Asset Deflation Strategy

Dear Friends,

I would like to share a simple investment / trading strategy with you that should not go very far wrong in the longer term.

All you need to do is to look at asset prices from a general viewpoint. The key questions to consider are as follows: -

• Are the key stock indices of the world, lower or higher than it was 2 years ago, a year ago and 6 months ago?
• Are property prices in a number of general areas (not one specific area) lower or higher, 2 years ago, a year ago, and 6 months ago?
• Are commodities prices, e.g. gold and oil prices, lower or higher, 2 years ago, a year ago, and 6 months ago?
  

In general, you will find that the stock markets, property prices, and commodities prices all over the world are lower today than a year ago, and 6 months ago. Most asset prices peaked about slightly more than a year ago, i.e. between July 2007 to October 2007, while Oil and Gold prices were the last to peak.

This simple "rule of thumb" formula informs us that we are in a Negative Sum Economic Game, where Asset Deflation is the name of the game. What does this mean? In a nutshell, it means that Asset Prices, whether it is stocks, properties or commodities are becoming cheaper by the day. It also means that the smart people are expecting asset prices to become even cheaper in a year's time.

The investment strategy you should adopt then is very simple. When prices are falling, SELL. When prices are rising, BUY.

There is no reason to buy assets when prices are falling, like today. Why? Because the probability is high that you will lose money in the longer term. In general, asset prices will be cheaper in a year's time compared to today. The mere fact that you are holding assets in an Asset Deflation Environment, means that you put yourself at risk.

BUT, I can't sell when I haven't got an asset, you may say. Let me give you an example of how you can do it.

Let's say that I am looking to short (sell when I don't have stock) GOLD at the right time. Let's also say that my Global Macro Analysis has convinced me that the current price level of between US$880 to US$860 (2nd October 2008 price) is not likely to hold for the long term, although, due to the "Flight to Safety" hypothesis, there are people actually "investing" in gold today. Can one really "invest" in a commodity, or is one merely speculating, is a whole long discussion by itself, but let's not divert.

If you analyze the rationale further, the "Flight to Safety" rationale for Gold Investment is a short term phenomenon, unless you expect all hell to break lose, i.e. a super, hyper inflation environment with a US$ devaluation crisis the world can't even imagine. Then, Gold will move up even in the long term. Whilst plausible, this is not a likely scenario, and I would consider it a long shot to buy Gold on this basis.

If you agree with this argument, then why would anyone buy Gold? Because, it doesn't matter what the Market Truth is. George Soros has said that the key to making money is to "Ride the Trend of Market Untruth, and get out before the market truth prevails."

If investors are thinking that Gold is a good investment, i.e. it will go higher, who are we to argue with the crowd, irrespective of whether the reason is correct or not? We have two choices here. Either we jump in the musical chair, which is what a number of Gold investors are doing today, or we sit back and watch until the market frenzy to buy slows down, and reality starts to set in.

What reality are we looking for? The reality that in an Asset Deflation Environment, ALL assets go down in price eventually, over the longer term. In the short term, price can go anywhere, up or down. But over the longer term, the market truth will prevail.

So, in my opinion, the odds of success are high, that one year from now, Gold price will be much lower than today's price of US$865 per ounce. If you sell now, and buy back at US$700, you would possibly be making quite a lot of money.

But how do you sell something you haven't got?

This is where you need to broaden your horizon of opportunities in the financial markets. There is a new type of financial intermediary in the financial services industry today, i.e. the internet brokers. Despite all the "hoo-haa" on curbing short selling and even prosecuting short sellers, you can do it legally with CFDs (Contracts for Differences). No problem at all, and it's all very legal.

Check out the websites of the likes of IG Markets, Saxo Capital Markets and Interactive Brokers, CMC, etc.. However, one word of advice. These new type of financial intermediaries are not very well regulated today, and their innovative products like CFDs, Forex and Binaries can burn a hole in your pockets within minutes if you don't know what you are doing. This is because of the high level of leveraging. Also, they will close out your position if you overtrade and don't have enough money to cover your losing position on the spot.

They don't call you for margin calls. The computer will just close your position and take the loss for you, and it's all legal. That's the way this new financial intermediary works. The good news is that you can buy US$1 million of Euros if you think Euro is going to appreciate over US$ with only a commission spread of US$200. The moment the Euro moves 0.02 cents (not 2 cents but 2% of 1 cent) against the US$, also known as 2 pips in the forex world, you would have covered back the US$200 commission. This can happen in two seconds.

Since the Euro moves about 150 pips a day, you can lose US$15,000 in a single day with a trade exposure of US$1 million of Euros (EURUSD). So, be very careful and learn the necessary skills before you play.

These brokers give you free trial access when you can trade with live data, on a minute by minute basis, or even second by second, on a wide range of instruments, ranging from crude oil, soya beans, gold, forex, stock indices, individual stocks (a few thousands counters in US Stock Market alone), and you can buy and sell big names like Google, Microsoft, HSBC, Standard Chartered Bank, Citigroup, Nokia, General Electric, Siemens, etc.

Plenty of choices; plenty of opportunities to make money; and plenty of opportunities to lose money. The advantage is that you can be an agnostic on the market direction, i.e. you can sell first, buy later, or buy first, sell later, depending on your view of the market. Some brokers allow the opening of account with only US$200, but this is too small to do anything decent, and chances are, you will lose it in less than an hour.

I opened my account with S$10,000 and after a few hundred trades, worth a few million US$ of trading turnover value, over a period of one year, the capital is still intact, despite the commissions I have incurred. This is why I am a competent trader, but no better than that. I'm a great analyst, but still learning as a trader. This is what I need to improve in the near future.

Do check out the websites, and since it is free, do play around with their live trading simulation / demo. BUT, please be warned that if you don't know what you are doing, you can wipe out your $10,000 capital in a matter of days.

Also, you need to be proficient at order entry. There was a day when I stalked the Euro US$ (EURUSD) for 4 hours, waiting for the US$ to reach a market top and weaken. Finally, it happened, and I keyed in the order as the US$ broke down almost immediately.

Wow! I thought. I'm making good money within a second of my keying in the order. Then, I saw my Live Profit Balance, and it was going down with losses instead of profit. I couldn't understand it, and for about two seconds, I was dumbfounded. Then I realized that I had bought Aussie Dollar instead of Euro in my excitement, and the Aussie was practically crashing in price.

I immediately closed the position within the next second, and did a new trade. I was able to make enough on the last Euro trade, to cover the loss incurred by the error of the Aussie Dollar trade, but not much profit.

What a waste. Sitting, patiently watching the screen for 4 hours, for the exact moment, only to fail by taking the wrong trade. Sigh .... some people are really stupid hah! That, my friends, is the life of a Day Trader.

This is why it is so important for you to play with the trading simulation until you become proficient before attempting live trading.

Anyway, the key point here is not to be restricted by only buying before selling. In an Asset Deflation environment, when you expect asset prices to be lower a year from now, buying first doesn't make sense.

One last word of caution. These so called Internet Brokers range from solid internet bank, dealing with all the big boys in forex, to small internet brokers that are about to close down. So, please be smart. Open your account only with a reputable broker. Do your homework, or somebody else will be spending quality time with your trading capital.

In summary, in an Asset Deflation Environment (Negative Sum Economic Game), sell first, buy later. In an Asset Inflation Environment (Positive Sum Economic Game), buy first, sell later. In a Neutral Zero Sum Economic Game, it's a very tough market to make money. Somebody's got to lose before you can make. Today is a Negative Sum Game, i.e. Asset Deflation Environment. That is the big Strategic Picture, and the Investment / Trading Strategy is to Sell First.

I hope that this Strategic Big Picture of the 3 Economic Games and their "rule of thumb" tests, are of profitable use to you.

Best wishes,

Ooi
© Copyright of Praesciens.blogspot.com, 2008

P.S. Please note that I do not have an account with all the internet brokers mentioned, and some are only known to me by name, from newspaper advertisements. Please perform the necessary financial strength due diligence before you open account.

Lastly, I would highlight that I had actually emailed this article out on 2 October 2008, but have decided to reproduce it here on my blog as it is still relevant today.