Today we’re going to finish up our discussion on what may be in store for your beloved U.S. Dollars. As rumors circulate that Lord Bernanke will wave his magic wand on November 3rd and inject another $1 trillion or so to excess reserves, negativity on the Dollar is boiling. Last week we talked about a couple different ways to look at currencies and explored the concept of purchasing power parity.
But first, congratulations to our four winners!
Last night I selected the lucky folks using a highly-scientific random number generating algorithm (rolling dice). I’ll be contacting you through Facebook today and you guys will all be receiving 100 Trillion Dollars in the mail shortly. Don’t spend it all in one place.
Thanks again to everyone who participated. Engagement ratios on Facebook pages typically run well under 1% but for this it was up over 15% which is, like, outstanding. We feel kinda honored to have such an enthusiastic and intelligent group of readers. If anybody has any other neat ideas about ways we can interact with our community, contact me at Feedback@TheDraconian.com.
Stuff worthy of your attention
Before we get started I want to quickly draw attention to two things.
The first is this week’s Hussman newsletter. I’m sure many of you follow John Hussman — he has one of the most popular and influential newsletters in the business — and his latest weekly missive is worth checking out. Dr. Hussman doesn’t talk down to his readers and his newsletters can get highly technical, especially this week’s. But he explores a couple of concepts that we’ve been talking about for a while around here: the velocity of money and liquidity traps (aka “pushing on a string”). As usual, he does a much better and more convincing job with the material than I do. Long story short, he’s also concerned that the risks of QE2 outweigh any benefit that the economy may see and he too is watching the velocity of money as a catalyst for inflation.
The second is this week’s landmark TIPS auction. Those of you who have been with us since last summer know that I looove TIPS. TIPS are government bonds that adjust their price with inflation. This week the government auctioned off a fresh block of 5yr notes and for the first time in history, the yield was negative. Yeah. That means that you will get paid back less money than you lend.
What kind of world do we live in where rational people make investments that have a negative yield?! There are two factors that make this possible. The first is the market’s inflation expectations. Since TIPS adjust their price with inflation, an auction like this means that the market is telling you — very explicitly — that it believes the Fed will be successful in its efforts to kindle some inflation. The market believes that future price adjustments will offset the negative yield.
The second piece of the negative yield puzzle is the generally crappy level of interest rates. You only usually see negative real yields when nominal rates are abnormally low, and nominal rates only get abnormally low when the economic future looks bleak. So the markets right now are signalling that rates will be low, growth will be slow, and we’ll have a little bit of inflation to move things along. That’s not my opinion, that’s what the data is saying.
Good bonds are one of the few things I’ve been publicly excited about since the crisis and honestly, I had no idea that would work out as well as it has. But in the last month or two my excitement has waned and today it’s virtually non-existent. The raw math of the bond market is difficult to justify at best and downright risky at worst. This is a historically difficult environment to earn a decent rate of return. We’re going to try, though, and in the coming weeks we’ll look at a few other things investors can do.
You might be pissed at the government for the bailouts and the stimulus and all the partisan bickering. But in my opinion, more people should be more upset about this zero-interest rate policy we’ve got going on. I’ve mentioned time and time again that this is an era of sacrifice and in times like this, everybody pays. Well, this is how fiscally responsible savers with stable jobs are sacrificing. I think people like that should be rewarded but instead they are being punished for their prudent decisions with abnormally low yields.
Thanks, Captain Ben!
The perils of universal “truths”
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
-Mark Twain
In the last year, two events stand out in my mind with respect to the currency markets.
The first was around December of last year, when basically the entire world was in agreement that the Dollar had nowhere to go but down. Any time that everybody agrees on a forecast it should make you skeptical by default. Always question predictions that are universally assumed to be true. Do I need to remind you that just about everybody (including instrumental figures like Ben Bernanke) believed that housing prices would keep rising and never go down? Remember when dot.com companies were “changing the world” and “needed to be owned” in this era of “permanently increased growth”? Some of you old timers might even remember the crazy things people were saying about gold in 1980… or 2001.
Just as those horrendous misconceptions were not limited to the investment community, the belief that the dollar is going to crash was one that was shared by both Wall Street and Main Street. Last winter investment bankers, cab drivers, and the lady behind the counter at Starbucks were all talking about what was going to happen to the U.S. Dollar.
But then the Dollar started to rally, and it kept rallying right up through the heart of the EU debt crisis. At that point I distinctly recall the visceral Euro hatred. Everybody in the whole world hated the Euro with a passion and was totally convinced that the Euro was headed straight for parity with the USD. On CNBC all that Maria Bartiromo could talk about was how the weak Euro could only get weaker. Yet again, right at that moment when everybody had piled onto the same side of the seesaw, the Euro started to rally. It’s been rallying since as investors seem to have forgotten all about Greece’s brief scare with insolvency.
The Dollar’s recent stumble began when the rumors of QE2 started to circulate. The further it falls, the more everybody hates it and the more everybody is convinced that it will only fall further.
Any student of history will point out that this phenomenon has existed for all time. All assets go through cycles such as these, always seeming to revert right when the repulsion is strongest.
Why, I can hear you asking, does this pattern exist?
Past performance is NOT indicative of future results
In the world of psychology there is a concept known as the recency effect. It’s a cognitive bias that describes the disproportionate emphasis humans place on recent events, especially when it comes to forecasting the future. When we look out to tomorrow, we think of yesterday and assume we’ll see it again.
When it comes to investing, it is the assumption that past performance will indicate future results. For some reason, nobody takes this ubiquitous disclaimer seriously and the reason is that their brains simply aren’t wired to. That’s why there’s a disclaimer. To protect people from their own dangerous biases.
As it pertains to the U.S. Dollar, consider the following recent events:
1. A massive rise in commodity prices over the last decade.
2. Substantial depreciation against most major currencies over the last decade.
3. The Dollar is now one of the cheapest currencies in the world on a purchasing power parity basis.
So it’s no surprise that everybody hates the Dollar. And because of the recency effect, everybody assumes this trend will continue.
As far as the eye can see
It’s really easy to buy into this feedback loop, too. The Fed hasn’t explicitly said that it’s trying to devalue the Dollar but everybody knows that a weaker Dollar helps solve a lot of policy problems, not least of which are the trade deficit and public debt overhang. Why bother fighting the Fed?
Well, pursuing an inflationary agenda is a delicate balance. The U.S. owes $12 trillion to creditors of many varied stripes. Hyper-inflating away that debt is undoubtedly a viable solution to that problem. But don’t forget that the U.S. still needs to borrow about $1 trillion per year for the next decade to pay for its projected budget.
While none of us know what the markets are going to do, take solace in the fact that all of us know what the government is going to do. It’s going to spend money. They have told us that they will, and have so far delivered on these credible promises. On top of that, we all know that political realities at present demand that they spend money, especially if there’s another bump in the economic road. We can count – year-in and year-out – on our Senators’ and Congressmen’s slavish desire to protect their own job security and they do that by making promises to us voters. These promises cost money and this reality transcends the differing political views of Democrats and Republicans.
As sure as we are that the government will spend money, we are equally sure of its evil twin. The money will not be there for them to spend. Thus, they will be forced to borrow it.
There is absolutely no way anybody in the world will lend the U.S. $1 trillion (read: TRILLION!!) per year if they don’t think they will get paid back, or will be paid back in dollars that have no value. Seriously, these countries aren’t stupid.
So if the dollar collapses – and there is always the chance that it may – it will do so against the efforts and desire of literally the entire planet.
A steady, orderly decline is more likely to be the order of the day. In fact, stability or even modest strength would be both probable and tolerable. There’s less life in the short-USD than a lot of people might think. With every passing day the expected returns drop, and risks rise.
At this point investors should not be asking if an epic Dollar crash is in front of us. They should be asking if it’s already happened.
How to play it
Jens Nordvig, director of currency research at Nomura Securities, was on Bloomberg earlier in the week and the host asked him about his number one trade for the next couple weeks. He said, “the next couple weeks you want to be long the dollar going into the [FOMC meeting]. I think the dollar is going to surprise you.”
He actually got laughed at! Though Tom Keene, classy bowtie-wearing guy that he is, followed the laughter up with a compliment for taking such a bold, against-the-grain view.
It carries risk, but that’s one thing you can do. Just hold on to your dollars for the time being. I know that interest rates are super low right now but this is one of the best times in history to sit on a large pile of cash. Your purchasing power has actually increased a little bit in the deflation of the last few years and even with more quantitative easing on the horizon, there aren’t too many serious threats to your purchasing power. It takes a lot of discipline and I’ll understand if your hunger for yield sends you down another path.
Commodities are the worst things to own in a Dollar rally. Things like crude oil and corn gets killed when the Dollar strengthens. So be careful with that stuff or companies that are direct plays on the commodities boom. Don’t panic — I like that kind of stuff over the long run because we all know:
- The Dollar always goes down over the long run against real assets and physical goods.
- The world’s population and need for resources will keep increasing for as long as most of us are alive.
So a Dollar rally can be a good time to pick up stocks like that a little cheaper than they usually trade.
If the markets still make you nervous and skeptical, the good news is that you don’t have to be an active investor to benefit from all this new currency knowledge. A more fun way to play the Dollar is to use what you know about it to your advantage as a savvy traveler.
It’s hard to believe that a night at this hotel:
costs basically the same as this one
for the American traveller.
This is how big a difference purchasing power can make. I have actually stayed at both of those hotels. I’d, uh, recommend the latter. It sounds nuts but you can stay four nights at the Fiesta Americana Grand Los Cabos for $169/night and get a $200 credit for food! This is the kind of thing that’s possible when you take a stronger currency to a country where the local currency is weak. I can’t even wrap my mind around how awesome a deal the average Brit gets in Mexico right now.
When you’re planning your next a vacation, take these factors into consideration. Grab a PPP table or the latest findings from the Big Mac Index and hit up the countries that are cheaper. Now’s a good time to visit Latin America and the Pacific Rim (ex Japan). It’s not a good time for that Great European Adventure you’ve always dreamed about. Don’t worry, though, the Euro will have its day in the gutter. And when it does, I guarantee they’ll appreciate your tourist dollar!
Here’s the Big Take-Home Point
In the last two weeks we’ve discussed the two ways to evaluate a currency.
We all know that over the long run the Dollar only gets cheaper against the goods we buy. We feel this intuitively and see it when we look through our past. After today, you guys all know why that trend must continue. Let’s hope that Chief Bernanke is able to kindle a little bit of inflation to get things moving again. We’re a long, long way from Zimbabwe.
Because of this, most investors lack appreciation for the Dollar in the capital markets and don’t properly identify opportunities. From their perspective, their dollars just get cheaper and cheaper over time and they don’t understand that every other country is pursuing a similar policy objective. In order to identify the real opportunities in the currency world, one needs to understand all the different ways to measure value. Tools like cross rates and purchasing power parity will help you spot these opportunities. They might be big-money macro bets like shorting the Japanese Yen against the Turkish Lira or they might be something simple like helping you enjoy a week of the good life on vacation in a country like Mexico or China.
A lot of people are afraid about a Dollar crash right now, but they’re about ten years late to that party. The time to worry about a Dollar crash was in 2001 and by any stretch of the imagination, that’s exactly what we’ve had since then. It’s certainly possible that the Dollar isn’t done going down, and in fact, it’s highly probable that it will keep going down against real assets over the long run.
But in the meantime, the Dollar will bounce all over the place. And against the other major currencies, don’t be surprised to see it exhibit some relative strength in the coming decade.
As the Fed warms up the printing presses on the good ship QE2, a new round of Dollar worries emerge. Everyone seems to think that Captain Greenback will wind up on the rocks. Is there any chance Ben Bernanke might be able to thread this ocean liner through the narrow canal?
This week we take a look at the world of currencies with a focus on our own. Rather than panic and drown in a sea of inflationary talking points, we’re going to calmly put on our life preserver and build a framework through which we can make sense of this madness. We’ll do it in two parts. Today we’ll get our tools ready and next week we’ll come to some conclusions and discuss some strategies.
But first!
In honor of the Federal Reserve’s latest efforts to re-inflate the economy we have another Crazy Draconian Giveaway:
I have come into possession of a few 100 TRILLION DOLLAR BILLS from the Reserve Bank of Zimbabwe. These are the real deal and were actually printed for circulation in early 2009. Today we are giving them away to our wonderful Draconian readers.
It’s easy to win. All you have to do is go to our Facebook page and click the “like” button or post a brief comment on the latest post. That’s it. Next week I’ll pick four names at random and I’ll mail these out to four lucky readers.
It will take you less than 15 seconds:
- Click here.
- Post a comment or click the “like” button on the most recent post.
- Win 100 Trillion Dollars.
Quick, do it right now. Go ahead. I’ll wait…
In the meantime, here’s proof of authenticity:
Great! Thanks for participating, and as always, thank you so much for reading every week.
Lessons from Zimbabwe
Zimbabwe is a classic story of debt, inflation, and bad policy gone horribly wrong. The dictator Robert Mugabe eviscerated their economy in the 90′s by repossessing land from white farmers and redistributing it to his cronies who had no clue how to farm. The country’s food production plummeted and economic growth stopped. So the government borrowed a ton of money from the IMF and other ballsy creditors to pay for their bloated government expenses. When Zimbabwe couldn’t pay these loans back, they just started printing money as fast as they could which kick-started a vicious cycle of hyperinflation. They tried all sorts of other dictatorial tactics like making it illegal for merchants to raise prices and forcing people to use the Zimbabwe Bucks instead of more stable foreign currencies. But nothing worked.
It pretty much destroyed all the wealth of the country.
What’s wild is that there was once a time when a Zimbabwe Dollar was about equal to one U.S. Dollar. When those 100 Trillion Dollar Bills were put into circulation early last year they were worth about $30 and a month later they weren’t even worth the paper they had been printed on. I guess 100 Trillion Dollars is sort of the threshold. When your country starts printing those you know there’s a problem.
The sad thing is that this isn’t the only time in history that this has happened. Reinhart & Rogoff chronicled some of these episodes in their book. The ancient Romans did the same thing with the denarius, devaluing it over time by minting it with less and less silver. The Romans weren’t the first to do it and Zimbabwe won’t be the last.
Today, a lot of Americans are worried that something like this might happen to them.
It wasn’t that long ago when we had our own inflationary scare and that’s still a recent memory for many people, especially our policy makers and central bankers. So it’s no wonder why we’re always so touchy in this country when it comes to inflation. Everybody thinks about their childhood in the 70′s and early 80′s and remembers the stagflation. They remember the energy crisis and the gas lines. They might even recall when Richard Nixon tried to control prices and wages by setting legal limits on each. A mere decade later the U.S. Dollar was worth half of what it was and people were were mad as hell and were shouting that they weren’t going to take it anymore. Everybody bought gold.
It’s a visceral memory. Emotions are powerful things. But there’s an academic sensitivity to inflation as well. There is a collection of sensible, rational people that are highly attuned to the mechanics of inflation and spend a lot of time devising new reasons to be concerned about it. Most of them wear horn-rimmed glasses and bow ties.
Let me boil all of their knowledge down for you with one easy chart, one of my favorites from my personal archives:
Alternatively, that chart could be titled “The Amount of Stuff $100 Used to Buy You”. As you can see, the actual amount of stuff is less and less.
By most standards I am still considered a “young whippersnapper”, but even I remember how much cheaper everything was when I was a kid. I remember paying less than $1 a gallon when I first got my driver’s license. A date at the movies was like ten bucks. You could buy a starter home for well under $100k for a few grand extra you could put a new Dodge Neon in the driveway. Chicken McNuggets, oddly, were the same price, but the concept of a Six Dollar Burger was heresy.
And I know you old timers totally have me beat. I’m sure that more than a few of you remember your first job paying $5-$10,000 per year. Some of you might even remember lusting over Harley Earl styled Cadillacs on the showroom floor. That was when a couple thousand bucks was a lot of money, enough to purchase a gas-guzzling status symbol.
Anyway, my point is that there is a very strong, inverse correlation between the value of a dollar and time. There is a lot of academic evidence to support this conclusion and there are countless personal anecdotes that reinforce the same story.
Nobody needs much convincing that this is the reality we have always faced and will continue to face. So let’s take a look at why things are this way.
A slow leak
Why does it have to be like this? Why can’t we just have dollar that’s strong and stable and a proper store of wealth? We even tried to do this during the adolescence of our nation and fixed the value of a dollar to certain amount of gold. What happened? Why does the value have to always go down?
There are two major reasons, a complicated one and a simple one.
The complicated one is that we are a debtor nation. Our country finances a large portion of its budget by borrowing money from its citizens and other countries. Like any business, the U.S. earns money and then spends it. It earns money from taxes and then spends that money on things like national defense, public schools, and first class plane tickets for our elected representatives. Sometimes, it spends the money it makes to bailout failed banks. (Sorry, that was a cheap shot.)
But the problem is that the United States spends more money than it earns, and with a policy like that it takes the concept of debt management very seriously. Countries like China or Japan call up the U.S. and say, “Hey, we will loan you $1 trillion so you guys can buy more stuff. Pay us back in thirty years and in the meantime give us a little bit of interest.”
The U.S. happily agrees. They borrow a few trillion dollars that they get to spend right away and as long as they can maintain some positive inflation — and they’re pretty good at this because they also control the printing presses — the U.S. gets to pay all these people back with Dollars that are less valuable. It’s a sneaky way to get a bigger bang out of each buck that we borrow.
The other major reason why we have adopted an inflationary policy is that it induces people to spend money. When somebody spends money, a business somewhere makes a profit. As businesses make more profits and pay more salaries to their employees, the government gets to keep a piece of that action for themselves in the form of taxes. The more money businesses and people make, the bigger the government’s slice!
It’s a very natural cycle, too. When people in the U.S. make money they want to spend it because spending money is fun. But they are also psychologically programmed to believe that if they don’t spend it, they won’t be able to buy as much with those dollars later on. They remember how much cheaper gas and houses and Chicken McNuggets were when they were kids and assume that when they get older, those goods will only be more expensive. An inflationary policy keeps them spending today and not next year.
Ben Bernanke’s single greatest fear is that we all suddenly become Japanese. That is not to say he’s worried we’ll develop an unhealthy interest in robots and karaoke, but rather that our psychology turns deflationary. Deflation and the deflationary mindset that it causes give people a big time incentive to not spend money. They walk into the Cadillac dealership and decide that while the deal of the month may be a pretty good one, all they have to do is wait a few more months for an even better deal. The young family out shopping for a house chooses not to buy because prices will probably be cheaper next year.
That, my friends, is disastrous for an economy.
Deflation may seem cool because your dollars get more powerful with time, but it’s actually really scary because everything in the economy grinds to a halt. GDP goes down, tax revenue dries up, and the U.S. is forced to borrow even more money to pay for stuff, debts that it has to pay back with more valuable Dollars. Ugh. So you can see why the Federal Reserve wants to slowly increase the price level over time and why they want the rest of us to be afraid that our paper dollars have nowhere to go but down.
Now that we’ve made peace with a slowly shrinking Dollar and understand why every year it buys us less of the things we like to consume, we can broaden the scope beyond our borders. In the global currency marketplace we’ll see that things work a little differently.
A brief, non-academic primer on the currency markets
The most important thing to understand about currencies is that they are priced in terms of other currencies. Technically, they’re just ratios. There isn’t really an absolute standard by which currencies are valued and there is no Cadillac or starter home to use as a universal benchmark. Some people like to use an ounce of gold as a historical baseline, but even that has complications.
Instead there are all sorts of currency cross rates in the market with wonkish names like Dollar/Euro Yen/Dollar or Dollar/Aussie. It’s confusing to keep all of these things straight, especially in an era of globalization. Global trade isn’t about bilateral arrangements anymore, it’s multi-lateral.
To make things easier on their modeling system the Federal Reserve actually created an official U.S. Dollar Index. It’s made up of a basket of foreign currencies. About half of the basket is the Euro, and about 14% is the Yen. The rest consists of the British Pound, the Canadian Dollar, Swedish Krona, and Swiss Franc. Because all these other countries are trying to do the same thing as the U.S. and devalue their currencies against physical goods, the Dollar Index chart looks different than that first one we showed.
The Dollar goes up and down relative to these other currencies:
You can see that over the long run the U.S. has done a marginally better job than its peers at debasing its currency.
Go USA!
It’s weird to think of currencies this way, in terms of how much they are worth relative to other people’s currencies but that’s how it’s done. Right now you can see that the Dollar is pretty cheap relative to these other countries. In fact, it’s historically cheap. The Dollar Index is near all-time lows against the currencies of other developed countries.
The U.S. certainly has its share of problems, but are they as bad as the problems in these other nations? Are we really in as much trouble as Europe? Do we have the same massive problems that Japan does? If it came down to it, would you really rather have a pile of Euros or Yen instead of Dollars?
The U.S. Dollar might stink, but it’s probably the least dirty shirt in the currency closet.
When you put it that way, it softens some of the hate and the Dollar doesn’t seem all bad. So let’s get back to root of this brewing Dollar hatred.
As we talked about earlier, it’s much more intuitive to think of a Dollar’s worth in terms of other objects. Like the classic Cadillac and how little we used to pay to fill it up, things like that are easier to wrap our brains around. So what if we could package that concept up and use it — instead of wonkish cross-exchange rates — to determine which currencies were expensive and which were cheap?
What if we could take all that information about relative values and assign simple numbers to highlight who’s got the the strong and weak currencies?
Well, it’s your luck day! Enter the idea of purchasing power parity.
A brief, non academic primer on purchasing power parity
In short, Purchasing Power Parity (PPP) is just an official way to calculate this concept that we’ve been discussing. It’s a way of pricing currencies against a fixed basket of goods. PPP is based on the “theory of one price” which basically says that absent things like tariffs and other barriers to trade, identical goods should have identical prices all around the world.
The most famous example is The Economist’s “Big Mac Index” which measures how much a Big Mac costs in different countries around the world. Using this global icon as a unit of exchange, you can get a sense of which currencies are strong and which are weak. Based on their latest highly scientific findings, the Big Mac baseline here in the U.S. is $3.71. We know that Canada has a strong currency and it costs about $4.18 up north. That’s not too bad, but in Brazil, it costs $5.26 and in Switzerland it costs $6.78! The average for the whole Euro area is $4.79, which is more than I’m willing to pay for fast food.
On the cheaper end of the Big Mac spectrum is Russia, where one costs $2.39. South Korea is interesting at $3.03 per Big Mac, but China is the big winner in terms of having undervalued currency. Over there it costs $2.18.
There’s a little bit more work and a whole lot of math that goes into the official calculation of Purchasing Power Parity. But the concept is exactly the same.
Here’s a table of some major countries. A value above 100 means that the currency is stronger (more expensive) than the U.S. Dollar. A value under 100 means the currency is weak, and has relatively less global purchasing power than the U.S. Dollar.
| United States |
100 |
| Canada |
118 |
| Mexico |
66 |
| Australia |
134 |
| Japan |
145 |
| South Korea |
76 |
| New Zealand |
117 |
| Czech Republic |
79 |
| Denmark |
155 |
| France |
116 |
| Germany |
111 |
| Greece |
103 |
| Hungary |
72 |
| Ireland |
132 |
| Italy |
115 |
| Norway |
156 |
| Poland |
69 |
| Spain |
102 |
| Sweden |
125 |
| Switzerland |
164 |
| Turkey |
85 |
| United Kingdom |
155 |
Again, Switzerland appears to have the most overvalued currency. Not only are Big Macs twice as expensive in Zurich but everything else is too. It costs 164 US Dollars to buy $100 worth of stuff in Switzerland.
Noticeably missing from that table is China. Those PPP figures are all calculated by the OECD (Organization for Economic Co-operation and Development), of which China is not a member. We’ve all heard stories about how cheap things are in China, from food to lodging to labor. A few years back a friend of mine went to China and he said they would buy beer for about $0.40 a bottle and enjoy them on the beach. So we already know that the RMB is super-weak relative to the rest of the world. It’s pegged to the Dollar at a very low level.
If you were thinking about shorting the Dollar keep in mind that it’s already one of the cheapest currencies in the world on a PPP basis. On top of that, when you short the Dollar you’re also effectively shorting the Chinese RMB, widely agreed to be one of the most undervalued currencies in the history of the world.
Come on, who really wants to bet against 40 cent beer???
Next week on The Draconian…
That’ll do it for this week. Next week we’ll have some more exciting charts and we’ll get back to that question of what might lie ahead for the U.S. Dollar. As a bonus, we’ll discuss some strategies on how to cope with the Dollar’s ever-shifting value.
I’ll be at the Race for Research this Sunday morning down at Idlewild Park. Stop by and say “hi” and make a donation to fight Multiple Myeloma while you’re at it.
See you then!
Today we discuss the latest rumors about how the government will stimulate the economy. There are a lot of really cool charts up ahead and if that kind of thing gets you excited you should find this week’s newsletter a real delight. But first, a quick word about the stock market.
The market continues to drift higher and higher. Ordinarily I’d be happy about that but a disproportionate number of the people that I talk to are not participating. They, like a lot of retail investors, are sitting on the sidelines and watching the market with skepticism. After all that investors have had to deal with in the last decade — negative average annual returns, scandals, crashes, cheating banks, and crazy-high volatility — I honestly can’t blame them. How can the guy at home be reasonably expected to navigate these shark-filled waters?
I’m watching this negativity and cynicism about the markets very closely. At some point I think that will signal a very strong “buy” for stocks. All I’m waiting for are attractive valuations. It only happens a few times in a lifetime, but I believe we’re all going to get a shot sometime later this decade. Stocks will be fundamentally cheap, the cheapest they’ve been in a long time, and investors all around the world will hate stocks with a passion. They’ll hate stocks the way that people who have been burned by real estate hate that market.
The history of the markets is cyclical, not linear. Right now we are cycling from a peak of exuberance in the late 1990′s towards a trough of despair. These cycles have historically taken between 15 and 20 years. Here, see for yourself:
Nearly every single one of those valuation troughs was an awesome time to buy stocks. When the next one happens, I’m going to load the boat with domestic equities. I won’t time it perfectly but I’ll let you know when I do it. And mark my words: you’ll all think I’m crazy for doing so.
That, my friends, is the sign of a good trade!
The most money is always to be made in places where one’s thesis is fundamentally correct but stands in opposition to the consensus view. At least when it comes to macro perspectives.
Fuel in search of a Fire
The buzzword of late is “quantitative easing.”
What is this wonkish thing? It’s basically money-printing. The goal is to boost the nation’s money supply and thereby stimulate the economy.
Rather than simply turn on the printing presses, the Fed goes about it in a modern and efficient way. They wave their magic wand and and press a button which credits their own account, manufacturing electronic dollars out of thin air. Pretty cool, huh? I’m sure you can think of a few people or companies that wish they could do the same thing. As matter of fact, there have even been a few African dictators who have done exactly that.
After creating dollars out of nothing, the Fed then tries to put the dollars into the system by buying stuff from the banks. Usually the Fed buys bonds — US Treasuries or other intra-bank notes. Last year they bought about $1.2 trillion of mortgage backed securities. This is fun for the banks because they get cash in exchange for those assets, cash that they can use to buy whatever they want. Ideally, the banks use the cash to make loans to people and small businesses and thus stimulate the economy.
“Whoah, whoah,” you might be saying. ”Hold on a second! With way more dollars in the system doesn’t that mean that the value of each dollar is less?”
The answer is complicated. More dollars in the system only leads to inflation if people actually spend them, exchanging them for goods and services. The mere existence of more dollars doesn’t necessarily disrupt price stability.
To put this into terms that I know all of you Nevadans will understand, it’s like the summer fire season. Think of quantitative easing as a series of spring rain storms, showers that make a whole lot of desert grass and shrubs grow. It’s nice to have a lot of grass in the hills, but when the storms stop and summer settles in, all that grass dries up. Dry grass isn’t a problem in and of itself. It’s only a problem if someone drops a match. Then you get some pretty spectacular flash fires.
The money that the Fed’s quantitative easing programs have injected into the system is akin to filling the hills up with grass, grass that is now dry. Check out a chart of the adjusted monetary base. This is basically the total amount of currency in public circulation and dollars held as reserves at the banks:
I’ll concede, that’s a very dramatic chart. That’s about $1.3 trillion that the Fed has added to the monetary base since the crisis. This is one of the data sets that inflation hawks point to when screeching about the evils of quantitative easing and the risk it runs of setting hyperinflation ablaze.
I’m not too concerned right now. The Fed has given these reserves to the banks and said “here, lend it.” But so far, that hasn’t happened:
As you can see, the banks aren’t lending the money out. Mortgage loans are down. Credit cards & auto loans are down. Small business loans are way down. All of these items have been trending lower and lower since the crisis. And it’s not without good reason.
First and foremost is that today’s borrowers are generally less credit worthy. There’s a weird hypocrisy in the political economy right now. We are angry at the banks for making all these crappy loans to sketchy borrowers but at the same time we are angry because they’ve corrected that problem and have cut back on their lending. I’m not sure how many people understand that those two objectives directly oppose one another. Nobody in Washington D.C. seems to.
The second reason the banks aren’t aggressively lending the money is that they’re still in bad shape themselves. Again, a similar hypocrisy exists. We want banks to maintain cleaner and better-capitalized balance sheets but at the same time we want them to freely hand out money to those that ask for it. Which is more important? A stimulus-addled, hyperactive financial system or one that’s better capitalized and slower moving?
Regardless of our political wants, the data clearly indicate that we are trending towards a system with better capitalization but with more conservative lending policies. We’re in a cycle of deleveraging, a perfectly natural thing after a long cycle of aggressive credit expansion.
The consequences of deleveraging
As you may have guessed, deleveraging is rather deflationary.
The Fed can give banks reserves but they can’t force them to do anything with it. This is the famous “pushing on a string” cliche and it’s why many are critical of quantitative easing as a method for stimulating the economy. The Fed only gets a good bang for its buck if this money moves around throughout the system and so far that hasn’t happened. It’s just sort of sitting around. If you’re a bank, you’ve probably parked it on deposit at the Fed or bought Treasuries where you can earn a nice spread. If you’re an individual, you’ve probably just stuck it in the bank or paid down some debt.
We can measure the aggregate of this movement by looking at the velocity of money. It’s basically the number of times that a single dollar changes hands in a year:
No surprise — the velocity of money shot up in the late 70′s as people got concerned about inflation. Then it collapsed in the following recessions before embarking on a massive trend upward through the 80′s and 90′s. The collapse since then has been equally breathtaking. People are clinging more tightly to their dollars than they have in twenty years. There might be a lot of inflationary kindling out there, but until people start moving some of these dollars around, I expect prices to remain stable.
The Inflation Chupacabra
At some point, probably later this decade, inflation might become a concern. Right now there isn’t any in sight and there isn’t any reason to expect anything anytime soon. Despite what you may have read from your favorite gold bug or radical newsletter service, the market confirms this view.
Let’s take a look at a chart of the spread between TIPS and Treasuries. It’s a measure of what the bond market thinks the average annual inflation rate will be for the next ten years.
Right now the market says that inflation will average about 1.5% per year for the next decade. Expectations for the next thiry years are only marginally higher. That’s hardly something to panic about.
Now before I get a bunch of hate mail — Feedback@TheDraconian.com — let me add a few caveats. The first is that I really do like gold for a lot of reasons that we’ve discussed at length, none of which have anything to do with inflation. The second is that the TIPS/Treasuries spread has started to increase a little bit since the rumors began of a new quantitative easing program and I’m watching this closely. Food and energy prices have each risen quite a bit this year and that could also be affecting these spreads and our psychology. Finally, it’s possible that the market could be telling us that we are teetering on a seesaw that will ultimately tip in one of two directions: 1970′s style hyperinflation or Japanese style deflation. 1.5% annual inflation might merely be a mathematical midpoint between and inflationary brush fire and a deflationary winter freeze.
Until the market’s inflation expectations decisively reverse or until I see the 30yr Treasury yield go nuts, I continue to believe that the more likely outcome is an economic future that looks more like Japan than the 1970′s. To me, these deflationary forces represent more of a concern than inflation. And that holds true over for any length of time that a reasonable individual might be interested in.
If you need further convincing that inflation is nothing to fret over consider stories like these. That’s like…whoah. The Fed has only two legislative mandates one of which is price stability! To risk that should indicate how concerned they are about deflation and how much confidence they feel in their ability to manage the risks of halting it.
As always, I’m willing to abandon these viewpoints as soon as the data tells me otherwise.
In the meantime, is QE a good idea?
Just because I think deflation is the bigger risk, doesn’t mean I’m in support of a new round quantitative easing. There are a couple of things that concern me about QE and they should concern you too.
The first is its relatively poor track record of goosing the economy. They’ve been doing this exact same thing for a long time to fight deflation in Japan. Thus far the Bank of Japan (their version of our Federal Reserve) has been powerless to stop their deflationary spiral.
The second is the marginal benefit we’re likely to get from another few rounds of QE. In theory QE encourages the purchase of all sorts of bonds which has the temporary effect of pushing down interest rates. Lower interest rates — again, in theory — make it easier for people and businesses to borrow money to finance expansion. I’ve heard some analysis claim that an additional $500 billion of QE will lower interest rates by about 25 basis points. I’m sure Ben Bernanke lays awake at nights and wonders if a massive increase in the Fed’s balance sheet is worth another 0.25%. Is that extra little bit going to encourage people to borrow and spend money? If you didn’t already run fanatically out to buy at house at 4.5% are you really going to do it if rates go to 4.25%?
That being said, the Fed’s first round of QE last year was very effective at re-inflating asset prices. Mere discussion of serving up another round from the QE punch bowl has caused the market to rally over 12% since the end of August. Who cares if it’s artificial — higher asset prices instill confidence and confidence is what this economy really needs right now.
The concern, however, is that the price level gets out of control. Which brings our discussion back to inflation.
With all that dry grass out there, what are some matches that might set it ablaze?
Unlit matches
If you’re concerned about inflation here are some under-the-radar things to watch for, some indicators you can follow aside from the price of gold:
Lower capital standards for banks (low probability) — Basel III is still ongoing so keep your eyes peeled for these new international capital standards. Lower capital standards means more leverage and monetary movement. Personally, I love the idea of counter-cyclical capital buffers — that means banks have to hold more reserves when times are good and are permitted to hold less reserves in times of crisis. It’s a terrific and effective idea but it runs against human nature. I am skeptical that it survives the political pressure to change it and you’d better believe there will be pressure to change it when things are rocking and rolling once again. That could could be a firestarter.
Failed regulation (medium probability) — This would give incentives to the banks to be loosey-goosey again with their controls. This is where the “too big to fail” and moral hazard themes come into play. I’m not confident that those issues are sufficiently addressed in the Dodd-Frank financial regulation bill. There aren’t any new rules that put limits on the size of these banks. Do you doubt for a second that if Citigroup or Bank of America found themselves in serious trouble the government would step in and bail them out? We might say we don’t want anymore bailouts and politicians may promise that there won’t be anymore bailouts, but if we wind up in another situation where a major bank is teetering on the brink, I fully expect that everybody rises up and begrudgingly swallows another bailout. This effectively permits banks to behave badly, and that bad behavior could be an inflationary catalyst.
Perception of inflation (medium probability) — People don’t really believe there’s going to be inflation. Not yet. Yes, they’re buying gold in droves, but I believe that’s simply performance chasing, people looking for something to buy that, unlike most other markets, is actually trending up. But if that perception changes and people start rapidly trading their Dollars for all sorts of other stuff, that increased velocity of money could trigger the fire. Again, I don’t think this happens overnight You’ll get advance warning. The TIPS/Treasury spreads will shoot up, the long bond will go crazy, and gold will probably shoot the moon. But extreme Dollar fear is something that could get the velocity of money moving again.
So far so good
This year in Nevada, we made it through the dry season without any disasters. It was a lucky summer. Will the Fed make it through another round or two of quantitative easing without any bouts of inflation? Just as we have tools to fight fires in the mountains, the Fed has tools to fight the forces of inflation. Today we discussed the question of whether the fire even gets lit. But at some point we might have to start a debate about how to fight the fire once it’s burning.
I hope that’s never the case, because as the Volcker Fed taught us, those are where the really tough decisions lay. On the one hand is a skyrocketing price level where everything gets more expensive, especially things like physical commodities and oil. On the other hand is a world of higher interest rates and much slower economic growth.
We should be so lucky if what this market data is telling us today turns out to be the truth.
Two brief items of business before we get to the meat of the matter.
First, see what it’s like to spend a day at a hedge fund! Check out a virtual tour of our Reno offices over at our Facebook photo gallery. I don’t think you need to be a Facebook member to view the pictures, but make sure to hit the “like” button if you haven’t already!
Second, if you’re one of our local readers, make sure you check out Kelsey’s Race for Research webpage. Her mom was diagnosed with Multiple Myeloma a couple years ago and Kelsey’s inspirational response was to create her own non-profit organization and hold an annual charity race to raise money for Multiple Myeloma research. Draco Capital Management is proud to be one of Kelsey’s sponsors. I’ll be there on October 24th, along with Mrs. Draconian and the Mini-Dragon. Stop by and say “Hi.” If you make a donation, you even get a T-shirt!
As I mentioned last week, today’s newsletter will be a little technical. If you can get through it, you’re on your way to becoming a savvy portfolio manager. This is the kind of stuff the pros do. My guess is that all your friends at the club are probably more interested in hot stock tips than sophisticated portfolio strategies, but in the case that they are wowed by ideas, prepare to be the talk of the clubhouse!
Risk on / Risk off
One of the most common frustrations that I hear from other traders and fund managers in the industry is that everything today is correlated. If you haven’t had your morning coffee yet, don’t panic. ”Correlation” is just a fancy way of saying that two assets tend to move together. When one investment goes up, the other goes up. When one goes down, the other is likely to go down as well.
Back in day, what clever portfolio managers would do is build an investment portfolio with assets that didn’t correlate with one another. That meant that if an asset went down one month there was a good chance that some other assets in the portfolio may have gone up. A portfolio of uncorrelated investments has the pleasant side effect of lower volatility and greater returns per unit of risk.
It works with investment strategies as well. Investors like volatile strategies because volatile strategies tend to generate higher rates of return. But if you combine uncorrelated, volatile strategies with one another you can keep the same high rates of return but with lower volatility.
Here’s a graphic we use with our investors to illustrate the difference.
In the world of portfolio management this is an extremely important concept. It was a concept that was pioneered and formalized in the 1950s by Harry Markowitz, and later on he would later receive a Nobel Prize for this groundbreaking work. He called it “Modern Portfolio Theory.” I would have called it Markowitz’s Awesome Model to Reduce Risk and Reap Rewards.
The trouble with Modern Portfolio Theory is that it hinges on this notion of combining uncorrelated assets. But today nearly everything in the market seems to be moving in lockstep. It’s really difficult to find assets that are going up when everything else is going down. Instead of a smooth steady line like the one above on the right, multi-strategy portfolios are looking a lot more like the single-strategy graph on the left.
Something has changed in the investment marketplace.
Before we dig a little deeper into the nitty-gritty of what’s going on, I need to give credit where credit is due. The inspiration for a lot of this newsletter comes from local reader Keith Averill. Keith runs Top Tier Managers so he knows a thing or two about investment correlation and portfolio construction. He even sent me some great charts which we’ll get to in a moment.
The Myth of International Diversification
In the past, one of the most popular things that equity investors have done to get diversification and bring down the level of correlation inside their portfolio is look internationally.
It’s easy to understand why most domestic stocks all move together — they’re all largely driven by performance of the U.S. economy. When the economy is healthy and consumers and business are spending money, it’s good for just about every stock. In recessions, everybody suffers and most stocks drop alongside each other. The Dow, S&P 500, and NASDAQ indexes are each composed of totally different companies but if you turn on CNBC you’ll notice that all three are always moving up or down together.
So the theory went that foreign markets were driven by a totally different set economic factors. The performance of Europe’s economy and stock market wasn’t so tightly linked to the performance of the United States. It was a different world over there. They were all doing their own European thing. Going to Mallorca or buying tiny, weird-looking cars and eating stinky cheese.
But in the last few years that hasn’t been the case. Nowadays, everything over there seems to move right alongside the stuff over here. As an active participant in the marketplace I’ve felt this correlation intuitively, but it wasn’t until Keith sent me this chart that everything came into such dramatic focus:
Pretty incredible, huh? Since the financial crisis international stocks have correlated almost perfectly with domestic stocks. That’s on top of a 15 year trend of increasing correlation.
This chart also reminds us that it wasn’t always like that. European markets really used to be different! Before the last decade there wasn’t much correlation at all between the U.S. and international stock markets, fluctuating from modest correlation to statistically insignificant correlation.
Check out this next chart:
What’s perhaps even more disturbing is the fact that these markets are correlating almost perfectly during market drawdowns. And drawdowns are exactly when you don’t want your investments to correlate! When one investment is going down, it’s really nice to have others that are going up or at the very least, aren’t going down as much. But with international stocks, not only are they all moving in the same direction, they are even moving in the same magnitude.
Again, this wasn’t always the case. It used to be that a bear market in another country didn’t necessarily translate to a bear market in the U.S. Nowadays a -40% drawdown in domestic stocks pretty much means a -40% drawdown in international stocks. For an investor who’s only really interested in his final rate of return, what’s the difference between an investment in the S&P 500 or the MSCI Europe/Australasia/Far East Index? If you already own domestic stocks what good is diversifying into international stocks if they do the same thing at the same time and to the same degree?
It gets worse, however.
Everything else is correlating too
The really sophisticated portfolio managers used to venture beyond equities altogether and make investments in things like commodities, real estate, or even hedge funds. Yale’s David Swenson is the guy that most people credit with the popularization of this model. Many of us in the hedge fund space owe him a debt of gratitude for opening up the eyes of institutional investors everywhere to the world of alternative investments. Indeed, back at UCLA we even used his book as a textbook for one of my upper division economics classes.
Diversifying into totally different asset classes worked for Mr. Swenson for a while, but in the last few years even these alternative investments have correlated with traditional ones.
Check out this correlation matrix. The darker green a cell is, the higher the correlation coefficient.
That’s downright scary.
Since 2008, the Dow, the S&P, technology stocks, small cap stocks, Japan, China, the BRICs(!), real estate, and hedge funds, have all correlated tightly. Even crude oil and commodities, the once “great diversifier,” are showing meaningful correlation of movement in this modern marketplace.
One thing, however, has done a pretty good job of not correlating. Gold.
Gold doesn’t really correlate with anything and never has. Historically, this has been a popular reason for owning gold and it’s a very good reason for owning gold. But lately this has been overshadowed by all sorts of new reasons that people are inventing on the fly, many of which are momentum based. I’m very cautious of gold at this particular moment of time. There is no doubt that is overextended right now and there is no doubt that it is very expensive relative to most historical metrics. It remains to be seen if these valuations will be justified by future metrics.
For as long as I can remember, I’ve been telling everybody that they need to own gold for one reason and one reason only: it’s different. I just wish that it wasn’t such a difficult moment to initiate a new gold position. It’s a much better time to decrease the weighting of gold your in portfolio. A lot of people buying gold right now have never gone through one of gold’s epic corrections.
I see a couple of you old timers out there just chuckled knowingly. All these gold newbies will be receiving a serious wake up call in the coming year. If you don’t own gold and really want to, that’ll be a good time to swoop in. A retest of the 1100ish level is probably in the cards. In the gold market, 20% corrections are par-for-the-course. Remember that this was an asset that went down for twenty years.
Anyway, the specific risks in gold make our quest for uncorrelated assets even more difficult. Perhaps if we understand what is causing this phenomenon we might be able to work ourselves towards a solution.
Why is everything correlated?
I think a lot of it is attributable to the increasingly global economy. Our economy today is much more directly linked to China’s economy, to Japan’s economy, to Europe’s economy, and even emerging economies. If your company slows down and you lose your job, it hurts businesses like Target because you spend less money on the goods they sell. It means you don’t buy that new house, which means less new home construction is needed. That means that builders don’t buy the copper they’d need to build it, which hurts copper prices and copper exporters like Australia. You have to erase any previous dreams of buying a new TV from Japan or getting a new iPad that’s made in China. The Italian leather handbag that your wife wanted for Christmas? Forget about that, too.
When our economy slows down, we buy less stuff from other countries. That slows their economies down and decreases the amount of stuff they buy from other countries. It’s a chain reaction. On top of that, nearly every major corporation today has a global footprint, whether their labor is sourced overseas or their products are sold overseas. These are the fundamental side effects of globalization.
I think there’s another cause, and it’s one that is more difficult to pin down quantitatively. Over the last decade — and the last several years in particular – the market has become increasingly speculative. There are a lot of reasons for this.
To be sure, there are demographic trends at play, an increasing number of baby boomer retirees who are trying to engineer their portfolios in such a way that they deliver specific rates of return. One of the dominant investment themes to emerge from the legion of boomers (and their generational predecessors, the Silent) is an altered perspective on savings and retirement. Unlike the years before World War II where people basically saved up a big pile of money and then lived off of that money or moved in with their children after they were no longer capable of physical labor, modern generations have redefined what it means to be retired.
Nowadays, it’s about making specific investments, investments that grow over time and theoretically grow large enough such that at some magical point, they generate enough annual income to independently support an individual’s lifestyle. Ideally, that income will be further supplemented by things like a pension plan. Nevermind the fact that these are dependent on the exact same principle, this wonky notion of earning a reliable rate of return that throws off enough annual gains to pay all plan participants their entitled benefits.
These retirees even had a specific number in their heads: 10%. (Most pension plan managers have always used 8%/year as their target.)
To be blunt, those numbers are poppycock. Or codswallop, if you’re one of our European readers. These numbers simply do not exist in the traditional marketplace and cannot be sustainably achieved without taking on risk that inappropriate for individuals of retirement age. Don’t believe me? The average annual rate of return for the Dow Jones Industrial Average during the last decade was -3.2% per year. The average annual rate of return since 1982 — the beginning of the greatest bull market in American history — is 6.3% per year. Where on earth did this 10% figure come from? Is it because it made for easy math?
Those numbers won’t exist any time soon, not until all these structural headwinds have been resolved and the foundation for a new super bull market is laid. But that’s a subject for another newsletter.
In any case, much of this increased correlation is driven by speculative behavior from institutional investors. It is these pension plan managers who manage trillions in assets that are running around the world pulling out of the same markets at the same time and chasing identical other markets. By definition, these guys are speculators. Active asset allocation is a necessarily speculative endeavor; it requires a manager to make a forecast about the most appropriate assets to allocate to at any point in time.
The problem is further exacerbated by the fact that these guys all are familiar with Markowitz’s Modern Portfolio Theory. So every last one of them is hungry for stuff that doesn’t correlate and when they seem something moving in a different fashion, they all rush in for the kill. And that spoils all the wonderful lack of correlation that used to exist.
What’s happened is that all this co-movement has boiled down to one single trade: risk on or risk off. Investors of all shapes, sizes, and locales are either buying risky assets or they are selling them.
“Risk On / Risk Off” makes for difficult investing because it requires proper timing. I speak from experience when I say that timing is the most difficult thing to get right in this business. Some say it’s impossible.
Is there a way to build a portfolio with lower risk and higher returns that doesn’t require perfect timing?
The Solution
For me, it comes back to relative value.
In a world where everything goes up and down together I think that being able to determine the degree to which one asset will outperform or underperform another asset will be a valuable skill. It’s tough for investors to make a buck or design a really good portfolio when very few assets move independently of everything else. It’s tougher still to differentiate yourself when the choice is simply whether or not to take risk. Most professionals that I know are interested in much more than this frustratingly abitrary yes/no question. They want to construct whole portfolios that are better than their individual parts.
I think you can do this with relative value strategies. I’m of the belief that the yes/no question of whether to put risk on or take risk off is better avoided altogether. We’ve talked about relative value trades around here before (see: The Trade of the Decade). I think those kinds of alternative strategies make a lot more sense in this particular environment, and in my mind are one of the few places that offer above-average returns with below-average risk.
They also won’t correlate with the market because a relative value strategy has a certain degree of market neutrality built in. The HFR Equity Market Neutral Index only has about a 33% correlation with the S&P 500 over the last decade.
It won’t always be this way. I don’t think this condition of global correlation persists forever. At some point certain asset classes and investments will decouple from the rest of the train. You’ll start to see different assets behaving in different ways and you won’t see the generally high level of volatility and skittishness that dominates the current environment. And that’ll be a good time to cycle back towards directional strategies. Don’t worry, we’ll let you know when that happens.
Other options
The bad news is that relative value strategies are tough for the average investor to implement at home. As an example, our market neutral strategy typically has between 120 and 180 different trades on at any given point in time. Even if the investor at home had the proper signals and algorithms to identify the right trades, a portfolio of that size and complexity requires a professional-grade infrastructure.
But there are a couple things you can do from the safety of your own living room. They will definitely help you lower your correlation, though I’ll warn you: they aren’t very exciting.
Cash. One answer is to hold more cash. Cash never correlates. But I always get two common objections to the suggestion to hold cash, objections which happen to contradict one another.
- “Cash pays me nothing!” It’s true. The Fed, in its efforts to get people to borrow and spend money, has slashed short-term rates to zero. Sorry, savers. I’m not sure why the Fed hates you so much. In the mean time try and find solace in the fact that the prices of many things are going down and your purchasing power remains strong.
- “I’m worried about inflation.” You might be worried about inflation, but the markets sure aren’t. The Inflation Chupacabra is nowhere in sight. And it won’t sneak up on you in the middle of the night, either. You might not know it but you actually have a super-duper inflation alarm system. It’s called the 30-year Treasury bond. When inflation becomes a real threat, the 30-year yield will go bananas. Then you can start converting your cash to other assets.
Investment grade corporate debt. With bonds, it’s important to emphasize the investment grade. It is junk bonds that are forming a bubble because it is their higher yields that everyone is starving for. Don’t fall for that trap. Junk bonds tend to correlate with stocks and they won’t help you during market dips. High-quality corporate debt, on the other hand, doesn’t correlate at all with stocks. Since 2008 the correlation coefficient with the S&P 500 is 0.05. Since 1996 the correlation coefficient is -0.01. The R-squared is 0.00! If you’re a professional portfolio manager those kinds of statistics probably make you squeal with joy.
Again, the problem here is that this kind of stuff only yields about 2-4%. Most people would say that you can’t live off of that and instead should reach for higher yields. My response would be to save more money before you retire or learn to live off of less. Work for a couple more years, don’t buy that new car, move into a smaller house. Whatever. In my mind those are better solutions to the problem than reaching for the yield required to sustain a retirement that suddenly feels a whole lot more difficult to sustain. Every day I talk to people that disagree with this or aren’t willing to do these things. I won’t judge. Do what you will. I wish you good fortune on your quest for more yield!
Invest outside the box (or off the exchange). With everybody in the world chasing the same assets, seek out some stuff that nobody’s chasing. Start a business. Make some loans to local businesses that you know and trust or invest capital in them some other way. I’m not even sure where to begin on this topic because it is enormous. I simply encourage you to be creative, but cautious.
A final word
It is possible to find stuff that doesn’t correlates but it means making peace with a lower yield. It means owning a bunch of the “risk off” stuff.
This is a theme we talk about every week on here and it’s a difficult one for investors to hear. Bear markets are not about generating above-average returns. The risks are unbalanced. Bear markets are about protecting the gains that you made during the last bull market and they’re about staying intact to participate in the next bull market.
Do that, and you’ll have what it takes to go pro.
