Allocation Choices November
We believe to be prepared for what is coming over
the next five years, one should be positioned with large cash or gold
holdings, (preferably gold, as the cash could be devalued by excessive
money printing), short most large cap stocks, long some inflation-protected
government bonds, and possibly some foreign stocks or other assets,
and stocks and commodities with good supply-demand fundamentals such
as gold and oil. Debt should be paid down with any available funds.
There is a massive worldwide campaign of money printing and seemingly
unlimited availability of credit providers in an attempt to sustain
economic and corporate growth. The battle is being lost, as more and
more debt is required to add smaller and smaller increments of growth.
The danger is that a rise in the very low, and in some cases 0%, interest
rates will implode the system, resulting in massive defaults. While
it is becoming clear that we are in a deflationary environment, there
is an ongoing risk that governments will attempt a coordinated re-inflation,
which could have quite opposite implications for different asset classes.
view of these developments, you should seriously consider the impact these
reckless economic policies could have on your
choice of assets for investment and wealth preservation.
We will give a brief rundown of various asset choices and the pros and
cons of each.
STOCKS - While it is always
possible to find some good stocks, stocks in general, are largely overvalued.
We are in an economy where companies can no longer produce sufficient
earnings, due to a structural decline in profits that has everything to
do with excessive use of debt. Easy credit has resulted in a serious misallocation
of capital that is in the early stages of being unwound. Stocks can provide
some hedge against inflation, but generally perform miserably in deflationary
times. If we encounter an inflationary environment, certain stocks, which
are commodity-based, such as oil stocks can thrive, however, in a deflationary
environment such stocks might be especially vulnerable. Financial stocks,
such as banks and insurers, could be most at risk as defaults mount.
BONDS - As with stocks, bonds depend
on huge inflows of foreign capital as a balancing mechanism to the huge
and growing trade and budget deficits the US is running. Continued money
printing could scare off foreign funds, resulting in sharply higher rates.
Government bonds do well in deflationary times, however, corporates and
municipals could be risky during periods of high defaults. Many advisors
are recommending municipal bonds and insured bonds to investors that are
currently looking for safety. For those that are risk averse, this is
questionable advice. Currently, a high level of municipalities and states
are running severe and growing budget deficits that can only be remedied
by tax increases, which would be a drag on the economy, or spending cuts,
which would have the same negative effect. States and municipalities do
not have the luxury of simply printing more money, as does the Federal
Government. Government bonds are really the only good choice and with
the risk of re-inflation prevalent, short-term maturities are the only
safe choice considering risk and return. Insured bonds are only as good
as the insurer, which is also highly suspect in this environment. Bonds,
with the exception of inflation-adjusted bonds do poorly during inflationary
times. They are an excellent choice in the current environment, particularly
considering the low opportunity cost versus potential reward.
CASH - Cash performs during
deflationary times as prices of things go down, but purchasing power is
seriously eroded during inflationary times. A strong caution is warranted
regarding money market funds and now one should ONLY invest in Treasury-only
money market funds. Generic money market funds today invest in commercial
paper, asset-backed securities such as credit card receivables backed
by dubious assets that have much more equity-type risk than is widely
perceived. Stay away. Also avoid money center banks that are much more
leveraged on their equity than smaller conservative banks. In particular,
avoid JP Morgan Chase, which could be the most leveraged company of our
times. Cash has the ultimate advantage of being highly liquid and can
be reallocated most easily if conditions change. Currently, cash is safe,
however, if the US along with other governments begin a policy of re-inflation,
there should be sufficient time to switch into other assets that would
protect you from inflation such as gold or inflation-adjusted securities.
REAL ESTATE - Normally,
real estate provides a good hedge against inflation, however, in today's
environment, the record levels of debt per property make the asset class
overly vulnerable to rising interest rates. Prices have been outpacing
income growth and are therefore clearly unsustainable. Foreclosures could
cause prices and rents to plunge. It is not widely known that after the
depression in the 1930's rents did not bottom until 1942, which should
caution those holders of income-producing properties that the rental incomes
they are counting on to service their debt may not hold up as planned.
Local government budgets, which are already widely strained, could also
result in unexpected tax increases at the worst possible time.
COMMODITIES - Commodities
provide a good hedge against inflation and the CRB index has been breaking
out to the upside, in spite of an economy, which threatens to tip into
deflation. This could be due to the low levels of investment in this area
over the past decades. In a serious deflation, commodities with favorable
supply - demand characteristics could see the demand unexpectedly drop
off. In an inflationary environment, this should be among the best performing
asset classes as the price of all real things rise.
GOLD - Gold is not widely
considered money in the U.S., however, actions in Japan, Argentina, and
India argue otherwise. Gold is the ultimate money or cash. In spite of
that debate, gold stands as an attractive investment, even simply as a
commodity. Jewelry demand alone has not been satisfied by new mine production
for many years due to low investment in gold exploration and production.
Production is in decline and will require much higher gold prices to stimulate
new mine production. A re-linking of gold to paper money could possibly
set off an unprecedented appreciation in the price of gold. After totally
de-linking from gold in 1971, gold rose from $35 an ounce to a peak of
around $850 an ounce, a 30-fold increase in less than ten years time.
It is highly recommended to own physical gold and take possession, storing
it in a safe place. With all of the derivatives activity revolving around
gold over the past decade, you want to be certain that the gold you think
you own actually exists.
GOLD STOCKS - Gold stocks can be strong investments during
periods of inflation, a weakening dollar, and excessive printing of paper
money as the world slowly loses confidence in the paper money. Gold performs
at its best when central banks fight deflation. Gold stocks are generally
leveraged to gold, although have not had a history of keeping up with
huge moves in gold such as we saw in the 70's. They are riskier than gold
itself due to debt levels and price hedges but they have the advantage
of liquidity and no need for storage.
FOREIGN ASSETS - Foreign
assets must be considered on a country-by-country basis and should be
considered when the US goes on a money printing spree as it has over the
past few years. Countries with high savings rates and conservative spending
policies should hold up much better than the US dollar if the printing
of money continues unabated and encouraged as it has in the US.
CONCLUSION - Based on what we view as an increasingly
deflationary worldwide environment the big question is, what might the
government and central bank responses be? If central banks are not aggressive
in fighting the deflation, bonds should continue to perform quite well.
That seems unlikely in light of the ongoing accelerating worldwide money
printing we are seeing, so bonds of any duration over two years offer
very poor risk to reward. Cash will serve holders quite well as in Japan,
if deflation does keep its grip on the world and has the advantage of
being liquid and most easily and readily re-deployable. This will be important
if money printing continues and the value of currencies fritter away as
with Germany in the 1920's. In such a case, there will be a need to shift
into real assets such as gold, oil, lumber, real estate, etc. Real estate
currently has a major drawback in that record levels of debt are attached
and appreciation has vastly exceeded income growth, paving the way for
potential defaults. Stocks, excepting special situations, look to be a
poor choice based on extremely high valuations, poor earnings prospects,
and over-leveraged holders. In this environment it is most important to
hold on to your money as well as its purchasing power. Gold stands out
in that it does well as deflation is fought.
Richard J. Greene