"There are two times in a man's life when he should not speculate: when he can't afford it and when he can." - Mark Twain
Happy Holidays from Indonesia! I am traveling with my new in-laws and enjoying a marvelous trip that started in Seoul, took us here to Jakarta, and will conclude in Bali. As we rapidly approach the New Year, many of us take this time to both look back, reflecting upon the year that was, and look forward, thinking about what we hope to accomplish in the next twelve months. While I typically eschew giving general investment advice for a variety of reasons in a medium such as this, breaking from the historical analysis I began last blog to offer some contemporary observations may be timely.
If there is one thing last year should have conclusively proven, it is the perils of speculation and greed. For years, nattering nabobs of negativity such as myself have been concerned about the unsustainability of an economic boom predicated upon the inflation of paper assets and home values. US incomes after inflation have barely gone up in the last ten years. Yet first stocks and then real estate values escalated rapidly. People spent more and saved virtually nothing.
Worse, the housing bubble encouraged people to pile on mortgage debt at levels that were literally unprecedented. It was as if people collectively lost their senses, believing that by buying and selling their homes to one another, vast wealth could be created. Of course, in reality this massive misallocation of capital (which is what always occurs during financial bubbles) has led to the unprecedented destruction of wealth and crushing debt burdens.
As far as 2009, do not expect any quick rebounds in the real estate markets. I have heard some make the pitch that with home prices this depressed, tremendous opportunities exist. I could not disagree more strongly. For years residential real estate construction and investment exceeded population growth by a factor of roughly five. For over a year, more than one in three homes was being sold either as a non-primary residence or for investment purposes. The combination of over-supply and hyper-speculation will likely take much longer to work itself out than 22-24 months (roughly the point at which US home prices peaked). Weak to dismal job prospects coupled with huge numbers of adjustable-rate mortgages resetting at higher rates in the coming months will mean that foreclosures and falling prices will be the likely hallmarks of the US real estate market.
Beyond buying homes, let me identify what I believe to be the worst investment for 2009: long-term (30-year) US Treasury bonds. As I write this, these bonds are yielding a most paltry 2.61%. There are three main reasons why this represents a catastrophic investment for anyone with a long-term horizon. First, the US budget deficit is exploding. It is likely to get much worse as the US government seems hell-bent on saving every heretofore well-heeled Wall Street financier whose Hermes wallet happens to be empty. This will lead to the US Treasury flooding the market with bonds to finance this spending/bailout orgy. Basic laws of supply and demand indicate that the US must offer higher yields in order to goad investors into absorbing future US debt issuance. This would mean that the value, or price, of currently issued US debt will go down.
Second, the Fed in its inestimable wisdom has put the world on notice of its intention to inflate the economy by any and all means. This means printing dollars. Indeed, even before Bernanke was hand-picked by Greenspan to succeed him, the current Fed Chairman's nickname was "Helicopter Ben." He got this name as a result of his response to a question about the prospect for America falling into a deep depression like that of the 30's with price levels falling. Bernanke noted that such a prospect could be averted, as the Fed could drop money from helicopters if necessary. While this may be comfort to pilots currently out of work, it scares foreign holders of US bonds to death. Such action (running the printing presses to pump money into the economy) erodes the value of the dollar vis-à-vis other currencies. Yet we rely upon those same foreign investors to buy the majority of US bonds. Any appreciable decrease in purchases from these overseas investors will also cause long-term bond values to decrease in the future.
But the third, and most important, reason to avoid long-term US Treasury bonds is precisely because Bernanke (or his successors) will at some point likely succeed in their efforts to reinflate the economy. Over the last 200 years, average returns on long-term US Treasury bonds have been more than 3.5% above inflation. So to achieve just average returns, a holder of a 30-year US Treasury bond at today's yield, inflation would have to average -1% through 2040!!! Essentially, the US would have to be in one generation-long depression. As bearish as I have been, even I think that is almost impossible. If inflation simply returned to its post-WWII average level, investors would have negative after-inflation returns, despite tying up their funds for 30 years. Far worse, should inflation return to levels seen in the 70's, investors would see massive capital losses on 30 year Treasuries. In sum, it boggles my mind how any long-term investor would for a moment consider such an investment.
Accordingly, I think it is highly prudent for individuals in the New Year to liquidate any mutual funds they own which have significant holdings of long-term Treasury bonds. Obviously, if investors directly hold such instruments, they should be sold now.
There is actually a way to make money in the event that long-term Treasuries decline in value. However, I would not recommend it for most individuals. ProShares UltraShort Lehman 20+ Year Treasury Bond (ticker symbol TBT) is an exchange traded fund (like a mutual fund, but trades like a stock) that goes up in value 2% for every 1% decrease in the price of long-term treasuries.
While I personally own it, there are several reasons why typical investors will want to eschew it. To begin with, just because long-term Treasury prices have reached record/bubble-like levels does not mean they can go even higher. Indeed, TBT is down substantially from the level I first bought it at. Most investors hate losses more than they love commensurate gains. This problem is magnified by the fact that the fund is leveraged 2-1, thereby increasing the amount of money lost to investors in the event long-term Treasury bonds continue to go up in price. Finally, I am a firm believer that individuals should not own investments, the nature of which they do not understand. Since most individuals do not find the bond market to be enthralling (who can blame them?), few possess the knowledge critical in determining whether TBT is appropriate for their portfolio.
In general, I expect 2009 will continue to see extreme levels of market volatility. While the real economy throughout the world will likely worsen appreciably, it is possible that stock markets may see significant run-ups. However, with weakening economic fundamentals, I continue to see few investment opportunities on the long side that represent real value for the investor (as opposed to speculator). Having said that, keeping a few gold coins under the mattress may not be such a bad idea.
I hope everyone has a very Happy New Year!
Thursday, December 25, 2008
Wednesday, December 3, 2008
From Whence We Came Part I
"Those Who cannot Remember the Past are Condemned to Fulfill It."
- George Santayana
My doctor has recently informed me that my blood pressure has escalated. Having had a front row seat to the unbelievable policy-making that has emerged from our nation's leaders in response to our economic crisis, it is no wonder.
Before launching a whole series of invectives in a future blog concerning the unjust and incompetent decisions emanating from what was once, and should have remained swamp, aka Washington D.C., a little review of past history is in order. There was once a quaint and innocent time in American economic history when: people used to be required to put at least a 20% down payment before buying a house; bankers used to be dour individuals, reticent to lend money to those but the most credit-worthy; and investment advisers used to caution people about the steep losses that might befall those investing/speculating in potentially risky assets (i.e. stocks and real estate). It was a more sober time perhaps. People were worried more about the prospect of capital losses than capital gains. While less fun than the carefree modern era of finance, it was also more stable. Most people relied upon setting aside part of their incomes on a regular basis in the event that rainy days should come to pass. Great fortunes were not gained as frequently, but neither were vast fortunes lost.
But starting in the 80's, change began to occur. Not, from my perspective, all for the worse mind you. Far from it. Paul Volker proved himself to be perhaps the most courageous and talented central banker in American history. By raising interest rates in a time of economic crisis and inflation, he arguably caused the most severe recession since the depression. But in so doing, he also broke the back of what had been rampant inflation since the days of LBJ's The Great Society programs. Moreover, the economic power of unions began to wane significantly, thereby unshackling to a large degree human capital, and leading to greater employment. Absolute and marginal tax rates were lowered, providing greater incentives for both individuals and corporations to work hard.
But with the good, usually comes the bad. As corporations prospered, particularly in the financial sphere, so did their influence grow in DC. This, coupled with more conservative politicians, led to legislation pushing all forms of deregulation concerning financial institutions. As the good times of the 80's continued into the 90's, something quite pernicious began to develop. Fewer and fewer controls and oversight were in place to regulate financial institutions.
Increasingly egregious conflicts of interest arose for financial services companies as they tried to serve the interests of their clients and their shareholders. Similar conflicts confronted individual brokers and financial advisers, as they were compensated through commissions only received by selling certain financial products. And the more they sold, the higher their incomes.
All of this came to a head as we approached the turn of the millennium. Stock prices, and particularly those in the tech sector, had achieved returns that exceeded anything seen in modern US financial history. They were so fantastic that anyone with a cursory understanding of investing history should have been aware of the fact that it was unsustainable. There has never been a major asset class which has appreciated ad infinitum without facing serious price declines along the way.
Had the financial institutions safeguarding the vast majority of American savings and investment funds been properly serving the interests of their clients, two types of warnings would have been issued. First, the institutions themselves would have disseminated "sell" recommendations on hundreds of tech companies, and the sector as a whole, based upon the gross overvaluation of the sector. Ahhhh, but Wall Street was reaping billions and billions of dollars in fees creating IPOs and providing other services to the very tech companies it was making buy and sell recommendations about for its retail investment clients. Often it was the very same individuals at investment banks that first launched an IPO for a company and then issued the bank's "analysis" of the company from an investment perspective. Virtually without exception, every tech company was a great "buy" for the investing public. Far be it for Wall Street to have the courage to bite the hand that was feeding it by declaring that the vast majority of these companies being rushed to market: had no track record of success; operated in wholly speculative market sectors; were largely run by tech wonderkids who had little, if any, management experience; and were massively overvalued by any objective finance metric.
Second individual brokers and financial advisers would have been calling each of their clients warning them of the dangers of an precipitous fall in US stocks. Remarkably, from the anecdotal evidence I gleaned at the time form talking to friends and colleagues, the opposite occurred. Brokers and advisers were mostly encouraging their clients to "follow the returns." Even though the gravy train had long left the station, and was about to be utterly derailed, the average retail investor was still being sold on the story of vast profits to be made by investing in companies engaging in tech endeavors that few brokers/advisers took the time or effort to understand. As these financial service professionals usually generated more revenues for themselves by having their clients purchase stocks or equity-based mutual funds, it appears that greed and neglience trumped prudence.
This takes us to the precipice of the new century in our story, as well as the role (or lack thereof) played by the Fed and the agencies tasked with overseeing financial companies. But that will have to wait for the next installment.
- George Santayana
My doctor has recently informed me that my blood pressure has escalated. Having had a front row seat to the unbelievable policy-making that has emerged from our nation's leaders in response to our economic crisis, it is no wonder.
Before launching a whole series of invectives in a future blog concerning the unjust and incompetent decisions emanating from what was once, and should have remained swamp, aka Washington D.C., a little review of past history is in order. There was once a quaint and innocent time in American economic history when: people used to be required to put at least a 20% down payment before buying a house; bankers used to be dour individuals, reticent to lend money to those but the most credit-worthy; and investment advisers used to caution people about the steep losses that might befall those investing/speculating in potentially risky assets (i.e. stocks and real estate). It was a more sober time perhaps. People were worried more about the prospect of capital losses than capital gains. While less fun than the carefree modern era of finance, it was also more stable. Most people relied upon setting aside part of their incomes on a regular basis in the event that rainy days should come to pass. Great fortunes were not gained as frequently, but neither were vast fortunes lost.
But starting in the 80's, change began to occur. Not, from my perspective, all for the worse mind you. Far from it. Paul Volker proved himself to be perhaps the most courageous and talented central banker in American history. By raising interest rates in a time of economic crisis and inflation, he arguably caused the most severe recession since the depression. But in so doing, he also broke the back of what had been rampant inflation since the days of LBJ's The Great Society programs. Moreover, the economic power of unions began to wane significantly, thereby unshackling to a large degree human capital, and leading to greater employment. Absolute and marginal tax rates were lowered, providing greater incentives for both individuals and corporations to work hard.
But with the good, usually comes the bad. As corporations prospered, particularly in the financial sphere, so did their influence grow in DC. This, coupled with more conservative politicians, led to legislation pushing all forms of deregulation concerning financial institutions. As the good times of the 80's continued into the 90's, something quite pernicious began to develop. Fewer and fewer controls and oversight were in place to regulate financial institutions.
Increasingly egregious conflicts of interest arose for financial services companies as they tried to serve the interests of their clients and their shareholders. Similar conflicts confronted individual brokers and financial advisers, as they were compensated through commissions only received by selling certain financial products. And the more they sold, the higher their incomes.
All of this came to a head as we approached the turn of the millennium. Stock prices, and particularly those in the tech sector, had achieved returns that exceeded anything seen in modern US financial history. They were so fantastic that anyone with a cursory understanding of investing history should have been aware of the fact that it was unsustainable. There has never been a major asset class which has appreciated ad infinitum without facing serious price declines along the way.
Had the financial institutions safeguarding the vast majority of American savings and investment funds been properly serving the interests of their clients, two types of warnings would have been issued. First, the institutions themselves would have disseminated "sell" recommendations on hundreds of tech companies, and the sector as a whole, based upon the gross overvaluation of the sector. Ahhhh, but Wall Street was reaping billions and billions of dollars in fees creating IPOs and providing other services to the very tech companies it was making buy and sell recommendations about for its retail investment clients. Often it was the very same individuals at investment banks that first launched an IPO for a company and then issued the bank's "analysis" of the company from an investment perspective. Virtually without exception, every tech company was a great "buy" for the investing public. Far be it for Wall Street to have the courage to bite the hand that was feeding it by declaring that the vast majority of these companies being rushed to market: had no track record of success; operated in wholly speculative market sectors; were largely run by tech wonderkids who had little, if any, management experience; and were massively overvalued by any objective finance metric.
Second individual brokers and financial advisers would have been calling each of their clients warning them of the dangers of an precipitous fall in US stocks. Remarkably, from the anecdotal evidence I gleaned at the time form talking to friends and colleagues, the opposite occurred. Brokers and advisers were mostly encouraging their clients to "follow the returns." Even though the gravy train had long left the station, and was about to be utterly derailed, the average retail investor was still being sold on the story of vast profits to be made by investing in companies engaging in tech endeavors that few brokers/advisers took the time or effort to understand. As these financial service professionals usually generated more revenues for themselves by having their clients purchase stocks or equity-based mutual funds, it appears that greed and neglience trumped prudence.
This takes us to the precipice of the new century in our story, as well as the role (or lack thereof) played by the Fed and the agencies tasked with overseeing financial companies. But that will have to wait for the next installment.
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