How are we to invest, now that we’ve witnessed the worst year for investors in 7 decades? There are no shortages of opinions from the talking heads on CNBC, CNN, and other stations/shows.  Should we base our investment decision making on their views?  Here’s a funny story that will speak to my opinion on the talking heads on TV financial news. A few weeks ago a viewer’s email was read. The viewer’s note exclaimed they held a short position on the US stock market, had made some gains, and were soliciting opinions from the panel of guests on whether to sell or continue to hold the short position. What followed was something akin to the background sound of crickets being picked up by microphones as if to note the complete silence from the panel. None of the esteemed panelists wanted to answer the question. I have to assume they did not want to answer because they did not want to appear to have an opinion that the stock market was (still) over-valued. This was a striking juxtaposition to the usual rancor of the panel that has a vociferous opinion on everything. In displaying this obvious lack of opinion, they tipped their hand that they are biased in the long direction and that something bad would befall them were they to indicate they thought the US stock market may have more to slide (maybe they would not be invited back to the show?).  

 

Of course, were I to be offered a regular spot on one of these national shows my opinion would markedly improve. (tongue firmly in cheek)

                               

Here are the major factors influencing my investment decisions in the near term:

  • Ability of home prices in the US to stabilize / increasing number of US households under water with respect to their mortgage.
  • Ability of US consumers to increase personal savings rate and return to the (responsible) savings levels seen 10-15 years ago.
  • The fact that the Federal Reserve has set interest rate policy with a target range of 0 – 0.25%.
  • A new US President takes the helm.
  • Is this the year the Big 3 finally file for bankruptcy.
  • A US deficit that will reach $1T this year.
  • America is involved in 2 wars.
  • US unemployment to hit its highest levels in several decades.
  • Instability in China, Russia, Pakistan, India + the usual hot spots (middle east, Africa – the continent, not the country)
  • Oil is $37/barrel – not $150. A 75% decline in half a year.
  • The recent surge in the US dollar value.
  • A precedent of bailing out companies “too big to fail”.  The inevitable failure of some companies “too big to fail”.

The resulting investment tactics:

US Equity:

  • This is no time to be a hero by investing large positions in equity. I’m still recommending portfolios with small equity positions (5-10%). The equity positions held will be hedged.
  • Look for an Obama rally in January & February. This may see the S&P500 index rise from current levels (850 when I wrote this) to 1000. If this happens, I will respond by doubling the short position on the S&P500 we hold. Why? Because this will be a great buying opportunity of the short fund we use –given that I am expecting to see the S&P500 in the 600s this year.
  • Short positions in the S&P500 will be held until we see the S&P500 slide down to the mid 600s (summer /fall 2009).
  • I still contend that we’ll only see $40 of earnings out of the S&P500 index in 2009. So a 600 value looks pretty defensible since it would agree with the long term P/E average of 15. Scary Note: we could see a common bear market P/E of 10 – meaning the S&P500 would be valued at 400. This could happen in late 2009 if a floor is not put under US residential home values.  
  • If we see home prices stabilize (3Q, 4Q 2009) we will aggressively unload the short equity positions, and load up on US small cap value, mid cap value, and large cap value. Overweight Small caps since they have the highest risk adjusted returns.

US Bonds:      

  • EVERYONE seems to have rushed to US Treasuries in the past two months – in an effort to park somewhere safe.  This has driven Treasury bond prices up (& Treasury Bond Funds), and yields down. I suspect yet more of the investing public will bolt towards treasuries once they get their year-end statement in mid-January. This will force Treasury prices higher & yields lower. The first Quarter of 2009 may be a good time to re-finance a mortgage since long term treasury yields may be in the 2.5% range. 30 year Treasury yields are already at record lows of 2.8%.
  • Look for the Treasuries pricing trend to reverse sometime in 2009 so we end up with Treasuries priced closer to par by the end of the year. OPPORTUNITY: this is a chance to unload the long & intermediate bond positions we have and then actively SHORT TREASURIES. I’ll be looking to do this over the coming months via an ETF that shorts long treasuries.
  • I’ll be adding a small position in high yield debt sometime in 1Q. High yield debt lost 20-30% in 2008 with most of the loss coming in the 4th quarter. At these prices, bond markets have priced-in record levels of default.   
  • We’ll maintain a very large position in a short term ETF that holds primarily short term treasury notes and short term investment grade corporate notes. Currently in the range of 40-50% of client assets, this position will be dramatically reduced to buy new positions in other asset classes.

International Equity:

  • As 2009 unfolds, we will increase international equity positions in an effort to assume risk where it is more warranted, and to profit from what will have to be a prolonged slide in the value of the US dollar over many years.  
  • Continue to hold small positions in Canada, Brazil and China. China is the most risky due to potential civil unrest. If the world economies stabilize (perhaps in late 2009), China will benefit most because of its strong balance sheet and ability to deliver fiscal & monetary stimulus.
  • Canada has exposure to declining commodity & oil prices, as well as exposure to bankruptcy in auto manufacturing (yes, that’s all bad). Eventually we’ll see oil & commodity prices rise – which will be very good for the Canadian economy. Canada has a strong banking system and has had 10 years of surpluses so there is room for a fiscal stimulus.  
  • Brazil will hold a presidential election this year. Election years usually see better than average stock market returns. Brazil has seen its number of poor cut in half in the past 6 years. The middle class is now 52% of the population. Brazil boasts a young population, democratic government, loads of oil, gas, commodities, and a stable banking system.
  • Continue to avoid Japan, Germany, England (Europe overall), India, Russia, and Korea.

International Bonds:

  • We will continue to hold fairly substantial positions in short & intermediate international bond funds (10-15% of client assets).
  • The objective continues to be to earn returns not correlated with the US equity markets, and to earn a return from the slide in the US dollar.
  • Currently, international interest rates are higher than they are in the US. If central bankers lower interest rates to compete with the US, we’ll see bond price appreciation like we have in US bond prices recently.
  • Granted 2008 was a rough year to be in international bonds. The short term fund we use earned less than 0.5%. The intermediate term fund lost almost 10% because of a sudden gain the value of the US dollar.

Commodities:

  • Oil. What a ride 2008 was. We entered 2008 with oil at $100 per barrel. Then we saw it climb to near $150 in late summer, only to see it crater to under $40 in December. There will be upward pressure on oil prices from OPEC, and because oil is priced in (soon to be declining) US dollars. Once this global economic gloom ends, oil will be under immense price pressure.  I have no exposure to oil as an investment. I will revisit this if we see oil drop to $30/barrel.
  • Gold. Investors in gold have earned virtually nothing for several decades. Gold was $850/ounce in January 1980!  Given its price volatility and low historical returns, you were better off in money market. (Of course the same could be said of many other asset classes at this time.) So why hold gold? Gold is an insurance policy against a currency crisis. Given the state of banking an economics, a currency crisis would not be remote.  Interestingly, gold is trading (in December 2008) where it was in January 2008 – around $870. We hold a small position in an ETF that holds gold.
  • Water. We have not yet held a position in a commodities fund with emphasis on water related development. This has been researched several times over the past year and each time left as a wait & see effort. 2009 may see us take a small position in an ETF that invests in water-related development. Some of the largest water ETFs have seen their share price cut in half in 2008. Given the urgency of fresh water business activities and development, a water ETF will be revisited again.  

Currency:

  • US Dollar. We need a slow, predictable slide in the value of the US dollar to help bail us out of this economic mess. Unfortunately everyone else needs the same thing. We may see central bankers in a race to the bottom in terms of interest rates. The Fed has already effectively set interest rates at 0%. If no other central bankers blink (& reduce their rates to zero), we’ll eventually see a slide in the US dollar which will be good for our economic growth and will de-value our foreign-owned debt. But the slide must be manageable. If not, we risk seeing a sudden loss in value of the dollar from international central banks flocking to other currencies (the Euro, the Japanese Yen).  A currency slide is all about confidence (as I am learning from Nobel prize winning economist Paul Krugman).
  • As in previous model portfolios, it will be our objective to build positions with large non-US positions (up to 50-60% in non-US positions). As the year progresses and we unload the large short term bond fund position, we will be buying more international equity and marginally more international bonds.