The Rules, Part XXI

Before I start this evening, I have a request for readers, and a comment for new readers.  (Note: if you are reading this anywhere but directly at my blog, please realize that you have to come to my blog for me to hear what you are saying.  I do not read comments anywhere else but at Aleph Blog.)  First the request: I would like to test the robustness of the Impossible Dream TAA model on another country.  If any of you have data on any non-US market, which would require the following:

  • Index price series
  • Earnings series
  • Dividends series
  • And a fixed income return or yield series

Contact me, and we can discuss whether you should send me the data or not.  Monthly data would probably work best, but I am open to other periodicities.

Second, for new readers, welcome to my blog.  Why do I write this after 4 1/4 years of blogging?  May 2011 is my biggest month ever, largely because of the “Impossible Dream” pieces.

For new readers, here is what you have to understand about me: I write about a lot of different things.  I have lots of interests.  I almost named this blog “The Investment Omnivore” but didn’t, because I planned on creating a firm called Aleph Investments back in 1996.  It eventually happened — 14 years later.

So, if I don’t always write about investment strategy, or any other single topic (all crisis, all the time) please don’t get disappointed.  I write in proportion to what is of current interest, and what discoveries I have been making.

So, travel with me on this trail where I cover everything from the global macroeconomy to personal finance issues.  My goal is to help you learn to think about economic/finance/investment issues, and help you see the interconnections between markets, so that you can develop your own perspective on the markets, and not just parrot me.  (Not that many do… 😉 )

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All assets represent future goods.  The prices of assets represent the trade-off between present goods and assets.

I wrote a piece recently called Inflation Speculation.  The idea was to explain how it is difficult to save for the future in a way that will transfer today’s purchasing power to the future without diminution, particularly when you have a central bank trying to stimulate the economy through the creation of credit, and the nation as a whole is overindebted.

So, if the Fed is patting itself on the back for:

  • lowering corporate yield spreads
  • rising stock market prices

I would tell them: it is easy to change the discount rate, but hard to change the cash flows.  Yes, as you flooded the market with credit, the values of risky assets rose.  Big deal.  Most executives are smart — they still see that demand is punk, and won’t do any real creation of plant and equipment that they weren’t already planning to do.  Little new investment took place, the value of existing assets got revalued up.

When asset prices are high, it means that money today will not buy a lot of future goods.  High P/Es, low interest rates tell us that new investments will have low yields, absent some amazing transforming technology that improves productivity dramatically.

Some people will say to me, “I need more yield today.  Yields are so low.”  I say, “When yields are so low, it is time  to avoid yield and preserve capital.  The time to seek yield is when yields are high, and no one wants to part with money to lend to them.

In March of 2009, I helped to rescue the firm of a friend.  He needed cash in the midst of the crisis, and a few of us lent to him at rates exceeding 10%, with warrants, realizing that he might be bankrupt in short order.  But things turned, and not only did he survive but he thrived.  I am still receiving interest, but will likely be redeemed soon.

Maybe that’s not such a good example.  I put 40% of my congregation’s building fund into high yield and low investment grade debt in late 2008 — made up for a lot of 2008 losses.

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Think of it a different way: shares in corporations are a proxy for the future well being of the country.  When P/Es are low, the potential for capital gains is large, as is the ability to keep up with inflation.  When P/Es are high, the potential for capital gains is small, as is the ability to keep up with inflation.  Same for bond yields — better to be aggressive when rates and spreads are high, and defensive when they are low.

Thus I would tell Ben Bernanke to lay off the quantitative easing.  It has not helped.  Yes, you have pushed asset prices up, and interest rates down, but has not created any significant new economic activity.  And why should it?  Consumers are still overindebted, and 30% of those with mortgages will lose money on a sale.  The real problem was the debt overhang, and you did nothing to to address that, not that you could, or should.

Buffett once said that most people should not be glad when they see asset prices rising, because they will need to invest more in the future, and will now have to pay higher prices.  Thus times like September 2008 offer the future at a discount to those who have ready liquidity, whereas 2007 offers the future at a premium price.

To the extent that you can, commit capital when it is most needed, and avoid chasing markets up.