Monday, November 03, 2008

Turning Point

Hello again everyone...

Well, this is the third economic "newsletter" I've sent out so far. May, July, and now October. Scary Halloween huh? That seems to be what everyone was saying on the news, but knew it was coming...Right? That's why I'm calling this a turning point. I'm not calling a bottom and I believe there could be a long way to go before the markets reach their previous levels. However, I believe the panic of this crisis is over because everyone is now aware of their "new" surroundings. Also, even though the election is hours away, I'm going to leave politics out of this as usual. I know it's close, but from a financial perspective, I don't believe it is immediately pertinent. Again, if you don't want my econ crap showing up in your inbox...just tell me. I promise you won't hurt my ego. Lastly, Info for Active Investors is in blue. If you're not an active investor, and just read this for water cooler fodder, skip the technicals.

A quick recap

"Fundamentally, I believe the United States is on the verge of a major economic event. Perhaps a crash, almost certainly an extended contraction.

"Well, June was the worst month for the DOW since the great depression. Sorry if I was too candid.
" Update: October made June look like a picnic.

"There is also talk that Fredie Mac and Fannie Mae are insolvent" Update: Freddie and Fannie - were nationalized two months later.

In all fairness to you and myself shopping list was pummeled - more than the S&P - over the last 3 months. The only symbol that would have gotten you any love was gold...and it was still down 22%, compared to the S&P's negative 33%. OUCH! That's 4-6 years of average portfolio growth wiped out in 3 months. Simply, there was no place to hide, and that was a valuable lesson to learn so early in my investing career.

What's Next

Probably more of the same. I know that sucks to hear, but I'd be a liar if I said I knew exactly what's next, or that it looked good. After all, "Incremental is the nature of change."

Factors to consider:
  1. It's obvious that we are now in a U.S. led, global recession
  2. The U.S. needed to raise the debt ceiling by a trillion or so to give banks $800B
  3. 1:5 home owners are "upside down" on their mortgage.
  4. The pace of layoffs has been accelerating
  5. There is still a wave of Alt-A mortgages that are scheduled to reset next year (read: FAIL)
  6. The pace of home sales has been accelerating. However, prices are still falling.
  7. The U.S. has just recently seen the largest bankruptcy ever (Lehman Bros.)
  8. 17 Banks have failed this year.
  9. Though October had some of the biggest one day market gains, it was a huge down month.

So let's take a look at all this.
This "crisis" was brought on by people not being able to pay for their homes...not by some credit market. The failing mortgages locked up the bank's cash supply, thus credit. Now, we have 1:5 home owners upsidedown that probably don't want to keep paying the amount they agreed to....on top of the fact that they might not be able to. Adding to this is the employment situation, which is based partially on the housing situation. Therefore, I'm not really seeing how this "credit" issue is going to come to a close. Sure the govt kicked in some cash, but that's like...if you give a man a fish. far as I can tell, we're done till the U.S. comes up with a new product. First it was our resources, then manufacturing / autos, and finally computers / tech. Our latest product for export has been inflation.

If we do not innovate a new product (read: renewable energy) for the world, how can people keep their jobs, pay their bills, keep the companies profitable, keep the govt profitable, and finally...keep up the U.S. standard of living that has obviously been eroded?
Please stop and think about this point for a moment. It is a black and white fact that our military power is a product of our economic power. We as people and as a country have been borrowing to live. We now have few choices at our disposal. Rape our remaining resources, rape our labor pool, or innovate. It shouldn't be difficult to understand how our inability to meet our financial obligations ($352,000 per household for entitlements) is morphing into a national security issue. No need to believe me, others are catching on too. Seeking Alpha just penned "The Shallowest Generation" a harsh indictment of the baby boomers. Fortune just published "The Bigger Economic Disaster" an examination of our ballooning financial obligations (read: 78 million boomers hitting SS and Medicare). Lastly, yesterday BusinessWeek published "The U.S. Economic Crisis: Three Growth Scenarios," where they echo the same points and choices; Stagnate, Cut back, Innovate and grow.

Earlier I inferred something about a "next" crisis, as did the articles. If the U.S. does not change it's tack, the "next" crisis I refer to is the inflation / spending / money / borrowing crisis. DO NOT THINK FOR ONE MOMENT THAT THE GOVERNMENT CAN SIMPLY PRINT TRILLIONS OF DOLLARS (TO SAVE BANKS?) WITH NO REPERCUSSIONS. This example is just the largest and most recent continuation of the same borrow-to-consume money policy. The effects of the U.S. monetary policies have been very real to U.S. citizens, but also U.S. investors. Some countries are now becoming skeptical of both U.S. policies and U.S. government generated economic data. They feel they have been duped into "buying-in." Some even feel the U.S. has "plundered" them by buying with dollars overvalued by insincere data. If these nations turn rhetoric into policy and rebel against the dollar, the effects would be devastating. I don't imagine they'll sell off all their U.S. based investments, but that they will decline to make new ones...thus choking off the U.S. government credit card. Hmmmmmm.

What to do next...

Hurry up and wait. The problem is, EVERYONE is panicking about EVERY asset, and may continue to till things stabilize. Nearly every company, commodity and country has been sold off. It's way too late to hedge. So, unless you're into catching falling knives, hurry up and wait. Wait for cooler heads and colder cash to prevail. Sure there are been huge jumps in the market this month, but let's use an example to understand the magnitude of these jumps. If you have an asset that's worth $100 and it falls's now worth $60. AND, if it gains back 40%...your asset is now worth $84. Wait!?!? where'd that other $16 go? If you have a 40% drop, you need a 56% gain to break even. So....After a 40% market drop and more bad news ahead, don't get all excited if you're missing out on 10% gain.

Another point of interest to be considered is Japan. Before this malady was in full swing, many were making comparisons to Japan. Japan had also had a housing asset bubble and also "solved" the problem with cheap money. In return, their stock market was nearly stagnant and was referred to as the "lost decade." Well folks....Japans market just hit 1989 levels. They're now calling it the "lost quarter century." I'm certainly not saying that Japan is a bellwether for the U.S., but one must consider the similarities and likelihoods of similar outcomes. Ultimately though, the lesson is this...If the U.S. does not take action to avoid a similar situation, we may see market losses well after the markets stabilize.

Based on what I've learned over the last few months,
I now think it is prudent to ALWAYS have a portion of an equity portfolio dedicated to the market falling (hedging). For active investors - I think the allocation should be adjusted at set intervals based on your own thesis. Traditionally, we've been told that a "short" strategy is risky...and that has traditionally been true. Based on the options available, the only ways to wager on a falling market were options and shorting. One method virtually guaranteed a 100% loss in even a chilly market, and shorting opens an investor to nearly unlimited risk (like losing your house). However, there are now publicly traded funds (ETFs) that allow an investor to "buy" into a wager for a falling market. Simply, if the market rises, your investment shrinks. If the market falls, your investment grows. Assuming you buy into a fund with a 1:1 payout ratio - where your investment grows +10% for every -10% the market falls - The market would have to double before your investment reached $0. If we use the height of the market last year, we'd have to go back to a hypothetical buy in date of 1997 for your hedge to now be $0. Oh...ETFs didn't come into existence till 1993 with the introduction of the "spider." No wonder no one ever told you to hedge.

In the same circles that revealed the depth of this mess to me - more than a year ago - there is talk of buying. I'd need to be pretty bold to call a bottom, so you can forget that. I also wouldn't recommend buying into GM, Ford, the airlines, retail.....nearly anything really.
There are however countries and companies - that are flush with cash and demand - and should soon begin sailing out of this mess. I hope to highlight some of them early next year. Here's a hint, the U.S. and U.S. manufacturing aren't among them. If you have a wad of cash burning a hole in your pocket now though....I'd say ETFs focused on energy, currencies of governments that have avoided this mess, and dividends. Energy because our current structure is based on finite resources and increasing demand. Currencies of OTHER governments because our government just put 10% more cash into circulation to save banks (rolls eyes), thus making the dollar "cheaper." Dividends because these are the companies that are limited in growth and still making enough cash - without credit - to be able to provide dividends.

I feel that the only way to get the U.S. back on track, financially, is to balance the budget and invest in infrastructure - primarily renewable energy. Otherwise, we'll be left borrowing to pay seller's prices for resources that we - as individuals and as a nation - need to survive. As tax receipts continue to drop, it is also not difficult to understand the real effects a faltering economy on our national security.

On a personal note....

Despite the dismal tone of my economic perspective, life is simple, going very well, and keeping me content. It's taken a couple decades for me to realize that, for me, living simply actually translates to living well. The converse is spreading myself too thin, not executing well on ideas, neglecting those around me, etc. With that being said, I'm still commuting by bike, only. I'm still going to school (and pulling As, woot!). I left Nytro at the end of June and I'm now working two jobs. One doing graphics / production work for a clothing company, the other as a tutor for the college I attend. The obvious contrast between the two has been surprisingly refreshing. I also wouldn't have imagined how fulfilling it is to be a tutor. I've often told people I view things in terms of math and numbers. As I've talked to more people, I realize there are many of them at the other end of that spectrum searching for a middle ground. Helping them to understand something that can be as complex as our world itself, seems to be a good fit.

Till next time, take care of yourselves.


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