Friday, July 29, 2011

How to take advantage of the U.S. debt circus - II

How would you buy, say the DIA spider, in today's markets? It is nearly impossible to predict the current market gyrations although they're probably down in general until, my guess, September when vacations come to an end and the Debt ceiling issue is past us one way or another.

Historically, September is one of the worst months in the stock market year, but the current mood is quite black so don't expect this to be just another September month. One of the possible outcomes of the debt ceiling story may be that it will be raised in a series of steps each of which is linked to a deficit reduction target. This plus the upcoming U.S. election in 2012 would create a lot of investor insecurity and thus poor overall market performance.

So, we're not in a hurry. Say we have $5000 to invest. With a discount brokerage fee of $10 per transaction, even splitting this money up into 10 investments of $500 would result in a commission rate of 2% which is less than that of a full service broker not counting minimum commissions. I suggest to use slightly larger chunks of $1000 and thus a commission rate of 1%.  Start buying your first tranche coming Tuesday and the next one the following Friday. This should be at the most intense level of fracas. Then slow down your pace and make your next investment say in early September (1st week), the fourth at the end of September and the last $1000 in the 2nd half of October.

Usually, stock markets pick-up in October and this year that may be the case as well. Markets climb around 4 to 5% typically between the lows of September and year-end (see figure below). Funny, you remember the expression "Sell in May and go away"? Yeah right look at the graph.

An important warning though, seasonal trends and this year's performance do not necessarily agree. The figure below shows that clearly. But over the long term, you will profit as shown on this blog over and over again.

Maybe this is a good time to re-iterate what we have learned from our various stock market simulations. First of all, ‘buy and hold combined with dividend reinvestment’ provides the best returns for most retail investors (you and me). If you move in and out of the market with your entire portfolio, even when timing your highs and lows well, you still underperform over the long term. If you used a market timing strategy as discussed in an earlier post starting in 1973 until today, you would have been out of the market entirely during 73 of the 460 months; you would have been fully invested for 54 months and for 330 months you would have been only partially invested. During the times that you were out of the market or only partially in the market you would not have made as much dividends as when you were fully invested for the entire period. Those are dividends that you could have reinvested and that caused the underperformance. (Buy and hold works but you’ll need nerves of steel)

Secondly, if you make a one-time purchase during a market lows, say at a 20% discount of the average market valuation (P/E), your annual return is 12.1% using an earlier 30 year stock market simulation based on U.S. stocks versus 10.3% if you bought at a market peak. So it matters somewhat whether you buy at a market peak or low but a regular contribution plus reinvestment of dividends and no selling is your best long term approach.

It is hard to admit that most of us do not outperform the markets. Many professional mutual fund managers with every piece of desirable data at their fingertips including teams of analysts do not help you to outperform the market especially when you have to pay for their management expenses (MER and commissions). So, do not think that you are any different in that regard

Overall, you will not become rich or stinking filthy wealthy from just saving and putting money in the market. You will do fine and you will become financially comfortable, but to reach the stinking filthy level you need special breaks such as the ones described earlier in the year. But how do you recognize those breaks? You see, that is where your investment knowledge and acumen comes in. You not only need breaks; you also need to recognize them!

Thursday, July 28, 2011

How to take advantage of the U.S. debt circus

Well we seem to be nearing the climax of the debt ceiling circus. As mentioned earlier, this may be a major buying opportunity for Canadian investors with the loonie near the top of its trading range. The U.S. government is at the point to reduce its budget deficits one way or another. Today's struggle is probably the first of many to come about the deficit reduction strategy. In the end, it doesn't matter, because with resumed economic growth (no matter how weak) tax revenues will rise and neither will there be a need for major stimulus efforts such as TARP since U.S. corporations are stronger than they have been in years. In fact, a lot of TARP money may be recovered over time possibly at a profit to the U.S. tax payer.

Oil prices are capped by economic growth and vise versa as discussed in earlier postings. So Canada's upside is somewhat limited. This may sound strange, but really, how much higher do you think potash prices, base metal prices, gold and oil will go? One of the few laggards is natural gas, but that will come back sooner rather than later as well. What resource industries typically seem to do at this point in the cycle is that they'll see their operating costs and capital costs increase while profit margins decrease or stabilize.

With expectations too high in Asia, the big gains will be made in the U.S. and later possibly in Europe. There where the pain is greatest, the opportunity for gains will be the best. So let's look for dividend, large cap multinationals that have significant global income, that are U.S. dollar denominated and that we can buy with Canadian dollars. Here is a list of such companies:

These are the corporate crown jewels of the U.S., each a giant in their own right. These are the 30 companies that make up the Dow Jones index. You can buy them as an ETF through your discount brokerage with minimal commissions ($10 per transaction) and management expenses. The SPDR Dow Jones Industrial Average ETF (symbol DIA). This ETF provides an instant diversified portfolio with a dividend yield of 2.18% (better than a 1 year GIC), a very modest P/E of 12.5 and an annual earnings growth of 9.22% over the last 5 years. Below you can see the asset allocation of this ETF:

To top it off here is the SPDR DIA performance (all this data was honestly stolen from their website):

In fact most numbers are as of the end of June. Right now, the DIA's dividend yield is even better: 2.3% But with the current market volatility that may change rapidly: better or worse. So don't fret about individual companies, buy the entire Dow Jones and become an owner of the world's most powerful corporations at a big currency discount.

Saturday, July 23, 2011

How high can loons fly anyway? (Part I)

With the Canadian loonie hovering clearly above parity somewhere between Cdn. $ 1.05 to 1.06 per U.S. dollar, the time has arrived to wonder how much higher this loon can fly? This may prove to be a critical weekend for the Canadian versus U.S. dollar relation. Now that the fires of the European debt crises have cooled a bit, the currency question definitely should be on the mind of Canadian investors.

I have updated the foreign currency graph from an earlier posting: Who really pays for all the money that the U.S. is borrowing? In this post I concluded that it is the rest of the world, or better those countries that hold U.S. debt via banks, investors or foreign currency denominated bonds, that pay for a large portion of that debt through a gradual U.S. dollar devaluation that started as far back as 2001 (Fig 1). Remember the German banks and the Irish banks that bought repackaged U.S. subprime mortgages by the bucket full (Structured Investment Vehicles and CDOs) that soured in 2008-2009? The result was forced government intervention in particular by Ireland which subsequently went broke; they basically bailed out a lot of U.S. debt.

Figure 1 Change in U.S. versus the Canadian Dollar (CAD); Australian Dollar (AUD); Japanese Yen (JPY); Euro (EUR) and Chinese Yuan (CNY) over the last decade.

So Canadians who invested in U.S. bonds in 2000, saw their principal value reduced by nearly 33.8%; Australian bond holders took a 44% haircut; Europeans lost 35% and the Chinese 22%. No wonder, the Chinese wanted to keep their Yuan being pegged to the dollar. They are holders of close to U.S. $1.3 trillion debt and they saw the principal of that debt drop by nearly 20% or 260 billion dollars when expressed in Yuan. To top that off, the Yuan itself is currently losing 5% annually in purchasing power (inflation). Only 2008 – 2009 interrupted the trend of continuous U.S. dollar devaluation with a temporary ‘flight to quality’. The U.S. is a safe haven? You must be kidding

How high can loons fly anyway? (Part II)

There is another way of reducing debt than devaluating the currency. Think about your mortgage payments and your personal debt/asset ratio? If you take a mortgage on your house, over time your house increases in value and thus your debt/asset ratio improves. But also, your income, by means of salary increases, will grow and your mortgage payments will become smaller as a percentage of your income. The same is true for economies. The economy usually grows and this is expressed as 'real GDP growth' or GDP growth after inflation. Western Developed economies are doing just fine at an annual GDP growth rate of 3%.
Figure 2 Assuming nominal GDP growth of 5% per year, a Debt/GDP ratio of 60% decreases over 25 years to 19% provided no new debt is taken on.
Including current inflation at 2-3%, nominally such an economy would grow at around 5% per year. Thus any debt as a percentage of GDP decreases every year by a few percentage points. You may think this is trivial, but that is not right. Figure 2 shows that over a 25 year period, starting at a debt/GDP ratio of 60% (current U.S. debt load), this ratio would shrink (without further debt additions) to 19%. Now add to that the devaluation of the U.S. dollar over the last decade or so!

The debt ceiling issue may be scary, but really, the discussion is not about how much more debt to take on; rather it is about the way to reduce the U.S. budget deficit. When drilling down further it is in fact about cash flow. You need cash to spend on projects that you want to realize and if you have not enough cash to spend on the things you want to do, then you can't do them. When government debt gets too high (as a percentage of GDP) then government has to pay too much of its money towards interest and it has not enough money to spend on projects such as roads, healthcare, etc.

The other thing you may have picked up from this story is that no government, including that of the U.S., is planning to ever pay back a penny of its debt to its creditors. In the worst case, it will borrow money from other creditors to pay for expiring debt. So, the Chinese will never see a penny of the money they're owed by the U.S. Neither does any other investor in government debt.

Debt is an asset for the creditor that creates cash flow in the form of interest. You can see it with the mortgage on your house. You pay interest every month to your mortgage holder and sometimes you pay off a bit of your debt, but really that paying down of principal is just smoke and mirrors. The bank would prefer you never pay off your mortgage because how else are they going to make money of you? If you pay off your mortgage the bank has to find someone else to whom to lend the money you paid back.

So for lender as well as for creditor it is about assets that create cash flow. The only creature that does not use assets to create cash flow is the consumer. It consumes assets! Now you may better understand how insidious government debt is but we are not quite there yet!

Lending your savings (assets) to governments creates cash flow for you and provides money for the government to execute a capital project or roll over expiring debt. So let's look at the cash flow your government bond asset produces. Your cash flow is the interest payment based on the bond's coupon rate. Say currently you get on short term treasury bills, or 'T-bills, 0.5% interest and 3.75% on a 5 year government bond. In Alberta current inflation is at 3.1% and money invested in T-bills over a period of one year at 0.5% results in a loss of 2.6% (0.5 – 3.1%) in terms of purchasing power. Your 5 year bond would result in a 3.75 – 3.1 = 0.65% increase in purchasing power.

Oh… Not so fast, we did not consider taxes. In Alberta you pay 38.6% (top margin) taxes on your interest income. So the T-Bill interest after taxes is 0.5-0.386x0.5= 0.307% minus inflation of 3.1% is a loss of 2.793% in purchasing power. And the 5 year bond would be 3.75 – 0.386x3.75 – inflation is a loss of 0.79% in purchasing power each year.

So no matter what, you always lose! No wonder that the government is in a panic when we're getting deflation because then the story would completely change! Governments like to have zero percent interest or very low interest even when everybody is up in arms about the 'security' of the government debt in many countries. Because especially when interest rates are below inflation governments win and you lose! So if you're thinking that you support government only by paying taxes, you better think again.

U.S. government corporate tax policy taxes profits coming in from foreign subsidiaries that are brought back into the U.S. to their parent companies. Companies like Microsoft may have stashed away billions in cash overseas that they can never pay out to their shareholders or that can be brought into the U.S. economy without triggering a lot of taxes. So if the U.S. government was really so concerned about their foreign debt and their current account deficit you would think they would make it easier to bring all this money into the U.S. But 'au contraire', they discourage it. So do you still feel so smart about investing in government bonds?

How high can loons fly anyway? (Part III)

As said earlier, the gig may be up for a falling U.S. dollar. The U.S. government is cornered! If they don't control spending the rating agencies will lower the U.S. debt rating from 'AAA' to 'AA'. This would mean that the U.S. can no longer borrow at excessively low rates – just at low rates. When that happens more people would want to invest in those bonds because their interest rate is up, which in turn would drive up the U.S. dollar.

On the other hand, if the political parties do get an agreement on reducing their deficit then the U.S. dollar is likely to rise as well as people are feeling more secure about investing in U.S. debt. So either way, it seems that from now on, the U.S. dollar may start to rise again. A recent survey of major successful investors by City Bank shows that many expect the U.S. dollar to turn around. The Canadian Dollar, in U.S. dollars hasn't been this expensive since the early 1980's and one wonders whether it is realistic to foresee a Canadian dollar price at U.S. $1.20?

Taken this all together, Canadians may never have been able to buy U.S. denominated assets as cheap as today. Real Estate is way too risky. If you don't believe me about the risks on investing in U.S. real estate then listen to one of Canada's foremost real estate experts: Don Campbell and in particular his 6 rules for investing in the US

Overall, the U.S. economy is still weak but on a gradual path of recovery. By investing in U.S. dividend paying stock you get paid while waiting for this recovery. However, even more rewarding may be the fact that many U.S. large cap companies are linked no longer to only the U.S. economy but also to that of the rest of the world and in particular high growth economies such as India and China. You buy many of these U.S. multinationals not only at a severe discount using Canadian dollars to buy U.S. denominated assets but you also buy them currently at a low P/E (share price divided by earnings per share). The earnings of companies such as Apple, Microsoft, MacDonald's, Kraft and Coca-Cola have lately blown off the barn doors but because they are considered part of the lack-lustre U.S. economy rather than of a stronger global economy their valuations are very reasonable. My guess is that the multinationals that make up the Dow Jones are set to take off in a significant way. Not only the charts are indicating this (see ealier post this week) but even more so, the fundamentals are doing so as well. Buy ETFs that mimic the Dow Jones Industrial index or buy the multinationals individually.

Next week, when the U.S. leadership proves not able to reach a compromise about how to reduce their deficit and their failure to raise the debt ceiling, these share prices may temporarily become even cheaper. So be ready with your cash to take advantage of this buying opportunity. Because I think we're not far from the point that our loonie won't fly much higher.

Thursday, July 21, 2011

Here we go again!

The Dow has outperformed the TSX this year so far (as I predicted early in the year - puff, puff). Commodities and commodity based stocks have underperformed this year and so have Canadian banks; hence the TSX's poor performance.

But the summer correction may be over and if you look at the Dow Jones chart below sourced from GlobeInvestor, you may notice that the U.S. large cap index is ready to break out into new high territory. Seems the Dow is about to test the 14000 high of 2007 before the year is over.

Commodity price charts such as Jim Rogers' RJA-N are showing an uptick in price but whether this is a turning point or just a rally in a correction is not certain. My bet, though is that it is the start towards new commodity highs. Oil prices, in particular Brent Crude, look also poised to go back to old highs. The question is whether the economy can handle $125 Brent prices or not. My guess is that it can for now.

Europe's debt questions are being addressed, although in nerve wrecking fashion. Now that Germany seems to accept a 'partial Greek default' the clouds look less dark. The U.S. debt ceiling issue remains, but the markets seems to ignore it for now. I am still waiting with cash in my hand for a significant correction if Obama et al. don't work it out in time. But, my long-time stockbroker pointed out that we had the same fight between Democrats and Republicans during the Clinton years. In those days no agreement was reached and the government was without funds for about 6 days. Apparently the impact of this 'incredible' event has been forgotten by most of the media. Be ready for a buying opportunity, however, yet another 'end-of-the-world' scenario seems unlikely.

It is so strange to watch this circus with the market potentially poised for either a major upturn or a downturn. Cash holdings remain very high and a recent survey of major U.S. investors by Citybank suggests that those investors expect an upward moving U.S. dollar. Hmmmm. So, when is all this cash coming off the sidelines?
My overall view now that we're entering the 2nd half of the summer (already? The snow is barely gone!) is that we'll likely get a market set-back because of those darn U.S. politicians but that this rapidly will be forgotten and we'll enter the final profitable phase of this year – only 5 more months to go! (Darn it). Here comes Santa. JJ Just to make the game juicy. My forecast for yearend: TSX vs Dow will be a tie at 14,000! WTI oil will end the year around $115 and Brent at $127.

Sunday, July 17, 2011

Buy and hold works but you’ll need nerves of steel

Many world famous investors have told us that you need to buy and hold shares. Statistics show over and over again that the longer you hold your stock portfolio the less risk of loss. It seems nearly counter intuitive that if you sell on highs and buy at lows that you do not necessarily outperform a buy and hold investor.

Not only that, but 'buy and hold' also works in today's market. Yeah, I was in one of my spreadsheet moods. I thought, granted you cannot time markets, but what if I sell when the market is down 10% from its peak and buy once a market has risen 10% from its previous bottom over a month's time? Those are significant moves that would likely be precursors of bear markets or of bull markets. I used the Dow Jones index from 1973 until today as my market model.

Here is the strategy described in more detail. Starting in October 1973, I 'saved' every month $100 and added it to my cash stash until the market rose month-over-month by 10% then I went into the 'buy' mode, i.e. the likely start of a bull market. If the market dropped 10% over a month I switched to 'sell' (prepare for a bear market). For the remaining time I  was in 'hold' mode. You may think that markets do not move up or down by 10% over a month, but I had 54 buys and a whopping 71 sells, with the remaining 330 months labelled as hold. When a 'buy' occurred I put all my money in the market; when a sell occurred I sold all my shares and when a hold happened, I did nothing other than adding every month $100 to my cash stash. Over the study period, I contributed $45,500 at $100 per month.

Today, if invested as described above, my portfolio would have been worth $228,151.65 (don't mind the pennies). Wow, that is impressive, I thought. I bet if I invested that $100 every month straight in the market without paying attention to market movements, I would have done a lot worse! Enter the power of the spreadsheet and I was shocked. Had I be a simpleton and ignored all market movements and just invested $100 in the market every month my portfolio was worth $277,487.13. Eh??? Let me repeat that: $277,487.13 that is nearly $50,000 more! Below the story is shown in a graph.
To see a larger version of this graph, just double click on it.

But this is without dividends! I'll bet that makes the difference. Sell when down 10%, save $100 per month plus dividends and buy when the market has jumped 10%. Yeah!!! That is… a, yes now we're talking: 365 thousand bucksos! To be precise: $365,290.99 All right! Just to be sure, let's see how the stupid buy and holders are doing when they invest every month $100 plus the dividends – losers! Eh… Eh…. Oh my gawd! They made… kid you not… over half a million!!! They made $552,246.71!!!!!

I don't have exclamation marks enough for that! Look at the graph below. I guess, ignorance is bliss, after all. What the graph also shows is that the absolute portfolio value fluctuates enormously. Look at the 2008-2009 recession; the portfolio crashed from $556K all the way down to $298K. That is a $250K swing! Can you imagine what would have gone through your mind in early 2009 when headlines screamed that the Baby boomer retirement was all gone up in smoke? Two years later, it turned out that that didn't happen after all and the ignorant buy and holder is back on top of the heap. Not only that, even during the dark days of 2009, in spite of his tremendous 'loss', the ignorant buy and holder still had a larger portfolio than his/her less fortunate siblings. Of course, all stock investors outdid the guy who put his cash savings every month diligently under the mattress or in a non-interest bearing account. That one ended up with a paltry $45,500 – but that is still more than the person who didn't save at all.
To see a larger version of this graph, just double click on it.
Ah… Godfried, you always advocate 'buying at the right price'. How did that work out in your simulation? Well… eh… red face… I did a scenario where no shares were sold but with shares only being bought after the market jumped more than 10% in one month. It turned out that the returns were not as good as that of the ignorant buy and holder, but… not by much. My strategy gave a portfolio end value of just under half a million, $484,173.64 to be precise. But this is only for the market as a whole, not for individually selected stocks.

However, considering that with increased age, the chance of me becoming less agile in the grey matter increases significantly or even for the convenience of not always having to be involved with my investments, this is for sure something to think about. Buy and Hold definitely works wonders, especially when combined with dividend reinvestment.

Saturday, July 16, 2011

Before the storm

When people expect a hurricane they don't abandon their house, but they cover up the windows and remove loose ends. The same is true for your investment portfolio. It is possible that the U.S. debt ceiling debacle goes sour. So we must take care of loose ends. In this case, the investor reviews his portfolio and checks for investments that have lost relevance:
  1. A remnant from a spin-off.
  2. An investment that has not grown along with the portfolio and that even in the event of significant appreciation would have virtually no impact on total portfolio performance.
  3. A lost cause – Yellow Pages comes to mind.
  4. Any investment where you lost confidence in management or where you do no longer expect real performance.
I tied up loose ends this weekend and added the proceeds to my cash position. If the ceiling debt deadline passes I have a war chest ready for buying opportunities. In the meantime I also have crystallized capital losses that may reduce my yearend tax bill.

Another matter: If you work with Canadian and U.S. dollar accounts transfer all cash to Canadian dollars as it is most likely to benefit from this debacle. When using leverage in Canadian dollars, more aggressive investors may even consider paying off their Canadian debt with U.S. dollars.
House cleaning is painful as you're confronted with past mistakes and that is like pulling teeth. Swallow your pride and take the pill.

The key is that you are in the market

Investing is frustrating and does not make you rich overnight. How is that for encouragement? It is the last thing you may want to hear as a budding investor, yet it is reality! If I was a mutual fund salesman this was probably not something that I would tell you. But then I am not, and as such I could not careless if you buy my arguments.

My mandate, that I set when starting this blog, was to help people to start investing – to, as they say, give back to the community. I landed in Canada from the Netherlands in 1979. I didn't come here because Holland was such a great place to live in; and although I still have a soft spot for the Netherlands, Canada is in my books the best place to live in the whole wide, entire, total, world. It provided me with a successful career in the oil industry; I found here my wife and partner in life; and now that our children are grown up and we're standing at the cusp of an entire new phase in our life, I want to give back.

In general, Canadians are affluent and have a good income. Especially when combined with a spousal income, many of our households live in unparalleled prosperity. We, Canadians are great in offense, i.e. earning money from our work. But we are not good at living off our money. We forget that our life is staged as 25 years education, 25 years of work and the rest of our life - 25 to 60 years - of living off our money. I guess, I expect some of us to reach the ripe age of 110 J

So we have only 25 years to bring up our kids and to finance another 25 to 60 years of financial freedom. That does not necessarily mean that at age 50 our life of personnel development and growth has stopped; that from then on-wards we're waiting for the coffin while leading a stagnating life of golf, travel, wheelchair card games and bingo! Heaven, forbid! No, it only means that we are after 50 years entirely beholden to ourselves. We are no longer reporting to a boss, we're our own boss and we can do anything we want – not necessarily making money, but to lead the life of our dreams. Some may have been as lucky as me and lead a life close to our dreams while still in our earning years. At fifty we may change our lifestyle in a very gradual fashion – I don't think geology will ever be far from my mind. Others will make a 180-turn and change their life completely the minute they reach financial independence. It all depends on who you are. But… whatever we will do with our true adult life, first we have to build the means, the wealth, to achieve freedom 50.

That is what this blog is about, to help younger people to plan and develop the skills not only to achieve true adulthood but also to have the skills to enjoy your adulthood to the fullest, whatever your fancy! So, let me tell you again, investing is frustrating and does not make you rich overnight. When you start your first job and made some money, don't waste it on a stupid BMW or Lexus! After 10 years, whether you bought a Lexus or whether you bought a 'previously-owned' KIA, you still own a pile of rust! After ten years of investment, the money that you didn't spend on that first luxury car has likely doubled – and after 20 years it quadrupled or grew even more! Now, if you after 20 years still want that Lexus… you just use one year's investment return or less to buy it… cash! You probably won't even feel the expenditure.

One aspect of successful investing is living below your means. That way you always save more than you spend and your wealth continues to increase. But investing your savings is truly frustrating. It is not that you're becoming rich overnight – this blogs has many posts about that and I recommend you to review those posts and remind yourself of this fact. Not only should you not expect to become rich overnight; your net worth won't even go up in a straight line. It is two steps back and three or better two-and half steps forward. We call that market volatility!

Some people consider market volatility to represent risk! That is wrong. The risk is when you sell your investment at a loss at the bottom of a market or when the company you invested in goes broke! Every market is volatile; it goes up and it goes down; however, overtime it will result in increased net worth. In the meantime you have to survive! You have to have funds to live off and to be in a position where you're not forced to sell – especially not at a market bottom. To survive you need cash flow. Cash flow from your work, from dividends, from interest, from partnerships, from real estate, from etc. You can even generate cash flow from the sale of investments – hopefully with a capital gain – but that is not a reliable form of cash flow especially if it results from a forced sale. That is the last thing you want.

Right now, we live in' interesting times' – as the Chinese curse goes. In today's world it is even more important to have cash flow than ever. If you are worried about the U.S. debt ceiling, that will pass – good or bad. If bad, you may see another major downturn, but it will end and overall things will right themselves…, provided, you have enough cash flow to live from and even better to have enough cash flow to invest even more while everyone else panics and sells.

It is possible that dividends will get cut. It may be possible that interest income goes even lower, you may lose your job, your rental income may fall, and the world may end. But unlikely, all that will happen at once. Even if it will happen at once, then it will happen to almost everyone around you as well, and your severely reduced cash flow may look outright luxurious when compared to that of your neighbours. So, just like one-eye being king in the land of the blind, you would still have a better chance to get by than your non-diversified neighbours. Percentage wise, your net worth probably hasn't changed compared to your non-diversified neighbours either. "So what's the worst that could happen?", as Danny DeVito's movie says.

Don't let the European debt crises and the U.S. debt ceiling bickering get to you. Investing is frustrating and your wealth is more likely to grow in fits and bursts rather than that you get rich overnight. The key is that you're in the market in the first place!

Sunday, July 3, 2011

Investing is believing that things will get better

You read everyday expert predictions of impending doom. But really, if the world is about to collapses then why invest? The investor hopes that the companies he/she invests in will make higher profits. The investor hopes that the economy, notwithstanding temporary setbacks, will advance, that business will innovate and increase productivity and that problems will be sorted out.

Some investments seem geared to profit from doomsday scenarios such as short selling and gold. But their performance is only beneficial to fight portfolio volatility. Some stock market researchers see price movements as a 'random walk' akin to Brownian motions of particles suspended in fluid. But guess what, short term the particle motion may be random, but overtime these particles will settle on the bottom of the lab beaker!

Just like there is long term direction in the lab beaker, there is long term direction in real estate and stock markets. Our houses get better; our land becomes more productive and our economy evolves with mankind. Look at the figure below, despite all setbacks, over the last 40 years both real estate and stock prices have increased. That is what investing is about – rather than consuming your net worth now, you invest in the future; you express your believe that tomorrow will be even better than today.

 Nothing goes up in a straight line. Even rockets don't. Does a rocket launched in China go up in space or does the one launched around the globe in Europe go up? In an earlier post, I discussed risk: All Kinds of Risk and I depicted the graph below. Markets go up over time, but price movements oscillate around the trend line. You could buy at the blue market peaks and still have a handsome profit when you reach point E. People say, "I won't buy now; I'll wait until the next crash. Only when you are near the top of a market like at Blue B in the figure and you wait until Red C you may have a bit of an advantage. A bit of an advantage if you don't count the dividends that you missed out on while waiting for the crash.

In an earlier posted series of market simulations titled Next Time I won't sell! , I assumed we bought shares at 20% below the average market, so during a bear market, then we held the shares for 35 years. The result was a return of investment of 12.1% per year compared to 11.3%. A $100 portfolio was after 35 years worth $3,541 versus $2,753. When the simulation bought at a peak (i.e. 20% above average market value), the return fell to 10.32% or $2098. Yes, a substantial difference in performance that illustrates the value of investing in good companies during a recession. However, buying at the peak still gave good returns, provided you do not panic and sell during a bear market. Hold for the long term!

You may think that my optimism displayed in previous posts about China and the new economy is naive. That is because I refuse to get beaten down by a continuous stream of depressing news from the media. In fact, such news makes me even more upbeat, because during downturns I can buy more good companies at a discount. This may sound like a cliché and that is true, but the cliché is stating an investment principle that works!

In some ways advocates of index investing are right. Buying individual stocks is riskier than buying the entire market. On the other hand, by buying individual stocks I, the investor, may be able to separate the excellent companies from the bad and get slightly better returns. This is more risky and I am not always right so I still need to diversify. Overall, good stock selection can improve your returns but only few investors or investment managers do outperform the markets consistently. That is why I suggest to starting investors to buy ETFs, to stay in the market at all times and especially during down turns to buy more. Always look for dividends. My favourite ETFs are mimicking the TSX and TSX60; they pay currently dividends at yields of around 2.4%. Some experienced investment advisors suggest owning a dividend six pack portfolio. Examples are Gordon Pape and Michael Graham who suggest a portfolio that typically includes companies such as BCE, the Canadian banks, TransCanada Pipelines and even Manulife. However no matter the details of their strategies, investors believe that over time things get better.

Friday, July 1, 2011

It’s a new economy… again!

Remember the High Tech Boom and the talk about the 'new economy'? Well pretty soon thereafter we learned that stock valuations are driven by earnings and the craze came to a screeching halt. But that does not mean that the economy did not change or that the world did not change. They did, just like the world changed and investment changed after 9/11 or after the Enron debacle. China and India are certainly changing but all within the principles and laws of economics, of society and of the physical world. We just should admit that we may not know all those principles and laws yet and we certainly don't know their impact. We don't think very well in a non-linear fashion trying to estimate the combined effects of all those interacting laws and principals (That is David Dreman speaking – see earlier posts on stock valuation and maybe a bit of Ken Fisher as well – where is a black swan when you need one).

We are now at a new stage in our social and economic evolution, and yes, history repeats – to some degree. These new changes will affect our life in a more fundamental way than anything we have ever experienced before. We have reached or are close to peak oil production. Not only peak oil, but also peak copper and peak-whatever-other-commodity we have taken for granted in the past. The world population continues to grow but in many countries this growth has already slowed or is even stagnant. Demographics and their economic consequences are about to change dramatically as well. First world population may peak in the second half of this century (at 9 billion people or so) and then it may even start to decline. This combined with us living longer probably will lead to a much older world population – think health care but also think stable or declining growth.

Yes a lot of the world lives still in poverty in conditions we consider of the 18th century. But they will catch up. So even if population growth comes to a halt, the momentum as reflected in GDP growth may still go on for some years; just like a massive tanker that keeps moving forward for some time after it ran out of fuel. However, there will come a time that we reach our peak in material possession – when everyone has a dishwasher, an electric car, a computer and food. So what more do we want? Of course, there is the little problem of peak resources and added to the effects of a stagnant world population our economy may slow down much earlier than just based on demographics alone.

So what about tomorrow rather than the day after tomorrow? Well, whether we want to or not, we will live in another 'new economy'. We have observed the consequences of this new reality now a number of times and the picture is becoming clearer. We are coming out of a period of financial collapse, but was this collapse caused by overheated real estate, cheap credit and an overconfident financial establishment that invented ever more obscure and intricate financial derivatives, or was it caused by the rising price of energy, in particular oil? This is still a topic of controversy amongst economists; although – just like with the climate change debate- some may claim the delusion of scientific consensus – yeah right!

Deleveraging ourselves out of the financial ruins of the latest subprime mortgage and the real estate debacle will restrict economic growth. Heck, if we have to reduce our debt burden we can't spend as drunken sailors like when we could max out our credit cards and live of the smoke-and-mirror appreciation of our residences. So we consume less and then… wonder of wonders, retail sales go down and bank profits decrease because we don't pay that much interest any more, and factories will produce less… and the economy does not grow as fast as after past recessions caused by other matters than financial collapse. We have seen this before and overtime our growth will resume its more normal pace.

Simultaneously, all this economic growth and consumption led to the record oil prices of 2008. Cheap energy which had fuelled the booming economies of the 1990s became too expensive; we went into recession. Subsequently, energy demand in the developed world declined so much that despite continued economic growth in emerging economies, energy and commodity prices fell in early 2009. When at the start of this year, oil prices shot up again the economy responded with a minor slow down and this summer's stock market correction. Record economic stimulation by the world's central banks (except in the BRIC countries) using QE3, and historical low interest rates did not matter that much. Then this month, oil prices contracted again somewhat while the European debt crises has survived another fever attack; the economy is picking up its feet and stock markets are coming out of their latest correction.

It starts to look like our economic growth is no longer governed by central bank interest rates but more by commodity prices – in particular by oil prices but also by metals and, of course food prices. When speaking of food, in fact we're talking energy all over again. Oil production is peaking and soon, as Jeff Rubin has noted, demand will outstrip supplies. So, along with deleveraging, peak oil will set or cap the economic growth rate for some time to come. We may all dream of alternative forms of cheap energy but Japan's earthquake has reminded us that despite all its shortcomings, we are going to depend for a long time to come on those much hated fossil fuels. Environmental activists that now so vigorously oppose projects like the oil sands, Keystone and the new pipelines into BC are nothing more than the same reactionaries that fought the advance of the steam engine! In their hippie youth these activist groups earned kudos, but now rather than adding a constructive voice, their only goal seems to stop our evolution and trying to turn back our progress.

There is no doubt in my mind that working towards a sustainable economy where, just like boy scouts, we are 'wise in the use of our resources' is the way to go. We see numerous experiments aimed at achieving such goals, but stopping pipeline construction and oil sands projects while forgetting about the oil we're importing from Middle Eastern or African dictatorships makes not much sense. Yes, someone needs to ensure that our energy industries do the best they can regarding safety, environment and all stakeholders and in that today's environmental activists help us to stay on track. But their arguments are shrill, often sensationalized and hysterical. Their ideals and motives are as suspicious as those they accuse the industry and governments to have.

As investors should we expect a world of slower economic growth and does that mean lower profits? Are stock market returns diminished forever or will we return to the historical norm? Working towards a sustainable world with less material demands may result in higher efficiencies that offset the demands for resources. In the end, we will achieve even greater profits while working to a more sustainable world of robotic vacuum cleaners and clean transportation; a world of continuous sustainable improvement. When I look at today's advances in construction – the increasing number of LEED buildings - I think our economy and prosperity will continue to grow while we are adjusting to the new realities. The stock market will probably stick to its historic returns like it did over the last 200 years or even before we applied modern econometric tools consistently as we try do today. The more things change, the more they stay the same. We evolve; we learn and adjust to yet another 'new economy'.