So far in this series, we've covered the importance of debt avoidance, stable growth, stability in one's personal life and investing earlier rather than later; the protection of property and creation of capital as the ultimate source of wealth; the idea that values of investment-grade assets tend to move in spurts and that it's ok to earn little or nothing for periods of time; and a method of assessing one's tolerance to risk, which can serve to increase the odds of participating in up-moves and avoiding downward ones. In this installment, we'll elaborate on the idea that it's not only ok to earn little or nothing for periods of time, but that such times can yield surprisingly good returns.
Amazing Rates * Many of you know that I am winding down my stock market positions built largely in October-November 2008 and March 2009. While I'm not moving completely to cash in the form of .2% yielding money market funds and 2% CDs (I tend to favor more exotic instruments for my personal portfolio), there is nothing intrinsically wrong with a failure to stretch for higher rates. Why?
First, the higher the rate, the greater the risk. Finding an investment yielding 8% is fine, so long as its value doesn't plummet by 28%. Therein lay the problem in risky economic times: there is no guarantee that an 8% payer won't end up in bankruptcy court. In fact, there's no guarantee that such a payer isn't operating a Ponzi scheme, where he ends up in a different court. You really don't want to invest in either scheme, do you?
Second, there are times when 2% is a fabulous return. Consider October 2007 through March 9, 2009, when almost every asset class plummeted in value. Which would you rather have had during that time-frame: stocks, real estate, high-yield bonds or CDs? (For the record, prices of the first three collapsed by 20% to 70%.)
You might be able to buy more. And, your earnings may be greater than you think
Third, cash buys more of other assets after they've dropped in value. Consider: you could have purchased twice the average stock, twice the real estate in CA, FL, NV and AZ and almost twice the amount of high-yield bonds on March 9, 2009 than in October, 2007. While no one can time such peaks and canyons perfectly, proper risk management can be used to ratchet up and down exposure in order to avoid most of the carnage of bear markets and reap much of the benefits of bull markets (or bear-market rallies). Another way of looking at this is the bucket of cash normally intended for investment essentially increases in value by 100% (ok, 103% with the interest) during periods of time that stocks drop by 50%.
Fourth, while the bucket of cash intended for expenses and emergencies doesn't do well in eras of consumer-price increases, it does very well in deflationary environments. According to the latest figures the Consumer Price Index has dropped, for the first time since the Great Depression, by 2.1% (and, if housing prices were included, 6.1% according to Mike Shedlock at globaleconomicanalysis.blogspot.com/2009/07/whats-real-cpi.html).
Because the purchasing power of cash increased by 2.1% (or 6.1%), uninvested cash earned the equivalent of that rate, while invested cash earned the nominal return plus 2.1%. If your cash is in a taxable account, there's also a hidden tax benefit to a deflationary environment: you don't pay taxes on the 2.1% (6.1%) increase in purchasing power. If you're in a 25% marginal income tax bracket, you'll pay .5% and keep 1.5% plus the 2.1% (6.1%) deflationary "advantage," for a total return of 3.6% (7.6%).
Finally, cash is, for investors, a temporary "parking" place while awaiting the next investment opportunity. As shown in the Wealth of Individuals: Part 3 in the winter 2009 edition of Wealth Creation Strategies (
www.dougthorburn.com/cmsAdmin/uploads/35-ThorburnWinter08-09.pdf), assets with investment attributes tend to move in "spurts." After a good spurt upward has occurred (the recent bear-market rally, for example), it's best to shift assets to cash so you're not facing an oncoming train. Since we never know the precise dates of those price bottoms and peaks, hedging-buying and selling incrementally-can make sense. And, assessing your personal risk tolerance with the goal of increasing the odds of participating in upward moves and avoiding downward ones was more fully described in the spring 2009 issue (www.dougthorburn.com/cmsAdmin/uploads/36-ThorburnSpring09.pdf).
What is deflation and why cash will likely continue to be King This installment would not be complete without mentioning what may be one of the great contrarian indicators ever: advertising that one should invest in this or that. Full-page ads touting stocks in 2000 were, for the contrarian, screaming "sell." Full-page newspaper ads lauding real estate in 2005 were one of the great "sell" signals of all time. Ads promoting foreclosures and foreclosure seminars in 2007 were a terrific clue to the idea that foreclosures of that era were just the first round (they were). Currently, obnoxious ads every 20 minutes on talk radio are imploring us to buy gold. This could be one of the great contrarian signals of all time, where we should do the opposite of what is suggested, particularly since gold has already more than tripled from the $283.20 low in 2000 (and where, might we ask, were those radio ads then?).
How can we reconcile the apparent logic of the idea that Federal Reserve, by pumping up the money supply, should hypothetically be fueling inflation, with the contrarian view that the U.S. is in the throes of deflation, which will result in an increase in the value of dollars and a decrease in the value of everything, possibly even gold?
A clue to the conundrum is something that my friend Robert R. Prechter, Jr., has been for years telling subscribers of his newsletters at
www.ElliottWave.com to be ready for: a contraction in the value of debt-denominated instruments, or credit.
Mike Shedlock ("Mish") explained the problem this creates in his Global Economic Trend Analysis (GlobalEconomicAnalysis.blogspot.com February 19, 2009) by re-defining inflation and deflation as something different from what we usually think (an increase or decrease in consumer prices, which are, instead, an effect).
He explained, with emphasis added: "Inflation is a net expansion of money and credit. Deflation is a net contraction of money and credit. In both definitions, credit needs to be marked to market....The mark to market value of credit is contracting faster than base money is rising." ("Mark to market" means that a $500,000 debt instrument on a piece of real estate that has fallen in value to $250,000 should, for this purpose, be priced at $250,000, or even less to account for transaction costs of foreclosing on the underlying asset.)
Prechter and Mish have essentially redefined money as "cash plus the value of credit (debt instruments)," which can either be inflated or deflated. Both are saying that the value of the $50 trillion in debt outstanding in the U.S. is collapsing at a far greater rate than the Federal Reserve can possibly print money, which comprises only a few trillion dollars. This is the best explanation for recent financial events, which holds predictive value.
Cash could easily continue to be marked up in price relative to other financial assets, including gold, which suggests that gold bugs could be wrong-for now. Rather than suffering inflation, we could experience a continuing deflation until excess debt is wrung out of the system. Cash could, therefore, continue to be King for several years.
The sub-title came from Brian Whitmer, writing on the subject in the European Financial Forecast, an ElliottWave International publication published by Robert R. Prechter, Jr. I'm in debt to Whitmer and Prechter, along with Mike Shedlock, for helping me clarify the ideas presented, as well as to my friend Marty Kreisler for the inspiration in writing this installment.
Doug Thorburn operated as a sole proprietor for several years before founding Income and Capital Growth Strategies, Inc., in 1981. The purpose of the company is to help clients:
•Increase savings, capital and purchasing power via growth, income and tax-sheltered investments
•Protect savings, capital and purchasing power through risk-reduction using diversification strategies, budgetary savings and tax strategies, balancing the goals of tax reduction, deferral and elimination
•In limited fee-only insurance, retirement and estate planning
•Increase awareness of the adverse financial impact of substance addiction in others with whom the client has personal or professional relationships, in particular on clients' ability to preserve capital and produce income
•Optimize income-producing potential using Keirseyan Temperament Theory and the Myers-Briggs Type Indicator
For more info go to
www.dougthorburn.com For media interviews contact Promotion in Motion at 323-461-3921 or
brad@promotioninmotion.net