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We believe to be prepared for what is coming
over the next five years, one should be positioned with large cash or gold
holdings, (preferably gold, as the cash could be devalued by excessive money
printing), short most large cap stocks, long some inflation-protected
government bonds, and possibly some foreign stocks or other assets, and
stocks and commodities with good supply-demand fundamentals such as gold and
oil. Debt should be paid down with any available funds.
There is a massive worldwide campaign of money printing and seemingly
unlimited availability of credit providers in an attempt to sustain economic
and corporate growth. The battle is being lost, as more and more debt is
required to add smaller and smaller increments of growth. The danger is that
a rise in the very low, and in some cases 0%, interest rates will implode the
system, resulting in massive defaults. While it is becoming clear that we are
in a deflationary environment, there is an ongoing risk that governments will
attempt a coordinated re-inflation, which could have quite opposite
implications for different asset classes.
In view of these developments, you should
seriously consider the impact these reckless economic policies could have on your
choice of assets for investment and wealth preservation. We will give a brief
rundown of various asset choices and the pros and cons of each.
STOCKS - While it is always possible to find some good stocks, stocks
in general, are largely overvalued. We are in an economy where companies can
no longer produce sufficient earnings, due to a structural decline in profits
that has everything to do with excessive use of debt. Easy credit has
resulted in a serious misallocation of capital that is in the early stages of
being unwound. Stocks can provide some hedge against inflation, but generally
perform miserably in deflationary times. If we encounter an inflationary
environment, certain stocks, which are commodity-based, such as oil stocks
can thrive, however, in a deflationary environment such stocks might be
especially vulnerable. Financial stocks, such as banks and insurers, could be
most at risk as defaults mount.
BONDS - As with stocks, bonds depend on huge inflows of foreign capital
as a balancing mechanism to the huge and growing trade and budget deficits
the US is running. Continued money printing could scare off foreign funds,
resulting in sharply higher rates. Government bonds do well in deflationary
times, however, corporates and municipals could be risky during periods of
high defaults. Many advisors are recommending municipal bonds and insured
bonds to investors that are currently looking for safety. For those that are
risk averse, this is questionable advice. Currently, a high level of
municipalities and states are running severe and growing budget deficits that
can only be remedied by tax increases, which would be a drag on the economy,
or spending cuts, which would have the same negative effect. States and
municipalities do not have the luxury of simply printing more money, as does
the Federal Government. Government bonds are really the only good choice and
with the risk of re-inflation prevalent, short-term maturities are the only
safe choice considering risk and return. Insured bonds are only as good as
the insurer, which is also highly suspect in this environment. Bonds, with
the exception of inflation-adjusted bonds do poorly during inflationary
times. They are an excellent choice in the current environment, particularly
considering the low opportunity cost versus potential reward.
CASH - Cash performs during deflationary times as prices of things go
down, but purchasing power is seriously eroded during inflationary times. A
strong caution is warranted regarding money market funds and now one should
ONLY invest in Treasury-only money market funds. Generic money market funds
today invest in commercial paper, asset-backed securities such as credit card
receivables backed by dubious assets that have much more equity-type risk
than is widely perceived. Stay away. Also avoid money center banks that are
much more leveraged on their equity than smaller conservative banks. In
particular, avoid JP Morgan Chase, which could be the most leveraged company of
our times. Cash has the ultimate advantage of being highly liquid and can be
reallocated most easily if conditions change. Currently, cash is safe,
however, if the US along with other governments begin a policy of
re-inflation, there should be sufficient time to switch into other assets
that would protect you from inflation such as gold or inflation-adjusted
securities.
REAL ESTATE - Normally, real estate provides a good hedge against
inflation, however, in today's environment, the record levels of debt per
property make the asset class overly vulnerable to rising interest rates.
Prices have been outpacing income growth and are therefore clearly
unsustainable. Foreclosures could cause prices and rents to plunge. It is not
widely known that after the depression in the 1930's rents did not bottom
until 1942, which should caution those holders of income-producing properties
that the rental incomes they are counting on to service their debt may not
hold up as planned. Local government budgets, which are already widely
strained, could also result in unexpected tax increases at the worst possible
time.
COMMODITIES - Commodities provide a good hedge against inflation and
the CRB index has been breaking out to the upside, in spite of an economy,
which threatens to tip into deflation. This could be due to the low levels of
investment in this area over the past decades. In a serious deflation,
commodities with favorable supply - demand characteristics could see the
demand unexpectedly drop off. In an inflationary environment, this should be
among the best performing asset classes as the price of all real things rise.
GOLD - Gold is not widely considered money in the U.S., however,
actions in Japan, Argentina, and India argue otherwise. Gold is the ultimate
money or cash. In spite of that debate, gold stands as an attractive
investment, even simply as a commodity. Jewelry demand alone has not been
satisfied by new mine production for many years due to low investment in gold
exploration and production. Production is in decline and will require much
higher gold prices to stimulate new mine production. A re-linking of gold to
paper money could possibly set off an unprecedented appreciation in the price
of gold. After totally de-linking from gold in 1971, gold rose from $35 an
ounce to a peak of around $850 an ounce, a 30-fold increase in less than ten
years time. It is highly recommended to own physical gold and take
possession, storing it in a safe place. With all of the derivatives activity
revolving around gold over the past decade, you want to be certain that the
gold you think you own actually exists.
GOLD STOCKS - Gold stocks can be strong investments during periods of
inflation, a weakening dollar, and excessive printing of paper money as the
world slowly loses confidence in the paper money. Gold performs at its best
when central banks fight deflation. Gold stocks are generally leveraged to
gold, although have not had a history of keeping up with huge moves in gold
such as we saw in the 70's. They are riskier than gold itself due to debt
levels and price hedges but they have the advantage of liquidity and no need
for storage.
FOREIGN ASSETS - Foreign assets must be considered on a
country-by-country basis and should be considered when the US goes on a money
printing spree as it has over the past few years. Countries with high savings
rates and conservative spending policies should hold up much better than the
US dollar if the printing of money continues unabated and encouraged as it
has in the US.
CONCLUSION - Based on what we view as an increasingly deflationary
worldwide environment the big question is, what might the government and
central bank responses be? If central banks are not aggressive in fighting
the deflation, bonds should continue to perform quite well. That seems
unlikely in light of the ongoing accelerating worldwide money printing we are
seeing, so bonds of any duration over two years offer very poor risk to
reward. Cash will serve holders quite well as in Japan, if deflation does
keep its grip on the world and has the advantage of being liquid and most
easily and readily re-deployable. This will be important if money printing
continues and the value of currencies fritter away as with Germany in the
1920's. In such a case, there will be a need to shift into real assets such
as gold, oil, lumber, real estate, etc. Real estate currently has a major
drawback in that record levels of debt are attached and appreciation has
vastly exceeded income growth, paving the way for potential defaults. Stocks,
excepting special situations, look to be a poor choice based on extremely
high valuations, poor earnings prospects, and over-leveraged holders. In this
environment it is most important to hold on to your money as well as its
purchasing power. Gold stands out in that it does well as deflation is
fought.
Richard J. Greene
Managing Partner, Portfolio
Manager
Thunder Capital Management
More articles by the author can be accessed by the
"Research Articles" choice at: www.thundercapital.com
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