Think back to your primary school science class. Clear your mind and try to remember. This might evoke images of planetary models, explanations of Newton's Laws of Motion and experiments with growing a little seed in a cup full of soil. While this is all great for opening the minds of young ones to the disciplines of science, you would have to be crazy to trust that this knowledge properly girds children for the realities of things such as industrial research and aerospace engineering. It should now be a sobering thought that this is how governments of the nations of the world approach economic policy, and that this has very serious implications for the safety of your portfolio.
Complex systems meet simplistic solutions
To kick off this discussion, let's answer this question: Why does an interest rate exist? Interest rate is the fulcrum that balances production choices, the market's proclivity for consumption versus future consumption, and prices investment weighed against other possible investments that might occur in the market. Some investments that are feasible in some markets - which are the same markets with low interest rates - are not feasible in other markets. If the interest rate is forced to 0 for a very long time, this fulcrum no longer does its job of balancing, and you will see many, many more bankruptcies. Using stock market equity as savings will lead to bad results by the same principles. Prices will go up, but bubbles and crashes will occur. Interest rates are an indicator of economic reality, and filter out investment and productive choices that are out of line with the present reality of the markets. This is what the interest rate should be.
Now let's take a look at the big picture of what, in our context, the interest rate is. In the eyes of policymakers and Federal Reserve chiefs, all of the nuances of the commercial activity of seven billion humans can be summed up in a few economics-sounding buzzwords that are learned in the freshman year of an economics program. "Aggregate" supply. "Aggregate" demand. Propensity to consume. To this simplistic end, interest rate can be used as a tool. Do the production and investment choices that businesses and people make matter? Of course not! Apparently all that matters is that people demand things in the aggregate in order to give producers a hobby to keep busy with. This cannot be restated enough: Keynesian doctrine does not discriminate between good and bad investment. So, when speaking of innovation, all of the "innovative" monetary policy that Ben Bernanke stands proudly behind really just boil down to intricate ways of creating money. The conscious efforts thus are directed towards creating bubbles to counter crashes. Take the early 2000s recession. What did Keynesian prophet Paul Krugman suggest in '02 to counter it?
"The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble." [Source]
There it is in black and white. We are led to think that the economy is nothing but an arms race of creating bubbles to replace bubbles. A house of cards. Already we have seen unprecedented bubbles in commodities and REITs. Both of these cases show the desperation of savers that have been priced out of the business of saving, and therefore seek to hedge against monetary policy by investing in the "sure things." Real estate and commodity investments are often looked to as a substitutes, but every asset takes the refugees of saving. This only makes asset bubbles more catastrophic, as financial fates are doomed with mispriced assets. In this game, it isn't market participant versus rival market participant, it is every market participant versus a government that is toying with forces that it cannot control.
This leaves us with four-year long policy of near zero interest rates with no end in sight. This is, by the way, unprecedented in our country. We have never had such a low interest rate for such a long time.
But if you really want precedent, look no further than Japan. They have had near zero interest rates for the better part of two decades, and have also been permanently stuck between recession and mediocre growth.
Japan had and has constant asset collapses. The fact is that the everyday reality of Japanese economic life is asset bubble followed by crash and liquidation. This is a vicious cycle caused by savers being priced out of saving by money creation and into buying assets to protect their money. This often leads to ruin, and for political expedience, an endless cycle of bailouts. Healing deflationary corrections to astronomically overstretched credit has been fought tooth and nail by the Japanese government and central bank for twenty years. A true recovery has never been allowed to occur.
For us Americans, the Fed's permanent open market operations have and will continue to create more bubbles through misallocation and malinvestment, whatever the flavor-of-the-month crusade may be. If you ask for answers, everyone in charge will bury their heads in the sand. By the Federal Reserve's own narrow metrics, there is no inflation to worry about. It is curious then, that the buried heads themselves implicitly tell us that inflation is inevitable; Ben Bernanke's stated view is that, since deflation is the real evil, central banks need to be biased against it and towards inflation in their policy. The bias of inflation is as real as ever and this money is being absorbed by assets. We have seen consistently inflating stock market and commodity figures to match this. If we consider that banks make "virtual" money in addition to their reserves and look at the true supply of money and money substitutes (TMS1 and TMS2 respectively), it is a startling picture.
What to look for
Vowing to defy the smothering hand of Keynesian monetary policy is the first and easiest step to win this game. Finding specific hedges is the key. What often happens is that as dis-economic policies accelerate, there is a shrinking pool of safe havens in the stock market as companies that would normally be "safe" absorb inflated credit, enter bubbles, fail to absorb inflated credit and finally crash, ruining the would-be savers. But there are ways to resist.
- Look for companies that have their absolute debt under control. Debt-to-equity ratio is less useful in our context, since a shrinking ratio could just indicate capital flight to equities and a bubble. Shrinking of both absolute debt and D/E is even better, since it indicates a discipline, contrarian strategy that may even lead to a decrease in earnings in the short term, as less prudent competitors can bid away scarce resources from them with free government money. In the end, the prudent company will have steady growth where the credit-junkies have bankruptcy and liquidation.
- Look for earnings that grow about as fast or as share price. In the case of REITs, we saw a spike in share prices across the board without symmetrical growth in earnings, and then a downward correction occurred.
- Look for a P/E below 25. This gives room for money that is seeking refuge from inflation to be absorbed and grow share price within reason.
Tread lightly on foreign soil
While the U.S. financial system is in a sorry state of affairs, foreign markets, particularly developing ones, have increased exposure to risk, and look to be following in the footsteps of the USA's bad behavior. Due to slowing growth, Chinese central banking authorities have dropped hints that interest rates will be lowered to "counter" this trend. This worry compounds the sober truth of endemic Chinese malinvestment. High debt exposure and constant pet projects encouraged by municipal authorities will only accelerate with a feverish global monetary policy.
I would advise against investments in Chinese financial institutions and raw material firms that rely on currency manipulation and foreign markets, and have been propped up due to the communist government's heavy industry emphasis. Energy companies are particularly reliant on exports, real estate and industrial demand, and should be approached with caution, in China or at home.
Other BRIC countries, presumably due to their continued brisk growth, have kept their interest rates at sane levels. This does not mean that they are the promised land for the sensible first world investor. India still has a serious inflationary problem despite interest rates above 7%, leading to scrambling over commodities. In any nation, refugee capital from developed nations can easily flow in and pump up sexy but questionable businesses, while more down-to-earth ventures are neglected. Regulatory, fiscal and corruption burden are higher than in the USA, all of which can lead to just as bad if not worse results than we see from our conundrum.
Ideas for the interest rate skeptic
Specific recommendations are much trickier. Any easy answer to hedging against asset bubbles can clearly lead to ruin, as we have with the "safe" assets of real estate and commodities. For those looking for safety and dividends, Johnson & Johnson (NYSE:JNJ) is a mega-cap producer of diversified consumer products, including packaged goods and pharmaceuticals. This is a rather recession-proof company, with its finger in many income-inelastic pies, with a flawless dividend history to back it up that only increased, even during the depths of the recession. This big-brand giant has a reasonable P/E of 20.50. Keep a close eye on JNJ's P/E staying down earth, as nobody is safe from being overvalued when savings refugees want a "sure thing". Additionally, earnings have grown with asset price, and debt has shrunk over the last year. All of this points to a sober and alert strategy that may not have glamorous short term results, but will succeed as a saver's savior.
I have recently fortified my portfolio with Shanda Games Limited (NASDAQ:GAME), and I implore the more risk tolerant among us to consider this buy. Agile and relevant, it is the polar opposite of a video game publisher that I have covered in-depth that is a good idea to sell. Shanda Games, on the other hand, is a clear buy. In the macro sense, the video game industry is tolerant of economic downturns; even during the recession, total sales only accelerated. Shanda Games in particular is in this position because a majority of its games offer a "free to play" model, a business model where the game is offered for free, but revenue is generated via in-game impulse buying cash shops. Much of GAME's revenue is from releasing and managing online games from the west for Asian markets, which is a low-risk strategy that leads to reliable revenue.
Looking past the safe and not very exciting side of the business, Shanda is a key player in the mobile games market. This new video game market is exploding, accounting for larger and larger chunks of video game sales, and specifically China's consumer market for mobiles devices and games is even more of a growth prospect. On Thursday, July 18th, Shanda's mobile game Million Arthur sat among top three grossing apps on Apple's mobile store in China within eight hours of its release. This led to a sharp upward correction, but the rise is far from over. In addition, Shanda has a relatively low and increasingly falling debt-to-equity ratio, and its P/E is 8.19 due to a share price discounted for fears about the macro condition in China and cooling earnings. This is a growth player for a value price, though it understandably does not pay dividends regularly.
In some consolation to the dear reader, slowly but surely Keynesians have retreated from their own doctrine as it has both failed to stand up logically within economics and has failed empirically - constantly leading to an endless cycle of asset bubbles, bankruptcies, liquidations and economies guttering. The cycle comes full circle when policy makers can use the weakened economy as rationale to make the same exact mistakes. On some level, the Keynesian economists recognize all of this, though they wouldn't admit it. And so we have neo-Keynesians, and then the post-Keynesians, and then the New Keynesians. These are all distinct schools of economic thought (I wish I were kidding, check the Wikipedia links) that each show the evolutionarily steps of slowly conceding Keynesianism's main arguments, where now even the Keynesians themselves don't believe in Keynesianism. This does not seem to be an obstacle to hell-bent policymakers still using abandoned ideas for a politically expedient "look, we're doing things to solve the problem!" proclamation. It is up to us, the voters, to make their policy behavior honest or make their policy behavior historical.
Disclosure: I am long GAME. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.