Investing In Dangerous Times

Those that read this site regularly know my pessimism regarding the future.

People frequently ask: “What do I do to protect myself and my family?” or “What should I invest in?” While this discussion will not provide you with specific answers, it should provide a framework that may be useful.

Investment Advice

Investment advice is not provided here. I am not licensed to do so. Even if I were, investment advice needs be tailored to each individual’s circumstance. That is impossible to do properly without some hours of consultation to understand goals and the particulars of a situation. The face-time can be reduced via comprehensive questionnaires and informational data, but it still should occur so that your advisor can gauge that your answers are consistent and proper. At least as important is your assessment of him/her.

Good financial advisers are difficult to find. They may be “certified” and conscientious, but these may not be sufficient in these interesting times. For most, their training is adequate to provide reasonable strategies for clients. However, the world has changed as Mohamed El-Ehrian observed with his “The New Normal.” Most advisers were trained for a different world.

After the economic crisis, many were “re-schooled.” The last couple of years have represented a return of good stock market performance. Advisers may feel comfortable in that sense. An important point in meeting with a financial adviser is to for you to understand his worldview. Does he believe these are normal times? If not, what does he expect to happen? Will he work to achieve your strategy or will he want to impose his own on your portfolio? How comfortable are you with delegating that strategy?

You should get answers to questions like these before you begin presumably a long-term relationship.

Forecasting

I provide my view of what the future holds. However, recognize that this is my opinion only. I have no special sense that enables me to see tomorrow with great clarity.

Forecasting is not an analogue where you can say, “If this, then that.” Humans, governments, corporations and central banks are purposive actors who adjust behaviors as conditions develop. Current or historical behavior should not be extrapolated forward with the assumption there is validity gained by doing so.

Economic forecasting is tenuous and a fool’s errand. The proper term is “economic opinion.” As John Kenneth Galbraith wisely quipped:

The only function of economic forecasting is to make astrology look respectable.

With Mr. Galbraith’s caution in mind, let me add a few of my own:

1. No one can see the future clearly.
2. While reasoned, my forecast may be no better than your own, regardless of how you arrived at it.
3. Knowing what might happen is not enough for investing success. You can be correct on what is going to happen and still not capitalize because your timing is wrong.
4. Forecasting accurately is extremely difficult and subject to luck. Forecasting timing is even harder.

The World Has Changed

The first thing to recognize is that the world has changed. It is unlikely to return to its prior state. Whatever old market nostrums worked in the past are likely not to now.

The most dangerous rule-of-thumb that I can think of is “buy and hold.” It ranks right up there with “real estate always goes up,” “this time is different” or “that’s impossible.”

No rule-of-thumb, no matter how well it served in the past, should be accepted at face value. Everything should be analyzed against what are changed conditions. The past is gone. Do not make too much of it in your considerations of the present and the future.

A Dying Country

A dying country is not a dead country. It is in a process of decline. It is sick, but possibly not terminal. Its past economic growth rates are not possible and its GDP could even shrink. The economic pie will likely grow slower than the population, meaning real incomes will shrink.

That is the condition of the US. In fact, it is the condition of much of the developed world. There is no Great Depression, although one could occur one quickly as a result of a crisis. The US underlying economy is akin to the stagnation of Old Europe, or perhaps the “lost [two] decade[s] of Japan”

This economic purgatory is characterized by a Main Street that has not recovered, low employment and little to no growth. A financial system collapse was narrowly averted, but the underlying risk still remains.

What Comes Next?

Your answer to this question provides the basis for your investing strategy. Do you believe that the economy will recover to its old self? Do you believe we are in for economic stagnation for a prolonged period? Do you believe that conditions here and around the world are such that something will trigger an economic collapse?

Another financial crisis is possible/likely. Deteriorating conditions in Europe, a still weak banking system in the US, massive derivative risk in the system, a stagnant economy, an inflationary or deflationary blow-up, a collapsing currency, etc. etc. are all potential triggers.

My Opinion

In my opinion a Great Depression would have already occurred without massive government interventions around the world. These interventions have merely deferred what is almost surely an inevitable event. The cost of the deferral will show up in a bigger event than it otherwise would have been.

Fundamental economic problems and distortions can be covered up for a time, but they must be resolved in order for an economy to return to normal growth, productivity and efficiency. Government economic policy for the last forty years has been an attempt to prevent this economic resolution of imbalances.

The Federal Reserve is unlikely to stop QE willingly. Stopping would mean a Depression plus the recognition that government is insolvent and unable to pay its bills with the Fed creation of money. No politician has the incentive (or will) to discontinue QE. When conditions worsen, expansion of QE will likely be the first response. No politician or bureaucrat wants to be branded as the next “Hoover.”

Market forces are impersonal and don’t care about politics or political legacies. They will eventually stop the nonsense in whatever fashion and at whatever time they choose.

Any number of market events could trigger a crisis — a bank run in Europe (or the US), interest rate rises around the world, a collapse in the bond bubble, another stock market crash, etc. etc. The immediate reaction to most of these would be increased QE, but ultimately continuing or increased QE is met with a collapsing currency and rapidly rising prices,

Continued liquidity likely means higher stock prices. A cessation of liquidity likely means another Great Depression and a stock market collapse. At some point markets will say “enough” and the Ponzi economic system that has been developed will collapse.

What To Do

You must determine how long you expect our economic purgatory to continue and how it will end. Regarding the purgatory, that could well take a lot of time as Japan is showing.

Ultimately the ending involves a Great Depression characterized by deflating prices and defaulting debt. However, the route to this end is unclear. The political establishment and the Fed will do everything possible to prevent this outcome. In doing so, they are likely to create and inflationary blow-off that forces the interventions to stop.

Determining the route to the Great Depression is critical for your investing/trading strategy. The two scenarios call for opposite strategies. If you believe deflation is the likely route, then you should gravitate toward cash, fixed income investments and away from hard assets. If you believe inflation is the route, then real estate, gold and other basic materials make sense. Stocks should perform well, at least for a time in an inflationary scenario.

No one should be certain how this economic crisis plays out. Thus, the above comments should be viewed in terms of portfolio allocations rather than absolute commands. Even if you believe deflation is coming, you might still want to keep a small portion of your portfolio in stocks just to hedge against being wrong. The suggestions for either scenario should be taken in this context.

What I Am Doing

For some of the reasons above, I believe that an inflationary crisis will precede a Great Depression. That means I am still focused on stocks (and keeping an eye on the sickly, underperforming inflation-hedge assets).

However, I hold stocks in one hand and the cord to my parachute in the other. Market momentum, not my predispositions, will dictate to me. The object of this game is not to be right, but to make money (or at least avoid losing it). Economic opinions take a back seat to this objective.