Is It Time for Capital Preservation Mode?

by: Mycroft Friedrich

The motto and strategy of my firm is “Capital Appreciation through Capital Preservation” and when implemented properly this strategy has shown to work very well. When I talk with potential clients, I always start off by telling them that the first thing I will do with their money is look at the world from a Capital Preservation point of view and only when I feel the environment is safe to invest their assets, do I then turn to the Capital Appreciation part of the equation.

I came up with this motto reading this quote:

“I am more concerned with the return of my money than the return on my money.” ~ Mark Twain

This quote ranks up there with this jewel:

Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

~ Sir John Templeton

Basically, the way I implement my motto is to look for catalysts that are either powerful events or powerful statements from master investors that I respect. In late 2008 I went to cash after hearing Warren Buffett speak these words:

When credit is as frozen as it has been and when banks are unwilling to lend to each other, and when 8 percent of deposits in American banks have had to be moved in the last couple of weeks to solvent institutions ... this is an economic Pearl Harbor.

~ Warren Buffett

So understanding the importance of Capital Preservation in one's portfolio is very important as anyone who moved to cash after reading the above statement would have saved themselves about 40% on the downside and put themselves in a position to benefit just six months later after the markets crashed and the “Point of Maximum Pessimism” became present. So since Capital Preservation looked secure it would have been prudent to switch over to a Capital Appreciation mode and go fully invested.

From March to November 2009, gains of anyone following this thought process would have been huge as the markets shot up 50%+. The negative catalysts, Bear Sterns, Lehman (OTC:LEHMQ), and Emerging Markets' Collapse etc. were over and the positive catalyst of government stimulus and record low price to free cash flow numbers became the new standard. With the lack of negative catalysts and a very weak dollar environment the stock market (with the exception of Gold) was the only place to be.

So that was then, but what about now?

I can tell you now that I have gone from a Capital Appreciation mode to a Capital Preservation mode again as this Dubai incident was a huge wake up call for me. Dubai was always thought to have an unsustainable expansion growth rate, but one figured with the U.A.E. having $700 Billion in reserves, that they could afford building such a showplace in the desert. When I saw indoor ski resorts and saw that they were building man made islands, I thought that these were crazy things, as I always thought that Las Vegas was a crazy place to invest. In the past I never gave Dubai much thought as it did not affect my clients as Dubai World was backed with mother U.A.E’s money.

The shock of last Wednesday’s news was a shocker and a serious negative catalyst, which has the potential to be a big problem down the road. But one problem does not make a bear market, but puts up a big red flag nevertheless. It’s not that Dubai World owes so much money that is the problem. The problem is that we just don’t know what’s on their books, similar to not knowing what was on the books of the banks in 2008. I found out Tuesday from reading this article.

That Dubai World is also heavily invested in many luxury hotels and are backed with debt from USA banks. This shows me that there is more to this than meets the eye.
So there is another negative catalyst.

On the home front a report Tuesday signaled that construction spending signaled growth and was the first increase in six months, largely due to strength in home building. The increase was just 0.04 percent and was mainly due to a rush by homebuilders to begin work before the expiration of a tax credit for first-time homebuyers. The credit was extended last month and expanded to some existing homeowners. But this is just due to stimulus, which is positive, but when the money runs out and no more money comes down the turnpike (due to the money going to the health care bill instead) then we have that positive turn into a negative catalyst.

This article shows the reality of the construction industry on Main Street and what will happen when the stimulus money runs out.

Some key points in the article:

Highway-construction companies around the country, having completed the mostly small projects paid for by the federal economic-stimulus package, are starting to see their business run aground, an ominous sign for the nation's weak employment picture.

Since the recession began in 2007, employment in the construction industry has fallen by 1.6 million, the Labor Department says. Though the housing sector accounts for many of those job losses, road builders have also suffered, and executives in the industry expect layoffs to rise next year.

More broadly, the Congressional Budget Office late Monday said it estimates that the federal stimulus package sustained between 600,000 and 1.6 million jobs in the third quarter, and raised gross domestic product by 1.2 to 3.2 percentage points higher than it would have been without the program.

So what I am waiting for is the jobs numbers on Friday before I can even think about Capital Appreciation again. With Iran talking about building ten additional nuclear plants instead of dismantling the one they have, we have more negative catalysts. All we need to happen is for Israel to bomb Iran and the weak U.S. Dollar will suddenly become the strong U.S. Dollar and the markets, which have been trading up every time the U.S. Dollar falls, will get hit hard. A further negative catalyst is the tremendous debt of various emerging market countries. Those levels are unsustainable and with the rapid rise of those markets shows maximum optimism, which is a further negative catalyst.

So, with so many negative catalysts I have put my clients in Capital Preservation mode.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice.

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Disclosure: No stocks mentioned in article