Deficits-R-Us

Successful investing in today’s uncertain markets requires a flexible financial plan and a willingness to consider investments beyond the scope of most Wall Street shills. Profitable strategies of the ’80s and ’90s, like buy-and-hold investing, no longer cut the mustard. Here’s why…

Two years ago, I made fun of gold and those who held the precious metals at a conference in New Orleans.

Since then, the price of gold has risen 25%. Not bad, I say, and better than most financial indexes. But I still think those who hold the metal in bullion form are playing with less than a full deck.

I am, however, all for holding proxies for precious metals in a portfolio. These proxies can be in the form of gold/precious metals shares or options. In fact, my readers have been invested in the metals for more than a year now. (I must admit, I am the furthest from a gold bug as far as investing goes, but do I do believe in the concept of a strong currency backed by strong fiscal and monetary policy.) Pretending to be a doomsayer would be too easy. Pretending to know when gold will reach that next magical plateau of $500, if ever, would be crazy. I am a pragmatist. What I do know is that the value of my currency, the dollar, is being eroded daily with no end in sight.

I could blame the politicians or the Federal Reserve for taking the dollar down the low road…but they are only doing what many of my countrymen are doing, borrowing today and hoping to pay back tomorrow. Now, if I were a foreigner, that might not be such a bad deal…I could borrow dollars today at very low rates and pay them back later with even cheaper dollars. Now, that’s a good trade. But for my fellow countrymen, the weak dollar is nothing to be proud of and certainly nothing to continue to cheer about. As long as we want handouts, the dollar will fall. As long as we are at war, the dollar will fall. As long as we mismanage our personal savings, the dollar will fall. So you see the strength of the dollar is in our control to a large extent. The multitrillion U.S. deficit may seem passé, but it is quite real. The continuous deficit spending that adds to that debt is real. Yet we sit back, like the proverbial deer in the headlights waiting to get slammed by a fast-moving semi that has a leaky hydraulic braking system. As a country, we can’t let go of entitlements that were once reserved for the poorest and least fortunate in this country. We look to the government, an extension of ourselves, to bail out every failing institution. Yet the government only complies after being given permission by you and me. We tend to overlook the fact that we are the government and the government is we. Take, for example, the overburdened corporate pension system that was created when the U.S. manufacturing base was 100 times stronger than today, when foreigners could not compete, when the regulatory environment was put in place to guarantee high profits. Today, competition is rife: Foreigners sell us goods – that we want, and wholeheartedly embrace at our local Wal-Mart – at cheaper prices, and we cry about it.

Pension Benefit Guaranty Corp: Bankruptcies All Around

The Pension Benefit Guaranty Corp is running a deficit of $10 billion, and just last week, two major airlines, United and US Airways, declared that they would stop funding the pensions of employees. Who will make up the difference? The PBGC, of course. How so? How can a bankrupt government agency bail out a bankrupt private organization? Easily, it will borrow more money from a bankrupt government. So it is possible for money to be created from thin air, after all.

The PBGC problem is the first of many that we will see in the next decade. Next will be Social Security, created as a safety net for the poor, but seen now as an entitlement for everyone – whether at the wheel of a rusted-out Chevy or behind the wheel of a Maybach. Next come Medicare liabilities…

The borrowing, my friends, has just begun. This continuous bailout process will not end in my lifetime unless we (1) magically transform into a nation of savers, (2) magically transform into a nation of taxpayers with marginal rates of 50 – 70% or (3) come to our senses and realize that supporting government bailouts is the same as reducing our standard of living. I bet that none of the above will occur. When you are fat and lazy, even reaching for the remote is an ordeal. If you believe – as I do – that our currency is being debased, our deficits are not shrinking and only we are to blame for the problems, then you need to adjust your financial plan. You must be able to invest in ideas that outpace the loss of your purchasing power (not the 1% annual CPI increase that we are all constantly told to believe), but the 40% increase in fuel costs (in dollar terms), the 11.2% annual increase in health insurance premiums, the 10% annual increase in college tuition and the constant increases in those luxuries that we need, like auto insurance, home insurance, property taxes, etc.

Of course, you could soften the impact of the increases in a different way – you could buy two cars and get a multicar discount!

Pension Benefit Guaranty Corp: The Writing on the Walls

It has been far too easy to ignore the writing on the walls of government. We the people are going to make “us the people” suffer. It is high time for those of us who realize this inevitable crisis – whether it comes for us or for our children or grandchildren – to take some steps to act on a strategy that can counter a trend that is defined and gaining momentum. This does not mean selling all your stocks and hiding in a cave surrounded by dead presidents. It means taking the time to reevaluate your portfolio and engage in alternative investing. Alternative investments usually don’t come cheap. They require education and cost you time. But the rewards from understanding strategies that could invigorate your portfolio are more important today than ever before. To me, alternative investing is not about buying a “weird” security, but adopting a mindset that allows me to invest in different sectors, using different strategies without feeling lost. Don’t look to your broker for this type of direction – it doesn’t have a symbol or a commission. The first step is figure out how much of a contra-dollar asset you need in your portfolio. I am not recommending euros or yen or Malaysian ringgits or even renminbis here. As far as I can tell, there are just as many deficits-in-waiting abroad as there are here. The answer is to accumulate shares in high-quality resource companies that will benefit from higher commodity prices. There will be ups and there will be downs, but in the end, the tangible asset will overcome losses from the asset is little more than faith and hot air.

It is nothing short of common sense to protect and insure yourself from financial calamity. It is also common sense not to take a view that there is only one outcome. It may be different 10 years from now – I truly hope so. But that would take monumental sacrifice and changes in our fiscal and monetary system…not a likely outcome. Waiting for the bell ringer to announce that a crisis is here is not the answer. The answer is to prepare for a variety of outcomes, including that which may result in a weaker currency and weaker economy. With an endless supply of dollars and the endless demand from U.S. consumers for disposable, instantly gratifying products, there will be hell to pay at some point. If you don’t plan now, that hell will look like this: a lower pension, a smaller check from Social Security – if you get one at all – a higher deductible for Medicare, a smaller home, a smaller car and a less-fruitful retirement.

Regards,

Karim Rahemtulla
for the Daily Reckoning
September 28, 2004

Editor’s Note: In addition to regularly contributing to the monthly communiqué of the Zurich Club’s U.S. chapter and running a private equity investment group, Karim Rahemtulla is the editor of two U.S. options trading services.

What’s the next Japan? What’s Japan next?

The questions arose at the MoneyWeek Roundtable last night – a freewheeling monthly discussion of investment topics, attended by fund managers, investment strategists…and your editor.

The subject was Japan.

Japan is of special interest to us because we still feel “we’re turning Japanese.” Which answers the question: What’s the next Japan? We are.

Japan has been in a slump since 1989. The stock market topped out early in 1990 and went mostly down for the next 12 years. Recently, though, there are signs of improvement.

“The Japan story is the opposite of the U.S. story,” James Ferguson explained. America is at the beginning of a major down cycle. Japan is at the end of one.

“Japan boomed when it was selling products to Americans and the yen was too cheap. All of that is over. The economy no longer depends on exports to the United States. The yen is fairly priced. And companies that got into trouble at the end of the boom years have sorted themselves out…one by one…over the last 15 years.

“Japan is now a deindustrializing story. We went through this in Britain two decades ago. It’s difficult. It’s painful. You lose factory jobs and make them up with jobs in new industries that depend much more heavily on intellectual capital. That’s why we’re all here.

“Japan can become the financial capital of Asia…and it is making money in things such as computer games, property, pop music, cartoons…

“There are some great companies in Japan that are throwing off a lot of cash. They’re much, much cheaper than they were 20 years ago. There may be a cyclical downturn in Japanese stocks in the short run…but the long-term outlook is very good.”

“Yes, stocks didn’t go up in Japan because the companies were fundamentally good,” countered another member of the group. “This latest rise was due almost entirely to buying by Americans. And Americans have no idea what they are doing. They are so simple minded about these things. As soon as they hit a rough patch…or someone tells them that Japan is not the recovery story they thought it was…they’ll pull out and the market will go back down.”

What’s ahead for Japan? We don’t know. But if we had to hold stocks, we’d rather hold ones written in Japanese than those in American English. The Japanese variety may or may not go up…but they’ve been going down for so long there must not be much more downside left.

What’s the next Japan? Japan was the Bubble Nation in 1989. America was the Bubble Nation in 1999. By 1994, Japan was the Comeback Nation. But it was a comeback that never came back. The Japanese recovery stalled…and then came the long, slow, soft slump that took Japanese stocks down 80% below the peak. Consumers stopped buying, businesses stopped expanding and only the government would spend money. In an effort to get the economy going, the Japanese central bank cut rates to zero and began a huge public works project: pouring 10 times more concrete per capita than the United States.

America’s central bank cut rates faster. And while the Japanese poured concrete, Americans blew it up. Rather than dam up rivers or put down rail lines, George W. Bush embarked on a huge military spending program. But there is no sign thus far that America will be any more successful at cheating fate than the Japanese were. Japan’s debt expansion has been largely deflated. America’s debt still expands, but it will not expand forever.

Here’s the news from Eric Fry in New York:

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Eric Fry, from the center of the financial universe…

– “Would you like to live in paradise?” asks John Mauldin. “There’s a place where the average daily temperature is 66 degrees, rain occurs on average once every five days and the sun shines most of the time…Welcome to Dallas, Texas.”

– Mauldin is a Dallas resident and means no disrespect to his fair city, but Adam and Eve would never have confused it with their Home Sweet Home. Nor could any modern sojourner ever confuse the climate of Dallas with that of Papeete, Phuket or even Pasadena.

– “The weather in Dallas wouldn’t qualify as climate paradise,” Mauldin admits. “The summers begin their ascent almost before spring arrives. On some days, the buds nearly wilt before turning into blooms. During the lazy days of summer, the sun frequently stokes the thermometer into triple digits for the year, though, the average temperature is paradise.”

– The stock market is similarly paradisiacal. “The AVERAGE investment returns over the very long term have been some of the best available,” Mauldin explains, “but the seasons of the stock market tend to cycle with as much variability as Texas weather. In the 103 years from 1900-2002, the annual change for the Dow Jones Industrial Average reflects an average gain of 7.2% per year. During that time, 63% of the years reflect positive returns and 37% were negative.”

– Amazingly, only five out of 103 years produced an actual gain between 5% and 10%, close to the average return. By contrast, Mauldin points out, “Almost 70% of the years were “double-digit years, ” when the stock market either increased or decreased by more than 10%.”

– The simple fact is that the stock market rarely gives you an average year. This simple fact leads to an equally simple conclusion, courtesy of Mauldin: “The stock market can be a very risky place to invest. The returns are highly erratic; the gains and losses are often inconsistent and unpredictable.” Fortunately, stock market returns become much less “erratic” and “unpredictable” when an investor buys stocks cheaply.

– Since we excel at pointing out the obvious, we would point out an obvious fact that most investors ignore…to their peril: Starting price matters.

– “How strong is the link between starting P/E and subsequent long-term returns?” asks Cliff Asness, who is managing principal at AQR Capital Management LLC. He attempts to answer the question by quantifying the connection between starting P/E and future returns.

– Asness explains: “I place every 10-year period from 1926 to 2001 into one of six buckets, based on the starting P/E of the S&P 500 (Schiller’s 10-year method). I then…examine the median inflation-adjusted return (the stock market’s return minus inflation – also called the real return) for each range of starting P/Es, as well as the worst total return ever achieved…In other words, I look at what happens historically (median and worst case) over the next 10 years if you buy the S&P 500 when its P/E is in a certain range.

– “Looking at all decades that began with P/Es in the cheapest range of 5.2- 10.1, the median inflation-adjusted annual return was 10.6%,” says Asness, “and the worst 10-year real return ever achieved was a respectable 45.1%. However, buying equities when their P/Es started in the most expensive range of 19.0- 31.7 was not so attractive. The median decade-long annual return was actually less than inflation (a slightly negative inflation-adjusted return), and the worst decade was devastating (stocks losing 36.1% of their purchasing power over 10 years).

– “Quite simply, the higher the price you pay for stocks, the worse you have done on average over the next decade,” Asness concludes. “Looking at worst cases, equities are historically infallible over decades if purchased on the cheap, but very fallible, and in fact quite dangerous, over decades when purchased at high prices.”

– Remember, investment returns are a function of only four variables: (1) the beginning P/E ratio, (2) dividend yield, (3) earnings growth and (4) the ending P/E ratio. A would-be buyer of common stocks may control only one of the variables: beginning P/E ratio.

– Today’s P/E ratio weighs in at a hefty 19.7 times trailing earnings, which would place the index in the priciest “bucket,” as measured by Asness. That’s the zero-return bucket.

– Hmmm…maybe there’s a little trouble in paradise.

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Bill Bonner, back in London:

*** “How many Western analysts actually speak Japanese?” we wanted to know.

“Not very many,” James Ferguson replied. “But I’m not sure that speaking Japanese does you any good. Japanese is a very subtle language. And the more Japanese you speak, the less you can communicate, because you are focusing on the words themselves rather than the other cues. And when you learn to speak their language, the Japanese give you less help. They almost think it is presumptuous of you to try to speak in their native tongue.

“I’m not sure you realize this, but even between America and Britain, the language may be the same, but it is used very differently. You can have a dinner party with Americans and Brits…every word will be said in English…but the Brits can carry on a hidden conversation all evening that Americans won’t recognize. Americans just don’t seem to recognize sarcasm and irony. But the Brits are pretty good at it.

“The same thing is true in Japan. You may think you speak the language, but you won’t pick up the hidden conversation where they’re making fun of you…”

*** “What exactly have we gained…from our uncritical support of the Bush administration’s Middle Eastern policy?” asks another Ferguson, Niall, in The Spectator.

Ferguson points out that the “special relationship” between Britain and America is a bit of a fraud. Both nations refer to it when they need each other and conveniently forget about it when they do not. Britain needed America, or thought it did, in 1917…and again in 1942. But after WWII, the United States was not helpful; Franklin Roosevelt “made the breakup of our empire an explicit object of American policy,” says Ferguson.

In the early ’70s, Britain turned away from the United States and toward Europe, believing its destiny lay at the “heart of Europe,” rather than with the Anglo-Saxon world of North America. And today, British attitudes are more closely aligned with those of Europeans than with those of Americans. Americans go to church; however, like Europeans, Britons do not. Americans support George Bush; the British are united with the Europeans in their hopefulness for a Kerry administration. Americans tell pollsters they are ready to die for their beliefs; like Europeans, Britons are ready to reconsider theirs.

“Many of us still fondly imagine that we have more in common with undefinedour American cousins… than with our continental neighbors,” writes Ferguson. “It may have been true once (though I find it hard to say exactly when). But it is certainly not true now. Travel to the United States and then to the other European Union states, and you will see: The typical British family looks much more like the typical German family than the typical American family. We eat Italian food. We watch Spanish soccer. We drive German cars. We work Belgian hours. And we buy second homes in France. Above all, we bow before central government as only true Europeans can.”

Americans, who live and work in Europe…traveling between London and Paris every week…cannot help but notice that Ferguson is right: Brits and Americans are an ocean apart.

But he is wrong, too. He doesn’t really understand the subtlety of old continental culture nor the servile gestalt of America’s new one. The Europeans bow before central authority…but not in good faith. They promulgate edicts, and then take great pride in finding ways to ignore them. The French, for example, take neither their laws nor their leaders very seriously. If you want to bump off the president or his ministers, you can find them – protected by only a few harmless attendees – at lunchtime, hunched over a good table at an expensive Paris restaurant.

If you want to see real bowing and scraping, on the other hand, go to the United States; whenever the presidential entourage passes – with its thousands of praetorian guards, its hundreds of lackeys and self-important agents, its innumerable local gendarmes and polizei…wired, armed and bristling with violence – Americans bend so low they put their backs out of joint.