Eliminating Asset Class Choices: Understanding the Big Picture

Getting the big picture correct is by far the most important thing in investing. The second most important thing is timing. If you get the first right, but not the second, your performance can still be good. If you get both right, you can have an outsized performance. But if you don’t get the big picture correct, and invest in the wrong asset class, good timing cannot help you much.

In that case, good timing can only happen for nimble traders. The probability of you getting it right is usually small. And the probability for profitability is even smaller because the market on the whole is losing money.

Investing can be like answering an SAT/GRE question. You can arrive the answer not just by knowing the right answer, but also by eliminating the wrong answers. The more choices that you can eliminate, the higher chance that you can get it correct.

So here are THE multiple choices for everyone. Which of the following asset class should you invest in:

1. Stocks
2. Real estate
3. (longer term) Bonds
4. Commodity (and related stocks)
5. (short term) Cash
6. Gold/silver (and related stocks)

To get to the right answers, one must look at history and understand what has transpired. High-tech stock bubble blew up in 2000. Based on human history, no financial bubble can go back to its height and/or back in fanfare for about 20 years, or basically an entire generation. It takes time to forget about all the stupidity and greed. Until all the stupidity is worn out, the same asset class simply cannot be back in vogue.

The general stock markets established a big double top in 2000 and 2007; the former helped by the high-tech bubble, and the later helped by financial/real estate stocks. The US stock market has been in a strong bull market since 1980, for 20+ years. What is the chance of a continual annual 10+% return?

These are all the questions that one must ask before putting more money into the general stock market. Portfolio allocation is about weighing percentage of your money in proportion to your projected future probabilities of return.

My own answer to those questions is obviously that investing in the general stock market such as S&P 500 is not going to be the best place to be.

The second choice of real estate is much easier. It is a big NO. The bubble has just burst in 2007. If history is of any guide, your inflation-adjusted annualized return for most real estate investment will be negative for the next 20 years (if you count from year 2007). Yes, I do mean negative.

And I also don’t believe that a super slow-moving market can reach a bottom in two years. Gosh, it even took two to three years for the fast-moving stock market to reach a bottom in 2002/2003 from 2000. Anybody out there telling you that the housing market bottom is in is lying. Real estate markets move in a much slower pace compared to other markets. I will never listen to any words spoken by any people who cannot (a) realize that housing market was in a bubble, or (b) understand that the housing bubble cannot make a bottom in two years.

And if you want to believe those lies, sorry, your greed has covered your eyes from seeing the truth. Want to flip another property for $100K? Be my guest. There is actually quite a real estate investing revival crowd in 2009, as far as I can tell. And they will probably be the dumbest crowd ever. It’s dumb enough to chase the housing market. Now, it’s even dumber to catch the falling knife just after two years of bubble bursting.

The third choice of bonds is a little difficult, especially after you’ve partially eliminated the first two. But history can help us out here a little. Note that long term bond yields (or 30 years treasury) have been falling since year 1981/1982 in the above chart.

Falling bond yields mean that bond prices are going up. So from 1982 to 2009, that is also a very very long 27 years of bull market.

Again, the question that should be asked is that what is the chance of bond prices to continue going up after 27 years? Of course, the factor in favoring bonds is that bonds are an interest-yielding instrument. So besides the raw prices that go up and down, you get partially covered by the paid interests. My own forecast for bonds is that they will probably drop a lot for the next two years. After that, they may go up for some three to five years.

But beyond that timeframe, I believe that inflation will be with us for a long time. Because it is hard to time the market, I choose to stay out of long term bonds too, especially since I believe the magnitude of fall will be much bigger than the interest yields that you can get. Just this year since January, long term bonds have fallen by 25%, giving back all the gains made from the anomaly rising of last year (caused by front-running the Fed’s purchase of long term bonds).

The market strain is quite evident in this usually stable bond market. If bonds can go up and down by 25% in 5 to 6 months, you know stock markets can double that volatility easily.

The fourth choice of commodity was one of the favorite choice, and is the most favorite choice among inflationists. There are people who group the last choice of gold together with commodies, and I was one of them also.

But after the 2008 stock market crash, I realized an important distinction: gold is money, and almost as good as cash (if not better), but commodity is NOT. In fact, gold does quite well during liquidity crisis and deflation, but commodity will do very poorly in a deflationary environment. If one chooses to invest in commodity, then one must believe in mild to high inflation. Inflation can be caused by two things: (a) currency drop or loss of purchasing power in one’s domestic currency, and (b) excessive demand of goods versus available supply.

While I believe in the long term story of a commodity bull market, and a continual and possibly sudden loss of purchasing power of US dollar, for the time being, based on the current economic reporting, I see an immediate deflation. That is, I simply don’t see (b) (excessive demand of goods versus available supply) happening.

Given all the (leveraged) debt defaults happening, they are destruction of money. Yes, I reckon that Fed has printed some 1.2 trillion dollar worth of money. But those money are simply sitting in the accounting books of the insolvent banks. Those cash are NOT lent into the economy at all. It’s just good for nothing. It is extremely difficult to time when those cash will get lent and circulated in the economy. But at this very moment, the overall climate appears to be very deflationary.

In fact, a short term (two to three years) deflation will create even more supply destruction, which will boost the long term commodity prices a lot once the current deflation is over. For now, I remain short-term (two to three years) bearish in commodity, but long-term (very) bullish in commodities.

The fifth choice, cash, is usually not on anybody’s radar. But one must always remember that cash is also a position that one can take. I also want to say that I prefer to stay in senior currencies: yen and US dollar, because senior currencies tend to rise in a liquidity crisis. My belief is that the worst of the financial crisis is still ahead of us, not behind, and therefore, I want to stay in senior currencies, instead of those commodity currencies (Australian, New Zealand and Canadian dollars). The euro economy can easily be worse than US, due to lack of economic policy coordination among euro economy. Therefore, I don’t want to take part in euros either. In a deflationary period, cash is a very good choice.

At last, we have gold and silver. Gold is more like cash/money, while silver can behave more closer to commodity. In a deflationary period, you want to put your money in gold rather than silver because of those characteristics. In a deflationary period, gold/silver ratio tends to go up, as demonstrated in the last liquidity crisis (see the chart below).

Although silver may eventually track the upward movement in gold at a later stage, you don’t want to be in too early, especially since the volatility and the potential loss/gain of silver is much higher. My advice is not to get too greedy. Anyway, gold made its last bubble high in 1980, and has fallen until 1999/2001 with a double bottom. It has risen by about 3X to 4X from the low of about $250.

Again, we should ask ourselves, what is the chance of gold continuing to rise after eight years into bull market? Are we still in the bull market? Or is the top of $1000 behind us? Technically speaking, gold, as one of the best performing asset class coming out of 2008, is obviously still going strong. The top of $850 in 2006 was certainly a little parabolic and bubble-like, but the last top of $1033.90 made in 2008 was more of a steadily climb-up.

In all fairness, given a very low participation rate from public, the bubble top in gold cannot possibly be in yet. The bubble top of any financial assets is always marked by public participation in a dramatic way (such as the recent housing bubble, and high-tech bubble). Therefore, gold is probably not the investment choice to be eliminated.

Going through all six investment choices, for the longer term (4+ years), I believe that we can probably cross out choices #1,#2,#3,#5, which are stocks, real estates, bonds, and cash. That doesn’t leave much choices left at all.

If my reasoning is correct, it will be quite obvious that most people who invest in the traditional investment of stocks, real estates, and bonds will not gain much at all. What kind of scenarios can result in such turnout? It is long term INFLATION, resulting losses of purchasing power for the majority of people. In other words, our living standards in the US as a whole will go down. Coupling with a long term fall in US dollar, this would fit “very nicely”.

For the shorter term however, I believe both cash and gold are probably better choices because of the unfolding deflation. At some point, one must make the switch back to inflationary investing due to all the supply destruction. However, I think we are still at least one to two years away from that.

Comments

[texpat:]

This is a good article from the big picture standpoint, but don't dismiss any asset class entirely. It's a market of stocks, not a stock market, so there are undoubtedly some good individual stocks (in sectors like, say, precious metal mining, energy, technology, or agriculture). For real estate, property in an area that has already seen a big correction might be a good investment. Finally, volatility is still high and asset deflation is still ongoing, so holding a sizeable cash position while looking for opportunities and signs of inflation would be a good idea.

Jun 23 09:02 AM

[James Wood:]

The article is well done in terms of listing options for asset classes. However, the author seems to consider only long positions. If the author would consider both long and short positions, he might find himself coming to different conclusions.

Jun 23 03:43 PM

[Loucleve:]

no doubt the problems in commercial real estate will continue. but rothschild said to buy when there is blood in the street, and IYR/JXI have been killed. at a 7% div yld - even with cuts - I think buying real estate at 50% off not a bad proposition. after all, they are not making it anymore.

Jun 23 07:57 PM