jim.shamlin.com

7: Survive the Downturn and Prosper in the Recovery

The economic crisis of 2007-2009 has not only weakened the financial service industry but also devastated the personal finances of many private individuals: equities fell, property process fell, commodity prices fell, interest rates fell, incomes fell. Only government bonds have delivered consistent gains for their owners.

We are not in a situation where many private investors are skittish of any financial investments, and suspicious of the companies that sell and manage them. This reluctance will persist even when there is a functional recovery in the markets.

The problem is that people still feel the need to save for the future, and feel that something must be done with their retirement funds and personal investments to maintain their wealth against inflation. So what is to be done with it?

Individual investors cannot wait on events to unfold at the macro-level economy, but must be more proactive in putting their own finances in order. That's the issue this topic is meant to address.

Disclaimer and scope

The author distances himself from the role of a financial advisor: as an economist, he can only give you an economist's perspective, make of it what you will. An economist can make informed predictions about the broad movements of markets and industries, but knowing precisely what to buy and sell, at which price, is not their area of expertise.

However, an economist can consider the principle features of a given economic scenario that has the potential to impact investments, for better or for worse. Consider his perspective to be considerations rather than directives.

In a general sense, the author considers the economic pattern we are seeing today to consist of three distinct phases:

  1. The financial crisis of 2007-2009 has put the world economy into a desperate abnormal state. This has already happened.
  2. At some point there will be a recovery,. Some would argue that it has already started.
  3. Afterward, a new normality will resume - hopefully somewhat different to the state of things preceding the crisis, as if it is the same, the cycle of crisis and recovery will continue.

He cannot be specific about when the phases will start and finish, or whether there will be a further setback. There are many hands in the work, as government and private sector alike are attempting to influence the situation, such that there is not a natural order that can be expected to proceed.

Residential Property

Given that residential real estate is a large part of the problem the author first considers this sector.

The most important consideration is that the housing boom was a global phenomenon, not localized to the United States - and indeed, America was not the most overblown of the world's housing markets: Ireland's homes were at 300% of value and Britain's were at 225%, compared to 130% for the US. There are seven other countries whose distortion was greater that the US: Spain, Australia, Norway, Sweden, France, Denmark and the Netherlands. Only a few developed nations did not have some degree of increase: Germany and Switzerland were about flat and in Japan prices actually fell.

Just because a market rises a lot does not mean it is overvalued - there can be other reasons, such as being undervalued to begin with. However, this seems unlikely: when comparing housing prices to Income, the UL peaked at 6.3 - or 170% of its long-term average of 3.7, the latter of which is more likely to represent fair value.

It's also plausible to consider whether the fall in housing prices was an overcorrection, and that there may even have fallen below fair value - however, given the standard of times-income value, there still seems to be some room for prices to continue to slide ... though admittedly, given that real incomes have fallen, it could be that the prices will stabilize when income rises.

In all, he doesn't expect that housing prices will return to their previous peak for decades: perhaps 2020 in America and much of Europe - and maybe even 2040 or 2050 in the Netherlands - and resume a modest appreciation rate of 4% per annum (more in developing nations)

Inflation in the markets could make a big difference to these predictions. In many countries, pay inflation is low to negative and as the economies recover, wages may continue to lag prices and interest rates - or if pay continues to remain flat or deflate, it can depress the demand for housing. There is also the matter of the availability of properties in the face of demand, such that underdeveloped markets will she sharper rises than overdeveloped ones.

Commercial property

The conditions are similar for commercial property, though it is worth noting that as the residential bubble deflated, many private investors moved their assets into commercial real estate, with "predictably dire" consequences: it created a bubble to a similar degree as had previously emerged in the residential sector.

Commercial real estate is a significant category, valued at $2 trillion in the United states - or about a quarter the size of the government bond market, which seems to be a ratio that is similar to other developed nations. Though it's noted that property yields in some markets were 0.8% lower than government bond yields, which is dismal for an asset class with low liquidity an comparatively higher risk.

During the period of recovery the returns may run to above 10%, but will likely be more modest post-recovery, particularly in developed nations where the demand for commercial property grows at a modest rate.

Interest on the wane

The author's overall prediction for interest rates is dim - the economy will be soft for years, and inflation will turn to deflation. But there will be differences between short and long, public and private, and what is charged for loans and what is paid for investing.

Short-term interest rates will remain at virtually zero in developed countries. This seems extraordinary, but it has happened before: the Bank of Japan maintained near-zero rates as early as 1999, and during the late 1930s, in the throes of depression, US Treasury Bill rates were at 0.01%. So long as the conditions that led to the rates remain with us, the rates will remain low - and the author expects this may be several years.

If interest rates were to increase, it would undermine the value of assets, including equities and commercial property, as well as increasing the cost of government debt, which remains high. There is considerable interest in keeping interest rates down.

There is some suggestion that interest rates may rise as the economy improves and government deficits are reduced, but historical evidence that this would not be beneficial. Under present conditions, increasing interest rates prematurely is likely the worst choice for the economy. Consider the Japanese authorities raising of the interest rates, which merely worsened their condition, which is widely recognized as having been a serious mistake.

Bonds

If the interest offered for government securities is going to be near zero for some time, than other investments must offer a better return.

Bank instruments (such as CDs) generally offer a better rate of interest and can be expected to do so, but will of course carry bank risk.

Corporate bonds are "an interesting avenue for investment." Their yields are based on the issuer's ability to obtain credit by other means: a company is only interested in issuing bonds if they are cheaper than other options for obtaining credit. The creditworthiness of each issuer, as well as the issuer's ability to generate a return on borrowed funds, means there is quite a spread between AAA-rated bonds and junk bonds to accommodate risk tolerance of investors.

However, the author feels economic conditions are and will continue to be unfriendly to corporate bonds, and there is the risk that companies who are strapped will find it difficult to meet their obligations and "many" will default. This is exacerbated by deflationary conditions, in which companies will find their selling prices falling while their interest obligations remain fixed, thereby intensifying he burden of debt and making default more likely.

Long and Short

All bond prices fluctuate as market interest rates vary - and under present conditions of near-zero interest in the money market, short-term bonds offer far less interest than long-term bonds, which offer greater returns for the risk of being locked into a rate the market may exceed.

Consider that there are bonds with terms of 30 and even 50 years. The fluctuations in the short-term interest rates are of minimal relevance to their pricing but instead investors must consider their expectations of inflation and currency debasement over the life of the bond. In short, if the rate of inflation exceeds the return of the bond, holders have a negative real return, and vice-versa.

As such, the returns of short-term bonds are assessed according to alternative options for credit and ultimately the market interest rate whereas long-term bonds are assessed according to inflationary expectations.

An interesting metaphor: the performance of bonds is like a length of string blowing in the wind, with one end nailed to the present and the other being blown about by expectations for the future.

Bond Market Prospects

Considering the low yields of bonds, could they fall further? During the Great Depression, long yields were below 2% in the US, and in Japan in the 1990s the 10-yier yields went below 1%. The likelihood is if short-term rates remain near zero, it's likely that ten-year yields could dip below 2%. This is great news for anyone who holds long-term debentures, and an opportunity for governments and other issuers of debt to refinance their outstanding balance at a much lower rate.

On the other hand, as central banks seek to bolster their currency and companies seek to scale back production, they are likely to decrease the amount of borrowing they will seek to do, making bonds rare and driving bond prices higher and yields lower. The central banks, however, often seek to mitigate interest by controlling the amount of credit instruments they issue.

Also, markets are constantly worried about the potential surge in inflation, and given the potential for debasement of currency due to enormous government debt, many market operators are extremely uneasy. At some point, there is likely to be a sharp sell-off of low-interest bonds by investors, which could result in a "bond bloodbath."

Even if that can be avoided, bonds must eventually have to return to a more normal level, which the author suggests should be 5-6% post recovery. IF China were to boost is consumption, driving demand for goods, driving the need to borrow capital to fabricate goods, bond levels could significantly increase sooner - though there is no present indication this is their intent.

Indexed bonds, whose rates adjust according to the market, are appealing to investors as a hedge against possible inflation - but under current market conditions are a boon to debtors and they are issued at a lower than market rate and interest has not risen.

Given that we are on the edge of deflation, the debtors may enjoy this advantage for the next decade. But given that bonds, as with many investment vehicles, were designed to be effective when inflation was to be expected, it's like deflation is a quirk that will complicate the assessment of any investments, but has a particular effect on those whose returns are nailed on one end to market interest rates.

Equities in an unstable world

During financial crises, there is often an impact to the equities market, based on the prediction that firms will make less profit in future, and some will simply not survive.

Between October 2007 and March 2009. The stock market lost over 50% of its value in the US, Germany, and France, and only slightly less in the UK. While this merely reset the market to where it had been six years prior, it was nonetheless devastating to many investors.

By contrast, the Great Crash of 1929-1932 resulted in losses of 85%, undoing two decades of progress. More recently, the Nikkei index lost about 80% between 80%, resetting to a level that was more than 25 years in the past.

The author asserts that equities did not participate in the bubble that affected real estate prices (EN: Though doubling in six years does seem to contradict this assertion), but he does suggest that the equities market had inflated and burst a few years earlier, during the dot-com boom and bust cycle.

Predictions for equities have generally been ghastly - the economic conditions of the next few years will be extremely difficult, with decreased demand and lower profits driving profits down. Forms have been controlling wages and salaries, which only serves to further depress demand for goods (or more aptly, the consumers' ability to purchase them).

There are nevertheless some positive signals in almost all western countries: lower interest rates and bond yields make equities more attractive; the general state of malaise has cause equities to be undervalued, promising a strong return when the recovery sets in; and the adjustments that will inevitably take place in currency exchange rates will further increase the value of future profits, which is strongly influential in the price of stock. For the last factor, the gain of some countries will be to the loss of others, but the first two can be broadly influential.

The primary determinant of equity performance will be the speed of the recovery: Phase 2 of the recovery is likely to produce rapid growth in corporate earnings and a surge in the equity market, which would create a period of abnormally high returns before setting back to normal performance.

Of course, it stands to note that there may be a few more significant fluctuations as large numbers of investors return and their price becomes overinflated, then another adjustment follows, and so on, though each fluctuation should be less dramatic as the market approaches greater stability.

There is also the question as to whether the earnings boost to corporations will be paid out as dividends or reinvested in operations, and in the latter case whether there is sufficient room for market growth to purchase the increased output of reinvestment. All things considered a long-term return between 6% and 8% seems to be a reasonable expectation for equities.

Commodities

Commodities are an interesting venue because they are most obviously related to real needs rather than financial ambitions, and the consumption of most commodities is stable regardless of the financial markets, with few exceptions.

Hard and Soft Commodities

The author distinguishes hard commodities from soft commodities.

Hard commodities, such as oil and minerals, are said to have value because they are limited in supply and eventually will run out. The author rejects this notion as a driving factor in their value: while it is true that we cannot "make" more oil or more silver, history suggests this will be a long way off, and the greater determinant of their cost and scarcity is the cost and time in extraction and refinement.

Soft commodities, such as agricultural goods, are subject to much the same limitations, and the same irrational considerations: there is a limited amount of acreage, but contrary to the Malthusian prophesy we are using less of it rather than more as population has increased. Moreover, much greater progress has been made in the efficient production.

China and India

Fundamentally, the author rejects the notion that demand in China and India will invariably increase the value of commodities.

Looking to the periods of economic development in the rest of the world, particularly the rapid development of America and Europe after the second world war, the real price of commodities fell rather than rose. While the population exploded, the means of production became more efficient at a faster rate.

Moreover, it is not true that there will be a huge increase in the demand for food as China and India continue to advance. It's quite simple: the two billion people in those markets are already consuming food - were they not, the populations would be dwindling. For that matter, it is a common pattern in developing nations that demand for food is only slightly increased as personal wealth increases.

There is the argument that people who become wealthy switch to more expensive foods - particularly meat, because meat production requires a very heavy input in grains, there will be an increase in the demand for grain that is indirectly consumed. However, meat consumption in China is already just about the same as in the west, though their protein of choice is pork rather than beef, and while India consumes less meat, primarily chicken, there are cultural and religious reasons rather than economic ones, and India will likely never become a heavy consumer of meat products.

Switching back to hard commodities, the popular conception that there will be an insatiable demand for hard commodities does not stand scrutiny. The greatest demand for hard commodities is infrastructure: roads, factories, and airports require massive amounts of materials, but only for a short period of time. There will be periodic spikes in demand to build a roadway or a power plant, but these will be moderate and temporary in nature.

Moreover, China and India are not large countries in terms of their geographic size. (EN: China is about the same size in terms of square mileage as the United states, 3.7 million square miles, while India is roughly 1.2 million.) This suggests a limited need for infrastructure, not to mention that has already been considerable development in this regard.

The most remarkable economic feature of these two nations is in their population, which consumes mainly soft commodities - consumption of hard commodities is a negligible part of consumer spending in all developed nations. While this is a considerable market, population tends to level off and even decrease as nations become industrialized, and consumption turns more to services than products.

Commodities

The author is simply not persuaded that commodities have long-term potential, and while there is some potential for the immediate future, it seems likely that growth in consumption will be slow and supply and demand will have ample opportunity to balance themselves, preventing any rapid rise in commodity prices.

In terms of demand for goods, consumers the world over are likely to be weal for a number of years - so while commodity prices may recover their former levels, it is difficult to believe they are set to take off.

While consumption of commodities will rise gradually, there is always some potential for them to come into play as vehicles of investment, with prices determined more by the financing of production rather than consumption - and should this happen, such that the basic consumptive needs of populations be negatively impacted by speculative activity, "I would not be surprised to see tight regulatory restrictions" in response.

Investment strategy

Ultimately, the question of interest is "Where do I put my money?" As always, the appropriate answer depends on the time horizon and risk tolerance.

At the time this book was written (summer 2009), government bonds still offer a safe haven with small returns and relatively little risk, and for short-term investors equities are "distinctly unappealing."

For the medium term, equities and commodities seem the best investment. The bond market, in particular, is unappealing and risky as investments are locked in, such that when equities turn around, holders of bonds will be locked into low-return vehicles that they will have to accept losses to liquidate.

The author is skeptical of hedge funds. They are the traditional route for investors, albeit limited to those with significant capital, and can profit when the market suffers losses by means of short selling or derivatives. But they can only succeed to the extent that other investors fail (or at least underperform) - and if sufficient funds are placed in hedge funds, the alternative investment strategy becomes the conventional one, nullifying their advantage.

Meanwhile, the fees charged by hedge funds are enormous, such that the lions' share of the profits go to the fund mangers rather than the investors. The author considers that if Warren Buffer ran his investment company by hedge fund terms, 2% annually plus 20% of gains, investors would have received only 8% ($5 billion of the $62 billion) of profits.

Avoiding the pitfalls

The author has considered the different investment vehicles and how they might fare in years ahead - but the greater factor for most investors is their own patters of behavior: their investment style.

Successful investing requires patience and long time horizons. Those that seek to make money fast are generally participating in a form of gambling, and take constant losses as well as gains, hoping the latter surpasses the former.

Consider that the financial markets have no profits in and of themselves - investors are buying and selling from one another and for each winner there must be a loser in equal measure.

And keeping to the gambling metaphor - remember that there is a house. The financial services industry, like a poker dealer, takes a share of the pot regardless of which player wins. As such, it's not even a zero-sum game, but one that will collectively lose money to the house.

The author advises looking to investment not as a part of the trading game, but as a means for creating wealth - investing in enterprises that will pay a return by virtue of their productive capability rather than the profit to be made swapping shares with other players in the market. That is, seek to acquire assets that are genuinely fruitful and take a profit from their success.

He further posits that when the value of an equity comes detached from the anchor of productivity, all hell breaks loose - and that is behind many of the crashes in financial markets, where people suddenly realized that they would not recover the price they gave in trade by the ownership of the assets they acquired.

The business of investment

The author asserts, "The business of investment is due for a shake-up." There are too many people employed in financial services, earning too much money, and delivering too bad a service for their clients. He had presumed that the dot=com crash would have cleaned out the stables, but the run-up to the recent implosion helped maintain their ranks.

All investors cannot beat the average - they are the average - and when enough people have lost enough money over enough time, they will smarten up or exit the casino. Though admittedly that might be a stretch because gambling addicts tend to ignore their losses and focus on their periodic gains, but even they will be tapped out with a sufficient string of losses, such as the present situation in financial markets.

But looking the investment firms rather than the investors, the more serious problem is the huge number of people and the little competence they show. Whether they are fooling their clients or themselves, it's clear they subscribe to "the most egregious of financial fallacies," such as:

There are exceptions, and really good financial advisors, but they are very rare. The majority haven't got a clue, and are interested in nothing but their own commissions, which they seem to understand all too well. Given this, there is a lot to be said for managing your own portfolio.

There are also a few exceptional performers - it would be very difficult to dismiss the long-term success of Warren Buffet, who is "probably the closest there is to an investment genius." But Buffer is rare, virtually a singularity, in a sea of dullards and swindlers.

Keeping your wits about you

The danger of the economic recovery is that, by ignoring the losses of the past, it will seem like a period in which opportunities are exploding, rather than a market returning to normal. Great fortunes can and will be made by a lucky few, and though they will be far outnumbered by the losers, nobody ever pays attention to the latter.

In all, the best the author can do is communicate some basic principles for keeping your wits (and wealth) about you while others are losing theirs:

  1. Avoid being too pessimistic about the future. There are many doomsayers, but things will eventually return to normal.
  2. At the same time, don't be too ambitious: the markets do not permit sustained annual returns of 20% - there will be growth, but it will be modest.
  3. Be patient. There are many short-term get-rich-quick schemes that work out well for the schemers, not their victims.
  4. Be highly attentive to commissions and fees and do your best to minimize them.
  5. Beware of cascading investments - putting your money into a fund that invests in other funds, which invest in other funds, etc. The fees and commissions consume more of your money than investing directly.
  6. Avoid investments that you don't understand. Furthermore, resist pressure to invest in things that the salesman can't explain, and likely doesn't understand.

These principles don't guarantee financial success, but they should help to avoid behaviors that most often lead to failure.

One last jab at institutions such as governments, central banks, and investment houses: keep a close eye on them. Given their role in creating and exacerbating the present crisis, you cannot give them your implicit trust and expect things to work out.

JIM.SHAMLIN.COM
DISCLAIMERS · CONTACT