Monday, October 3, 2011

Cash, cash flow and real diversification for tough times

Gordon Pape discussed this week the ‘long term bear’ Eric Sprott of Sprott Asset Management. Over the last 10 years Eric Sprott warned that sovereign paper holdings would likely decline in value, while hard assets like gold and commodities were to appreciate relative to the paper. Mr. Pape notes that for the decade, Eric Sprott was correct and that his funds returned annually nearly 18.4%. But the ultimate Armageddon forecasted by Mr Sprott hasn’t happened (yet) and last month his fund surprisingly fell nearly 18.9% and it fell 25% year-to-date. That, while living in the throes of the European (and to a lesser degree) the U.S. sovereign debt crises.

My stock portfolio performance has not been inspiring either; it shrunk nearly 15% for the year since I was overweight in oil and gas. Commodities lately have been considered high risk in the stock market and it is the reason that the TSX has lagged the performance of the Dow Jones especially taking into account the rising U.S. dollar.

Professional managers feel that retail investors are very emotional and hence sell during panics and buy during market highs; nearly exactly the opposite of what retail investors should do. The U.S. based American Association of Individual Investors performs a weekly survey and professional investors use this survey sometimes as a contrarian indicator. On average (since 1987) investors are 39% bullish; 31% neutral and 30% bearish – the graph below shows investor sentiment and stock market performance (S&P500) from 1998 until last week.



It indeed shows that during bear markets investor sentiment drops dramatically with only 20 to 30% of investors being bullish and today that is also the case (we’re just below 28%). Typically, sentiment numbers don’t fall much lower, although there are individual spikes such as in the spring of 2005 that fell as low as 15%. But during bear markets we get a cluster of low sentiment troughs. Sentiment lows are now at a similar level as in 2003, just before the on-coming bull market that lasted until mid-2008. The sentiment lows of 2009 were worse (20%). The most bearish sentiments (10-15%) did not occur during the 2003 and 2008 bear markets; it occurred in the 1990 bear market.

Professional managers interpret the current low bullish sentiment to indicate a market turn around. So you may think that bullish highs of 50% mean an impending crash. Strangely enough, this not always the case. Finally, it may be noteworthy that during the 1988 -2000 secular bull market investor sentiment often was below 40% while most bullish sentiment was measured between 2000 and 2004. My conclusion is that we may or may not be near the end of today’s bear market – now how is that for enlightenment?

But whatever your bear market strategies, the number one issue to keep in mind is cash management and nearly just as important is diversification. I agree with Eric Sprott that real assets are often the key. Stock market valuations are, especially in the short term, sentiment indicators. Bond yields are expressions of confidence in the borrower’s capability to pay interest and repay the debt. This confidence level combined with the inflation expectation sets the final bond yield.

That Eric Sprott’s fund performance was so negative was due to the fact that he still invests in paper assets not in the assets themselves. He invests in shares of gold mines, bullion ETFs and, to a lesser degree, in shares of oil companies. Yes these are harder assets than say banks or engineering consulting companies, but their prices are still an expression of investor confidence, economic expectations and futures market speculation. Many of these companies make money hand over fist, but it is not reflected in their stock prices.

Strangely enough, the only paper investments that hold their value these days are those that provide the investor with cash flow and that are not related to lending money (such as banks and insurance companies). These are dividend paying companies such as utilities, phone companies and pipeline companies. Remarkably, these companies trade at much higher P/Es than most other stock market investments. Why is this remarkable? Well high P/Es used to be associated with companies that promised high growth but that is not the case any longer (look at high tech companies).

Real assets are assets controlled by the investor! A prime example is your own business or real estate (your house or your rental property). I wrote earlier about the underlying trends in real estate (baby boomer 2nd homes and rental properties). My overall investment portfolio comprises now 50 to 60% real estate in various forms. Yes recreational properties were hard hit in 2008 and many have not recovered (yet) but residential real estate and rental properties are as a minimum stable if not increasing in value. Simultaneously, they also provide cash flow or in the case of your own residence it saves you from paying rent. But be aware, even real assets may develop an overvaluation bubble as our neighbours to the South found out.

Although this year my stock portfolio declined in value by 15%, my overall portfolio dropped only 6.4%. Always remember, this is a ‘paper loss’ which only becomes a real loss once you sell. If your portfolio throws off enough cash, especially when combined with your salary, you will not be forced to sell and you can wait for better times. If you sold off some of your riskier holdings as I described last week, then your current cash position should allow you to take advantage of buying opportunities to come or as a minimum it should help you to sleep somewhat better at night. A good night’s sleep is the best medicine against panic!

To get through tough times, you need cash, cash flow and real diversification!

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