Bonds and Gold

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I’ve been surprised to see both gold and bonds do so well over the last decade.  After all, deflation and inflation are opposites: when one performs well the other usually doesn’t.  This makes bonds and gold both doing well a bit of a paradox. 

But in today’s mixed message environment, it makes sense from a certain perspective.  Investors are running scared.  They seek safety in some form–any form. 

They correctly see that bad debt (lending which can’t be repaid) leads to deflation, so they want to own bonds as protection.  Just look at Japan over the last 20 years: bonds performed much better than stocks.  Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services.  Witness Weimar Germany in the 1920’s or the United States during the 1970’s.  In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works…until it doesn’t.  Let’s look at what Paul Harvey called “the rest of the story.” 

Bonds were a lousy investment from the bottom of the Great Depression until the 1970’s.  Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany…until hyperinflation ended.  Then it tanked.  Same with 1970’s inflation here in the U.S.: gold was great…until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing.  It only pays to ride the wave as long as you know exactly when to get off.  Getting the timing wrong–even by a little–will lead to poor results.  But, in case you don’t know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it). 

Warren Buffet doesn’t time the market.  Neither did Peter Lynch.  Look at the Forbes 400 some time and scout out the market timers–you won’t find a single one.  Trying to time the market doesn’t lead to permanent wealth–it leads either to temporary or decreasing wealth.

Which is why most investors shouldn’t focus on bonds and gold.  If you can time the market perfectly–and good luck on that–you can ride bond/deflation or gold/inflation.  If you are a mere mortal, then don’t try juggling nitroglycerin. 

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do–buy productive assets at cheap prices, which is when everyone hates them.  Productive assets are things that generate cash.  Gold doesn’t.  Bonds do, but the cash they generate isn’t protected against inflation (except for TIPS, but they have their own problems).  You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc.  These are assets you put money into and get back over time.  They can adjust to both inflation and deflation. 

Does that mean they do well in all markets?  NO!  Investing is not about what does well over a week, month, quarter, year, or even 5 years.  You invest for the long term, not for a short term kick-back–that’s speculation!

But, producing assets work like a charm during both inflation and deflation.  Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation.  They do poorly initially, but work very well over time.  That’s because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while…until they get slaughtered.  The cycle on bonds and gold tend to turn very quickly.  It will only be obvious in hindsight that the tide has turned–and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well–over the long run–regardless of whether we experience inflation or deflation.  That’s how I’m betting.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Bonds and Gold

Surmountable mortgage mess

I’ve been watching the housing and mortgage markets with great interest for years.

When working for my former employer (2002-2005), I watched (but didn’t follow) as he doubled- and tripled-down on investments associated with the housing market.  As his employee, I worked hard, struggling to understand the individual investments, but never fully got my arms around them.  I knew enough to be very cautious, but that was all. 

Now, after watching the boom and bust over the last decade, I believe I have a much better understanding of how the housing, mortgage and financial markets work (or don’t work) together.  I’ve watched, researched, studied, invested and blogged on the subject over the last six years (my blogs from the spring, summer and fall of 2007 are particularly revealing of my concerns). 

So, it was with great interest that I read an article in the Wall Street Journal today, The Mortgage Hangover.  I highly recommend it to anyone who sincerely wants to understand the boom and bust of the housing and mortgage markets over the last decade (and not just looking for evidence to confirm one’s conclusions beforehand).  The article is not perfect, but it does a great job of highlighting many of the important details.

Specifically, it describes how the mortgage market was distorted over the last decade in the Bronx.  You may think that Bronx real estate has nothing to do with Florida, Nevada, California or Colorado real estate, but it does.  In fact, I believe it represents a microcosm of all U.S. real estate.

The problem started with well-meaning politicians who wanted everyone to have a home.  That problem was exploited by real estate and finance workers who were heavily incentivized to take things to the brink (which was the inevitable result of bad policy).  When those problems led to collapse, the same well-meaning politicians tried to prevent the resultant suffering.  Once again, those efforts are creating new problems instead of solutions.

The good news is that the mortgage and housing problems can be fixed.  It requires that housing and mortgage markets be allowed to reach clearing prices (where free buyers and sellers agree to exchange without any distorting incentives from politicians).  When that happens, housing and mortgage markets can begin growth afresh. 

I’m not saying the process will be pretty, but it will happen.  The destination will be the same no matter how well-meaning those who disagree.  The only question, now, is how quickly or slowly we get there.  Policy can impact the duration of the pain, not its intensity.

The bad news is that politicians and voters are unlikely to take the fast approach.  This is unfortunate, because U.S. economic and employment growth are unlikely to recover until the housing market recovers.  The longer we put off clearing prices in the housing and mortgage markets, the longer until employment and our economy truly improves. 

Mortgage and housing markets need not wallow in freakish misery.  Recovery, both for those markets and the U.S. economy, could start soon.  But, with continued meddling in housing and mortgages, recovery will take much longer and be much less robust.  It’s time to face the inevitable, hold our noses, and take our medicine.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Surmountable mortgage mess

NOT just pieces of paper

Successful investing, like everything in life, requires the right approach.  Such an approach isn’t just a to-do list, but a way of thinking.  The wrong way of thinking leads one to easily stray from the correct path, whereas the right way leads one to successfully stay on track.

Weight loss programs are a great example.  If your weight loss plan is a crash diet with no thought for what happens after, you’re very likely to fail long term.  If your approach is to implement a permanent lifestyle change that includes diet and exercise, then you can and likely will succeed.  The thinking behind the approach is vital to success.

Nowhere is right thinking more lost than on investors.  Instead of thinking of stocks as partial ownership in businesses, they think of stocks as mere pieces of paper trading in a highly abstract “casino” somewhere in New York.  And that’s why most generate lousy results.

Santa Cutie, there’s one thing I really do need, the deed; To a platinum mine – J. Javits and P. Springer, Santa Baby, originally sung by Ertha Kitt

A stock certificate is partial ownership in a business.  You don’t own a piece of paper, but the underlying business.  Ertha Kitt is not excited about a piece of paper called a deed, or even what some other person is willing to pay for that deed on any given day, but for the platinum in the mine and what it’s worth in the real world.

Let me give an example to make this even more concrete.  If you have $20,000, and find four other friends with $20,000, you can buy a $100,000 house together.  If that house rents for $1,000 per month, then you’ll generate $12,000 a year of revenue.  If you have $2,000 of costs each year for real estate taxes, upkeep and management, then the house has net income of $10,000 per year.  That’s a 10% yield for each partial owner ($10,000 net income/$100,000 investment = 10%; $2,000/$20,000 = 10% for each of the five owners).

The deed to the home, or the partial deed specifying that you own 1/5 of the home, is a piece of paper.  But, what you actually own is 1/5 of the home and 1/5 of the income.

Now, suppose some bone-head comes along and offers $50,000 for the home you paid $100,000.  You and the other 4 owners are free to send him packing.  His offer is no sweat off your brow, because you have partial ownership in a stream of income–specifically: $2,000 for the $20,000 investment you made. 

The offer of $50,000 is no obligation for you.  You need not lose sleep at night or panic that such an offer is made.  You can check to make sure the home is still rented, count your annual cash intake, double check the expenses, and go about your merry way thinking very little about Mr. Bone-head.

This is the same attitude investors should have. 

Instead of freaking out when the deed to their partial ownership drops 50%, they should check to make sure the business isn’t going under and can still generate profits long term, but then go about their merry way.  There’s no need to panic if your partial ownership is generating 10% on original investment.  There’s no need to lose sleep when you own a business with profits and assets.  But, it’s very easy to lose sleep when you think you own of a piece of paper in some vault in New York and people are offering 50% less than what you paid.

Right thinking here is crucial.  If you know nothing about the profits of the enterprise, you’re likely to panic.  If you think of the deed as a piece of paper or symbol on a computer screen, you’ll probably panic.  If you think about the underlying business, you can remain calm.  In fact, you may even realize that a 50% drop means your 10% yield has become a 20% yield to the Mr. Bone-heads of the world and buy more partial ownership from them.

Most people lose their shirts investing because they panic and sell when Mr. Bone-head offers 50% off their original investment.  Sometimes businesses really do go under, but it’s much more rare than market panics.  On extremely rare occasions, countries and stock markets completely collapse and people lose everything.  The vast majority of the time, though, investors get lousy returns because they buy after things go up and then panic and sell when things go down.  They buy and sell like that because they are focused on stock symbols instead of businesses.

Stocks are not mere pieces of paper, but ownership in businesses.  Thinking of them as such can lead to success.  Thinking of them as blips on a screen is doomed to failure.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

NOT just pieces of paper

Market rollover has little to do with U.S. fiscal problems

One of the most important rules of statistics is that correlation is not causation.  What this means is that just because two things happen one after the other (or around the same time) does not necessarily mean one caused the other.  If I cough and then thunder roars, that doesn’t mean my cough caused the thunder.  A causal connection must be established before one can be connected to the other.  Statisticians, not surprisingly, have a name for mistakenly labeling correlation as causation: spurious correlation.

The stock market’s recent drop has lead many commentators to assume that recent action (or, more properly, inaction) by the U.S. government in dealing with its precarious fiscal situation caused the stock market to fall.  That’s not necessarily so.  Just because the two things happened around the same time doesn’t mean one caused the other.

In fact, the stock market most recently peaked late last April, and has been in the process of rolling over ever since.  More tellingly, U.S. Treasury bonds have rallied strongly since our government failed to deal with its debt problems.  If market participants were scared about U.S. government debt, they’d be selling U.S. Treasuries and buying commodities and foreign assets.  On the contrary, commodities (except gold) have been falling and foreign assets have been tanking, and U.S. debt has been rising strongly.

No, the real reason for recent market drops is slowing global growth.  ECRI (the Economic Cycle Research Institute, www.businesscycle.com) started discussing a global slowdown early last May.  Do you think, perhaps, market leaders and ECRI saw the same data in late April when markets peaked and started rolling over?

Indeed, recent economic data has been confirming that global growth is slowing.  Most interestingly, growth has been slowing markedly in China–which has been by far the biggest engine for global growth over the last 3 years.  At the same time, inflation numbers coming out of emerging markets, especially China, have been frustratingly high.

I don’t think markets are reacting particularly strongly to government inaction with respect to U.S. debt.  I think they are reacting to slowing global growth, and that more closely explains why bonds would be up and stocks and commodities would be down. 

The unique exception here is gold.  Gold is rallying strongly, probably because gold market participants expect the governments of the world to react to slowing global growth with more stimulus (spending borrowed money and printing currency).  Either bond markets or gold markets are wrong, although I can’t say I know which. 

What I do know is that tanking markets are a big opportunity.  Contrary to popular belief, it’s better to buy investments when they get cheaper, not when they get more expensive.  With that in mind, I’m hoping that markets tank and serve us up some super-bargain pricing!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Market rollover has little to do with U.S. fiscal problems

Debt binge reversal

Over the last 3 years, I’ve seen many explanations for our on-going economic malaise.

One of the worst–and most popular–is the greed of bankers.  This is wonderful stuff for those who believe in Marx’s class struggle, but it fails when confronted with the facts.  What?  Did bankers suddenly become greedy in 2006?  I don’t think so!  No, they were greedy all along and were simply reaping increasing rewards from a poorly designed system until the balloon popped.  They may have ridden the wave with aplomb, but they didn’t create it.

Is it the fault of the rich?  This is another popular target for Marxists.  People love to blame whoever emerges unscathed from a tight spot.  These blamers are the same folks who held the Jews responsible for the Black Death.  According to such rocket scientists, anyone who doesn’t perish must be the cause.  They pay little attention to cause and effect, like the fact that Jewish hygiene prevented them from getting the plague as much.  Such accusers just love to blame, blame, blame.  No, the rich didn’t cause the crisis.  They may have been smart enough to go into the crisis prepared, or may have ridden the wave with skill like the bankers, but they weren’t the cause.

Perhaps the fault lies with immigration, some say.  Yes, in the greatest country on earth, absolutely filled to the gills with immigrants, some morons think immigration is to blame.  If we hadn’t opened up our borders to Mexicans and Islamic terrorists–they seem to say–we’d all be in the Garden of Eden right now.  People who get someplace first always seem to say stuff like this, but it never holds up to the facts.  If immigration were to blame, this country would have been stillborn in 1600.  On the contrary, one element likely to help solve our problem, as is the case in Japan and Europe, is more, not less, immigration.

Okay Mr. Smarty Pants, if it wasn’t bankers, the rich or immigrants, what was it?  I may take a lot of flak for saying this, but the fault, dear readers, lies not in our stars, but in ourselves.  The wave we rode from boom to bust was debt.  It wasn’t just individuals, or private companies, or local, state and federal governments, it was all three.  We did this to ourselves with too much debt. 

Instead of saving to buy stuff, we borrowed to spend today.  We did it collectively.  A democracy only requires 51% of the vote, but we had a stronger majority than that.  Only a very small minority–minute really–said you can’t spend what you don’t have without consequences.  Voters spoke, and politicians listened.  Then, we spent and promised money we didn’t have.  We borrowed from those who had saved.  Now, we’re in deep doo-doo (sorry for the highly technical use of economic jargon).

When you’re digging yourself a hole, the first step to getting out is to stop digging.  But, to do that, you need to recognize that you’re digging a hole and stop digging.  Pointing fingers at other people will not solve the problem.  It has to start with a recognition of each of our role in the problem. 

We decided to promise benefits we couldn’t possibly pay for.  We decided to borrow money to pay for goodies today–whether vacations, or gadgets, or homes, or whatever–instead of saving up to pay with cash.  We decided to spend all the money we made and then some, and now that a rainy day has come along, we’re dreadfully unprepared. 

We did this to ourselves–our wonderful democracy shot itself in the foot! 

Now, we need to cut spending and save more, but no one wants to look in the mirror and admit that fact.  Even now, we don’t want to give up our promises or reduce our spending.  Even with the mathematical facts staring us in the face, we still want to have our cake and it it, too. 

We won’t get to.  And, putting off that day of reckoning just makes getting out of the hole harder and harder as each day goes by.  It’s time to stop blaming someone else, and recognize we did this to ourselves.  Only then will our debt binge be reversed and our future prosperity assured.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Debt binge reversal