Trading and Investing

Everybody is waiting to see what the Fed policy will be over the next 3-12 months.  Here are my thoughts.

The Fed is playing a waiting game right now.  Inflation is still a real threat but growth is slowing down.  The last reading on year-to-year Core CPI is 2.9%, which is above the Fed’s publicly announced target of 1-2%.  If inflation stays above 2% long term, the Fed will almost certainly raise rates.

Right now, the Fed is waiting to see whether a slowdown in growth, fueled by the housing sector, will be enough to cool inflation.  If the growth slowdown stalls inflation, the Fed will continue to pause or to cut rates.

So there is a two-dimensional vector that the Fed is watching:
1. High growth, high inflation - Raise rates
2. Low growth, low inflation - Lower rates
3. High growth, low inflation - Hold or lower rates
4. Low growth, high inflation - Economy screwed, but Fed must raise rates

The Fed is hoping for outcome 3, but 1 or 2 would be okay.  Wall street is hoping for 3 and is pricing this into the Dow.  I think Outcome 3 is extremely unlikely.  Outcome 4 is what people should be worried about, in which case the economy stalls at the same time as the Fed having no option but to raise rates.  This will likely send housing and the U.S. economy on a downward spiral.

I would assign probabilities of the four outcomes as follows:
Outcome 1: 35%
Outcome 2: 25%
Outcome 3: 10%
Outcome 4: 30%

This matters to real estate because it is impacted both by economic growth and interest rates:

Outcome 1: Good for real estate owners.  Bubble does not pop.  The question is how long can this last because Fed will have to raise rates.
Outcome 2: Medium outlook for real estate owners.  Rates stay low and hold up prices but real estate falls a bit.  This is the soft landing scenario.
Outcome 3: Best scenario for real estate owners.  Rates stay low and growth keeps housing afloat.
Outcome 4: Worst case for real estate owners.  Economy tanks at the same time the Fed is forced to raise rates and sends prices even lower.

Prospective real estate investors care about the part of economic growth that is *orthogonal* to rates.  If rates go up, we have worse financing but prices drop.  If rates go down, we have better financing but prices stay higher.  So the impact of rates should matter much more if you currently own property.  It does, however, affect future selling potential, in which case I would rather buy with high rates and low prices.

A gold investment will pay off huge in Outcome 4, which will be the exact outcome that will create an incredible buying opportunity in real estate.  Hence my bias towards gold.  Nobody else will have money because they lost it in real estate or the stock market, so l will be one of the few buyers.

Real estate investment opportunities will be best in 4, worst in 3, and medium in 1 and 2.  Investors and the Fed will just have to wait and see.

defo

Gold bugs have been pumping up gold as an investment for years.  Anti-gold bugs claim we are in a gold bubble right now.  Who is right?

I have a positive overall outlook for gold in the next 2-5 years for several reasons:

[] Gold has never fully recovered from it’s peak of $850 an ounce in 1980.  This was a real gold bubble and in fact one of the larger financial bubbles historically.  In inflation adjusted terms, that price today is equivalent to around $2,200 an ounce.   Gold has a long way to go to reach another peak like that since it is currently trading at $600 an ounce.

[] Why should the price of gold go up in the long run?  Gold doesn’t *produce* anything.  It’s not a company that has a product and can grow over time.  The answer is that gold has had fundamental value as a means of storing value for centuries.  While governments can print as much paper money as they want, the supply of gold is fundamentally limited.  So  gold is a real means of storing wealth.

[] Gold went through a 20 year bear market from 1980-2000 while the U.S. economy surged.  This has created a generation of investors who do not even have gold on the radar.  I bet if you asked people at a party, 9 out of 10 would have no idea that gold was even on the move.  They’d probably be surprised to learn that just five years ago gold was trading at $250 an ounce.

[] In the event of a dollar collapse or devaluation, both US and foreign investors will likely have a flight to hard assets.  Gold is one of the easiest ways to preserve wealth against a devaluation of paper money.  If you have not read “The Dollar Crisis” by Richard Duncan, put it on your To Read list.  The basic thesis of the book is that the current global monetary situation is unsustainable and that the dollar is headed for severe devaluation.  More on this in future entries…

[] There are now trillions of dollars in hedge fund money just waiting for the next big investment vehicle.  If the Dow does not continue to grow, where will they invest next?  Their ability to make huge swings with the push of a button give gold the ability to skyrocket in a financial crisis.

[] Finally, gold is a basic hedge against financial crises.  It should probably be a part of any diversified portfolio.  But if you’re worried about the US equities market and housing market like I am, a larger investment in gold may make more sense.

More on this topic in the future.

- defo

The Dow Jones Industrial Average broke 12,000 today to hit an all time high. The markets are rallying strong, with the Dow posting almost an 11% gain in the last 3 months. The question for investors is whether or not this trend will continue.

The Capital Asset Pricing Model (CAPM) is one of the fundamental models of modern financial theory. The basic idea is that an asset’s correlation to the overall market is one factor in determining it’s expected rate of return. For example, you might think that housing construction companies perform pro-cyclically while bankruptcy law firms perform countercyclically. Since countercyclical assets are desirable from a risk perspective, pro-cyclical assets must have a higher rate of return to justify their riskiness (for more information on CAPM, see http://en.wikipedia.org/wiki/Capital_asset_pricing_model).

But the other advantage to holding countercyclical assets besides their risk profile is that they allow you to invest after a crash in the procyclical assets. If housing and U.S. equities tank simultaneously, it will create one of the best buying opportunities in 50 years. But who will have any money to take advantage of it? Only those people who held countercyclical assets.

So if you are like me and you believe that domestic equities are overvalued, you want to hold assets that will allow you to take advantage of a possible decline. So what do you hold? A healthy combination of cash, hard assets (gold?), and dividend producing stocks will put you in a perfect position to buy when nobody else can. And you’ll make a killing.