Welcome
to the Briar Patch!
John Riley
Strategist
Mar 10, 2008
Skyrocketing
oil prices, real estate collapse, stock market dropping like a stone,
possible bank failures, billions in write-offs, recession, political
turmoil, terrorism, and war. What a great investment environment!
This is my world.
Welcome to the Briar Patch!
Very little
surprises us at Cornerstone. We expected many of the current headlines.
We even expect things to get worse before they get better. And here’s
the secret – Your portfolio with Cornerstone is set up to
take advantage of many of today’s and tomorrow’s problems.
Let me explain how.
The things that
worry you, they worry us too. But today, as never before, there
are investment vehicles available to profit from negative news and
a bad economy.
Here’s
a recap of some of the major concerns:
Concerned
about the stock market? So
are we. We think the stock market will probably drop another 50%
or more, before all is said and done. So we have bought funds and
investments that hedge the downside through various strategies and
will actually profit from stock market declines. So while everybody
else is moaning about the market collapse as they watch their index
funds, growth stocks and blue chips lose more and more money, you
can be comforted knowing you have part of your portfolio designed
to profit from the market’s decline.
Rising
oil prices have got to be bad, right? Rising oil
prices will impact a myriad of industries, directly and indirectly,
causing inflation to get worse, much worse than what the government
numbers show, in our opinion. The simple cure is to own a variety
of oil companies. We own oil services, refiners and explorers. So
as oil prices rise, and the oil company’s profits rise, the
investor benefits.
But rising oil
prices are also a fundamental cause of higher inflation. And it
impacts a wide variety of products. So we also invest in other areas
that traditionally have risen when inflation rises. These include
natural resources, hard assets and commodities. So when you go to
the grocery store and see higher prices for tomatoes, corn flakes
and steak, you can smile a little knowing you probably own a basket
of agricultural commodities.
How
does the Real Estate collapse impact me? Real estate
saved the economy for a few years. Consumers used their homes as
ATMs, pulling money out of their home equity, fueling the economy.
But with lower housing prices and higher lending standards, the
real estate ATM is virtually closed, leaving the economy looking
for another source of spending money. This will help push the economy
deeper into recession, and prolong its depth and length. Stocks
will likely have a hard time of it as the economy struggles.
But a declining
stock market is what we are expecting and investing to profit from,
so other than your own house being worth less, the real estate collapse
shouldn’t impact your investments too negatively.
I’m
hearing about brokerages and banks needing billions of dollars because
of write-offs of bad investments, mostly sub-prime mortgages. How
does this affect me? This is a complex issue that
will not be resolved for years. So far, the solution is to throw
more money at the problems. This is not the solution. It is simply
a way to keep these banks and brokerages from failing. Bottom line,
they made bad investments and they should accept the consequences.
If you made a bad loan to your good-for-nothing Brother-In-Law,
do you think the government would be coming to your aid, paying
off the loan for him? I don’t think so.
Simply put,
the bail-outs and cash infusions are temporary fixes. The long term
impact will likely be tighter credit standards and harder to get
loans. This will impact the economy by reducing the liquidity needed
to keep it going. Add this as one more reason we are negative on
the long term prospects for the stock market. And one more reason
we own the market hedges.
How
will the election affect things? Regardless of whoever
you are rooting for, they don’t stand a chance of fixing what
ails the economy. The next President is going to get the equivalent
of a flaming bag of economic poo. No matter what he (or she) does,
they are going to get #$%@ all over them.
Getting the
economy off its addiction to debt will be as much fun as a junkie
kicking heroin. There is no pretty way to do it. It will include
a recession, higher interest rates and a much lower stock market.
And it may take years to bottom out, not just a few months. There
is no quick fix available.
That doesn’t
mean the Government won’t try and that Wall Street won’t
hail whatever comes down the pike as the greatest economic plan
ever, but unless it somehow makes debt evaporate and at the same
time miraculously keeps investors whole, it will be nothing but
a quick-fix, with no long term economic benefits.
What this means
though is that there will likely be some rallies in the stock market
that can be traded. Bear markets don’t drop straight down,
and economic stimulus plans are a good excuse to rally. Our cash
positions are poised to take advantage of trades as they become
available.
Terrorism
and war are unpredictable, this makes investing too risky, doesn’t
it? Yes it does. Investing in the stock market becomes
much riskier. But, as we said before, we own hedges on the market.
They will benefit from any market declines. First, let’s clarify
what we believe. There will be more acts of terrorism and there
will be more wars, maybe even in new places like South America.
The economic impact of terrorism is usually short term, while the
effects of war can be longer term, depending on where and who is
involved.
While we don’t
pretend to predict when and where the next act of terrorism will
be or when the next hot war will flare-up, we know the impact on
investment portfolios are usually the same. Stock market declines,
and a rush to safe investments like gold and treasuries. By owning
the appropriate investments ahead of time, we are already prepared
for whatever happens.
I
know the Dollar is falling, but what does it mean to me? The
Dollar’s collapse is a result of the Fed’s decade long
easy money policies. The Federal Reserve has been keeping the money
supply “loose” which means it is easy to borrow money
and also puts a lot of Dollars in circulation. The more Dollars
are floating around the world, the less valuable those Dollars are.
Also, foreign
investors have been buying US bonds. These bonds have a maturity
value, in US Dollars. The declining value of the Dollar makes these
bonds worth less in the foreign investor’s home currency.
Think of it like this: You loan $1,000 to a friend. When the loan
comes due, he tells you things are tough for him and he can only
pay you back $990. You give him a week and he says he can now only
pay $980. After another week of waiting, all you can get is $950
for your $1,000 loan. At some point, you give up and take what you
can get.
This is the
fear of many Dollar watchers - that foreign bond holders will give
up and start dumping US bonds to get what they can before the Dollar
completely collapses.
The result –
much higher interest rates in the US. Mortgage rates through the
roof. Any hope for a real estate recovery are gone. Forget about
economic recovery. Hyper-inflation will likely be the result of
a Dollar collapse.
Can the Fed
prevent this scenario? Yes, by raising rates on the short end now.
Raising short term rates will protect the Dollar, and tighten the
money supply, curtailing lending. Of course, this will also kill
the US economy. The recession we are heading into would likely get
much worse. Have no fear, the jellyfish at the Fed are more concerned
with popular opinion than doing what is right.
The last time
we had a Fed Chairman with the foresight and intestinal fortitude
to make a move as controversial as this was Paul Volcker back in
the early 80’s. Volcker was hated at the time he made such
bold moves. Today he is revered as one of the toughest and smartest
Fed Chairmen.
So how do we
profit from a falling Dollar? Gold is the first best hedge on the
Dollar. As the dollar declines, gold goes up in value because it
is viewed as a store of real value, while paper currencies lose
value. The next strategy is simple, if the Dollar is falling then
other currencies are rising. So we invest in foreign bonds and equities.
They can benefit from the falling Dollar.
Why
can’t I just own a bunch of Index funds and Blue Chip stocks?
I’m told they always come back, so I shouldn’t worry.
This is true. They do come back, eventually. But are you really
willing to wait that long? The most recent bull markets in the US
took quite some time to recover. It took 25 years to break-even
from to top of one bull market, and 16 years to break-even from
the top of the second. In Japan, they are still down about 75% from
their market’s high. When was that high? 19 years ago.
When
will “It” happen? “It” is
probably happening right now. “It” is the market topping
out and the economy heading lower. Investors and strategists like
to single out one event or a single date as the point in time the
markets and economy changed direction. They like to be able to say
that the market will top out at “such and such” and
it will decline to “…something else.” That’s
not how it works. Market tops can be long drawn out affairs with
the peak only obvious well after it has happened. The seeds of the
top in both the economy and stock market are planted well in advance
of the top and are not obvious to most investors.
If someone pushed
us, we would have to say the Dollar is the key to everything. It’s
decline should trigger higher interest rates, push inflation higher,
kill any hope of a real estate recovery, cause an economic slowdown
to get even worse, and contribute to lower stock prices.
Any rally in
the Dollar should be short lived and give an opportunity to rebalance
portfolios. The only way the Dollar can see any real strength would
be if the Fed were to raise interest rates and debt levels were
to decline. Both of these scenarios would be bad for the economy
and the stock market in the short run,(a few years), but actually
lead to a healthier recovery in the future. The odds of this happening?
Slim and none. There is no Paul Volcker at the Fed these days.
What
should we do? The current environment and the future
problems require a strategy that is pro-active and flexible. Buy
and hold just won’t work. Running and hiding in CDs or T-Bills
won’t work either. Luckily, there are many unique and sophisticated
investments available today that an investment professional can
utilize within a portfolio to lower the overall risk and still be
able to give good returns to the client. Unfortunately, too many
money managers are still doing things the old way, and not taking
advantage of the opportunities we at Cornerstone are seeing.
For us at Cornerstone,
we are going to keep working on how to take advantage of the problems
that surround us. We are going to keep searching for ways to profit
from the negative headlines. So far, nothing much has surprised
us, we’ve expected just about everything that is going on.
High oil prices, rising inflation, geo-political tensions, declining
stock market and a collapsing Dollar, just another day in the Briar
Patch for Cornerstone!
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