Category: Investing

Where to Put Your Money: The Basics

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“Asset allocation” may sound like the kind of term used by rich money managers and Ivy League university endowments. In fact,  anyone with a savings account,  a 401(k),  a pension plan or real estate should be thinking about asset allocation. “Asset allocation” is just a fancy way of saying “don’t put all your eggs in one basket." By putting your money in several different baskets, you can reduce risk and potentially increase returns by diversifying your investments.

The remainder of this article can be found at the website Man Of The House.

Are You Your Biggest Investment?

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When it comes to your investments, you might consider your 401k or your house as the most valuable. Little do you know that your biggest investment is your career. Your career is an investment like any other and once you determine the financial value of your career, understanding how to invest the rest if your portfolio becomes much easier.

The remainder of this article can be found at the website Man Of The House.

Is My House a Good Investment?

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If you’re like me, deciding to buy a house was not only a big decision but also quite the investment. Regardless of the economy or whether I could make this house into a home, I had to put sentiment aside and think about real estate rationally. If buying a home is on your mind, take a look at my tips to consider while researching buying a home.

The remainer of this post can be found at the website Man of the House

Q3 Market Update: The Fed’s War on Savings

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The Federal Reserve recently announced that it would purchase up to $600 billion of US Treasury bonds in a program known as "quantitative easing", which is a fancy way of saying "printing money". This is actually the second bout of quantitative easing since the financial crisis, and thus this round has earned the nickname "QE2". The policy of printing money is a blunt economic instrument, with wide range of consequences, known and unknown. The announcement of the policy has attracted no shortage of critics, from World Bank President Robert Zoellick, to Sarah Palin, to the leaders of Germany, Japan, China and Brazil. All deride it as inflationary currency manipulation.

The Fed's ultimate goal is to prevent a Japan-like malaise of falling prices and shrinking consumption from infecting the United States. With short-term interest rates at zero, the Fed can't lower short-term rates any further. By printing money to buy longer-dated treasury bonds, the Fed accomplishes two things. First, by increasing the supply of money, it decreases the value of the dollar which helps create positive inflation. Second, by reducing interest rates of "risk-free" investments like cash and treasuries to below the rate of inflation, those investments become money-losers in inflation-adjusted terms. The goal is to bribe savers to shift investments from cash and treasuries into "risky" investments like corporate debt, equities and real estate and also into near term consumption of goods and services.

Pushing on a string in the US

There are three major problems with this policy. Americans are unlikely to increase their consumption markedly, given that they are determined to rebuild their savings after years of under-saving. In addition, real estate suffers from a massive debt overhang and isn't likely to truly recover for years. Businesses will gradually increase their investment, but generally act in their own interest and can't be forced into making investments they wouldn't otherwise make. For these reasons, the Fed's war on domestic savings will not likely be successful. In economics parlance, the Fed is "pushing on a string". Instead, we are seeing a shift of savings from investments that have a negative real rate of return (like cash and bonds) and into those that are considered inflation hedges like precious metals and commodities like oil, wheat and cotton.

Taking the fight to China

The second front in the Fed's war on savings is against the biggest saver in the world: the Chinese government. The Chinese government has systematically manipulated the world trade markets by recycling its export earnings into US dollar-denominated assets instead of into US-dollar imports. By mathematical equation, this results in a trade surplus in China and a trade deficit in the US. In the past decade, China has accumulated over $2 trillion of US-dollar reserves. By increasing the supply of US Treasuries and by holding interest rates below the rate of inflation, the US is essentially taxing Chinese savings. The weak dollar also pushes up the currencies of countries that compete with China, not only those of emerging market economies, but also currencies like the Japanese Yen and the Euro. China, Japan, Brazil, Korea, etc. have all been using export promotion policies like currency suppression to enrich themselves at the expense of exporters from the United States. The Fed is finally saying "Two can play at that game".

The current long-term trend of artificially-suppressed interest rates, a weaker dollar and higher commodities will play out until the world cries "uncle!". No one knows when this will happen, but when it does, the current trends will be reversed.

Economic growth ahead

The Fed has clearly learned the lessons of the Great Depression and of Japan. The TARP and the first round of quantitative easing were designed to prevent a second Great Depression, and were successful. QE2 is designed to prevent a repeat of the past two decades of deflationary malaise in Japan from occurring in the United States. If the Fed is determined to prevent deflation, they will. The downside, because there is no "free lunch" in economics, is a weaker currency on a relative basis (next to other paper currencies), and on an absolute basis (relative to precious metals and commodities). The decline in the dollar pushes up the prices of imported consumer goods and commodity products like food and gas, even while overall inflation may be tame. This hurts low-to-middle income Americans most of all.

Fixed Income

Looking at the interest rate complex, we can see that treasury rates are far below their equilibrium levels, with the exception of the 30-year treasury. Treasury Inflation-Protected Securities are showing negative yields right now, which is a sign that investors expect the Fed to be successful at maintaining positive inflation. The 30-year, which is the least manipulated issue on the curve, is expecting inflation to average 2.6% over the next 30 years, which is over the Fed's target range.

Source: Vanguard Funds, Bloomberg Treasury Rate Data, tylernewton.com

These rates are even lower than what prevailed at the time of my last post on July 11, 2010 (when I declared that there was not much more fun to be had in the fixed income markets…oh well).

So while the treasury complex is artificially over-priced, risk assets like corporate bonds, high yield bonds, muni bonds and equities are priced at above-equilibrium "spreads" over treasury rates, even if nominal yields are below equilibrium levels. If you are a long-only investor, it would be better to keep your fixed income investments in less-volatile shorter term maturities. If you are the type of investor that can short the appropriate treasury while going long on corporate, high yield and municipal bonds, you can enjoy better-than-equilibrium returns.

Equities

The rise in long-term inflation expectations explains the rise in the equity market since July.

Implied market returns

7/11/10

11/8/10

The implied long term return on equities is 2.4 percentage points higher than the yield on the 30-year treasury, versus an equilibrium spread of 2.3 percentage points. (This equilibrium spread is based on an after-tax equilibrium spread of 4.5 percentage points above the after-tax return on the 30-year treasury. Because equities are more tax efficient than treasury debt, the nominal equilibrium spread shrinks to 2.4 percentage points.) Note that I use a lower spread than the 6% or so often used in valuation textbooks.

Equities are a decent buy at this point if you believe that the Federal Reserve's policy of quantitative easing will be successful at increasing long term inflation expectations, weakening the dollar and supporting economic growth. So far the price of the 30-year treasury bond and equities are telling you that the market thinks that quantitative easing will be successful.

The Dollar

The value of the dollar also shows that the market believes that quantitative easing will be successful.

Major Currencies Index (nominal)

Broad Currencies Index (real)

Source: economy.com

Both measures of the dollar index are trading at the bottom of their long term ranges, which means that further upside in foreign currency trades may be limited.

Gold and commodities

Source: economy.com

Both gold and commodities reflect the effects of quantitative easing.

On a relative basis, oil and other commodities are cheap relative to gold.

Source: economy.com, calculations by tylernewton.com

Conclusion: A crowded trade?

In the past week (November 8-12), the QE2 trade has been reversing itself. Treasury yields and the dollar have been rising and gold and stocks have been falling, reflecting a classic "buy the rumor, sell the news" situation. The QE2 rally reflected a liquidity-driven rally, where everything except the dollar (stocks, bonds, commodities, and foreign currencies) goes up, and since November 8, we've had a classic withdrawal of liquidity trade, with everything except the dollar going down. This is different from a crisis trade, during which treasury bonds would also rally.

Possible reasons for the break in the markets this week:

  • European debt – In the past week, we've had the glimmerings of a renewal of the European debt crisis, as the yields on bonds of Ireland, Greece, Spain, etc. have returned to records relative to German bonds. If a renewed sense of fear regarding Europe were driving the markets, then we would see treasuries rallying, which we are not.
  • China slowdown – Another possibility is fear that QE2-induced inflation in emerging markets, particularly China, is forcing them to take unpredictable actions to slow their economies, fight inflation and/or erect capital controls. This is a distinct possibility, although I would expect such a scenario to lead to a decline in the dollar, which we are not seeing.
  • QE2 letdown – The markets may have been disappointed with the size of the QE2 program ("only $600 billion versus $1 trillion or more). This could be true, which would also support the following scenario.
  • Just taking a breather – The markets are just taking a breather after a good run.

The balance of risks tells me that the markets are likely transitioning from a liquidity-driven phase to a phase that will discount moderate-to-strengthening economic growth. Such a scenario would favor equities and commodities and support the spreads of risk assets over treasuries. The valuation level of domestic equities is relatively high, however.

QE2 will continue to drive investors into emerging markets, which will likely to blow a bubble in emerging markets stocks and commodities. I don't think emerging markets stocks are cheap, but the "story" will likely stay favorable for some time.

Action plan

As the current market pullback runs its course, I will likely trim a few of my precious metals (gold and silver) positions and add other commodities (a net neutral change in the commodity weighting for the whole portfolio). I will trim a bit of my foreign bond positions (which I added last quarter) and add foreign stocks. I remain neutral/underweight domestic equities at levels above $1,000 on the S&P 500. I remain neutral on bond duration in the US.

Waiting for "regime change"

I suspect we are in the last phase of "casino capitalism" in the international capital markets. While the leaders of the G-20 couldn't agree to anything last week, it is only a matter of time before the international currency and trade system slams into a wall of nationalism. At that point, international regulation of currencies, trade flows, bank leverage and hedge funds will become widely accepted to save the real economy from the whims of the financial economy. The financial system is meant to serve the real economy, not the other way around. The transition to the new system will be messy, so stay on guard in the meantime. Be conservative in your investment decisions, don't be afraid to hold cash and don't be a hero. I still have a strong suspicion that the best investment opportunity still lies ahead.

I am not a financial advisor, and write these columns for personal enjoyment only. Please consult your own investment advisor before acting on any recommendations you find on the internet.

Dad-Folio – The Essential Financial and Legal Tools Every Dad Must Own

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As a dad, you’ve got a lot on your plate. From picking insurance to paying for your children’s education, you have some serious decisions to make. If you’re looking for some answers to those important questions, take a look at my Dad-Folio. I included financial and legal tools that can make great additions to any dad’s tool kit.  

This article by Tyler Newton can be found at the site "Man of the House" HERE.

Get Rich, Slowly

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Slow and steady wins the race in investing. For every successful get-rich-quick hare, there are a thousand that end up road kill. Emulate the tortoise instead. Follow these five rules for slow and steady wealth-building:

This article by Tyler Newton can be found at the site "Man of the House" HERE.

Financial Planning with Purpose

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Set goals and achieve them. You have probably heard this your whole life, but when it comes to financial planning, setting goals and a vision is imperative to your success. By balancing the four pillars in your life – career, family, hobbies and community – your goals are clearer and become something to work toward. Once you set a long-term life plan, your financial goals become a lot easier to obtain.  

This article by Tyler Newton can be found at the site "Man of the House" HERE.

Q2 Market Update: Sometimes cash is the “least bad” option

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The S&P 500 has fallen 9.2% since my last update on April 16. The decline has been driven by a large shift in long-term inflation expectations, which have declined from 2.7% to 2.3% today (as determined by the 30-year spread between treasury rates and 30-year inflation-protected securities, or TIPS). This is consistent with the news coverage surrounding the European debt crisis, which has been raising deflation fears in the markets. As a result, the 10-year treasury yield has fallen from 3.8% to 3.1%. The dollar has risen, gold has been steady and commodities have fallen, all consistent with the global slowdown scenario.

Equities

With the decline in the assumed inflation rate, stocks are pricing in a 6.4% long term return, based on long term trend earnings of $58.40.

This return is below the target return of 6.8%. To produce a 6.8% return for today's assumed level of inflation (which coincides with what the Fed targets, so it's a good equilibrium assumption), you would need to see a S&P 500 level of 945.

Fixed Income

There's not much more fun to be had on the fixed income side of the house.

Unfortunately, everything is overvalued with the exception of long term munis, which are roughly fairly priced. The only way to get excited about bonds right now is to have conviction that we're headed into a deflationary double-dip recession.

I don't have that conviction. I'm more in the camp expecting that we'll stumble through a subpar recovery, with the economy weighed down by deleveraging in the consumer and real estate markets. If I had to put new money to work in the US, I would either keep it safe in cash or short term bonds for deployment later or I would buy stocks out of a lack of better options, where we could see a bit of a rebound as people realize the world isn't relapsing into recession.

The dollar

Major currency index – nominal

The dollar has rallied against the Euro and other major currencies recently, trading to the top of its long-term (downward-trending) trading range. This creates an opportunity to cycle some money out of US fixed income (like corporate debt or TIPS) and into foreign stocks and bonds.

Commodities

I'm not sure what to make of commodities. Commodities, as represented by the CRB futures index, are cheap relative to gold but expensive relative to consumer prices.

For all we know, gold could be overvalued, so I'm not enthusiastic about recommending buying commodities.

Housing

Housing prices are still a bit higher than their long-run, inflation-adjusted equilibrium level of about 100. Given how high prices were away from equilibrium during the boom, and that prices and sales are being actively propped up by the government currently, there is a great danger that prices can overshoot to the downside if the market relapses, which it easily could. My hunch is that commercial real estate is in even worse shape than residential.

Conclusion

Outside of taking advantage of the strong dollar to allocate some money into foreign stocks and bonds, I'm at a loss to get excited about any particular asset class. Not a bad time to take some bond profits and build up some cash. Cash may pay zero percent right now, but that's better than losing money.

This column is written purely for the author's pleasure. I am not a financial advisor. Please consult your own financial advisor before acting on any investment recommendations.

Q1 Market Update: The Stock Market is Now Overvalued

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Since the market bottom in March, I have been rationalizing the rally in equities by observing that the market seemed to be honing in on a target return on the S&P 500 of about 7%. What was changing over time was the market's view of long term inflation. Projected equity returns are calculated as the opening dividend yield (with the dividend based on the historical payout ratio on next year's trend earnings) plus the long term growth rate of inflation-adjusted trend earnings times the long term rate of inflation. As market prices have risen, the dividend yield has fallen, but the projected rate of inflation has risen. In 2010, however, the yield has continued to fall while the market's assumption for inflation has not risen commensurately.

Right now (April 16, 2010) the S&P 500 is pricing in a 6.6% return.

Such a low return is hard to justify. I can make the argument that 6.8% is a reasonable return (assumes a 4.5% equity risk premium over the equilibrium 30-year TIPS rate). Even a 6.8% return is much lower than the long term return that most market participants assume to be 8-10%.

The trend earnings being used in my calculation is $59.22, which approximates the projected 2010 as-reported earnings (as projected by Standard and Poor's analysts on a top-down basis) of $62.09.

In addition, I continue to believe that the market's assumption for long-term inflation of 2.7% is high. I view the equilibrium inflation rate to be 2.25% (the Fed's target), and feel that given the high debt levels in our economy we face more risk from deflation than from inflation. (I realize that this is not a very popular view, and that most people feel the opposite.)

If we look at the rates on fixed income investments, it appears that the long end of the yield curve holds the most value, for Treasury Bonds, Municipal Bonds and Investment Grade Corporate Bonds. (High yield bonds and TIPS, on the other hand, are overvalued.) Long bonds are not undervalued, necessarily, but deserve at least a target weighting in a portfolio.

I do believe that the stock market is likely to keep rising in the near term as the economy and earnings expand. It should be noted, however, that investors are now playing with the house's money, and that in the next recession stocks are likely to at least revisit the current levels, if not go below them.

Predicting Inflation: Gold versus Bonds

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Predicting Inflation

In my most recent market commentary, dated 2/9/10, I discussed how sensitive market prices are to future inflation expectations. To the extent that you can discern whether the market expectations for future inflation is too high or too low, you should be able to beat the market by using tactical asset allocation. During the market chaos of early 2009, long run inflation expectations had fallen to 1.0%. If you were able to predict that the federal reflation efforts would be successful (at least in the short term) and that market inflation expectations would rise to where they are today (2.6%), you could have caught the market bottom and benefitted from the 70%+ run up in the S&P since that time. I was too pessimistic and missed most of the run-up.

In normal times, the market appears to view 2.5% as the natural long-term inflation rate. The Fed claims to view 1.5-2.0% as its desired inflation rate. In my market equilibrium model, I have used 2.25%, but have tended to favor a range of +/- 0.25% with the acknowledgement that market outcomes aren't that precise. My general argument has been that the market is too focused on inflation, and that deflation is the primary threat. Many market pundits, on the other hand, have been proclaiming that the market (particularly the Treasury bond market) is massively underestimating inflation.

There are two primary market indicators for future inflation expectations: (1) the Treasury-TIPS spread and (2) the price of gold.

What bonds are telling us

As of 3/26/10, the Treasury curve looks as follows:

If you compare this curve to the curve at year end 2009, you'll see that the nominal Treasury rates have moved up slightly (the 30-year rose to 4.8% from 4.6%), TIPS rates moved up (the 30-year TIPS rate rose to 2.2% from 2.0%) and inflation expectations fell slightly (fell to 2.6% from 2.7%, yes there is rounding involved here). The TIPS curve is steep and the inflation curve less so, which makes sense. Below is what I consider to be the "equilibrium" yield curve, using my 2.25% inflation rate as a target:

The bond market is basically saying that the Fed will be a little slow to remove accommodation (which is why short rates are below equilibrium), but that long run inflation expectations are well-anchored.

What gold is telling us

The gold market is telling us something different. A rise in the gold price tends to lead a rise in commodities prices, which in turn leads a long term rise in CPI. Gold also has a history of volatility and of overshooting its equilibrium, however.

Below is a chart of the price of gold since the 1950s:

The gold price was fixed at its Bretton Woods price of $35 per ounce from the early 1930s to the late 1960s, jumped to (briefly) over $800 per ounce in 1980, fell to a new equilibrium range of around $375 per ounce from the mid-1980s through 1995, fell again in the late 1990s to $250 per ounce, and then rose during the past decade to over $1,000 per ounce.

If gold wasn't so volatile, we could expect it to rise steadily over time as the Fed promotes positive inflation. It should be noted that during the entire century between the early 1800s and the early 1900s, there was no sustained inflation in the United States as the dollar was convertible into gold at $20 per ounce. It is only since the Great Depression that the government has actively promoted inflation. In fact, because of the productivity of the capitalist system, you would expect prices to fall over time as producers became more efficient, not to rise as tends to be the case.

All things being equal, if you were expecting the Fed to target consumer price inflation of 2.25%, and you expect productivity gains of 1.75% per year, you would expect the gold price to rise by a rate of 4% per year to indicate that the dollar is being devalued accordingly.

Despite all the volatility in the gold price and inflation since the 1960s, the long term trend shows that gold has led increases in CPI, less a producitivity factor.

In the chart above, we can see from the trendline equation that CPI has been falling at a rate of 1.8% per year relative to gold since the 1950s, but that the relationship has been volatile. Gold was undervalued relative to consumer prices in 1970 and 2000, was overvalued in 1980, and was fairly valued in the mid-1990s. In many of my models I find that the mid-1990s was a well-balanced economy, before Robert Rubin's dollar bubble and the following dot com and housing bubbles threw the economy off kilter, to put it mildly.

One more factor to take into consideration is that economy-wide prices don't adjust instantaneously. I've found that it takes about 10 years for the overall CPI to catch up to a sustained devaluation of the dollar relative to gold. The inflation rate for the next 10 years is therefore dependent on whether monetary and fiscal policy are tightened enough so gold falls back in line with the current consumer prices, or whether prices keep rising to catch up with the new equilibrium level in gold.

My calculations of the theoretical gold price and CPI reveal the following:

  • If gold has overshot to the high side as a function of the financial crisis, and the treasury market's inflation rates are correct, then the current equilibrium gold price would be $550-600 per ounce.
  • If gold has found a new equilibrium level at the current $1,100 per ounce, then we should expect a 10-year inflation rate of over 5%.

This is a massive divergence.

  • If the bond market is correct, then bonds and non-precious metal commodities are fairly valued, and stocks are slightly overvalued.
  • If the gold market is correct, then most bonds are overvalued, TIPS and commodities are way undervalued and stocks and even real estate are slightly undervalued.

So what market should we listen to, gold or bonds?

The bond market is more liquid and understands the deflationary risks of high leverage. While the argument can be made that Treasuries are overpriced (yields too low) due to the Fed's holding rates too low and to Chinese manipulation. If nominal Treasuries were being manipulated by structural factors, then I would expect TIPS to be yielding nearly 0% across the curve. As can be seen above, however, the TIPS yield curve is showing positive real yields right around their equilibrium levels.

The gold market is a bit more ideological, attracting those that tend to dislike the government in power. It should be said, however, that the gold market was far more adept at tracking the debt bubble of the 2000s than the Federal Reserve proved to be, right through to predicting the extraordinary measures taken in the bubble's aftermath. The political landscape, on the other hand, is implying that consensus is building to fight the deficit, reform entitlements and to rein in financial system leverage. While that may be wishful thinking on my part, it would be hard to make the case that the wind is shifting in the other direction. My view is that the health care bill will be one of the last acts of giving us things for some time. The next decade will be occupied mostly by our government taking things away.

Conclusion

The answer to the debate is not obvious. Risk management, therefore, should be the primary focus for investors. I'll do my regular quarterly market update in a few days, but the lesson for me would be to overweight TIPS, commodities and cash, and to underweight precious metals. At the very least, it is probably time to trim bond positions back to a neutral weighting (I have been overweight bonds for years now). It also probably makes sense to have at least a neutral weighting in stocks for the time being, if we are to assume that the ultimate inflation outcome likely lies somewhere between what the bond market and gold market is predicting.

I am not a financial advisor. These analyses are conducted for personal enjoyment only.