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“We have all heard the saying that markets are driven by fear and greed.  The way in which this manifests itself, is that investors become fearful of things that are priced low and greedy for things that are priced high.  It is the only area of our life that people seek to purchase overpriced goods and shun underpriced goods....


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“It is also referred to and perhaps conflated with momentum investing.  The emotion of greed kicks in at the wrong time.  If enough investors do the same thing, it will validate the decision in the short-term as the new wave of buyers push that asset class higher.


There are only two real choices when it comes to investing, debt and equity.  It has to do with the way real estate is funded and companies are built.  One can contribute equity or borrowed money, debt.  In the long run, aggregate equity has to outperform aggregate debt or no buildings would be constructed nor would there be any companies.  Under the equity category we would include tangible assets and common stock.  Under the debt category you would find cash, CDs, municipal bonds, preferred stock, sovereign debt such as U.S. Treasury bills, notes and bonds as well as corporate notes and bonds.


We would boil it down to three main choices to reflect the experience of most people, cash equivalents, debt equivalents and equities.  Cash equivalents are debt with a maturity of one year or less and debt equivalents are debt with a maturity of greater than one year.


We do that because debt generally involves a contractual agreement on the payment (coupon or income) and the maturity date.  In general, the price of these instruments will all fluctuate in reaction to prevailing interest rates.  Think of a seesaw.  If rates go up, debt prices go down.  If rates fall, bond prices will rise.


The reason is that debt represents cash flow to most people.  If rates are 5% and one borrows a $1,000 from a lender, the coupon or payment will be $50 per year until the contract expires.  If an investor bought one of these contracts and the interest rate doubled overnight, a smart person would try to dump the old contract in favor of the new one which now pays $100 per year.  That process of selling will stop when the value of the old contract declines by 50% so that an investor could buy 2 of the old ones and generate the same amount of cash flow as buying one of the new contracts.  That is why interest rates and the prices for debt move in opposite directions.


The severity of the price change will depend upon the length of time remaining for the contract.  The longer the maturity, the more severe the price movements both up and down as rates change.  Think of holding a whip in your hand.  As you snap the whip, the handle moves hardly at all as it is close to your hand.  At the tip of the whip, the movement is quite dramatic.  That is why changing rates have little impact on cash equivalents with a short-maturity.  The most volatile debt equivalents are assets such as 30-year Treasury bonds.


In the early ‘80s, government interest rates peaked at about 15% providing an income of $150 per year until maturity.  It was a very painful ride to that peak for those who had continued to seek the top in interest rates.  For almost a decade, buyers of fixed income were savaged as rates rose and their purchases fell in value.  After taking into account the 12-14% inflation at the peak, it was virtually a wipeout in terms of the real value of the asset class.


For those with an iron stomach or those who were just lucky, rates did peak.  For almost 30 years, interest rates declined.  Not only did the holders of the bonds enjoy an amazing cash flow, but the value of the instruments rose, too.


In our current world, rates are at all time lows.  A 30-year bull market in fixed income has passed.  Buyers of debt, particularly debt equivalents as defined above are taking tremendous risk.  At best, debt equivalents will generate minor cash flow and a guaranteed negative real rate of return.  At worst, if interest rates rise even a small amount, they risk severe price deterioration, negative nominal returns and very ugly real rates of return.  The so-called “Bond King”, Bill Gross, even used the word “vaporized” to describe what could happen to debt/fixed income prices if interest rates headed north.  We don’t know how to make the statement more graphically than that.


Fixed income, debt equivalents in our words, provides the worst risk/return characteristics of any asset class we have seen in our careers.  The famed, Jim Grant, calls this “return-free risk.” Standard dogma is a 60%/40% split between equities and fixed income.  That 40% would be severely negatively impacted under anything but the status quo.


Are we against fixed income?  Absolutely not.  Remember the seesaw.  You want to buy this asset class when rates are high, not when they are low.  The ride from low to high will be very painful for those not heeding the lessons of history.


Next are cash equivalents.  We defined that as debt with a maturity of 1-year or less.  Cash equivalents are traditionally employed when uncertainty rules the day.  Think of them as stepping-stones in a raging river.  That has been considered the normal form of safety for generations.  As a tactical move when formulating long- term strategy, it still makes sense.  As a long-term allocation, there are two problems.


The first is inflation.  There is virtually no income available for these short-term contracts.  In some cases, people have even opted for negative interest at the peak of abject fear.  Even if we accept the reported inflation rate at 2%, if you receive no income, you are settling for a guaranteed negative real rate of return.  For most of our clients, we use a baseline long-term target of 3% after-tax and after-inflation in our models that look at such things as retirement planning.  The models rarely work with a target of negative after-tax and after-inflation returns.


Using the original methodology for calculating the true rate, Shadowstats.com calculates the real inflation rate at the high single digit to low double-digit rate, not the 2% given to us by the government.  Most forms of cash and debt equivalents will generate severe negative real rates of returns just assuming that things stay the same.  Rising rates will be disastrous for long-term planning.


Turning to equities, the U.S. stock markets had a good year.  It is the policy of our Federal Reserve to push stock market prices higher.  They do this by holding interest rates artificially low and forcing people to seek higher returns from stocks.  This has been particularly true for the financial companies.


This is problematic for several reasons.  First, price discovery is neutered.  If the Fed prevents any decline due to normal investment considerations, one can argue that the move higher or the prevention of a decline is not real.  The second is that the money being printed along with the other trillions to date is ballooning our collective debt.  Some estimates are as much as $220 trillion in unfunded debts.  The on-books Federal debt is around $16.5 trillion.  Jim Grant gave us a way to get our mind around this.  Sixteen trillion is the equivalent of 380 million pounds of $100 bills.  We are “way over our skis”, to use a winter sports term.


So why is the Fed doing this?  Their belief is that when stocks move higher, people feel wealthier and are more likely to spend money.  There is truth to that.  Our only problem with it is that the increase should be real, not floated on money created out of thin air.  It is giving the perception of value, but much of it is illusory.  It is not a secret.  That is their stated plan.


Shadowstats has also estimated that the annual Federal deficit for last year was really about $6.6 trillion when one included all of the accruing liabilities and expenditures not included in the $1+ trillion estimate for the deficit.  The Fed has announced an indefinite printing of $85 billion per month.  We consider that to be the true estimate of the on-books deficit.  There was even a call last week to print $30 trillion.  It is out of control.


Despite what we have said above, there will always be value and viable themes in the world equity markets.  The themes that we believe match those criteria include energy, food, and technology to name a few.  We are not against equities, but we have been very circumspect about the positions.  Last year was as much about what did not happen as what did.  We did not have war in the Middle East or in East Asia.  We did not have a shutdown of the Federal government.  We were particularly cautious, as any of those events could have sent the financial markets in a tailspin.  We were thankful that things ended on a positive note, but last year could have turned out markedly different.


To summarize, of our three choices, cash equivalents, debt equivalents and equities, there is only one of them that has a chance to preserve and enhance wealth, after-tax and after-inflation.  That category is equities.  We do not like financial stocks.  It is impossible to analyze most of the companies given that they are quasi-captives of the various governments around the world.  We believe that equities that offer strong growth that take advantage of the powerful themes outlined above, will provide the returns necessary for retirement funds to meet their obligations and for individuals to realize the needs and dreams for themselves and their families.


We also believe that precious metals are the only currencies remaining that can preserve value.  This has been true throughout all of human history with the exception of the period since 1971.  That was the date that President Nixon “temporarily” closed the dollar/gold convertibility window, effectively abandoning the financial system set up after World War II at Bretton Woods, New Hampshire.


Gold and silver are money, not investments.  Their role is to preserve wealth.  While some would say that gold has risen at a compound rate of 16% for over a decade, we would say that it is the currency that is declining, not gold rising.  The Western central banks and Japan are careening down a disastrous money-printing path.  The Russians, Indians, Chinese, Arabs and many prominent investors are accumulating every ounce that the West puts up for sale.  Unfortunately, gold has historically flowed from West to East.  We are making the same mistake that our ancestors have made before us.


China’s objective is to have the world’s reserve currency.  To do so, they need gold, lots of it.  They have been the world’s largest miner of gold in addition to importing immense quantities on top of their own production.  World history is being made.


Energy is also a major focus for us.  We believe that world demand is rising at a time that world production is peaking.  It is a rare investment opportunity to buy very inexpensive stocks with low price-to-cash flow characteristics as well as income along the way.


Finally, the characteristic that most investors are seeking is income.  Ironically, the income is not in cash or debt equivalents in the past.  It resides in major corporations around the world, many with very solid balance sheets.  That is also a focus for us.


In summary, the standard approaches to asset allocation stopped working 4 years ago.  We saw it as asset class correlations converged on 1.0.  As we also saw in the late ‘70s, broad diversification was counter-productive.  The number one asset class was gold with high-growth equities in the number 2 spot.  We had multiple alternative currencies back then such as the Japanese Yen, Swiss Franc and the German Mark.  That is no longer the case. 


The only hard currency remaining is the gold/silver complex.  Another huge difference is that interest rates were high.  That is not the case in the current environment.  History tells us to stay the course with equities and tangible assets including collectibles and special situations in real estate.”


© 2013 by King World News®. All Rights Reserved. This material may not be published, broadcast, rewritten, or redistributed.  However, linking directly to the blog page is permitted and encouraged.


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Eric King

KingWorldNews.com

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