Big Risks, Big Opportunities

The future is always unclear, and therein lies the chief source of risk in the investment challenge. The degree of risk isn't continuously steady. It ebbs and flows, like market prices and the careers of Hollywood actors.

The fact that risk levels are dynamic suggests a connection. But our ability to model the connection and draw lessons is limited. In fact, at some points the relationship between risk and expected return is especially foggy.

This is one of those times, a state of affairs that creates unusually large opportunities and equally above-average risk. As such, all the usual caveats, and then some apply. Yet recognizing this condition is the first step toward exploiting the opportunity and/or defending oneself against the higher risk.

Macroeconomically speaking, a major risk overhanging the capital and commodity markets relates to the question of deflation and inflation. That is, which one will prevail? Moreover, will one dominate only to give way to the other? And if so, what will the timing be? Being on the wrong side of this uncertainty will be painful, perhaps financially fatal, and so it's the rare investor who can afford to make an all-or-nothing bet. Regardless of your view, a bit of hedging never looked better —just in case.

Certainly there are strong arguments for each possibility, including deflation first, then inflation, which happens to be my bias. But others argue that deflation will linger for a lengthy stretch and so the practical risks of inflation are virtually nil for the foreseeable future. Still others forecast that inflation remains the imminent risk, even if it's not obvious in current data. The chief evidence for this outlook comes from the massive surge in the Federal Reserve's balance sheet, i.e., the printing of money on a scale rarely seen in order to combat the current economic slowdown/contraction.

The fact that intelligent analysts and economists can debate the future on such starkly different terms only highlights the higher levels of risk of late. That's in sharp contrast to debates of the recent past, when dismal scientists were arguing if the economy was set to grow by 2.0% vs. 2.3%.

A telling example comes in the current issue of Barron's and its roundtable discussion. Consider this exchange between Fred Hickey (High-Tech Strategist); Mario Gabelli (Gamco Investors); Marc Faber (Marc Faber Ltd.); Oscar Schafer (O.S.S. Capital Management); and Bill Gross (Pimco):

Hickey: It's hard to predict the market when you don't know what the Fed will do. The Fed has tripled the size of its balance sheet and is plowing ground we have never seen before. Here are my facsimiles of deutsche marks from Weimar Germany [holds up sheaf of papers]. They collapsed in value when Germany started printing money after World War I. It happened very quickly and it can happen again.

The Germans were successful at reflating. But they weren't successful in saving their economy. [Federal Reserve Chairman Ben] Bernanke is on record saying, "I will not make the mistakes of the 1930s. I will not make the mistakes of Japan in the 1990s." He is pushing the limit right now.

Gabelli: So you're saying he's going to make the mistake of the Weimar Republic?

Hickey: There is a possibility of that. Every month that there is a horrible employment report the government prints more money.

Gabelli: It took Weimar Germany a brief time.

Faber: The worse the economy, the more they will print. It is like in Zimbabwe now, and Latin America in the 1980s. They had large deficits and printed money, and in local currency everything went up. But the currency collapsed.

Schafer: Isn't the federal government increasing its balance sheet to offset the private sector?

Gross: Exactly. The situation isn't similar. The Weimar Republic basically reflated to get out from under its wartime debts. Zimbabwe is a situation unto itself. In the U.S. there has been asset destruction in the trillions of dollars that has to be repaired. To say the Fed's balance sheet has expanded by a few trillion dollars and that this will create hyperinflation is a miscalculation.

Faber: I'm prepared to bet Bill that in 10 years the U.S. has very high inflation. With growing fiscal deficits that may reach as high as $2 trillion next year, it will be hard for the Fed to lift interest rates in real terms. Once they push up rates again, there will be another disaster.

Gross: Marc, you're smarter than that. You know that credit creation is at the heart of economic growth, and to the extent that credit creation has been thwarted, stultified, basically cut by 10% or 20%, economies can't grow.

Faber: The U.S. economy is credit-addicted. In a sound economy, debt growth doesn't exceed nominal GDP growth. Would you agree with that, or do you think debt should always grow at a faster pace than nominal GDP?

Gross: I'm with you there.

Faber: We come at this from different perspectives. You run a company that manages money, and I'm an outside observer of the U.S. financial scene, though I have to admit I bought some U.S. stocks for the first time in 30 years.

The fact that smart people can see such wildly divergent possibilities on inflation and deflation reminds that the potential for instability is alive and kicking. As Abby Joseph Cohen, senior investment strategist at Goldman Sachs, explained in the roundtable talk, "It is important to recognize that we are not starting from a point of equilibrium, where the economy and the credit markets are working properly. Instead, the Federal Reserve is acting aggressively to provide liquidity not just to the U.S. economy but the global economy." She added: "In many ways, the Fed is acting as the central bank to the global economy."

It doesn't take a genius to recognize that the Fed's not designed for such a broad increase in its mandate. Yes, to a certain extent the U.S. central bank has, for some time, been dispensing monetary medicine for the globe. That's one thing, when the global economy was humming along nicely; it's something else in a time of severe asset deflation and recession, the likes of which we haven't seen in decades.

So, yes, there are huge opportunities in the current climate, but those are tempered with huge risks. As such, a prudent risk management strategy is essential. For strategic-minded investors, that begins with taking advantage of sharp discounts on price at those times when available. In fact, the discounts were unusually large about a month ago. Prices have since popped. Did you take advantage of the pessimism? Or are you inclined to jump on the bandwagon now?

The macroeconomic risks are unusually large these days, but the biggest threat to investment success remains a familiar monster that dwells inside each of us: emotion that favors running with the crowd for, say, asset allocation decisions. Taming that beast is still the greatest challenge.

Comments

[MarvinMBA:]

Just look at what is happening with the money expansion and that has to tell you everything you need to know. This data is already here if you look at the Money aggrigates...look look look its all out there. M1, M2, M3 are all predicting inflation based on my analysis. Those Barron experts that claim they know nothing must have their head buried in the sand...the printing presses have been running for a long time already and where have they been???? And the Obama Administration promises more of the same. At some point the interest rates are going to take a big jump and if you believe like I do it will be a MONSTER JUMP.
The Treasuries are just another BUBBLE and those that buy into the Fed game are going to lose there ass. There is no such thing as a Free Lunch and that applies to the Federal Government also. Look for another financial bubble. My sage advice...KEEP YOUR MONEY SHORT TERM BECAUSE THERE WILL BE MORE OPPORTUNITIES TO GET SOME RETURN INSTEAD OF THIS OTHER BUBBLE THAT HAS BEEN FOISED ON US FOR OUR OWN GOOD(??????) MarvinMBA

Jan 12 02:22 PM

[Jared Schne...:]

The economy still has quite a lot of bad news to digest before it begins to turn around.

I do believe, however, that some of the greatest opportunities will come out of this recession. Also, the commodities market will boom even bigger than it did in the past couple years when emerging markets begin to make a come back. This coming wave of a commodities bull market will probably be the biggest we've ever seen. We will most likely have to wait 4 or 5 years for the situation to set up though.

Jan 12 02:32 PM

[Dave Wrixon:]

The problem is that everyone is fleeing to quality without having a clue what they mean. The fear factor is actually driving people to create the final bubbles of this unholy mess. Many of those seeking to salvage what they still have risk losing everything.

What a shrewd investor needs to be able to do is to see where all this is leading. All that is happening is that a huge global realignment that would have happened over a few decades is now going to occur in the most chaotic manner over a couple of years. The BRIC countries will emerge much stronger and richer, and the US in particular and parts of Europe will emerge weaker and poorer. Once you understand that much, it becomes obvious that selling up assets in China, Russia, India, East Europe and elsewhere to repatriate the money to invest in T Bonds is pure madness.

Jan 12 02:35 PM

[conciously_...:]

I think people are not fully grasping the concept of inflation here. The point Bill Gross is making is that the money printing going on today is just replacing the money being lost. That does not spur inflation. On the other hand, it does lead to the potential devaluation of our dollar, which would lead to higher prices of any imports, which would cause inflation. Inflation is usually a supply demand game, and right now there is no demand and enough supply.

As far as the quest to time it, I dont think we need to know exactly when deflation stops and inflation reignites, which is inevitable, unless you think the world is coming to an end. It is more important to just watch the expectations. This can be measured to some degree in commodity prices, but more so in TIPS versus their Treasury counterpart. Right now, there are 5 year TIPS yielding less than a 5yr Treasury, implying negative inflation for 5 years. The only thing to own during inflation is cash/equivalents, so if you think that we will have deflation for 5 years, then sit on your hands.

If you think, on the other hand, that the markets will be back to operation in five years, than buy the TIPS. I dont think this is a "fatal" move, as the author suggests. TIPS are issued from the government, so there is limited default risk(once again, we go back to the world ending).

Jan 12 03:30 PM

[BK GUY:]

"At some point the interest rates are going to take a big jump and if you believe like I do it will be a MONSTER JUMP." Not necessarily, the Fed can print money to buy treasuries to keep yields (rates) artificially low.

As for inflation/deflation, I am firmly in the deflation camp (for now). There is no velocity of money. No matter how much the Fed prints, it just sits there in the bank -- having no inflationary impact. Someday it may start to flow. Wherever it flows, there will be increased demand and so rising prices. If it flows to American consumers, you may have hyperinflation. If it is expatriated, some other country may have hyperinflation. If it all flows to oil, the Great Depression will look like a picnic.

Agree that dollar is being devalued. This is the explicit goal of the Fed (whether it is wise or not is another question).

Jan 12 04:10 PM

[PastTense:]

Could we have some comments on specifically what the big opportunities are?

Jan 12 10:17 PM

[Steven Hansen:]

a few commenters hit the nail on the head on the issue of inflation - it depends what you want to call inflation.

no one is saying we are in the grips of inflation today.

everyone is saying it is a concern for tomorrow. the argument comes from the way you think it will manifest itself. right now every currency is in trouble - and most are worse off than america. so most of the bailout to date in america is being done else where also. so everyone is debasing their currencies so i doubt you will see any effect.

most of the massive expansion of liquidity today is backed. when the fed starts buying t-bills because no one else is buying is the trigger point for future inflation for me.

good article and good comments.

Jan 13 01:00 AM

[ozcutty2:]

I think the US dollar is weak, but so is every other economy, most have even bigger problems than the US so US dollar will remain a safe haven.

If inflation trends up, US will raise rates which would actually strengthen dollar, at least short term.

Historically if US is in recession, emerging market always suffers the most. The US consumer stops buying but can still feed their family. I always think of the emerging markets as leverage to US growth, i.e. Dow goes up 20%, China goes up 40, and the reverse is true in a downturn.

Jan 15 08:35 PM