Grandpa, Where Should I Put My Money?

Tuesday, July 03, 2007

GRANDSON (25 years): Gran'pa, where should I put my money? The newspapers are filling up with worrying reports on the economy. I hear this word inflation on every corner and people say that the problems in the mortgage/housing sector may cause a spill-over effect into those sectors that are not yet affected. So far I see the stock market is doing well - brokers call it "to climb a wall of worries" - but the rapid rise of yields in bonds may indicate that this may go sour soon too?
GRANDPA (100 years): Well my boy, I should start with expressing my pleasure that you not only consume news but digest them as well. I agree with you that a sound economy looks different in comparison to what the facts are telling us. Actually, a lot of things remind me of the times when I was your age. You will have heard of the roaring 20s, when first a property boom and then the then-greatest bull market in history shaped a general feeling of perma-optimism...
GRANDSON: Gran'pa, sorry to interrupt you; I know what a bull market is, but now people start talking increasingly of the possibility of a bear market. What is a bear market?
GRANDPA: I can't blame you boy. You were born at the beginning of the longest bull market in history that propelled the Dow Jones Industrial Average from 1,000 to more than 13,000 points as of today.
GRANDSON: Did our economy expand 13-fold in this time?
GRANDPA: No, it only grew to 4 times of the starting value.
GRANDSON: But why did stocks produce such a stellar performance then?
GRANDPA: I would call it a paradigm shift. At the time I placed my first orders I preferred companies with a high dividend yield. I remember an old rule that said when the dividend yield of the Dow Jones components fell below 3% it was a signal to exit the market.
GRANDSON: I don't know many companies that pay such dividend yields.
GRANDPA: Then it may be a wise move to exit such positions not fulfilling this criterium.
GRANDSON: But some of these companies resort to other options in order to raise shareholder value. Home Depot recently announced a $22 billion share-buyback and I have read in modern economic books that this is actually benefitting not only shareholders but the company as well.
GRANDPA: Boy, when a company finds no other profitable uses for excess capital, don't you think that they should rather pay a special dividend when they don't know where to invest capital more eficiently and leave it up to shareholders whether they use this money to buy more stocks of the company or whether they put it at use elsewhere, expecting a higher return in other investment classes?
GRANDSON: So you mean that I should ride this latest fashion, called mergers & aquisitions. I have seen friends making huge bundles overnight by betting on potential takeover candidates
GRANDPA: Beware, a bounce in M&A often signals the end of a bull market. 7 out of 10 mergers don't work out the way originally envisioned. Also note that a lot of companies have recently pulled their plans to issue more debt in order to finance aquisitions, citing unfavourable market conditions which I translate into a gap between yields offered and yields expected.
GRANDSON: But yields have risen this year, making bonds more attractive, don't they?
GRANDPA: Don't forget that we are leaving a period of historically low rates and yields behind us. A 10-year yield just above 5% is nothing that gets me excited. When you look back you will see that it takes 8% yield on 10-year Treasuries to massively attract flows from stocks into bonds.
GRANDSON: 8% yield is something I have not seen in a long time, not even with riskier issuers...
GRANDPA: That's because investors have tended to completely disregard risk in the recent past which led to the smallest spreads between investment-grade bonds and issues below that in history.
GRANDSON: I have learned that in an environment of rising yields bond prices will fall. Is there any way to preserve my capital in such an environment?
GRANDPA: Basically you are left with two choices. You can either buy Floating Rate Notes (FRN) where the coupon is tied to a reference interest rate or you can buy TIPS, Treasury Inflation Protected Securities, that are tied to the US inflation rate. But remember that TIPS only protect the coupon payments. Every $100 of your invested principal will be worth only $82 after 10 years, based on an optimistic inflation expectation of 2% annually. If inflation rises to 3% you will be left with only $73 in real terms. Given the latest annualized inflation figure, which was 8.4%, yout initial investment will be worth only $41 after 10 years.
GRANDSON: That doesn't sound like a great deal. So what about the stock market? Wall Street so far seems resilient to act on that continuous stream of bad economic news.
GRANDPA: It depends on your interest rate outlook. If you expect the Federal Reserve to cut rates later this year to prevent the economy from going into a recession the stock market may see further gains. But I am worried about the corporate profit outlook because consumers are overstretched and are likely to spend less in the future in order to repay their higher mortgages. Higher interest rates also mean that companies have to spend more on their borrowings, diluting their earnings further.
GRANDSON: But the stock market has held up very well depite rising rates...
GRANDPA: Because people buy stocks on margin. The level of stocks bought on margin is the same as it was in 2000, before the Dow receded several thousand points, only to come back on the wings of the lowest interest rates in the last 60 years. Also note that this market has not seen a 10% correction since which is very unusual but may be explained with the easy and cheap credit of the past couple of years.
GRANDSON: Even in a bear market, as you seem to anticipate it, there are stocks that can buck the trend.
GRANDPA: This is true. In today's geopolitical circumstances we can only be sure of two things. People will not stop to eat and they will not stop to use all other forms of energy.
GRANDSON: So maybe I should allocate more funds into such stocks?
GRANDPA: I would be careful with stocks. I'd prefer to invest directly into commodities. This shields you from potential management failures at a company while you still reap the gains of higher prices. Always keep in mind that the USA has become a net food importer and that it will run into energy problems once Venezuela will have finished its pipeline to the Pacific coast in order to halve the distance for oil exports to China.
GRANDSON: As you mention China; what's your position on China?
GRANDPA: That's the shortest possible investment advice: Buy what China buys, sell what China sells. China sucks up commodities worldwide and turns them into finished goods.
GRANDSON: I have the impression that everybody and his pal is so focused on China that there is no spare room for thinking about India. Aren't they doing even better than China?
GRANDPA: India certainly has a better grip on inflation, thanks to their central bank. It also has a much bigger middle class than China, numbering more than 300 million people. It has the same problems as China as the country has only scarce commodities resources and virtually no domestic energy reserves. I tend to favor India because it is a democracy. China has only liberated the economy. But I would wait for at least a 30% correction that will come on the heels of foreign investors pulling out when all stock markets will go into reverse gear. Emerging markets always got hit more badly in a general downturn.
GRANDSON: Then what about Europe? The Euro is close to a record high and EU politicians see an upturn just around the corner and inflation has come back to the ECB's target range.
GRANDPA: If you can explain the miracle that industrial producer prices are going up at a much faster rate while official consumer prices are stable again, then I can learn something from you.
GRANDSON: We have now ticked off so many investment classes. Is there nothing where you see a chance that I could get rich with?
GRANDPA: I have mentioned it before. Buy commodities. Until now less than 10% of the global population have consumed most commodities and energy for their own well-being and comfort. I see a paradigm shift here as more than 5 billion people in the industrializing world will demand their fair share of the world's resources. As long as China and India do not fall on their nose, prices have only one way in the long term and that is up.
GRANDSON: OK, I get that one. I also learned that there is risk in almost every asset class these days. And you don't have to tell me more to know that the picture of the housing market, which was the driver of the economic expansion in the last six years, gets worse from day to day. Is there no place left where my money will bring heathy returns?
GRANDPA: Those gold ounces I bought in 1930 for $20 each will still buy me a complete man's outfit today. An ounce of gold will buy you the same amount of grain as it did 4 centuries ago. I have not come across a better inflation hedge.
GRANDSON: So you mean gold is the safest investment?
GRANDPA: 5,000 years of monetary history have proven that gold is the universally accepted currency #1 which never lost its value. Show me a paper currency with the same track record. There is none. No fiat currency has ever been around for longer than a human's lifespan. The Federal Reserve dollar will not be an exeption once more investors find out that it is backed by nothing.
GRANDSON: And what about silver?
GRANDPA: Seems you're looking into potential winners. Silver is not only the other monetary metal held in honour for the last 5,000 years, but it has a lot of industrial uses too. The supply-demand deficit in silver has not diminished over the last 16 years and it is also underpriced in a long-term comparison with gold. Historically the gold-silver ration had fluctuated around 1:15. Now we are above 1:50. This gap will close. But don't ask me when. Remember always that markets can stay longer irrational then investors can remain solvent.

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