Financial analysis, Year of the Rat

(Image from Preston City Council)

Disclaimer: You would have to be crazy to take investment advice from some blogger on the internet. If you are crazy, please do not read the following.

The metaphor for 2008 is of an army withdrawing from one battle and re-engaging on another front. The challenge is to redeploy assets as opportunities develop, while not allowing inflation and currency decline to eat away at the underlying value in the meantime by holding too much cash. Timing and flexibility are critical, though being late may not be as dangerous as being too early. The matter is complicated by predicted slow growth/recession in the US, accompanied by unpredictable effects worldwide.

Dollar-denominated investments start out with a high threshold on return (known as the discount rate), since real US inflation is probably running at something like 7%, even as it’s treated as being 3%. Even ignoring currency effects (which ought to even out over the long term), a decent investment ought to return a nominal 12-15% just to meet historical averages.

But when one is seeking high yields, safety becomes a major concern. The 2008-2009 market is potentially one of the most dangerous in a generation. On the one hand, the incumbents in the political system are doing everything possible to prop up the economy to protect their jobs, while the wellsprings of American wealth–its influence in the world, its creative energy, and the attractiveness of its market–are drying up. If it suffers a recession, the effects will propagate outward. Major trading partners like Mexico, Canada, and Europe will be hit the hardest, but no nation will be spared. As greed shifts to fear, investments in nations that lack transparency, notably China, may be hit by panics.

The currency shift toward the Euro is probably mostly done, but if one can get 4% interest, a 5% swing would still make this an acceptable, relatively safe, and liquid investment. The zero-interest Yen is more difficult, especially since there are indications (a comment by Kuroda of the Asian Development Bank in NNI) that Japan and China may have struck a deal so that the Yen will not become a reserve currency. Still, it’s unlikely the Yen will significantly weaken, especially since it started off the year with a bang. The Swiss franc and the Swedish Krona are other possible plays, with fairly good interest rates available on the Krona. The Rydex currency funds are something to check out for long positions.

Bond funds are another potential way to play dollar weakness. Closed-end bond funds, which are less liquid than their open-ended counterparts, are deeply depressed because of fears of a credit market seizure. However, these fears may be overdone. There are many concerns about buying funds of this kind under current conditions: a recession or armed conflict would weaken the quality of the debt, currency fluctuations can reverse, and inflation can undermine returns. In order to reap the rewards, one would have to hold them until after whatever is driving the discount is reversed. Probably one would be wise to expect to have to hold these investments until at least mid-2009 to get the benefit of the discount. Open end bond funds have no advantage on discount, but they are more easily traded. Here’s the case for bond funds.

Commodities are a third way to guard against inflation and currency risk. However, they are prone to price declines from recessionary effects. Of the commodities, gold is probably the least recession-prone. However, investment is difficult since gold miners are hedged investments, meaning they don’t do as well as one would think in times of rising price and may do worse than expected in times of falling price. One has to hold the actual metal to get the full benefits. Alternatively, rising incomes in Asia probably herald a boom in silver and perhaps palladium. There’s no simple way to invest in platinum. One way to get exposure is through a Vanguard closed-end mining fund, VGPMX.

Foreign equities are a means of guarding against currency risk. Still, recession in the US poses a growth risk to the rest of the world, meaning that equities will probably fall everywhere. Countering this trend is the determination of China, Singapore, and the Gulf States to use sovereign wealth funds to buy investments of all kinds. ADRs are a means of getting access to foreign markets. There are several problems. First, they may be thinly traded. Second, they tend to represent only the largest companies. Since any boom following the recession is likely to be in small technology companies, many of the best opportunities will not be available directly to US investors. So, the only route is through mutual funds/ETFs.

According to Wikipedia, the Chinese Zodiac associates 2008 with Earth as well as with the Rat. Earth “is associated with the qualities of patience, thoughtfulness, practicality, hard work and stability.” The Year of the Rat promises to be a difficult investment year, threadbare for the fearful and fraught with deadly traps for the greedy… but profitable for the thoughtful.