9 Critical Questions Investors Must Consider

Includes: BAC, JPM, WFC, XOM
by: The ETF Authority

This article was inspired by an article from Jeff Clark, Editor of BIG GOLD under the Casey Research umbrella. Casey Research is a firm that focuses on natural resource investing in the context of broad market trends. While the title of his publication should give away Jeff’s perspective on the world, he eloquently framed the fundamental questions he feels "smart money" investors should be asking themselves today and below please find some perspective on each in a Q&A format.

Q: Is real inflation likely to rise or fall over the next few years?

A: It depends how you define inflation. If you characterize inflation by wage increases creating the effect of "too many dollars chasing too few goods," then the acceleration of inflation in the years ahead is unlikely. With the March U-6 unemployment rate at 15.7% according to the BLS (includes discouraged workers and involuntary part-time workers), there is little reason to expect upward pressure on wages in the U.S. Similarly, if you measure inflation using the government’s core-CPI figure, which heavily weights housing related expenses (~40%) while excluding food and energy due to price volatility, you will also find subdued levels of inflation. If however, you observe prices at the pump, prices at the grocery store, or most importantly the supply of money, then inflation is already here and threatening our standard of living. Below is an updated chart of the Adjusted Monetary Base courtesy of the St. Louis Federal Reserve. However vast, there is only so much "stuff" money can buy, and when the supply of money increases dramatically relative to the supply of "stuff," it takes more money to buy the same amount of "stuff" as time goes on. This monetary inflation is a real danger to all of us in light of the government’s unprecedented stimulus measures.

Graph: St. Louis Adjusted Monetary Base
(Click to enlarge)

Q: Is it more probable that interest rates will remain depressed or move higher?

A: This is the question keeping U.S. government bondholders as well as officials at the Federal Reserve and Treasury Department awake at night. The total public debt outstanding as measured by the Treasury is in excess of $14.3T. This debt is owed to the central banks of foreign countries, large financial institutions, private individuals, and last but certainly not least the Federal Reserve. As is true of any borrower, the government is expected to pay interest commensurate with the risks assumed by holders of its debt in the form of bills (short-term), notes (intermediate-term), and bonds (long-term). Specifically, this interest rate serves to compensate bondholders (lenders) for things like credit or default risk and inflation risk to name a few. The bigger the threat posed by these risks, the higher the interest rate prospective bondholders command. Accordingly, one can imagine the damage done by rising interest rates when the principal balance owed measures in the tens of trillions of dollars. J. Kyle Bass of Hayman Capital estimates that each 1% increase in the the U.S. government’s weighted average cost of capital signifies an additional interest expense of $142B to the U.S. government, and by extension the American taxpayer. Therefore, we can expect the Federal Reserve to do everything it its power to keep rates subdued. As the Fed’s influence on capital markets is significant, expect the Fed to succeed for awhile, but the very long-term trend in interest rates is undeniably upward.

Q: Is the U.S. dollar likely to be stronger or weaker in the next few years?

A: When referencing the chart from the St. Louis Fed above, the obvious answer appears to be that the dollar will be weaker. The relationship between supply and demand determines price, and supply is clearly outstripping demand. However, relative to what exactly will the dollar be stronger or weaker? Relative to "stuff" or hard assets like commodities, the dollar appears to be losing purchasing power. However, relative to other currencies like the euro, yen, or swiss franc the answer is less obvious. If the "stuff" theory above holds true, expect the dollar to weaken against currencies of commodity based countries like Canada and Australia while competing for the "worst of the worst" amongst nations like Japan and the PIIGS, which find themselves in similarly dire straits.

Q: What is the best way to hedge against egregious debt and runaway government spending?

A: The simple answer is to own "stuff," or assets with tangible value, proven to withstand the ravages of inflation over time. Gold and silver, discussed in detail below, are popular methods to protect savings from currency debasement. Some sectors of the stock market also tend to perform better than bonds and cash deposits during periods of inflation, though that is not to say that stocks will broadly perform well by any stretch of the imagination, particularly in real or inflation-adjusted terms. Specifically, stocks whose top lines are driven by commodity prices like energy companies hold up relatively well. Companies able to pass through rising input costs to their customers also experience relative success.

Q: Which assets are most likely to make money over the next few years? Which should be avoided?

A: Let’s start with the easy question; which should be avoided? We have long derided financial stocks, specifically those of the "money center banks" like Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM), and Wells Fargo (NYSE:WFC). With the Financial Accounting Standards Board’s implementation of FAS 157 in the midst of the credit crisis in 2008, and subsequent re-interpretations or the rule, large banks were able to reassign toxic assets from "trading" to "held-to-maturity." This shift allowed banks to carry impaired assets at face value rather market value (mark-to-market). Fast forward to 2011, this re-characterization is still yet to be unwound, and substantial losses remain unrealized on the balance sheets of America’s largest banks. Understanding these latent risks, and struggling with what remains a weak lending environment, these banks will either choose to slowly shrink their balance sheets or again embark in reckless risk-taking. Both outcomes are negative for investors and we prefer to avoid the sector completely.

Now for the hard the question; which assets are most likely to make money over the next few years? To keep it short, we believe a diversified portfolio with exposure to commodities and other "stuff" will protect your investments from an inflationary outcome. Conversely, maintaining diversified exposure to cash and very short-term bonds as well as non-cyclical stocks like utilities will help your portfolio weather another deflationary storm. In other words, do not bet the farm on either deflation or inflation, and have pools of assets positioned for either outcome.

Q: Is it time to invest in real estate again, or will it take the rest of my life to see big profits?

A: Without question the housing market remains extremely fragile. Persistently high levels of bankruptcy at the household level immediately reduce the number of eligible borrowers. The pool of potential home buyers is further restricted by a stringent lending environment, requiring 20% down payments from even the most credit worthy applicants. Based on these factors, we should expect continued weakness in the real estate market. There is however an outside chance that some strength may begin to appear in 2012 and 2013 based on the chart below which depicts monthly mortgage resets.

At the height of the credit bubble, many home buyers secured Adjustable Rate Mortgages which offered very low initial interest rates. These interest rates are locked in for 5-7 years, before adjusting based on the level of prevailing interest rates. As we later found out, many borrowers were not qualified to receive financing of any kind, while others anticipated selling their home well before the adjustment period. When the real estate market sank, fledgling home buyers were stuck with illiquid properties and in many cases a loss of employment income, diminishing their ability to pay. Due to the Fed’s efforts to maintain low interest rates, the glut of mortgage resets shown below has not been as painful an experience as many predicted. In fact there could even be a bit of recovery after these resets begin to clear the market. However, if the Fed is unable to keep rates subdued, then all bets are off, because the demand for housing is very much contingent on the rate at which financing is available.

Q: Will the global economy be on solid footing during the next few years?

A: The global economy will remain volatile in the years ahead; there is simply no way around it. Developed nations, which have been the primary drivers of economic growth for decades remain on the verge of a debt crisis. Reeling in spending and adjusting taxes to address growing deficits is deflationary and such measures run the risk of sinking the economy into a double-dip recession if not outright depression. Conversely, printing money in an attempt to devalue outstanding liabilities can test the faith of capital market participants and can serve to erode the standard of living of the lower and middle class. To expect economic volatility to subside or the "global economy to be on solid footing" is highly irrational at this point in time.

Q: Is oil – or something else – the best energy investment?

A: In the near-term, it appears oil and oil companies will remain sound investments due to their ability to adapt. While transportation remains almost entirely dependent on oil, and a feasible alternative appears many years away due in large part to the tremendous cost of such a transformation, expect emerging investment opportunities in green technology such as geothermal, solar, and wind energy. While a bit more controversial, natural gas is also drawing the attention of large integrated producers like Exxon Mobil (NYSE:XOM) as a cleaner burning fuel source. Nuclear power remains a strong growth prospect in emerging markets, though the tragedy in Japan has affected the U.S. appetite for growth in nuclear power usage. We are not energy experts nor will we pretend to be, but meaningful exposure to a broad range of energy investments in your portfolio is certainly warranted in the years ahead.

Q: Are gold and silver in a bubble, or will they push higher in the coming years?

A: The price of silver has declined precipitously over the past two days falling from just under $50/ounce to just over $40/ounce. While the bubble callers are out in full force, it is important to understand the reason for the decline. First, this market was long overdue for a correction induced by profit taking and short sellers after surging upward almost 70% year-to-date at the peak. This backing and filling price action is healthy in a bull market and serves to separate weak hands from their positions. Second, and not to be discounted, is the series of margin increases implemented on the commodities exchanges. These measures serve to discourage speculation, particularly amongst smaller investors, by requiring larger capital commitments to establish positions. The fundamental factors driving the silver market remain unchanged however. According to the Silver Institute, the industrial demand for the metal in 2010 amounted to 878M ounces of the 1.056B ounce supply available. This leaves just 178M ounces for investors, which even at the elevated price of $50/ounce represents just $8.9B, a drop in the global financial bucket.

The gold market also displayed weakness over the past several days though not nearly to the extent of the silver market. Gold is much more of a monetary metal as opposed to an industrial metal like silver. Investors concerned with the lack of fiscal responsibility in developed nations as well as explosive increases in money supply see gold as a safe haven. Further supporting gold prices are extremely low interest rates, which serve to eliminate the opportunity cost of holding a non-yielding asset. In other words, when dividend yields on stocks and coupons from bonds are relatively high, investors may be less enthusiastic to hold an asset like gold that produces no cash flow. However, to assert that gold is in a bubble is an exaggerated claim in our opinion. According to CPM Group’s Gold Yearbook 2010, global investments in gold amounted to $1.5T or just 0.70% of global financial assets. In 1980, the peak of the previous bull market, gold investment represented 2.80% of global financial assets. Therefore, we believe gold has not reached the over-loved, over-owned phase characteristic of asset bubbles.

In closing, both gold and silver are supported by accommodating monetary policy and continued fiscal irresponsibility. Silver, which is more sensitive to industrial demand and thus economic cycles, will exhibit greater price volatility than gold. It will take a collaborative effort between serious fiscal reform and a Federal Reserve determined to squash inflation to sink the metals. Accordingly, we continue to believe that both belong in your portfolio as insurance against currency debasement.

Disclosure: I am long CEF.