Financial Analysis, Year of the Tiger
Posted by Charles II on January 1, 2010
What will The Year of the Metal Tiger bring?
According to the Chinese calendar,
“Tigers are physically powerful, gracious, independent and brave, they are extremely bold animals. They are friendly and loving but can also selfish and short tempered. Tigers seek attention and power; frequently they are envious in a relation. Tigers live dangerously which often leads to trouble. They are intolerant, take risks and are always searching for excitement. Tigers are also instilled with a good dose of courage.”
It’s again time to ‘fess up to last year’s failures and make some new mistakes.
Well, 2009 is the Year of the (Earth) Ox in the Chinese mythos, a year of prosperity through hard work and fortitude. That sounds about right. Nouriel Roubini says the market can fall another 20%, meaning a Dow of about 6500 or 7000. He says that 2009 will be the worst year of the recession, with hedge funds collapsing left and right and Emerging Markets defaulting on debt. He also thinks there’s a significant chance of an L-shaped recession, meaning a very slow recovery of markets. We still have to get through the wave of Commercial Real Estate and Alt-A defaults. And the tidal wave of money that the US and other countries are generating has to end in inflation or devaluation.
So, in the short to medium term, expect more pain. But someday this will all be over, and the people who didn’t panic will have made some money. In the meantime, the safest choices are, in descending order: cash, foreign currencies, hard assets, dividends, infrastructure, and possibly well-capitalized technology-based industries. Other stuff may be good for trades or for long-term investing, but if you might need the money in the meantime, play it safe.
That was a pretty decent call, wouldn’t you say?
For reasons too complicated to describe, it’s difficult to present an assessment of my strategy except to say that it was both remunerative and robust. When the final count is in, I expect to have beaten the S&P by roughly 15-20 percentage points by focusing on relatively low-risk “cash, foreign currencies, hard assets, dividends.” This was a safe strategy that would have been decisive if the second wave of the correction had been deeper or longer.
Nouriel Roubini gets props for predicting the bottom, which occurred at slightly above Dow 6500. On predictions of hedge fund collapses and emerging market defaults, not so much. Of the 2100 hedge fund failures since the start of the credit crisis, very roughly 30% were in 2009. Eastern Europe got very shaky, Dubai is in doubt, and Honduran bonds are pretty iffy, but most emerging markets are doing very nicely, with bond yields at historic lows. The L-shaped recession is still a maybe, but the markets have so far recovered far more quickly than they have in similar circumstances, a direct consequence of deliberate asset inflation by the Federal Reserve and Treasury, which chose to direct most of the money to bankers rather than bankees.
With the S&P north of 1100 and the Dow above 10,000, they are about where they were in 1998-9. Meanwhile, the dollar is down by 30%, and what the dollar can buy is down by another 30%, so a millionaire in 1999 would have halved his wealth by investing it in the stock market. S/he would actually have done much better to buy and hold real estate, which is still up 50% in nominal terms (down roughly 10% in constant dollar terms) over where it was in 1998-9.
Barry Ritholtz notes that the big winner for the year was the technology-heavy Nasdaq (+45%) vs. the S&P. That is normal for recessions, when banks are more willing to take slightly higher risks to lend. That allows small companies, especially technology companies, to do projects that otherwise would have been impossible. Later in the business cycle, rates go up, banks become more selective, and the big corporations, especially financials, surge. But in this cycle, banks have been unwilling to lend to even very sound small companies, placing many at risk. The Russell 2000 (small caps) outperformed the S&P but very much lagged the Nasdaq. Internet-related companies like Apple, Amazon, and Google, healthcare technology companies like Human Genome Sciences and Life Techologies Corp. and financial technology companies like (who would have guessed it) Goldman Sachs were up 100% or more. Such a large run-up in technology suggests that leadership, at least to the upside, will move elsewhere.
Some of the main issues that we will be facing are these:
But there is one critical myth out there. First, a dollar crisis based on quantitative easing (“printing money”) is much less likely than most commentators imagine. What the Fed has done is a dangerous game, but in my opinion it’s more likely to end up in deflation than in inflation. They have swapped bad assets for good assets, allowing the financial companies to pretend that their balance sheets are in good shape long enough for them to make some money and even possibly for some of the bad assets to mend themselves. At some point, the taxpayer and the shadow banks will split the losses.
It’s a necessary game, but still potentially very dangerous. If the illusion is broken, the Fed will go down, causing a really, really bad crisis with a deflationary edge. The only way that it becomes inflationary is if the banks really lever up again and allow the money into the real economy. Instead, consumers are paying down debts rather than spending, unemployment is so high that wage pressures will probably not return for another five years, and the only inflationary pressure is coming from dollar weakness/commodity strength.
A dollar crisis is also less likely than many think because the western nations and Japan are all running massive deficits. The US deficit is a lot less scary than the Japanese or the Italian, especially because Japan is so susceptible to natural disasters and Italy barely has a functioning government.
And we are already at levels of the Euro and Yen that are very painful to European and Japanese manufacturers, though not so to multinationals that outsource to the developing world. If the dollar falls much further, it will gravely harm their domestic industries. The Chinese could oblige by allowing the Yuan to rise, which would raise Chinese standards of living, though at some cost to employment. But the antagonism that has developed between China and the US, manifest at Copenhagen, makes it more likely that China will continue its Bad Neighbor Policy.
There is one thing that could precipitate a dollar crisis, namely a loss of confidence in the financial system. If the Republicans create a debt ceiling panic, for example, that could do it. Everyone knows that the house of financial cards is stacked on the full faith and credit of the US Treasury. And heaven knows that the Republicans are insane enough to do this.
There are other myths. For example, the markets assume that the Treasury won’t raise rates. It will if there’s a dollar crisis, even if that brings growth—and the markets—crashing down. There’s the myth that we’re in a strong recovery, that things are back to normal. There’s the myth that Washington can keep pouring money into homebuyer credits, home refinancings that fail, and other non-productive spending. All too little spending has gone into the kind of infrastructure projects that everyone knows we need, into green energy, and into other things that will raise efficiency and lower costs in the future.
So, what kind of inflexible courage should the Metal Tiger have? Should s/he have the inflexible courage not to venture into an insane investment environment despite the temptation provided by a rising stock market? Possibly, especially if losing money would be catastrophic. Or should s/he have the inflexible courage to bet the farm on what looks like a total crapshoot? Possibly, especially if s/he is young and financially secure.
My prediction is that what Mr./Ms. Tiger needs is the certainty that any crisis caused by the Republicans is fictitious. I think that if they trigger a crisis, it will cause both a market crash and a significant drop in the dollar, but that these will reverse (over a year or so) when their tactics come to light. And so here are some investment ideas (which of course are not investment advice, since what sort of idiot gets investment advice from some guy blogging on the Internet?):
First, separate from anything to be invested, enough money (either in the bank or reasonably expected from a safe job) to ride out two more tough years, during which cashing in investments may mean eating losses. Then:
Notice how far this is from the usual allocation of about 50% stocks, 40% bonds, and 10% cash or alternative investments. It combines a very low beta investment (cash, metals, currencies) with high beta investments such as options, oil, and foreign stocks.
(*) Opportunistic investment can include not only conventional investments, but spending on needed home repairs, education, or whatever else will increase income in the long term. But these ought to be calculated realistically. To take one example, in my experience, contractor-installed insulation and new windows are terrible financial investments, and will remain so unless gas goes up by a factor of 5-10. They may improve the comfort and livability of a house, however. Similarly, education beyond a few years of college is often a terrible investment. Depending on the field, technical training may be a better use of scarce dollars.
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