


Equities (Stocks):  I hate stocks.  I have no idea what real earnings power is.  If governments ran balanced budgets, as well as individuals, what would consumption be and thus what would earnings be?  Stock are not cheap; they are very expensive when you consider what earnings will be in the future as governments and individuals are forced to de-lever and run balanced budgets. That said, publicly traded companies may be able to grow even in a shrinking economy to the extent they gain market share, i.e. eat a larger piece of a shrinking pie.  But, I believe the macro economic decline will be so large that even market share gains won't be enough.


In addition, at the end of this year, the tax rules on capital gains and dividends are set to change (unless the government passes a new law, which I doubt in an election year).  Capital gains taxes are set to increase from 15% to about 23% and dividend taxes from 15% to about 43%.  This will lead to huge selling pressure of high performers (such as Apple) as investors want to lock in capital gains at the 2012 15% capital gains tax rates.  Likewise, the high dividend paying stocks, which have performed so well, will be worth much less when the income is taxed at 43% instead of 15%.  Now, I fully acknowledge that the government could pass new legislation that continues the current tax system or only increases rates slightly.  But, this most likely wont be resolved until after the November elections, and if Mr. Obama is re-elected he has been very vocal about raising taxes on the wealthy.  And, capital gains and dividend taxation is a logical place to implement his philosophy.  In summary, there is nothing but downside from this issue and it should weigh on stocks.


Currencies:  Euro-US dollar exchange rate?  I could make an argument for 150 as easily as 100.  It all depends on what Germany does.  Too much "coin tossing" to bet one way or the other.  Regarding the US dollar vs Aussie/Canadian/Singapore dollars, while the US has problems, the global slowdown will have a bigger impact on these economies and thus their currencies.  I believe that over the next 2-3 years, Aussie and Canadian dollars will approach 70 to the US dollar (i.e., 1 Canadian dollar will only buy 0.70 US dollars), despite their stronger fiscal positions.  The coming fall in commodity prices will just be too powerful of a force.


Commodities:  Dont believe they are an inflation hedge.  Their prices move mostly based on economic activity and resulting demand, and to a lesser extent the direction of the dollar since they are all priced in dollars.  Given I am so negative on the global economy, no interest in commodities.  One caveat.  Over the much longer term, say 5-10 years, I am a bull on US natural gas since I believe it will ultimately replace crude oil to fuel cars.


Gold:  Gold has nothing to do with risk-on or risk-off.  Gold is a currency.  If the US Federal Reserve implements QE and increases the money supply, gold goes up.  If the Fed pulls back on QE, gold goes down.  It has no intrinsic value (does not generate income), so I would not buy gold.  But, if you believe the Fed will do a third round of QE, then gold is a good investment.


Bonds:  Which leaves us with bonds.  I am 100% invested in bonds.  I believe that reductions in government spending (which has to happen), the Fed realizing that QE does not fix the economy’s real problems and ultimately the Fed having to shrink its $3 trillion plus balance sheet will all lead to decreases in asset prices, which is deflationary.  In a deflationary environment, bonds are the best investment.  At the beginning of 2012, my forecast was for the US 10 year treasury note to hit 1.25% and the US 30 year treasury bond to hit 2.25%.  I am sticking by my forecast.  "Pundits" will tell you that you should not buy long term treasuries because you only earn ~2-3%, but the reason to own them is for capital appreciation.  Since March 30th, long-term treasuries have increased in price by about 23%, crushing the returns in the stock market.  That said, I am not advocating to get into long-term US treasuries now, given how much they have increased in value and are now approaching my 2012 price targets.  There are other areas of the bond market to invest that offer better risk-adjusted returns.


Real Estate and Farm Land:  Actually, my favorite asset classes are directly buying real estate housing rental property and farm land.  And, not via securities, since prices are subject to the whims and liquidity flows of the markets.  Instead, I want to directly own these asset classes.  People have two basic needs:  food and shelter. And, given my bearish views, these seem to be good investment options.  From a practical standpoint, buying farm land is not a simple task.  And, governments distort markets via policy, increasing the risks in investing in agriculture.  As a result, I focus more on residential housing rental properties.  I am actively searching for rental properties to buy, which do offer an inflation hedge (if my overall thesis is wrong) since rents reset and also a deflation hedge since everyone always needs a home to live.  You just have to select the correct markets and pay the right price.


International - Japan:  I love Japan as a country and place to live but I hate Japan as an investment.  Japan's culture is antithetical to western views on investing.  Ask a westerner the purpose of a company and the answer is to generate profits for the shareholders.  Ask the same question to the Japanese and the answer is to provide for the well being of the employees, first and foremost, and then their customers and vendors.  Shareholders are at the bottom, assuming they are on the list at all.  As long as this is the culture, companies (in the aggregate) will continue to decline.  Japan is a "melting ice cream cone".  Warren Buffett is wrong on Japan and I am happy to debate him any time on Japan.  He has not lived there and does not understand the culture.  I lived in Japan for 6 years and ran a 10,000 Japanese employee company (very domestic, not a western company in Japan).


International - Asia ex-Japan:  De-coupling is a lie.  The declines in Europe and the US will impact Asia, which is so export dependent.  The problems at European banks will be particularly troubling given the volume of trade finance they provide.  As European banks get smaller in order to meet capital ratio requirements, trade finance will shrink.  I doubt the Asian banks can make up the difference in trade finance, although its not impossible.


Finally, I have no vested interest/bias one way or the other.  I am investing my own money, so I care about capital preservation and returns and therefore if the world changes, then I will change my mindset.  Most money managers manage other peoples’ money and profit from the volume of assets managed or the returns.  As a result, they have an automatic bullish bias and lack intellectual honesty.  Will they really tell investors that equities stink and that their investors should take their money back and sit in cash?  Of course not, because then they go out of business, or at a minimum make lower fees.  So instead they rationalize why stocks are cheap, etc.  Buy and hold is the biggest scam perpetrated on individual investors.  There is nothing wrong with being 100% cash at times.  In the summer of 2006, I went 100% cash.  I missed the next 30% upside, but also missed the ensuing 60% decline.  I basically stayed in cash until March 2011 when I started putting my money into bonds.


I hope you find this helpful in your investing.