Dear Diary,
And so it came to pass that investors saw a bright star in the East… directly over the Marriner S. Eccles Federal Reserve Board Building, at the corner of 20th Street and Constitution Avenue in Washington, D.C.
“What comes after me goes before me,” said Janet Yellen, so confusing investors that they bid up the Dow over the 18,000 mark, a new milestone and a new record.
It is the season of miracles. Investors are convinced that Ms. Yellen can perform a trick worthy of Christ Himself.
It was He who multiplied the loaves and the fishes… made the blind see and the lame walk… and turned water into wine. It is She who creates real wealth out of nothing.
At least, that is what the common folk believe. And the wise men too.
For it was neither something solid nor important that made stocks more valuable last week; it was something gassy and impossible.
Wealth Without Work
Federal Reserve policy is the opiate of the people, the cynics will say. Maybe so.
They may not understand its mysteries, but they like it. After all, it promises wealth without work… or saving… or self-discipline… or investment. The wealth just comes, by the grace of Janet Yellen and her fellow Fed governors.
Last week, it came in abundance.
“Hallelujah,” said equity investors.
Ms. Yellen let it be known that she would be patient about letting interest go whither they wouldst.
She’s got them right where she wants them. And she intends to hold them there until she’s sure the lean years are over… or until Kingdom Come… whichever comes first.
We are convinced that holding interest rates down does indeed increase the likelihood of a bubbly stock market. But we are damned if we can understand how twisting interest rate arms makes businesses more valuable. As near as we can make out, it merely puts their shoulders out of joint.
This is an age of wonders. Anything is possible.
But let us get our feet back on the ground… let us return to our crash course in money and investing.
Finding Value
We were discussing value investing. Here we repeat ourselves, because this is important, and because we can’t think of anything new to say.
A stock is a share of a business. Its value is determined by figuring out how much it will earn in the years ahead and then adjusting the number to its present value (a bird in the hand is worth two in the bush)… and then some (leaving yourself a “margin of error” in case something goes wrong).
If you do this diligently and patiently you will not necessarily make more money than other investors, but you will deserve to make more money.
That is the only promise any respectable investment adviser can make. No one knows the future. You can only analyze the past and the present. Then if you find value, you buy. If you don’t, you don’t buy.
Beyond that, the results are out of your control.
Remember that it is impossible to do nothing. That is not an option. If you have wealth it is always in some form. You are “long” that form of wealth and “short” all others.
So, if you say you are in cash and think you are “doing nothing,” you are mistaken. You have your wealth in the form of cash.
A Critical Decision
This brings us back to the most critical decision of all: asset allocation.What will you be long of?(For a reason unbeknownst to us, old-timers use the expression “long of” or “short of” when they refer to their positions. What role the “of” plays, we don’t know. Grammatically, it is unnecessary. But it makes it sound as though you know what you are talking about.)Cash is not usually a good place to be. In a famous Bible lesson, recounted by Jesus Himself, the servant who kept his master’s wealth in cash (gold talents buried in the ground) got a beating.
And anyone who dared to keep his wealth in US dollars over the last 100 years has lost about 97% of his purchasing power.
Still, there are times when being in cash is not a bad thing. Typically, when other asset classes are overpriced, cash is a good place for your money. You stay long of cash until other assets retreat. Then you put your cash to work.
It is not necessary to do any major macro analysis to figure this out – at least, not in the case of the stock market. As prices rise, you are forced out of positions as they become more and more expensive.
That is to say you sell your stocks when they no longer are good value. Then if the whole market has been bid up – as it is from time to time – you must do something else with your money.
Cash is an option.
Or commodities. Or antique furniture. Or diamonds. Or bonds. Or real estate.
What to Buy?
The trouble with these options is they require a different kind of analysis.You cannot estimate the stream of income you will receive from a Louis XVI armoire because it doesn’t give you any stream of income. You only get the use of it.Commodities follow their own cycles and their own logic. Diamonds too.And bonds?
There the stream of income is easy to calculate; it is part of the debt instrument. But the value of that stream of income is a whole ‘nother ball game. It depends on the interest rate, inflation and the state of the bond market.
Central banks have the ability to influence the bond market. So any guess about the future of bond prices must take into account central bank policy.
Since it has been the policy of the US Fed to boost bond prices (and stock prices) for many years, it is probably unwise to expect a further, natural rise in the bond prices.
Real estate is easier from an analytical standpoint. You can usually figure out your return on investment fairly well.
But real estate requires more attention. It is a business as well as an investment. And like any business, it needs active management.
You need to get into it and stay in for a number of years before you are capable of operating your business proficiently. Most people don’t have the time, the interest or the competence to administer a real estate portfolio.
For the typical, sensible passive investor, stocks are usually the best investment.
Tomorrow… why this is NOT the time to be in US stocks… and what kind of cash to choose instead.
Regards,
Bill
The Case for Higher Interest Rates
The recent revision to the third-quarter GDP number means Janet Yellen may be raising interest rates sooner than even she expected.
Last Tuesday, the Bureau of Labor Statistics revised the third-quarter number for US economic growth to 5% from the previous estimate of 3.9%.
Providing a big lift was consumer spending. It was revised up to a 3.2% annual rate versus the previous estimate of 2.2%.
This follows a five-year high for the University of Michigan Consumer Sentiment Index, a widely watched measure of US consumer confidence.
It also follows news that personal disposable income, adjusted for inflation, was 3% higher in November than it was a year ago.
The 5% third-quarter GDP reading isn’t just a flash in the pan either. The US economy grew 4.6% in the second quarter.
That’s the highest back-to-back growth rate in a decade.
This better-than-expected growth comes on the back of the dramatic collapse in oil prices over the last six months.
At $2.40 a gallon, the price of gasoline is down 87 cents from a year ago.
According to calculations by former Merrill Lynch economist David Rosenberg, that’s well over $100 billion of savings for US car owners over the past 12 months… money that’s now finding its way into the consumer economy.
With the tailwind of lower oil prices blowing strong, Janet Yellen will have a harder time justifying zero interest rates.
Next time the Fed meets, it could signal the first rise in interest rates since the outbreak of the global financial crisis.