Best posts of July, 2011: independent financial advice

  

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Fixing government spending

Planning for Treasury debt default hurting 401K's

Two things you must know about debt crisis damaging 401K's

Which is better: real estate or stocks?

How to solve the housing crisis

    Investors should seek independent financial advice.

Protecting 401K from Treasury default: independent financial advice

  

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   There seems to be some hope of a solution as Congressman Ron Paul Says `No Doubt' debt ceiling will Be raised. He was interviewed on Bloomberg late Thursday 7-28-2011.

Also Roger Altman, a former Treasury Assitant Secretary did not feel we would have a Treasury default. He was interviewed on Bloomberg on 7-29-11.

   David Rosenberg of Gluskin, Sheff said today he feels that the Treasury won’t default and that the crisis could be cathartic resulting in steps being taken to make the nation’s finances better.

   My opinion regarding an extreme case of potential default is that if the government refused to pay vendors it could keep other services running such as transfer payments, salaries, pensions and of course debt service. So it could take several months before vendors get assertive and cutoff their big customer because they did not get paid.

     Also there will be a new period of austerity either due to higher taxes or less government spending, resulting in a dramatic reduction in purchasing power and liquidity for the general public and this will usher in an era of Japan-style Soft depression which means the only game in town will be to buy long term Treasuries. So I expect them to go up and most other assets to go down.

   The chart action today for the U.S. Treasury 10 year yield was great, it made dramatic lows down to 2.805%, which implies that in a few days Congress and the president will reach agreement to solve the problem. The invisible hand of the market would not have let rates go down so much today if the Treasury bond was going to become a bad investment.

 Finding a safe haven

    63% of the world’s AAA debt securities are U.S. Treasuries. They will still be quite good quality Bills, Notes, and bonds even if a business that calls itself a "ratings agency” claims to have detected a need to re-rate them a notch lower. Where were the agencies when they rated bad mortgages as AAA? Why should we trust them now after all the mistakes they made? Once the debt ceiling is lifted then the Fed can provide unlimited liquidity for Treasuries and they will be safe from default.

   By contrast, the Eurozone and Japan have worse problems. And if American consumers reduce spending then Asian countries may suffer, which may threaten their currencies. A deflation may make gold and commodities go down.

  I have written “Planning for Treasury debt default hurting 401k’s” and “7 things about deflation you know”.

    Investors should seek independent financial advice.

Fixing government spending crisis: independent financial advice

  

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   The Treasury debt crisis is due to excessive and ever increasing spending which is due to government paid medical costs spiraling out of control. Non-medical costs are projected to actually shrink. So essentially the problem is the Federal government is in the medical business and does not collect enough revenue to support it.

   In doing long term financial projections for clients I have noticed how a slight increase in expected investment returns and earned income and a slight decrease in inflation can make a huge difference when compounded over a lifetime.

  So when economists forecast the Federal budget 30 years in advance, the problem is that the confidence level of the forecast is going to be very low.

  There is the possibility that there will be less expensive new breakthroughs in the development of new medical products. What if there are no new breakthroughs in medical discoveries? The current medical technology will eventually go off-patent and become a cheap generic.

   The reason medical care has become so expensive is mainly due to new breakthroughs in medical technology. As a result of these breakthroughs people feel worse off because they have the opportunity to save their life by paying for expensive medical treatments that did not exist. So yes, the cost went up, but so did the benefits. The rising cost of medical care should not be seen as a bad sign because it is a result of new technology. Imagine if someone went to a doctor and said “to save money just treat me with whatever tools existed 40 years ago”. The cost would be much lower, especially if the patient went to a third world country.

   More people in the workforce could decide to change careers and become doctors, nurses, physician’s assistants. If society has a 200 year trend of becoming more educated where an increasingly greater percentage of the population becomes highly educated professionals, then perhaps in the distant future a much greater percentage of the workforce will be medical professionals and with the increased supply, the price of medical care will go up less than forecast.

     Assuming that there is a long term trend of Japan-style deflation and high unemployment that will continue for five or ten more years then on the margin more members of the workforce will change careers to health care and vendors will develop lower cost treatments. Once those career changers have changed and then the economy gets better then they may not want to change back to their old non-existent career and will stay in health care.

   The irony is that rising medical costs incurred by the government have lead to a debt crisis that will be solved by either cutting government spending or by raising taxes, both of which are deflationary and which if done in today's fragile economy will lead to a depression. And as a result of a depression more people will have to change careers to health care.

Unlock the secret: what caused the deficit?

   If the U.S. continues to be the first choice destination for educated professionals and for entrepreneurs and it increases this with intelligent tax codes (low income tax rates and high sales tax that is waived for exports) then the economy can try to grow out of its problems. If the country has a disproportionate number of upper middle class professionals who can work past age 65 and afford to pay higher income taxes than if they were in a working class career, then the country can realize a better than forecasted tax revenue. Assuming that corruption and cronyism continue to plague the Third World then more professionals and entrepreneurs will move to the U.S. assuming they are allowed to and are offered competitive income tax rules and rates.

   These things are too far in the future to have enough information to do a reliable forecast. However worrying about the unaffordability of government financed medical care is correct, but one must have a positive attitude that macroeconomic demographic and political changes can occur that will be better than forecast.

   During the Great Depression many people thought we would never get out of it and during the boom of the 1990’s many thought the boom would last forever. Trends can change. Further, all that extra spending on senior citizens medical care in thirty years has to go somewhere to someone who will earn money providing services, resulting in more income that can be taxed.

     I wrote a post "Thanksgiving things to be grateful for". Despite being bearish it is very important to keep positive attitude so as to be open to new opportunities.

    Investors should seek independent financial advice.

Debt crisis hurts 401K’s: independent financial advice

  

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   The Treasury debt crisis risk to your 401k maybe not merely that the investments will go down, but also that you could lose your job and be unable to contribute to it or even need to withdraw funds to pay for living expenses.

   The ultimate result of the Treasury debt crisis is that either taxes will be raised to pay for the debt or government spending will be cut. Either way, the result will be that less purchasing power will be available in the private sector, leading to layoffs, lower corporate profits and lower stock prices. This would be bearish for the economy, which will create “flight to safety” by investors who will pile into “A” to “AAA” quality bonds. So even if the ratings agencies downgrade Treasuries investors will still flee into Treasuries.

    An analogy would be a passenger on the Titanic manages to get on a lifeboat and then when the Titanic sinks the wake from the boat sinking splashes into the lifeboat making the passengers wet. But at least they are safe and during that situation people would gladly pay a premium price to get on board the lifeboat.

    The U.S. government has a net worth of $80 Trillion and an annual deficit of $1.5 Trillion. Most importantly, it pays its debt with its own currency, so the U.S. can’t default because it has a printing press.

    Once the debt negotiations have been settled then the dollar may go up in a relief rally and it may also go up because a period of austerity will create a “flight to safety” by investors who will buy Treasuries.

Is this all that will be in my 401K?

 I wrote "Two scenarios you must know about Treasury debt ceiling crisis making 401K's go down" and "How to protect your 401K from a Treasury Default".

    Investors should seek independent financial advice.

Planning for Treasury debt default hurting 401K's: Independent Financial Advice

  

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    Alice Rivlin, Former Fed Vice-Chair said on Bloomberg today that a Treasury debt default would spur "deep depression".

   John Brynjolfsson who runs Armored Wolf fund said Treasury rates will go down due to deflationary aspects of the government shut down.

   My opinion is that during the Lehman crisis gold and oil went down significantly, so these won't help investors and could hurt someone who bought them at the top of the market.

   The good news is that the U.S. has $80 Trillion net worth. All that is needed to avoid default (in the short term) is to simply borrow more.

    The bad news is that borrowing more is unsustainable and very dangerous. As the country gets weaker its cost of capital will rise to reflect the increased risk. What trumps net worth and assets is income or cash flow. It is easy for assets to go down in value or to be squandered; by contrast a cash flow from earnings is more stable, reliable measure of a company's value and is also more reliable way to gauge a borrower's ability to repay. Every three months the deficit grows by an amount equal to the current value of the nation's gold.

   A nation that needs to fix it deficit with big tax increases will take intrinsic value out of the stock market by increasing taxes on corporations. Since stocks are basically valued on their after-tax earnings then as corporations pay more tax they will be worth less than their current value. Also, as consumers pay more tax they will spend less and corporate sales and profits will decline.

   In Hungary the government required pension funds to invest in government bonds. One wonders if the U.S. government would force people to buy unwanted Treasuries and hold them in their 401K?

Will the government require you to buy Treasuries in your 401K?

    I wrote post “Inflation creation machine is broken” and "Contrarian view of inflation hysteria”.

    Investors should seek independent financial advice.

How do you “opt-out” of inflation? Independent Financial Advice

  

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    Today’s semi-geriatric graying Baby Boomers who are suffering from age discrimination in the job market and a surplus of labor are going to be unable to afford inflation and will (pardon the joke) have to “opt-out” of inflation. To opt-out of inflation simply reduce your standard of living. Buy only cheap generics using coupons, never eat out, take a no-fly camping vacation. Sell your house and rent a tiny apartment within walking distance of work. Sell your car. Of course, on a quality-adjusted basis you can’t opt-out of inflation, but to survive you may have to cut back on the quality of life, which means merchants will make less profit selling things to you and the stock market will go down because of that.

   As a metaphor one could try to opt-out of inflation by investing in foreign currency in a country that had no inflation, but there are so many counter-intuitive variables that influence foreign currency prices that one can not simply say that a currency's price correlates with its inflation.

  Gold bug Jim Puplava joked that you simply ask the merchant if you can buy things like gasoline and food at the "core rate" of inflation, but that is not possible.

   People worry how to protect 401k from government default. They wonder if Treasury bonds are downgraded and other bonds values are based on Treasuries then that implies all bonds will go down in value, so that implies one should buy stocks and sell bonds. The argument offered by others is that some stocks pay 3% and a bank CD pays 1% so you might as well buy stocks. The other argument is that inflation will return and destroy bonds so you better own stocks.

    It is very wrong to compare a CD to a dividend paying stock. The stock can go way down in price (remember GM, Enron, Chrysler, WorldCom, Lehman, AIG?). By contrast the CD is insured. The dividend can be cut, maybe permanently. There is the risk that high dividend stocks which are “Value” stocks may be a “Value stock trap” where the stock dropped in value making the dividend (as a percentage of the share price) look more attractive, so you buy it and then the stock goes down more because it had a hidden problem that was significant.

    If inflation returns it could severely damage bonds. However, there is also the risk that inflation makes consumers poorer (especially when they pay their adjustable rate mortgage or get their credit card cut off during a credit crunch) so they reduce purchases of high profit margin goods and switch to cheap, low margin goods, thus depriving corporations of profits. Stock values are based on profits, so if profits drop, then stocks drop. A study by Societe Generale showed that during the inflationary 1970’s that stocks did not protect investors from inflation and that cash (meaning short term T-Bills, etc.) was the best asset class. A book, "The Bond Book", said that the two year T-Note was the best investment in the 1970’s. So one must weigh the risk of inflation hurting long term and intermediate term bonds, versus the risk that stocks will be hurt be declining earnings and rising discount rates. Discount rates are the rate used to discount present value to calculate stock’s value, and this rate is based on benchmark interest rates that are in turn partly influenced by inflation. This may make stocks go down when interest rates are high. Interest rates rise during times of inflation, so that is another factor to reduce the PE ratio of stocks. A low and declining interest rate acts as a lever to raise stock prices; rising rates make stocks go down.

      A huge pile of cash is needed if inflation returns. What investment provides the best pile?

     Never overpay for an investment. Buy at a small discount below fair value during a time when the investment is out of favor. Stocks are in favor with the public, having had a record 100% increase in two years, and are trading at a PE10 of 24, instead of a reasonable 15 or a bargain “capitulation phase” price of 8 to 10.  So if stocks are overpriced then they can’t help is inflation comes. Rising inflation makes us poorer due to progressive income taxes, adjustable mortgages, adjustable revolving lines of credit that fund most businesses, medical costs that go up faster than CPI, so that is a time when the consumer tries to avoid buying consumer goods.

   Stocks are priced for perfection and a period of inflation is a bad time for business. If inflation returns it won’t be the labor union friendly inflation of the 1970’s where consumers kept getting pay raises, instead it will be an inflationary depression with big layoffs.

    My forecast is that inflation won’t return, but if it does return then it will be very different from the 1970’s. The Baby Boomers were young and in a rising earnings curve, plus homes were very cheap then and consumers had fixed rate mortgages, so they had a lot of capacity to defend themselves from inflation.

    I wrote post “Inflation creation machine is broken” and Contrarian view of inflation hysteria”.

    Investors should seek independent financial advice.

Solution to Treasury debt ceiling crisis: Independent Financial Advice

  

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   People worry how to protect 401k from government default. Wall Street has developed many sophisticated financial tools, so why not use them to “solve” the debt ceiling crisis? Here are some ideas:

    For example, have food stamp recipients assign their future allotment of food stamps to a new non-profit financing company which then funds the food stamp program by paying the grocery store when beneficiaries buy groceries. The non-profit trust would have no net worth and would borrow all of its needed funds from the Fed, offering Asset Backed Securities that were similar to the $30 Billion that the Fed lent against during the collapse of Bear Stearns. Have a mark to model accounting (instead of mark to market) for these Asset Backed Securities that assumes that the funds will eventually be paid so it marks the receivables at book value as AAA rated. Get the rating agencies to rate the securities using the same people who rated the subprime mortgage securities as AAA quality. Once they are rated AAA the Fed can loan against this collateral. Assuming eventually Congress agrees to raise the debt ceiling then the government will start paying on past due payments for things like food stamps, education aid, highway funds, etc. So each of these projects can be financed by a charitable non-governmental trust funded by a loan from the Fed and legalized by virtue that the accounts receivable are a tradable security rated AAA. Congress will need to temporarily repeal the recent law that took away immunity from Rating Agencies, but that is not the same as Congress raising the debt ceiling.

    During the final years of the Chinese Emperor’s rule before his regime collapsed, the government got so indebted that the Emperor made the peasants pay property tax 70 years in advance. In Chicago the government assigned parking meter revenue to an investment bank for 30 years in advance and then quickly spent the money in a few years. So why not assign (or sell the accounts reciveable in advance) future Federal tax revenue to Goldman Sachs and they can securitize it into an AAA rated security issued by a non-governmental trust and sell the security on Wall Street? Ever heard of a corporation called Maiden Lane? (The same name as the back alley entrance to New York Fed). If it worked for the Emperor of China why not use it today?

   The Federal government could arrest everyone on Wall Street who caused the subprime crisis and release them after they post an all cash bail (with no bail bonds allowed) equivalent to all of their assets. To avoid a liquidity crisis from sudden asset sales the Fed would loan against the defendant’s assets as collateral.

  Money shortage reviewed

   The reality is that the huge government spending that leads to huge deficits is unsustainable because raising taxes will take away purchasing power from consumers, resulting in a deep depression. Taxes can’t be raised because, based on Supply-Side economics, a high tax rate discourages the earning of income and reduces the ability of people to buy things. So cutting government expenses is the only solution, combined with retooling the tax code to encourage exports and savings.

     I wrote a blog post “Treasury default like the start of World War I” and “Treasury Debt Crisis 401k Investing”.

    Investors should seek independent financial advice.

Two scenarios you must know about Treasury debt ceiling crisis making 401K’s go down: Independent Financial Advice

  

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    People wonder how to protect their 401K from the debt ceiling crisis. The real problem is not simply that a 401K’s assets could go down in value, rather it is that there is a problem with the country’s finances: if the unsustainable deficit is not fixed then one of two scenarios will occur: either government programs will be cut by about 45% or else taxes will rise very significantly.

    If a massive cutback in government spending is enacted (possibly a 45% cut) that would be a reason for the economy to fall into a deflation or recession due to reduction of demand. Beneficiaries of government spending would have less money to spend and that would decrease demand, leading to an economic crash.

     If a massive tax increase occurred that was aimed at balancing the federal budget, with no cuts in spending then tax rates might rise by 20 percentage points. So moderate income person (a single person earning over $33,000 a year) in California who is now in the 25% bracket would pay 35% in federal income tax, plus an additional 10% of Medicare payroll tax (up from 1.45%), plus state income tax of 9.3%, plus Social Security of 6.2%. His employer would have to match the Social Security and Medicare taxes, which would dampen employer’s desire to create jobs and incentivize employers to reduce jobs.

   These taxes would be very deflationary. Econ 101 textbooks say “raise taxes to cool off the economy, cut taxes to stimulate the economy”. A deflation would make stocks go down to retest the SP’s low of 666 of March 9, 2009 and probably stay there.

    People may wonder what about a third scenario where the Federal Reserve simply prints money and donates it to the Treasury. There is no legal provision for this happen. People wonder will Congress simply keep expanding the Federal deficit and simply have the Federal Reserve Bank buy all the new issue of T-Bills? This is unlikely because Congress does not want to increase the deficit. Further, the government has an incentive not to create inflation because most of their costs are indexed to inflation: Medicare, Medicaid, college education, short term interest rates all go up with inflation and could go up faster than the CPI rate of inflation.

Open the door to new economic ideas

   There is no way to get extra stimulus to get out of the recession, instead the recession will be made worse by a cutback in government spending or by a massive tax increase. Therefore, the proper investments regardless of whether or not they are in a 401K are conservative, high quality investments that have the characteristics of low risks. For example if you insist on buying stocks (which I don’t recommend) then get stocks with all of the following: low debts, high corporate moat, steady and growing profitability, above average retained earnings, good management, and above all don’t overpay for any type of asset. My preference is to ride out the storm by holding the asset class of investment grade quality bonds. Avoid low quality bonds. Be careful about Mortgage backed bonds because of variable duration risk. Beware of Muni bonds as a Federal austerity program means that the federal government may not bail them out and a deflating economy means less tax revenue for Muni governments.

   I wrote a blog post “Are your funds trapped in a 401K?” and “Two things you must know about debt ceiling crisis damaging 401K’s”.

    Investors should seek independent financial advice.

Federal debt ceiling crisis worsened today: Independent financial advice

  

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   The Federal debt ceiling crisis got worse today when the parties were unable to meet a voluntary deadline to get a deal done tonight before the Asian markets open up. So now, in the first hour of Asian trading Hong Kong's Hang Seng market is down.

   There was an excellent article on 7-23-2011 in Wall street Journal about "Neon Swans" where Jason Zweig discussed how advisors were unable to decide how to protect their clients from a Treasury default.

    I do not think buying gold or similar investments will protect from a Treasury default. If a default occurs the result would be deflationary, making gold go down. If, on the other hand Congress was controlled by leftists who advocated massive Keysian deficit stimulus then the Fed might have to monetize the deficit which would cause inflation.

   Buying the VIX in hopes of profiting from a Treasury default might not work because there is the possibility that a last minute deal could be reached or that the markets would not panic. Meanwhile, if you buy the VIX it can go down in value if the anticipated bad news never materialized. Further, the VIX deteriorates over time like the time decay problem in buying options, so there is risk in buying the VIX. A similar strategy would be to buy a Put option on the stock market but that strategy has similar risks to the VIX.

U.S. Treasury contents after August 2, 2011

    My major theory is that the stock market is propped up by mentally asleep sellers of Put options coupled with hedge funds that are propped up with near zero cost of margin money. If the Fed loses credibility for any reason, including a false accusation about a problem caused by the debt ceiling crisis then the system that props up stock markets will fall over like a house of cards. I believe the SP500 should be trading at 800 or even lower, so if the markets panics it will go down to that level. If a panic occurs then a combination of expensive Put options and expensive margin rates will result in a hedge fund flash crash sell-off that will stay at depressed levels. That is deflationary, so gold, which may only be worth 800 to $1,000 might go down, not up.

     I wrote "Treasury default like start of World War I".

     Investors should seek independent financial advice.

Two things you must know how Debt Ceiling crisis hurts 401K’s: Independent Financial Advice

  

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    People wonder how to protect their 401K from the debt ceiling crisis. They want to know will Treasuries go down if devalued by the government? First of all Treasuries would not be “devalued” by the government. Instead, a default would make the marketplace reject Treasuries, causing them to go down in value. The word "devaluation" should be used in regards to the dollar going down against other currencies, rather than using it to talk about Treasuries. The dollar is not the same as a Treasury Bill, but has similar characteristics.

   The level of intensity and the stakes involved remind me of the Cuban missile crisis of October, 1962. People should see the movie “13 Days in October” to see how close we came to nuclear war and how the president and his advisors were unable to trust the military and thus they had to devise special channels to find out what was happening. That is a double analogy to the debt crisis: 1^st it is an analogy about the tension and danger, secondly it is an analogy about the inability of the president to get reliable data from his own chain of command, or to modify the metaphor, the president may not be getting reliable economic advice from the left-wing of his party.

    A Treasury default would cause interest rates to rise because many loans are based on a spread over Treasuries, so if Treasury rates went up then all type of interest rates would go up.

     The rate rise would hurt stocks because it would make the purchase of stocks (using margin borrowing) by leveraged hedge funds less profitable so they would sell off some of their stocks and the stock market would go down.

    In general a default would make the economy perform more poorly than it already is, thus justifying a bearish opinion about stocks, which would make stocks go down.

    The Fed could decide to fight this with QE3 and buy up Treasuries to force rates back down.

  

     People worry that their 401K will go down because of a federal government debt crisis shut down. Investors should focus more on their overall portfolio rather than simply their 401K. A 401K is simply an investment vehicle that has tax advantages (and disadvantages). It also is a vehicle to encourage saving for retirement and to encourage employers to contribute to retirement. Of course it may be some people’s only significant asset, especially if their house has no equity.

      A 401K has some “asset protection” aspects in event of bankruptcy depending on complex issues including what state do you live in and whether you have lived there for at least 40 months and other factors.

     A 401K is superior to an IRA because you get penalty free withdrawals at age 55 (or even age 54) if you lose your job in the year you turn 55. It is superior to an IRA because it allows loans.

   I wrote blog posts “Are your funds trapped in a 401K?” and “Treasury debt crisis 401K investing” and "Two things you must know about debt crisis damaging 401K's.

    Ultimately the Treasury can pay its debts because they are denominated in dollars, as long as Congress agrees to borrow more. It is a matter of Congress allowing the Treasury to incur more debt. Of course, in the long run (which is coming soon) the U.S. will not be able to borrow more, which is why it is a good idea for Congress to take the time to negotiate to obtain spending cuts.

  Investors should seek independent financial advice.

Two things you must know about debt crisis damaging 401K’s: Independent Financial Advice

  

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    People wonder how to protect their 401K from the Treasury debt crisis. For some people this is their only retirement nest egg other than Social Security. And Social Security needs a 23% reduction in benefits to remain solvent.

      Exotic Strategies to protect 401K’s:

1. Ask your employer for a brokerage window

2. Ask your employer for an “in-service” withdrawal rollover to an IRA

3. Borrow from your 401K and invest the proceeds as you wish

4. In a non-retirement account use derivatives contracts to invest in desired assets in the amount that is in your 401K and keep the 401K invested in a Money Market or Treasury Bill fund.

Strategies 3 and 4 are risky and could tempt people to engage in dangerous gambles so they should be avoided by most people. The derivatives investment could backfire, producing ruinous losses.

Unlock your 401K or stick with its resources?

    Consider using a 401K as a place to own high quality corporate bonds and Emerging Market bonds rather than stocks because for tax purposes Treasuries are best owned in a retirement account if you live in a high tax state. (Because Treasuries are free of state income tax they should not be in a retirement account because their income will not be free of state income tax when withdrawn from a retirement account, but it is free of state tax in a regular non-retirement account). Most 401K’s have a few reasonable (but not that great) choices of domestic bond funds, but no access to Emerging Market bonds.

    What will happen if the Treasuury defaults? The only precedent to a Treasury default would be analogous to the Lehman bankruptcy. The market crashed but quality domestic short term bond funds only declined by a modest amount and then fully recovered in a few months. Of course a Treasury default would be systemic, but then the Federal Reserve would start QE3 by buying Treasuries with a flood (of money) of Biblical proportions.

     I wrote a blog post “Are your funds trapped in a 401K?” and “Treasury debt crisis 401K investing”.

    Investors should seek independent financial advice. Consider these ideas for assets not held in a 401K:

Which is better: real estate or stocks? Independent Financial Advice

  

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   If you purchased a rental property home in the Easy Bay region of San Francisco Bay Area for $110,000 in 1981 and sold it in 2011 for $400,000 and collected rent would that be better than stocks? (This ignores commissions and closing costs, which are significant). Assuming a gross rent of about 6% of value and a 30% haircut for expenses for an absentee owned rental property this would result in about a 4.2% dividend (averaging roughly $980 monthly over 30 years) assuming no mortgage. This produces an 11.67% annual IRR, assuming dividends were reinvested at the same rate. This study does not consider taxes.

    Compare that with the Dow Jones Industrials. If you purchased $110,000 worth in 1981 when the price was 900 points, now worth 12,500 points (which is $1,527,777) with a 2% dividend (averaging $1,222 monthly dividend assuming a median value of $733,700), and assuming no debt was used. This assumes dividends were reinvested at the same rate and ignores taxes. 15.4% IRR.

   From a risk-adjusted viewpoint of Sharpe ratio or Information ratio the stock portfolio was far safer since it is diversified and liquid. From a convenience standpoint stocks are more convenient due to their ability to obtain a “no qualification” margin loan of 70% if the purpose of the loan is something not related to securities. This could be useful if someone had a personal problem they could raise cash without having to sell or refinance their rental house. From a tax standpoint the larger amount of capital gains from stocks produce even greater after-tax benefits to stocks than to real estate. The rental income net profit is taxed at ordinary income rates, but the dividends and capital gains are taxed at the 15% dividend rate. (The rates were higher before 2003, but still favored stocks). The study is a bit simplistic because the dividend reinvestment rate in the 2000-2011 period was certainly not at the long term 30 year IRR of 15.4%, but was more like 3%. The investor would need to have another source of cash to pay taxes in order to create these type of compound returns, and that would create an opportunity cost. Rental real estate has the ability to do a tax-deferred exchange, stocks don’t. But ultimately capital gains have to be paid when assets are sold unless the owner dies and basis is stepped-up.

    The study doesn’t consider depreciation deductions on rental real estate, but they last for 27.5 years, and are recaptured when the property is sold and are only on the “improvements” (the building). Since land is what really is a large part of an urban property then depreciation deductions are not that significant and they must be paid back. In this example the depreciation would be about $2,000 a year or about an extra $700 a year in “tax savings” which is repaid to the IRS when the property is sold.

   One plus for rental real estate is that when rental real estate is sold at a loss, the losses are categorized as a “business loss” and are thus fully deductible; by contrast stock market loss deductions are limited to $3,000 a year.

   If someone was afraid that being a renter and owning only stocks would cause him to miss out on the great real estate boom of the past 30 years they could have put some of their stocks into shares of Real Estate Investment Trusts (REIT’s).

   If someone says real estate is better than stocks because it allows more leverage, my objections to that are: investment options should be reviewed assuming they somehow could be bought for all cash. That is how it is taught in commercial real estate and the Modigliani-Miller theory in stocks agrees with that indirectly. Further, leverage is dangerous as many overleveraged home owners found out. To be safe a rental property investor should put a down payment (at most times in history) of roughly 40% plus closing costs to get a breakeven cash flow; further he would have to segregate some cash for reserves for future maintenance and vacancies, which does not occur with a passive stock portfolio.

   What is interesting is that my study looks at the best 30 years of real estate. The future may be a stagnant market with no appreciation until 2016 or later and then it may only appreciate by the rate of growth in the overall economy, which is now at roughly 2%. Further, my opinion is that real estate’s number one appreciation factor is growth in the personal earned income of the local community. So if earned income stays stagnant with a zero real growth rate then real estate will not appreciate. Add to that a rate increase by the Fed to normal levels and real estate will go down even after the real market has healed!

   Another caveat: stocks are overpriced, so to be fair the study should assume they go down about 33% and settle at roughly 8,000 or 9,000 for the Dow. Even then real estate is not as good. Besides real estate still needs to go down a little bit more, perhaps 10 to 20%.

   Real estate did worse than stocks partly because it is undiversified, and over-leveraged. Its potential tax rewards hypnotized investors and made them too eager to buy, so they overpaid for an asset with a perceived tax shelter value. Its ability to provide a 30 year non-callable loan with leverage of 30 to one (for owner-occupied properties) rather than a callable margin loan on stocks with a 2 to 1 leverage ratio attracted people who wanted leverage and that made buyers too emotional.

   This article does not discuss bonds, it is merely a comparision between stocks versus real estate.

     I wrote a blog post “real estate crash will continue” and “Has the economy recovered enough to justify the stock market prices?”

   You may want to consider a completely different investment paradigm:

Investors should seek independent financial advice.

Two things you must know about the Renminbi: Independent Financial Advice

  

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    People wonder where is a safe place to invest. Should they buy gold, foreign currency or something else? Looking at foreign currencies the old paradigm is that when the world goes into a recession then the rest of the world suffers more than the U.S. so the dollar goes up in value and the other currencies go down in value.

    However, time has come for a paradigm shift. The Asian Emerging Markets countries have lower levels of debt and are more solvent than the developed countries.

      People wonder if China’s economy is a bubble that will crash, resulting in the Renminbi currency dropping in value. China’s economy has debt of about 100% of GDP. But roughly half of that could be offset by China’s huge $3 trillion foreign currency holdings, making China’s debts the lowest of any major country in proportion to GDP. Further the Renminbi is a blocked currency and there have been only a few Renminbi denominated bonds issued in Hong Kong that the rest of world can buy. So it is unlikely that there would be a selloff of the Renminbi if China’s economy suffered from a crash.

   Many of the debts in China are simply private placement of debts where a wealthy person gave up the ability to spend by lending funds to a business that will spend the funds. So if the debtor fails then a wealthy investor will lose some of the value of his bonds or Notes, but if the investor is not leveraged and does not experience his own crisis then the Chinese economy can keep going despite the loss that the investor suffered. By contrast, in the U.S., the Shadow Banking system often sold bad loans (fraudulently rated by rating agencies) to commercial banks that were highly leveraged, resulting in the bank failing because the bad loans failed. This resulted in banks becoming unable to loan money to new borrowers.

   Assuming China’s real estate bubble is only financed by cash buyers then China will not be too badly hurt by the coming China real estate crash. Unfortunately some real estate is financed by debt.

Money from debt is risky

     China’s economy has made (and saved) a lot of money exporting things to the developed world. The cash flow from that is a more meaningful economic statistic than a balance sheet item such as debt or assets. If cash flow is the most important analytical tool for investments then it should also be so for looking at a country’s ability to keep its currency strong. Criticism of China has been made that they reinvest too much in building unneeded buildings and are thus wasting money while (giving the appearance of) increasing the GNP. But China makes money from exporting and you can’t export a building. So if even if China’s real estate crashes Chinese businesses can still keep making money in exports and will be able to hire workers at lower wages who lost their jobs in the construction industry.

    The imbalance of exports over imports and the lower level of debt are some of the key reasons why a country has a good currency. The whole world has a lot of debt and the part of the world that has the least amount of net debt when counting foreign currency reserves, is China.

    I do not expect the Renminbi to be devalued if China suffers a hard real estate crash.

     I wrote a blog post “China’s hidden loan bubble” and “China crash what are the risks?”.

    Investors should seek independent financial advice.

When will interest rates return to normal: Independent Financial Advice

  

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   Only 13.5 years until unemployment is back to 5%, according to the WSJ article of 7-16-11. I have been writing about this for some time that the labor market is crippled and it will take as long as the Great Depression of 1929-41 to heal.

    The number of factory jobs decreased by five million in the past decade and the number of mortgage and real estate bubble jobs permanently lost has been one million. It will take years for these people to realize they need a new career, get the training and then find an entry level job and then acquire the journeyman skills to justify getting a real paycheck.

   This reminds me of articles saying that the real estate market won’t recover for 28 years in some depressed areas.

    What this means is that low inflation and low interest rates may last for the rest of this decade. High unemployment is the number one factor in making inflation and interest rates low. This is why the bond market vigilantes are not energized by the recent price increases in vegetables and oil.

   The Federal budget deficit is primarily caused by the failure of Congress over the past thirty years to calculate and plan for the cost of increasing lifespans of Social Security and Medicare beneficiaries. So “means testing” will be legislated (it already has) and that means people under age 70 to 75 may have to pay a lot more to Medicare and receive a lot less of Social Security. So these people will need to stay in the labor force to pay for retirement, which means the jobless rate will be influenced by an even greater supply of job seekers. These extra job seekers will be upper-middle class people who will have to bear a disproportionate burden of “means testing” due to income, so they will stay in the labor force and use their superior job skills to compete with others, thus making it harder to solve the unemployment problem.

Unlock the secrets of low interest rates

     I wrote a blog post “Hidden economic weaknesses” and “Inflation creation machine is broken”.

    Investors should seek independent financial advice

How to protect your 401k from a Treasury Default: Independent Financial Advice

  

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   A 401K may have limited investment choices, so it may be difficult to find something to invest inside the 401K that will protect your money from a Treasury debt default. Many 401K's offer only a few equity mutual funds and two bond funds, with no way to invest in gold or foreign currency.

   One possible but weak solution would be to invest in a short term investment grade money market mutual fund or a “Guaranteed Income Fund” (GIC) offered inside of many 401Ks. Even those are risky. When Lehman failed a prominent money market fund lost 3% of value. And when some employers failed then the GIC’s in 401K’s also lost value.

      A GIC is a contract by an insurance company to provide a bond like investment where they guarantee the principal. The problem is that the insurance company can go bankrupt thus ruining the “guarantee”. So watch carefully when someone says “guarantee”. The insurance company should have an “AA” or higher rating to make their “guarantee” a reasonable bet. That is all it is, a “bet” that the insurance company will remain solvent. You have no guarantee of the “guarantee”!

   One hypothetical strategy that is too risky to recommend is to buy a futures contract on gold that is equivalent to the amount of your 401K assets. Then if gold goes up during a crisis that might offset the damage caused that a crisis did to your 401k. But I do not recommend it because gold has behaved in an unreliable manner and could go down and if coupled with the extreme leverage of a futures contract then you could go bankrupt, so please don’t do it.

   There is no guarantee that gold will go up in lockstep with a decline in the dollar. Gold could have been overpriced due to emotions of other investors and thus gold could go down. There is some reason to believe that a fair value for gold is between $750 to $1,000, so it may be overpriced at $1,600 today. During the 1970’s it went down 50% in 1975 and then in 1980 it went down 50%. Since futures contract are leveraged up about 20 times the initial deposit then you could lose 10 times your investment if gold futures dropped 50%.

    Fortunately most people change jobs every few years at which time they can roll over their 401K to an IRA where they have a huge amount of freedom of choices. Always ask your employer if they allow a “brokerage window” in a 401K that allows you to buy any publicly traded investment even though it is in a 401K and ask if they allow “in-service” withdrawals where you can roll it to an IRA. Never do a distribution of the money from a 401K directly to you, instead tell the new broker that will hold your IRA that you want him to pull the funds from the old 401k and roll it to the IRA. If you withdraw funds from a 401K by having a check payable to you then it is taxable transaction and probably can’t undone.

     I wrote a blog post “What is the proper value of gold” and “Are your funds trapped in a 401k?”

    Investors should seek independent financial advice.

Treasury Default Like the Start of World War I: Independent Financial Advice

  

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   Treasury default risk is a high stakes game. It is analogous to the start of World War I where the combatants took excessive risks resulting in vast slaughter. The combatants were used to thinking of the less lethal warfare of the 19^th Century and were not fully aware of the more lethal effect of modern warfare that resulted in unbelievable massive casualties.

   Fortunately after WWII the risk of nuclear annihilation caused both sides to carefully negotiate to avoid a war.

    In today’s economy the prevailing experience with bankruptcy is that life goes on and the bankrupt company’s functions are taken over by a healthy successor company. However a default by the U.S. Treasury would be very different from a corporate default because there is no precedent for such a huge default. Further the whole world’s economy is based on using the dollar in lieu of gold as the world’s reserve currency. That means that Central Banks have dollars instead of gold in their vault for reserves. If the dollars become worthless then the Central Banks of the world lose most of their reserves. Of course a Treasury default does not necessarily means that dollars will become worthless. However, because the dollar is a fiat currency then any event that shakes peoples’ confidence in the dollar could trigger a “run on the bank” resulting in a panic to get out of the dollar.

   This potential for damage to the world economy means that debt negotiators have the same responsibility as the negotiators during the Cuban missile crisis. This is a very serious matter.

    Ultimately if the Republicans are blamed by the voters for a Treasury default that created a depression then the left wing of the Democratic party would get into power and raise taxes, thus making things worse for Republicans.

     I wrote a blog post “Two things about Treasury default you must know” and “Two things you must know about debt ceiling crisis”.

    Investors should seek independent financial advice.

Two Things about Treasury Default You Must Know: Independent Financial Advice

  

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   Treasury default risk is a high stakes game. It reminds of the risk of nuclear war during the Cuban missile crisis. Fortunately both sides realized they needed to back away from a dangerous confrontation. That is probably the best precedent. There really is no economic precedent for a U.S. Treasury default. Such a default would be:

1. Not comparable with a corporate bond default because the Fed can print money to pay off the current creditors when their bonds come due assuming no creditors want to rollover their debt and if Congress allows more debt to be issued.
2. Not comparable to corporate debt default because the Treasury market and the dollar are the world’s reserve currency in lieu of the gold that used to be the reserve for the world’s Central Banks.

     When a corporation defaults on its bond the professional investors understand how to evaluate the debtor’s ability to repay and can judge the situation fairly. Further the corporation is simply one small part of the economy so its temporary closure while in Bankruptcy court may not affect the majority of the population. By contrast the collapse of the U.S. Treasury market would affect everybody in a manner analogous to a 19th Century commercial bank run and collapse where there was no Central Bank and no FDIC to bailout a failed commercial bank.

     A Treasury default could cause Treasury rates to become artificially high for a brief period during a panic. But ultimately the panic would subside, the problem would be fixed by Congress and meanwhile the panic will tip the global economy back into recession, making Treasuries prices go up in value to new highs. (Thus yields would go lower). It could be a great V shaped buying opportunity for Long Term Treasuries.

Impossible to compute what will happen if Treasury defaults

    If you are on the Titanic as it sinks you will be glad to get on a cold, wet, cramped, leaky lifeboat because there is no other alternative. The sturdiest of lifeboats are the U.S. Treasury Bonds, Bills, and Notes. Many other developed countries have similar or worse problems. The commodity countries of Australia, Canada, and Norway have good finances, but if a deflation is caused by a crash in China then there will be less demand for commodities and thus these countries' finances may end up in a much weaker situation.

     I wrote a blog post “Two things you must know about debt ceiling crisis” and “7 strategies for a dollar crash”.

    Investors should seek independent financial advice.

Four Reasons Not to Worry About Money You Must Know: Independent Financial Advice

  

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    Don’t worry about artificially low interest rates. Most of the time over the past 100 years “real” interest rates are about 3%, but if they come with high nominal rates of 9% then the after-tax and after-inflation return is zero. Today if you get 3% on a bond and lose 1.5% to inflation plus pay 33% tax (which is about 1% interest) then your after-tax and after-inflation return is 0.5%, so you may be better off than a retiree who earned 9% when inflation was 6% and taxes were 33% and who got an after-tax, after-inflation return of zero%. When people get high nominal interest rates they are fooled into thinking they are more prosperous than then really are so they overspend which destroys their retirement plan.

    Don’t worry excessively about the dollar getting devalued. Although one should be alert for trouble, history shows in forty years after the gold standard ended the fiat dollar has only dropped 0.8% a year against the major developed countries, which is less than the damage from inflation. It will go up against the Euro as the Euro will break up. Further, only 17% of expenditures are on imported things and domestic manufacturers can make substitutes for them if the cost of imports goes up due to devaluation.

     Don’t worry about the future of the country. Today’s young adults are smart enough not to trust the stock market and smart enough to boycott the housing bubble and be good savers. Skilled immigrants with college degrees are legally immigrating to the U.S. and stimulating the economy and generating tax revenues.

   The U.S. economy and demographics are much better than the other developed countries.

    Even though it is important not to worry about money you must still be prepared to defend yourself against investment mistakes. Please see my free guide “Avoid Investing Mistakes”.

     I wrote a blog post “Contrarian view of inflation” and “Will the dollar be devalued?”.

    Investors should seek independent financial advice.

Foreign Bond Crash News You Must Know: Independent Financial Advice

  

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   A client enquired about my rather large allocation to foreign currency denominated bonds. (The allocation is larger than what other advisors recommend, but not too large in my opinion). My reasoning is that the theoretical weighting should be 52% Emerging Market currency, so the client could be underweighted, not overweighted. This is because it is a bit unusual for an investment advisor to recommend so much in EM FX but based on the world economy and blindly assuming that the market is always efficient and that one must simply diversify in proportion to the word’s economy then people should have half of their assets in EM denominated investments in either bonds or stocks or real estate, etc. However, I don’t believe that the markets are efficient, which is why I recommend a very large bond allocation.

   Regarding why Emerging Market bond investments had a bad day on Monday, July 11 I think that ultimately bonds are the “shadow owner or contingent owner” of equities and real estate, so if equities and real estate go down (this Monday morning July 11 stocks crashed in Hong Kong by 3%) then that makes bonds in those regions look less reliable than before stocks crashed.

There are two conflicting theories:

1. The traditional theory is that when the world economy crashes that America is the only safe haven
2. A new paradigm (that I advocate) is that the U.S. is no longer that great of a safe haven and Asian developing countries have better solvency than developed countries. But no one can tell for sure.

Unlocking Financial Mysteries

    The new fear in recent days in the news media is that China is a bubble and if it crashes it will hurt other EM countries and when an economy is hurting then risk of default goes up and thus bond prices and EM currencies both go down. It is hard to tell if China is a bubble or if it crashes will its closed system with no foreign debt somehow keep the Yuan stable. Their debt to GDP as discovered by the news media keeps rising with the latest estimate at 90%, but about half of that is offset by foreign exchange holdings, making them still very solvent compared to developed countries. Further their restrictions on export of cash and refusal to allow foreigners (with few exceptions) to own their bonds helps to insulate them from a world crisis. But if they had a hard landing then the neighboring countries could become weaker. But the Asian countries did a great job of installing good financial ratios after the 1997 crash. I spend a lot of time reading about China and thinking about this.

      The theory that there has been a paradigm shift from the old pattern of the U.S. as safe haven is a new and untested theory, so one is justified in being apprehensive about my theory. The recommended investments were picked based on being some of the least risky of their asset class; rhetorically speaking, the alternative might be to “give up” on my paradigm and meekly sit tight in dollars and let the dollars get depreciated. Remember how badly the British pound behaved from 1945 to 1992.

     Some people ask what to read to understand foreign exchange movements. Regarding what I read, my self-education has been primarily periodicals including web published articles from things like CFA Journal or Financial Times rather than books. What I read is on my website at http://www.mayflowercapital.com/educate. I don’t know of a list of a few key books that someone could read to get up to speed on this matter. The news articles I read often contain synopsis of academic finance books.

   Trying to predict foreign currency movements is very difficult because it suffers more heavily from capricious government intervention than do other investments, reminding me of Churchill's statement about a "a riddle wrapped in a mystery wrapped inside a Sphinx".

     I wrote a blog post “Two things about devaluation you must know” and “Dollar devaluation investing”.

    Investors should seek independent financial advice.

Treasury Bond Rally: Independent Financial Advice

  

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    Bernanke hinted at starting QE3 today only a month after denying that he would do more QE (Quantitative Easing). "The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might re-emerge, implying a need for additional policy support," Mr. Bernanke said,

     Bond experts Hoisington and Hunt said today “… deflation is our largest concern and we remain fully committed to the long end of the Treasury market.”

      Komal Sri-Kumar, chief global strategist at bond fund TCW, talked on Bloomberg about the U.S. economy and Federal Reserve monetary policy. He said if he was allowed only one trade he would buy 10 year Treasury for a short term trade and hold until the rate went down to 2.5%. It now at about 2.89%.

   Bond guru Bill Gross has reversed himself, reducing bets against the value of U.S. government debt in June as investors sought safety in Treasuries. Pimco’s Total Return fund increased its holdings of Treasury debt for the second consecutive month.

     I wrote blog posts “7 things about deflation you must know” and “Ricardian equivalence” warning about how deficit spending can backfire and make the recession worse.

    Investors should seek independent financial advice.

Treasury Debt Crisis 401K Investing: Independent Financial Advice

  

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    People wonder if the U.S. debt ceiling is not raised and the Treasury defaults how will that affect their 401K? They wonder what is the safest place for 401K funds during a Treasury default. The answer is that a 401K is simply a container that holds assets similar to what you could buy outside of the 401K. With a 401K in the account owner’s mind this account value is the quantification of his or her future retirement and thus a decline in its value makes one feel worse than if a taxable account went down in value.

      If the Treasury defaults this would cause a panic and presumably corporate bonds, stocks and real estate would be hurt. Professional investors might even buy more Treasuries as a safe haven even though the Treasury was in default! Possibly people will buy gold and silver.

Is foreign currency the answer?

   A Treasury default would create condition of austerity (meaning there would be less government subsidies, welfare, etc.) and this could tip the economy into a recession. So that means high quality bonds would go up. But in a recession poor quality bonds will go down in value because of an increase in default risk. So there would be a panic like the Titanic passengers fighting over a seat in a lifeboat as investors rush to buy AAA rated bonds. A cold, wet, leaky lifeboat is better than drowning. This is called “crowding in” where people pay high prices for AAA quality bonds pushing interest rates to absurdly low levels. The Japanese government’s ten year Treasury bond went down to about 1.5% yield as Japan’s finances became worse because of crowding in.

   So it is all about seeking safety and avoiding the hidden risk of poor quality bonds disguised as high quality bonds. That means everyone should be careful that their Money Market Mutual fund does not hold Greek or European bank issued commercial paper, since a Eurozone sovereign default will hurt European banks.

     Most 401K’s have a short term government bond or short term high quality bond choice. That might be a place to invest, even under the threat of inflation, so as to avoid losses from another banking crisis. In the near future, the risk of loss of principal in the stock market and real estate market is greater than the risk of loss due to inflation that hurts or may in the future hurt bonds, assuming bond maturities are short term.

     I wrote a blog post “Are your funds trapped in a 401K” and “Prepare for a crash”.

    Investors should seek independent financial advice.

Are REIT’s a good investment? Independent Financial Advice

  

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    Some people think a strategy for hedging against the risk of inflation is to buy a REIT. My opinion is that inflation may not come for a long time and that it may take many years for the U.S. to get out of a Japan-style Soft Depression. Further, if inflation returns it would be an inflationary depression where people have less purchasing power in real terms and must cut back on purchases, including moving towards leasing smaller offices, smaller apartments, etc. Employers could continue the process of moving jobs to low cost suburbs, using “hoteling” for employee office space and encouraging employees to work from home thus freeing up office space. It is a myth that real estate becomes scarce “because they are not making any more of it” because there are ways that office and residential tenants can save money by reducing consumption of square feet of real estate and the quality of their standard of living.

   The search for higher yields than offered by bonds may have made investors overpay for REIT’s and thus REIT’s would not be a good investment.

  What makes real estate go up is not inflation but rather it is a long period of low inflation and low interest rates coupled with rising income which increase demand for more and better quality real estate. Society has been experiencing a long history of shrinking or stagnant real income going back as far as 1998, so this is time for consumers to cut down on the consumption of real estate by moving into smaller leaseholds.

    Assuming that inflation returns then interest rates will rise which will hurt the ability of people to buy real estate, thus making it go down.

    My forecast is for a moderate deflation so that inflation won’t be a problem and instead investors will find they have panicked and overpaid for potential inflation hedges. Commodities, etc. will go down in price as they did when Lehman collapsed in 2008. It is important in investing to wait patiently to buy investments at a discounted price and to avoid overpaying for investments.

     I wrote a blog post “Inflation creation machine is broken” and “Contrarian view of inflation”.

    Investors should seek independent financial advice.

How to solve the housing crisis: Independent Financial Advice

  

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1. To solve the housing crisis one might be tempted to think that the government could somehow have the Federal Reserve buy empty foreclosed homes with newly printed money and then simply keep those homes empty so as not to disturb the rental market. The Fed has no legal authority to do so and there is no reason to think Congress would approve a change in the Fed’s charter to allow this or that the Fed would want to do it.
2. Another wrong idea about how to solve the housing crisis would be to go retro and return to the world of easy qualifiers (liar’s loans) that existed from 1984 to 2009. But that is exactly what got the country into this mess in the first place.

    One must first recognize that a mistake was made during the great housing bubble of 1983-2008. There is no way to get reimbursed for the tragedy that occurred. People chose to overpay for a house because they were brainwashed by the “Greater Fool” theory and chased after a bubble. The people who made a mistake can’t expect society to subsidize them and make them whole for their mistake.

   The solution is for the market to mark down the values of homes to a low enough level that investors will buy houses for the purpose of renting them to tenants, instead of for short term “flipping”. The current price level is close to the proper level where the market will clear in a few depressed areas.

   Therefore Congress should do nothing to subsidize housing. Instead Congress should remove the tax benefits associated with home ownership. If people chose to be a renter (or to own a very small, low cost house or condo) why should they pay extra income tax to subsidize the deductions that homeowners with luxurious, gigantic homes get?

     I wrote a post “Real estate crash will continue” and “Surprising facts about housing crash”.

     High, long lasting unemployment has been attributed to the housing crisis. This is probably true, but re-inflating the housing bubble is not a realistic way to create jobs.

   What needs to happen is that the hard core, long term unemployed need to get career training in a new field that has minimal risk of being hurt by foreign competition and for which a lot of demand exists. These fields are:

1. Health care: nurses, medical technicians, nursing home operators, physical therapists, etc.
2. Information technology: domestic jobs involving security, IT training, retail sales, customer service. It may include using software for marketing and distribution especially when used to support sophisticated domestic services such as advertising agencies, entertainment, law firms, etc.
3. Education: there is a need for educators to train people for professional, vocational, paraprofessional skills. Also many foreign students come to the U.S. for college.
4. Foreign tourism: because Emerging Markets currencies are getting stronger many of their citizens will come here for vacation. They will need guides, drivers, translators, etc.

    This week there was an article in FT.com that said call centers in India are no longer cheap and it is now more efficient to open one in the depressed northern part of England. So the next time you call a software help phone line they will talk to you and say “Blimey Mate would you like some fish and chips with your software?”

      I don’t accept the theory that unemployed U.S. factory workers, Realtors, loan agents, etc. can’t learn to transition to the “New Economy”. When foreigners get desperate they learn a new language, a new culture, new personal skills such as automobile driving, a new career, new country’s customs and come to work here in the U.S. So I expect unemployed Americans to learn new skills and not come up with excuses that they are too dumb to be retrained or their personality is only suited for selling houses, etc.

    Investors should seek independent financial advice.

Four investment tools you must know: Independent Financial Advice

  

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   Investors have many tools to use to pick investments. Four tool investors must know are the Sharpe ratio, the Information ratio, the Sortino ratio or Schiller PE10 to name a few tools.

   The Sharpe, Information and Sortino ratios look at the relationships between risk and reward. They are based on historical fluctuations of share prices, so during a long term bubble the true risk does not show up in share price movements and at the same time investors are feeling too euphoric to think criticically. These tools could be considered more of a “momentum” trader’s tools, instead of intrinsic value tools. Momentum investing means to gamble that you think the other guy will overpay for an asset thus making it go up even if you have no proof of its intrinsic value. It is known as the Keynesian beauty contest or the "Greater Fool Theory".

    By contrast the Shiller PE 10 looks at intrinsic value and tries to estimate if the market is fairly priced.

     Howard Marks wrote in his new investing book “The Most Important Thing” a chapter on risk and said that defining risk is an art. I agree. Trying to use historical data about share price fluctuations (embedded in Sharpe ratios, etc.) to estimate future risk is an art. A bubble can get bigger and can last for many years. So examining how much a share price has varied is not necessarily a good way to assess risk.

   Instead I prefer to follow the attitude of Buffett who said one should buy a stock as if buying a business and one should assume the stock market will close for five years and they will be stuck with the investment. So in that case the standard deviation of the share prices in the past is not that important, instead the intrinsic value is important.

 Open the investment code

    Intrinsic value is best calculated using cash flow or income method. Once the stream of income has been identified then a PE ratio is applied to determine if shares are priced below intrinsic value. Income is hard to suddenly increase by a huge percentage, especially if averaged over several years. Each day’s income is like a vote from a satisfied customer in a world full of competition. If the product is inadequate or overpriced then the business will receive less votes than before (less sales and less profits). Averaging income over ten years with each year adjusted for inflation is the best way to judge intrinsic value.

    In addition one should examine the qualitative nature of the income. Does it come from a business protected by a corporate moat? Does it come from an industry that is becoming increasingly competitive with shrinking profit margins? Did the profit come because the R&D department was recently shut down? Did profit come from top line (sales) growth or from cutting expense items? Did it come from cutting costs with one-time write-off that was sent directly to the balance sheet without going through the income statement? Did the profit come from “discovering” a reserve account for losses was too strict and needed to be closed, thus boosting profits. Did revenues increase simply because a new company was acquired or did they increase because more sales occurred with no acquisitions.

     By contrast, using balance sheet items such as assets and liabilities to estimate intrinsic is risky because the assets could be overvalued due to a bubble or suddenly drop in value due to obsolescence of assets. Also the company’s funds could be squandered on foolish acquisitions at the top of an industry bubble.

    I wrote a post “Sharpe ratio versus information ratio” and “Sortino ratio versus Sharpe ratio”.

    Investors should seek independent financial advice.

Two things you must know about debt ceiling crisis: Independent Financial Advice

  

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   Two concepts: The world has no capacity to endure the extra risk caused by a Treasury default and the fiat dollar is a truly unique entity that must not be damaged.

   The Federal debt ceiling needs to be raised by Congress or the U.S. Treasury will default. The reason it is important to avoid a default is that no one has any experience about what this will do to the markets. The most relevant analogy would be the Federal Reserve’s tightening under Volcker in 1979 resulted in prime interest rates going to 22%, far, far higher than Volcker had estimated, which really surprised him.

   Today the world sits on a powder keg of risk: Japan is very weak, Europe’s banks face grave danger from the PIIG’s region, China has a real estate bubble, the commodity producing nations of the world may lose their boom if China cools off, and the U.S. has not fixed fundamental intrinsic problems but has instead papered them over with QE2 and removal of mark-to-market accounting. (About the only safe places are Scandinavia and Switzerland but they are too small to take care of seven billion people).

   With the tremendous amount of risk there is no room for radical experimentation with a Treasury default.

 Don't risk opening the door to panic

    The U.S. dollar is the reserve currency of the world’s Central banks. There is no substitute: not gold, SDR’s, Renminbi, Yen or the Euro can replace the dollar. If the U.S. Treasury loses its credibility that will trigger a “run on the bank” and then there will be no entity with enough stature or resources to bail out the U.S. The crisis would be simply unprecedented.

   By contrast if a small country or a large corporation goes bankrupt people can find ways to bypass the problems caused by such a default.

   Before 1815 there was no such thing as a world reserve currency. Then after 1815 the British pound, which was convertible to gold, became the world reserve currency until World War I in 1914. In the 1920’s the dollar became the world reserve currency. Gold convertibility ended for the dollar in 1971. For forty years the world reserve currency has been a fiat dollar. That fiat nature requires trust.

     When someone is hypnotized they are told to focus intensely on something which causes them to ignore other stimuli that may wake them out of their trance. A sudden distraction could awaken the world out of trance about the fiat dollar. Any sudden chaos or noise could destroy the hypnotic faith in dollar fiat currency.

   Therefore it is urgent to avoid rocking the boat. Congress should make the transition to a new debt ceiling as smooth as possible so as not to wake the sleeping giant of world public opinion and create a run on the bank.

   The only responsible way to debate the Federal budget is for Congress to first do whatever it takes to maintain the Treasury’s credit rating. Then the conservatives can to try to settle this matter after gaining a full mandate in the next election, rather than trying to overplay their hand in 2011 and risk getting blamed for creating another Depression.

    Regarding the value of fiat dollars compared to a Treasury debt default, technically they are two separate things, but practically speaking foreigners who own dollars do not leave them in interest free deposits but instead prefer to buy Treasuries to earn interest. A flow out of Treasury debt could result in a flow out of fiat dollars.

   To compare the size of the Lehman failure plus the TARP funding of 2008 to today’s Treasury debt, Lehman and TARP cost a total of about $1.4 trillion. The Federal Reserve has about $2.5 trillion in assets. Now contrast that with the U.S. Treasury debt of $14 trillion, it is ten times the size of the 2008 crisis and six times the size of the Federal Reserve’s assets. Of course, some of the Treasury debt is not due until 29 years, but it is important to compare the size of the debt to previous crisis.

    I wrote a post “US Treasury default is a bad idea” and “Government shutdown and dollar collapse”.

    Investors should seek independent financial advice.

Japan’s Monetary Policy: Independent Financial Advice

  

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     This book, written by Richard Werner in 2003, explains how the Japanese Central Bank created huge bubble in the 1980’s and then deflated the bubble in December, 1989 resulting in 20 years of a soft depression.

   The book is well written with clear explanations of what happened. The Central Bank forced commercial banks to increase lending so as to create a boom and a bubble. The banks went to bizarre methods to pressure corporations to borrow an excessive amount of money. This caused a ridiculous real estate bubble where the Emperor’s Palace was worth as much as all the land in California.

  What shocked me was that the Central Bank went to great lengths to disguise the bubble with Japanese domestic lending sometimes being conducted offshore in dollar denominated loans that were instantly converted to Yen and then wired home to Japanese corporations. This confused international economists.

Bubbles and Booms

     The deception reminded me of the mortgage bubble of 1997-2007 in the U.S. where vast amounts of poor quality mortgage loans were falsely labeled as “AAA” paper and then sold to unsuspecting banks. (In both cases the loans were authorized using asset based underwriting instead of the more reliable income method or cash flow method of underwriting). In both cases a major, sophisticated act of deception fooled economists. People need to be suspicious and remember the cliché “if something is too good to be true then it must be a fraud unless proven otherwise”.

   There is a huge gap between an over-idealistic economist (who assumes that all economic data is accurate and all market participants are reasonable, fair minded people who would not participate in a bubble) and who uses complicated math to understand the economy versus the real world of greedy, deceptive people who use fraud to create bubbles. This gap  has caused professional economists to miss something that in common sense was an obvious error of enormous consequences.

   The book implied that disputes between the Ministry of Finance and the Bank of Japan caused the Bank of Japan to engage in deliberate creation of a bubble and subsequent crash so as to pressure Japan’s government to change economic policies. The result was that for 21 years since the bursting of the bubble in December, 1989 that Japan has been trapped in a Soft Depression and has no sign of recuperating. So my analogy is that if the political clash in U.S. Congress over the budget deficit and debt ceiling is not handled properly then perhaps the U.S. will fall into a similar long term Soft Depression.

   However, another idea of mine is that since the Japanese Soft Depression was a man-made error that is a statistical outlier then perhaps deflationists should not assume that other countries will experience deflation because of what happened in Japan. In other words the Japanese Soft Depression is “not applicable” to the U.S., even though it provides valuable insights into how a deflation can last for a surprisingly long period. Also Japan's wartime system of a government micro-managed economy, which continued after the war, is very different from the U.S.

  There are differences between Japanese banking versus U.S. banking. In Japan loan applications for corporations are analyzed based on balance sheet items instead of the income or cash flow method used in the U.S. So that was prime incendiary material for creating an asset-inflation firestorm in Japan. In the U.S. (with the exception of now outlawed easy qualifier mortgage loans) lending has been based on income and cash flow analysis which is much more stable and reliable than asset based (balance sheet based) lending.

   The book did not mention China but the story of the Japanese Central bank creating a bubble reminds me of China’s great 30 year boom with extremely high growth rates and extremely high real estate prices. I worry that if China’s boom was similar to Japan’s then China will suffer a similar depression which in turn would affect the world economy. Since the world economy outside of Emerging Markets is very fragile then what happens to China will affect the world.

     I wrote a post “Western nations have learned nothing and may repeat Japan’s mistakes”.

    Investors should seek independent financial advice.

Boost yield on liquid assets: Independent Financial Advice

  

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    People wonder how is possible to get a yield that is higher than the 1% offered by bank CD’s.

1. Buy intermediate term investment grade corporate bond mutual funds yielding roughly 5%
2. Buy short term bond mutual funds yielding roughly 2.9%
3. Buy dividend yielding stocks that yield about 3%
4. Buy REIT’s. The median of the top 5% by yield were yielding about 9.5%
5. Utilities held in mutual funds. The top 20% by yield were yielding about 4%
6. Buy Emerging Market bond mutual funds. The median SEC yield is 5.5%
7. Buy mutual funds that hold International High Yield stocks. The median of the top 10% by yield were yielding about 5%

   The problem with most of the above except for 1 and 2 is that they are too risky and are thus not recommended. Number 6 is risky; it is necessary to pick bond mutual funds with a strong emphasis on a tilt towards low risk, rather than chase after the highest yielding funds.

   Even a high quality stock that yields 3% may be too risky, assuming that the stock market is in need of a 30% to 50% correction you won’t be happy if you earn a 3% dividend but lose 30% to 50% of your principal.

   Utility stocks have no guarantee of being low risk. Frequently news stories mention that utilities will suffer from carbon taxes to discourage global warming and government mandates to build more expensive, less polluting power plants. Telephone companies will suffer from destruction of their old protected monopoly including competition with cable companies.

    When a stock yields more than three percent that is often a warning sign that it is experiencing the “value trap” where its price can go even lower. A bond with a yield is sending a warning sign that it is evolving into a junk bond which means the price will get lower and the probability of default will increase. In the case of REIT’s some are mortgage REIT’s that hold risky junk mortgages. In the case of Emerging Markets bonds they may hold debt with a high yield that is high because the market is implying a high probability of a default.

    When bonds default they may be settled in bankruptcy court at 20% of face value and during a two year long bankruptcy they accrue no interest, thus if the lost interest is netted against the 20% residual value then a defaulted bond may pay very little. So this means investors should be very suspicious whenever they see an opportunity to earn a higher than average yield.

   Some foreign high yield bonds such as Australian bonds are risky because if China’s economy cools then Australia could fall into a depression and then Australian bonds would drop in value.

   Basically it may be best to accept low yields as a way to increase the probabilities of avoiding risk of loss of principal. It may be best to simply avoid searching for yield during a crisis when the Fed is making rates artificially low; instead search for low risk. If you need spending money you may be safer simply selling a sliver of principal instead of investing in high yielding assets.

   I wrote a post “Bond investing during low rates”.

   Investors should seek independent financial advice.

Best blog posts of 2nd quarter 2011: independent financial advice

  

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Retirement:

Will Relatives Destroy Your Retirement?

Boosting retirement income – avoid traps

Real Estate:

Real estate valuations may be wrong

Why real estate forecasts are wrong

Should you prepay your mortgage?

401K’s:

Buying a business with a 401K

401K contributions are not always a good idea

Tax traps in 401K’s

Treasury or dollar default:

Government shutdown and dollar collapse

U.S. Treasury default is a bad idea

Strategies for a dollar crash

Investing:

Buy and hold investing does not work

Inflation:

Inflation creation machine is broken

Contrarian view of inflation hysteria

    Investors should seek independent financial advice.