Friday, March 06, 2009
Chuck Cooper - How to Make a Small Fortune in the Stock Market
You may need this. The answer to the above is of course to start with a large fortune. Gordy is exactly right, as usual, in his investment approach. Now he tells us. And if you are one of those genius types who have been all in cash since the middle of 2007, you don't need any help. Just be sure you spread it around to fully insured accounts, or to money market accounts where "breaking the buck" means you only get back $.99. I could live with that.
But if you have been invested in just about anything, you may be wondering what happened to half of your capital. And what do you do now to a. get back your loses, or b. keep from losing the other half. For the first, my advice is to eat lots of fruits and vegetables, lose weight, no smoking of course, and be sure to take at least one drink of alcohol every day. The goal is to live long enough to see the markets come back. History, if you take a look at my previous post, shows it never takes much over ten years, and could be a lot quicker with all this stimulus package spending. From my lips to God's ears.
So what should you do in the meantime? Most experts advise not to panic and start selling your investments out of fear that they will go lower. No one knows whether we are close to a bottom or not. If it is just the flip of a coin, you might as well avoid the transaction cost. I think of investment shuffling the same way as switching lines in the grocery store, and you know how that works out.
That is not very helpful, so back to those folks that are in cash or near cash, or treasuries. You need to keep the funds safe, but now doesn't seem to be the time to be buying treasuries or anything long term. Interest rates are probably as low as they can get, and normally when agressive fiscal policy puts pile of cash into the system, the pressure is for rates to go up. For one thing, you would think the Chinese are getting tired of funding our deficits at a negative return. You don't have to be an expert to figure that if they ever stop buying, it is Katy bar the door.
Have a nice day.
Gordy Ringoen - So, What’s One To Do?
Or, in investing parlance: First, do not lose your capital!
In these times, preservation of capital is easier said than done. The hardest part may be psychological because it requires a dynamic tension between conflicting risks. There is no simple position to protect against all risks. All positions will not be profitable, but the objective is to not make profits but to protect the lion share of capital.
This discussion has to do with financial capital only. It does relate to real estate, collectibles or operating businesses. It is also from the perspective of someone of my generation who is essentially living off his capital. It would be different for investors in other circumstance.
Ben Bernanke in his college text defines risk as “the possibility that the actual return received on an asset will be substantially different from the expected return.” This is like saying that the risk of walking across the Bayshore Freeway in rush hour is that you may not make it to the other side. No, the risk is that you may never have a chance to ever walk anywhere again. So it is with the financial risk, it is not that you don’t get the expected return, but that you lose your capital and can not invest again.
As a prerequisite to examining investment alternatives, it is important to understand the risks we are trying to protect against. From my view, currently, the following are the risks that exist:
Nominal Risks: Nominal risks are simply the mark to market value of assets. This is the risk that is familiar to all. This is the risk that turned to loss for those that still own AIG or Citi stock selling for less than $1 or worthless Lehman bonds.
However, just looking at price can be misleading. For example, if you are able to buy stocks, as an inflation hedge, and even if they work, you may find it difficult maintain your capital because the inflation appreciation is taxed. The worst case would be inflation appreciation in a retirement account, at death, where the taxes will be able to take up to 75% of the appreciation.
On the other hand, in certain instances, the decline of nominal value can be beneficial. For example, if you have assets that you wish to pass on in an estate, like a house, you might want the nominal value to decline to reduce inheritance tax and to minimize the step up appraised value for property tax purposes.
The point is that capital gains taxes, regular income taxes for higher income brackets, and estate taxes are all going to rise in the years ahead and should be taken into account and not just nominal gains or losses.
However, the major concern today is that stocks and bonds may continue to fall as financial excesses are wrung out of the system and the world economy continues to deteriorate.
2. Currency Risk: This is the risk that the value of $US may be less in the future. You may be able to maintain the nominal value of your portfolio but it may not be worth much or, possibly nothing, in purchasing power because of inflation or government action. It can also occur because other nations handle their economic problems more efficiently and their currencies appreciate against the $US. And, finally the most serious circumstance could arise from the governments inability to reverse the economic fall, and faced between financial collapse and uncontrolled inflation, they effectively declare default on $US financial obligations and establish a new monetary regime. No one knows how that would be effected, but it would likely put all $US obligations in work out mode and a new, “blue money” would be established with built in safeguards to give it credibility. All commerce would be in “blue money” and, over time, our “green money” could be converted to the new money on a greatly discounted basis. Though this scenario would seem to be so remote that it should not be considered, it is instructive to remember that it would have seemed just as outrageous a few months ago that Citi and BofA were insolvent and may require nationalization, Fanny and Freddy would need to be taken over and Lehman would go broke. Until we some economic progress or we can see a semblance of a program that will lead us out of the morass, this possibility should be taken into account.
3. Liquidity Risk: This is the risk that your assets can not be sold, or the risk that you may not be able to buy what you want when you want. For example, during the Katrina disaster, only $US could be used for goods and services. No one would take a check and credit cards were not operational. The boat people from Vietnam could only buy passage with gold. Some security positions deposited at Lehman are still frozen since their bankruptcy. Two NY Yankee baseball players said that they are unable to pay any bills because they are part of the $50 billion money market freeze at Stanford’s bank. Currently, it is extremely difficult to buy gold coins with any currency. During times of financial turmoil, currency withdrawals can be restricted and currency conversion freezes are frequently instituted. On the other hand, you can’t use cash to buy an airplane ticket, some gas stations won’t take cash at night and many businesses will not take a bill larger than $20. Until recently, this was a risk not worthy of much thought. But, “times, they are a changing.”
4. Counter-party Risk: This is the risk that the party you deal with may not be able to meet its obligations to you. In nearly all of the financial assets in your portfolio, someone has promised something. The Lehman bankruptcy illustrated the risk of these promises. Many margin customers stood to lose the equity in their accounts because they became a general creditor to Lehman and had no rights to the securities in their accounts. Some of the products Lehman sold were represented to be secured by underlying assets but were only worthless general creditor promises from Lehman. Adjustable rate preferreds, which were marketed as money market alternatives, by many firms, lost much of their value and became illiquid when the brokerage firms failed to roll the securities. The Madoff swindle illustrates the dangers of a money manager that also acts as their own clearing firm.
Let us look at some asset classes and how they may help us reduce the risks to a portfolio:
1. Nominal Risk:
a. Cash Currency: The perfect protection against nominal loss and has certain advantages and disadvantages. It seems prudent to have some on hand for special circumstances.
b. Treasury Bills: It is near 100% protection for nominal loss.
c. Treasury Bonds: They too, have 100% protection against nominal loss when held to maturity but can suffer nominal mark to market loss if interest rates rise.
d. Bank Deposits: Near 100% protection when covered by FDIC. Although, the FDIC funds will likely be exhausted, it can be assumed that the government will honor their obligations.
e. Money Market Funds: These are a little more problematical. The government seems to indicate that they are going to back them, but to date; their actual promises are very weak. Government Funds are, for the most part, more secure than Commercial or Muni funds. Many of these funds would have immediate problems if the government was not supporting the commercial paper market.
f. Muni Bonds: These are subject to loss with falling interest rates but the even greater concern is their credit quality. Many, are rated highly because they are insured. But now, without government support, the insurance can not be relied upon. Most municipalities are experiencing financial weakening because of the poor economy. It is a market for experts.
g. Sovereign Debt: This is the equivalent of other nations Treasuries. The nominal value is near 100%, but only in their currency. They can have large nominal risk to a $US portfolio because of currency fluctuations.
h. Commercial Bonds: Some risks from both interest rates and credit quality. An asset class for experts.
i. Common Stocks: High volatility and price risk. A speculation. A market for experts.
j. Gold: High volatility and price risk. A speculation. It can be argued that there is not much value in “expertise” in this asset class.
k. Other Commodities: High volatility and price risk.
2. Currency Risk:
a. Cash Currency: No protection.
b. Treasury Bills: No protection.
c. Treasury Bonds: No protection.
d. Bank Deposits: No protection.
e. Money Market Funds: No protection.
f. Muni Bonds: No protection.
g. Sovereign Debt: A range of possibilities from no protection to total protection.
h. Commercial Bonds: No protection.
i. Common Stocks: Fairly good protection except in extreme conditions where there may be no protection.
j. Gold: Likely very good protection.
k. Commodities: Likely very good protection.
3. Liquidity Risk:
a. Cash Currency: Excellent in some circumstances and limited protection in others. May be restricted or difficult to obtain in quantity.
b. Treasury Bills: Excellent liquidity.
c. Treasury Bonds: Excellent liquidity.
d. Bank Deposits: Good liquidity. May be restricted in times of crisis.
e. Money Market funds: Fair to Good liquidity. May be restricted because of financial market problems.
f. Muni Bonds: Fair liquidity. Costly to sell and markets may be very thin or non-existent at times.
g. Sovereign Debt: Highly liquid in developed countries. Purchases may be restricted in stressful times because of currency controls.
h. Commercial Bonds: Fair liquidity. Markets can dry up during times of financial stress.
i. Common Stocks: Liquidity good under most circumstances.
j. Gold: Physical gold usually easy to sell if there are no government restrictions, sometimes, like now, may be difficult to buy. It can be the most liquid medium of exchange during severe financial circumstances. Its ownership or trading frequently is controlled by governments during financial turmoil. Normally, paper gold positions can be taken through ETF’s or Futures Contracts which are usually very liquid.
k. Commodities: Physical positions of commodities are impractical. Positions can be taken in ETF’s and Futures Contracts.
3. Counter Party Risk:
There is severe counter party risk from any financial institution that does not have specific government back up like FDIC. Margin accounts can be of particular risk. All securities possible should be in the “cash account.” Commodity Futures Contracts are at risk but are unlikely to be allowed to fail.
Cash and physical gold have no counter party risk but may be difficult to secure and transport.
Treasuries that are not on margin are very secure.
Absent fraud, stocks and bonds, not on margin, are quite secure.
It is clear that many of the portfolio alternatives are in conflict from a reduction of risk perspective. Each has its advantages and disadvantages. The key is to have the proper mix to prevent major loss of capital under any circumstances. The mix should be adjusted as circumstances change.
Based on current circumstances a portfolio might look as follows:
1. A cash currency position sufficient for emergencies only.
2. A physical gold position of 5-15% of the total financial portfolio. It would be a core position that would be kept under all circumstances. It is expensive to trade and can be difficult to accumulate so it is not appropriate for speculation. Once acquired, it has the advantages that no taxes are paid on appreciation until it is sold. It is also the only fungible physical asset for which its existence is not in a computer somewhere. It earns nothing, so it is not part of an earnings portfolio. Its only purpose is for belts and suspenders financial security. Although, it is pretty.
3. Money Market Funds: Sufficient levels to pay bills and satisfy operating needs. It is not a place to park excess capital.
4. Treasuries: The place to put excess capital and can be 40-80% of the portfolio.
5. Sovereign Debt: An amount ranging from 20-60% of the financial portfolio diversified in politically stable countries like Germany, Canada, and Switzerland. The positions are moderately expensive to put on and should be considered core positions. No taxes are due on appreciation until they are converted back to $US. The foreign funds can be transferred out of the country with little difficulty if desired. The positions need to be established in advance of major $US problems because currency controls might be instituted. During strong $US markets, the positions can be hedged by shorting currency futures contracts. During $US weakness, the hedges are removed.
6. Stocks and Bonds: They really don’t have a place in a portfolio with its prime objective of capital preservation during turbulent times such as now.
7. Commodities: Positions in commodities, including metals, oil, agricultural products, and currencies can be established at low cost as conditions warrant with a notational values of from 0-50% of the financial portfolio. They require no portfolio investment if done through futures contracts though they do require collateral which can be Treasury Bills. Or, they can be executed through ETF’s which require an investment.
8. Debt pay off: The most conservative investment is to pay off any outstanding debt. It is risk-less. Further, the interest saved will be greater than the interest earned on risk averse investments.