March 2009 Investing Outlook: Keep Your Powder Dry

Includes: GLD, IYR
by: Steven Hansen

I have just returned from an investment conference in Singapore on indexing and ETF’s. There were representatives of all the major ETFs from America and Europe, and investment managers from across Asia.

Networking, we reviewed the financial and investing climate all over Asia, and compared it to USA and Europe. At this point Asia appears to be in significantly better shape than the rest of the world arguably due to the 1997/1998 Asian Financial Crisis which deflated the real estate bubbles, and forced a more conservative government spending regime on the countries in the region.

The interesting difference between Asian and USA/European investors is their intolerance to loss. Wealth managers realize this and position their clients into conservative vehicles. One manager told me that the clients would leave him if he lost them money. There is a reluctance to purchase any ETN, or any ETF which is derivative based. There is a fear the issuer will go bankrupt – and the clients will be left with a 100% loss. Wealth managers are sticking with transparent ETFs where the underlying assets (stocks) are directly purchased.

The Asia region is hunkering down, and is not visualizing any recovery for a couple of years. The preferred investments appear to be bonds or bond ETF. Capital preservation is more important than making money in these uncertain times.

Back to America … the same investing philosophy should be adopted.

Overall Strategy

My investment strategy remains asset conservation. This is far more important than trying to make money. I am not long anything, but I do admit taking a shot here and there to pick up a few coins trading. I watch my money as I am retired. But I also was retired during the 2001 bubble burst and I realize that you do not have to try to make money all the time – I went cash flow negative for almost two years and was easily able to recoup. You will have an opportunity to recover lost ground whenever the economic winds are in your favor.

We are in the deeply destructive phase of this recession. Now the initial causes of this Great Recession are just footnotes as the symptoms (unemployment, industrial production, buyers hunkering down) now have become the drivers.

This economic collapse will not continue indefinitely. Many pundits talk about the reinforcing aspects of the collapse (sometimes referred to as a downward spiral) without taking into consideration that the hunkered down populace still consumes. To understand this dynamic, India is an extreme example. So much of India lives at subsistence levels it becomes very difficult to have an economic contraction with a rapidly expanding population – cutting back equates to starvation. There is a maximum level of contraction in America – and my guess is around 10% based on the firewalls built by the Fed and Treasury. However, my forecast remains a 5% economic contraction.

The danger now is the erosion of the economic underpinnings. Additional weaknesses in the US or world economy could cause a secondary economic collapse. Some of the more obvious weaknesses are instability based on deteriorating employment, debt in the frontier and emerging markets, or a major European bank failure. It is this second economic cascade potential is why I believe the markets are not investable – and why you need to be very conservative with your money until the financial system stabilizes.

Keep your powder dry and accumulate cash. Play close attention to what is happening economically. In the short haul the dollar is king, but in the long haul?

Investing Logic

Because of the instability, my position is that markets are not investable. If you have play money, gold or equities trading are my better bets for a quick buck. Treasuries or MMF are conservative investments, are relatively safe, but not giving much return. You should not be long anything as an unforeseeable event in these very unstable times can occur which will change the dynamics.

Inflation – We are entering the period of stagflation. This is when non-liquid assets (such as real estate) keep devaluing, while the prices of consumables rise. Consumables are going through supply destruction. This happens when the market prices fall below the minimum price that the item can be produced – the supplier shuts down or goes bankrupt. For the next six months I believe the non-liquid asset depreciation will exceed the consumable price rise. Therefore, you should not need to guard your investments (or cash) for inflation. The long range economic indicators do not forecast inflation during the next six months.

Equities – The markets are overpriced using future earnings indicators. Corporations will be restructuring to position themselves for a new normal – this will eat profits. Long term profit outlook is not good (this is a generalization – exceptions only prove the rule). I am out of the market except for trading (on occasion). The market does not seem to have priced in the very poor economic conditions we are now facing or will be seeing in the next six months.

Residential Real Estate - I see no signs the real estate market is leveling out. Some pundits point out that the backlog of houses listed for sale has dropped from a peak of 11.3 months supply in April 2008 to 9.6 months supply in January 2009. Unfortunately the volume of home sales continues to fall while the backlog falls. Common sense tells you that sellers have just given up trying to sell. To put the situation in perspective, housing prices have fallen from their 2006 peak approximately 23%, while sales volumes have declined 31% according to NAR data. Approximately 45% of all sales today are foreclosure related. There are way too few buyers at the current price level. The market is stagnant and needs to correct to a level buyers will enter. A large enough demand does not exist at the current price level.

On the above graph, you can see that quantities of houses sold during 2008 has remained stable until 4Q 2008 where they began declining again. The housing values have been declining at a fairly stable rate since mid 2008. The S&P/Case-Shiller data below shows the same housing price phenomenon using a different set of data.

This home price index produced by ECRI shows how home values performed during past cyclical downturns in real home prices. Although this index has only been updated through Nov 2008, it is easy to visualize that the home value destruction exceeds any modern day recession. Home price declines are already approaching those in the Great Depression, when they plunged 30% during the 1930s. Food for thought – according to Professor Shiller house prices in 1990 when adjusted for inflation were the same as in 1890.

Mortgage interest rates increased slightly last week to 5.07% for a 30 year fixed rate mortgage. 70% of all mortgage applications are for refinance.

Gold and Precious Metals – The price of gold and silver is trending up. My good friend Sanjiv Shah, Executive Director of Benchmark Asset Management (Mumbai, India) and I had a long discussion this past week on gold and silver pricing. India is the number one consumer of gold. The common man saves his money buying gold weekly and monthly. The gold merchants are the common man’s banker. Both of us see both upward and downward pressures on gold. We both see that gold speculators are driving prices upward and therefore reducing the gold investors demand. We both see larger and larger swings in the price of gold. Think of the effects on pricing if people start selling gold to eat. Under these conditions, gold is not stable. But I will admit my prejudice here as I am an investor in physical gold, and I believe the speculators are causing price instability. If I were to speculate on gold, it would be in the ETF GLD as it is an asset backed ETF.

Commercial Real Estate – The price collapse of this market is just beginning. From retail to commercial to industrial businesses, bankruptcies and shuttering will continue to grow at an ever increasing rate. The property markets are being hit with rapidly increasing vacancies. Property revenues are falling. Revenues are the basis for determining property value. The industry saw this happening as you look to the American Institute of Architects Index graph below which gauges planning for new properties.

As commercial real estate must be refinanced every 5 to 10 years, expect a rise in bankruptcy and significant falls in property values similar to residential real estate. Historically, commercial real estate follows residential real estate by two years. However, Commercial real estate prices in the U.S. dropped by almost 15 percent in 2008, more than home prices, with fourth-quarter depreciation the greatest in the national apartment market. The price decline eliminated the gains seen in 2006 and 2007 and returned values to 2005 levels

Cash – Cash is your friend today. We are in a low inflationary period, and it positions you to be able to take advantage when the time is right. The problem remains that you cannot get a return on cash right now with low interest rates. The returns on CDs or Money Market Funds are around 3% and under but as the financial dynamics keeps changing you need to limit your terms to 6 months or under. The lowest risk option is the normal interest bearing bank account which is paying literally nothing. You should validate that your bank or financial institution is sound (once every 30 days is good). Spreading your money between several institutions is prudent.

Commodities – The current low commodity prices are triggering a commodity crunch as supply evaporates due to production shutdowns caused from negative returns for producers. Short term fundamentals remain mixed to negative.

Currencies – The short term fundamental is for the dollar to be strong as deleveraging is still occurring. The yen is forecast to fall against the dollar. The euro is forecast to remain stable against the dollar. The British government’s policy is to devalue its currency. Let us call this period in currency stability the calm before the storm.

Bonds – Bonds should outperform equities in 2009. This is a signal of an upside down market as the less risky bond is thought to be able to outperform more risky equities. The risk of higher interest rates destroying a bond's value is not a problem short term. But there is a chance of bankruptcies (for non-Treasury bonds) destroying your invested capital. 2009 will be a record year for bankruptcies, which will affect the bond market. If I decided to buy into this asset class, I would do it inside of an ETF where you can exit quickly if necessary. Remember that bonds value varies and it is fairly easy to go negative in these uncertain times. I would use to screen my funds. I suggest you only select transparent ETF which directly purchase the underlying asset.

Debt – There are few ways to make money in 2009. For those who accumulate cash, you could consider paying off your mortgage or any other loans outstanding. The downside of doing this: 1) the government may come up with another bizarre scheme to help you pay down your mortgage; 2) the government may come up with another bizarre scheme to reduce your mortgage interest rate to almost zero; or 3) you lose the use of the money to be able to pounce on a great deal as it passes you by. In any event, you should take advantage of the low cost mortgage rates today and refinance your mortgage.

Disclosures: Sold one real estate property in Feb 2009 at approximately 65% of its peak value in 2006. I have one other for sale. Renters are scarce. Cash in MMF, physical gold and April Call on GFI.