The Twin I-Beams of Investment Success

Includes: GII, IGF, IPE, SEF, TIP, XLF
by: Joseph L. Shaefer

As a courtesy to paid subscribers, I normally wait a couple months before reprinting anything from Investor's Edge. But this is just too important to wait... Therefore, in its entirety, our current issue's lead story.

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This month's issue may be one of the most important in our long history, along with calling the top on the dot-com silliness three months before it began its death spiral, our analysis on the impossibility of oil staying at its then-price of $20 a barrel (and the energy investments we made to benefit from that call), and our decision to hedge on the downside in October of 2007 just as the market was roaring through 14,000. We saved and then made money from all those decisions, and I believe what I am about to discuss with you will do the same.

Virtually no one seems to understand that a sea change has taken place in the US and world markets this year. Most people treat this pullback as an interruption in the pleasant dalliance of making money on borrowed money, whether on margin, from their home equity, by buying other essentials on credit cards, or whatever, as the markets, US and foreign, went ever skyward. I've been out of sync with that group as I declared the onset of the bear in our October issue and have never wavered in that analysis. Now that most other analysts are in reluctant agreement that we are in a bear market — with some even admitting we are in an economic recession, whether we call it that or not — they are anxious to "get on with it." Their attitude by and large seems to be "let's shake out the weak sisters, finish the bear, and go back to the much more enjoyable business of making money." The debate already seems to be focused on "in which month will the market turn?"

I submit to you that this is just plain wrong. This is one of those rare turning points where the entire game has changed. For those too young to have missed the markets of the 1960s and 1970s, these will be uncharted waters. For those who hope to forget those days, it will be murky. But for those willing to learn from the past, our way forward will be defined, if not always crystal-clear. The dot-com bubble and the housing bubble are pikers — the real bubble that is now bursting is The Great Debt Bubble of the past quarter-century. Its bursting will create massive opportunities for the aware — and will wipe out fortunes for those who don't understand the new rules. Most analysts believe that there are short-term credit excesses solvable within a couple years even without government intervention. I, on the other hand, believe this is a long-term problem that will change the investing landscape for years to come.

Cheap credit was a drug foisted upon us by a Fed unwilling to take away the punch bowl — as the markets would have done if left alone. Business people do not typically seek out unusually high and unsustainable levels of risk — but when the Fed aids and abets it, indeed, places you at a competitive disadvantage if you don't avail yourself of it when all your competitors are doing so, you'd best go along. Under Fed chairman Greenspan, this created the illusion of economic success when in reality it was nothing more than the drug of cheap borrowing.

As a result of this, it's hangover time. I believe there are massive debt inventories that must be liquidated, over-investment in weak holdings thanks to easy credit, and overcapacity in too many industries because easy money allowed rampant expansion in anticipation of rather than in response to increased demand. In earlier times, this combination of easy money self-corrected when lenders got nervous. After all, it was their money at stake. But when it is the Fed and the Treasury fomenting it, what's to be nervous about? It's the taxpayers' money, so the bureaucrats have no skin in the game.

Today our government has the means to spend the economy out of its troubles. We can print money (debasing our currency, of course) and create public works that will inject capital into the economy at a time when business and consumers are simply unable or unwilling to do so. The current administration has signaled its willingness to leap in with our (taxpayer) dollars and save cronies on Wall Street and in banking. This doesn't provide the necessary surgery for the patient, it only staunches the flow of blood — for a while. It's a dreadful first step because it reinforces, and even rewards, irresponsibility in corporations and in government.

But to profit from this, we must do more than complain. We must recognize that this first step is the harbinger of many more. Having used this medicine once, the Fed and Treasury will use it again. However, they cannot afford, politically or fiscally, to bail out any more old friends. The money taken out of taxpayers' pockets cannot go to pay for billions of dollars in bonuses at firms that are madly trading (with each other!) but are contributing absolutely nothing to the asset side of the public ledger. For that reason, I will continue to avoid, or short, big banks and brokers like Citigroup (NYSE:C), Bank of America (NYSE:BAC), Merrill Lynch (MER), Lehman Bros. (LEH) and WaMu (NYSE:WM). I may not avoid but I will also use a fine-tooth comb to analyze any company that has done as the Fed induced it to do and laid on massive debt to leverage the balance sheet.

There will be short-term rallies but, as Ralph Wanger noted, "There's never just one cockroach in the kitchen" (or, it seems, in the executive suite). The banks' and brokers' financial problems run deep. I predict many more "disclosures" before either have turned the corner to real profitability based upon real assets and real earnings from conducting their real businesses instead of shilly-shallying around with Stuff Nobody Understands, Including the Inventors.

Does this mean I am going to step aside for the next few years — that's right, years it may take to unwind from this bacchanalia — and sit in cash? No way! I see two inevitable results of the unwinding of this lunacy. That's why the structure of our portfolios going forward the next year (or more) will rest upon two steel 'I-Beams':

(1) Inflation and

(2) Infrastructure.

Try as I might, I can think of no way out of this mess that is not deflationary for the dollar and inflationary for the rest of us. Yes, the usual catechism is that recessions nip inflation in the bud because people buy fewer things. But that only addresses the demand side of inflation. The supply side comes from too many dollars out there — and printing lots of dollars is what it will take to get us out of this mess sooner rather than later.

In previous recessions, we could honestly say, "When the US sneezes, the rest of the world catches a cold." But today, even as the developed world labors under this credit kerfuffle, China, India, Brazil, Russia, Indonesia, et al, will continue to move from bicycles to motor scooters to automobiles and from rice to fish to meat. Food and energy prices may retreat from their current levels — temporarily, as they have in July — but they aren't going into disinflationary territory! And if I'm correct about my second I-Beam, we aren't going to see serious drops in the prices for iron, steel, zinc, copper, asphalt, cement, timber, or any other building material, either.

If there is any one area that the US government desperately needs to invest in on behalf of the American people, it is in infrastructure. By infrastructure I mean everything from rebuilding military equipment that is worn down, used up, and literally has sand in its gears, to crumbling bridges, potholed roadways, a decaying power transmission system, and leaking-like-a-sieve water transmission and storage facilities. These are big-ticket items that often transcend any one state's bailiwick. We would have to repair this collapsing infrastructure, anyway. It's better to let the Feds throw money at something worthwhile for a change, instead of to whatever the 47,000 registered lobbyists pay them to throw it at.

That's what happened when Fannie (FNM) and Freddie's (FRE) lobbyists came a 'callin' and convinced Congress to let them lend *30 times* their asset base (now 33 times with the latest bailout), rather than the 10 times that had so "constrained" them until recently.

What kind of time frame am I looking at? What does it matter, since there will be money to be made betting on inflation — shorting Treasuries, buying gold, etc. — and buying infrastructure — water, gas, wind, solar, cement, food, etc.?

However, if we are looking for a time frame, it may help to note that Japan has taken some 20 years to finally rehabilitate its corporate balance sheets. I believe we have a younger and more entrepreneurial workforce, greater size, considerably more natural resources, and numerous other advantages over Japan. Still, I imagine it will take a few years for the US economy to once again be healthy. Since the markets are a leading, not a coincident, indicator, I imagine the market will respond as soon as it sees real progress.

For that reason, I won't speculate on the time it may take for plays beyond inflation and infrastructure to be worthwhile. I believe it will be at least another year. I plan to make hay with the twin I-Beams during this time and assess the situation anew each day to see if there is meaningful change.

For now, I'll stay defensive. Simplifying the focus of our inquiry and protecting what you have are the most important steps right now. Making money from our I-Beams should follow. If I'm correct, the "throwing in of the towel" that I've spoken about in previous issues is likely to occur in 2008 and 2009. People will increasingly stop saying impatiently, "Is this the bottom? Should I buy financials and housing now?"

Still weaker retail sales, lower capital spending by industry, job losses, credit card defaults, and a shadowy sense of doom is the way most bear markets end. They end with a whimper, not a cataclysmic down day during which we all sing "Happy Days Are Here Again." If I'm correct, you won't be fooled. Investing in the I-Beams will have protected you.