The Right Investment Strategy in Today's Economic Environment

Dear Friends,

Quite a number of you have been asking me how to make your money work for you in a more effective way. Obviously, many of you are not happy to just put your money in the bank, and earn very low income due to the ridiculously low interest rate era that we are experiencing today.

My answer has always been that this is an Asset Deflation Economic Environment, and thus, if you hold assets, you will lose money in terms of capital devaluation. Alternatively, for the more sophisticated traders, I suggested taking Short Positions, especially in ETFs (Exchange Traded Funds) like DOG (Dow Jones Industrial Average SHORT ETF) and SH (S&P500 SHORT ETF), at the appropriate moments in time.

However, most of you are not comfortable with a SHORT Strategy, and thus, are left unsatisfied with the alternative .... the low fixed deposit returns.

So, I have decided to do a bit of research to empirically substantiate my thesis that doing nothing, i.e. not invested in Assets (other than Cash Instruments) is better than being invested.

Of course, you can always quote to me, with hindsight, that so and so made money going in Long, at the right time. Yes, there will always be exceptions to any generalization.

However, I am interested in being on the right side of the fence, i.e. to take positions that give me a Higher Probability of Winning, and thus, I want to be in the two Standard Deviations of a Normal Distribution Curve. In other words, I want to be in the same Strategic Direction as the Market and thus, have a better chance to make money.

What is the Strategic Direction of the Market?

American Household (including NonProfit Organizations) Wealth (Net Worth) peaked at the end of the 2nd Quarter of 2007 (30 June 2007), at US$64.4 trillion. The Total Assets held then was US$78.3 trillion supported by Total Liabilities of US$13.9 trillion.

However, US Government Statistics showed that American Households' Wealth have dwindled to US$ 51.5 trillion as at 31st December 2008. The Total Assets have been reduced to US$65.7 trillion, while Total Liabilities actually went up, to US$14.2 trillion. This is despite the fact that Americans have been complaining that they cannot get Mortgage Loans to buy Housing Properties.

Whilst Total Liabilities grew by US$300 billion, Home Mortgages Loans grew from US$10.2 trillion as at 30th June 2007, to US$10.5 trillion as at 31st December 2008, thus, accounting for practically 100% of the total increase in Liabilities in the 1.5 years.

Nevertheless, it is true that Home Mortgages Loans peaked in the 1st Quarter of 2008 at US$10.6 trillion, and thus, the US Banks have collected repayments more than they have loaned out, by US$100 billion.

The statistics above show that Americans have lost US$12.9 trillion or 20% of their overall wealth, in the 1.5 years between the start of the Sub-Prime & CDOs Crisis, to the end of last year. The year 2008 was clearly a period of significant Asset Deflation .

A Basis for Comparison of Your Own Fund Management Performance

You now have a basis to compare how well you have performed, in managing your money, compared to the Average American with Wealth. If you had left all your money on cash, earning a fixed deposit interest of say, 1.0% per annum, you would be 21% better off, than 300 million Americans, and possibly, 2 billion more people around the world.

But, just how badly, or how well did you fare against the Wealthy, who can afford to employ the best Fund Managers in the world, to make their money work harder and more profitably for them?

The CapGemini Merrill Lynch World Wealth Report for 2009 stated that -

"At the end of 2008, the world's population of High Net Worth Individuals (HNWIs) was down 14.9% from the year before to 8.6 million, and their wealth had dropped 19.5% to US$32.8 trillion. The declines were unprecedented, and wiped out two robust years of growth in 2006 and 2007."

HNWIs are defined by the CapGemini Merrill Lynch World Wealth Report as "those having investable assets of US$1 million or more, excluding primary residence, collectibles, consumables, and consumer durables." while Ultra HNWIs are "those having investable assets of US$30 million or more, excluding primary residence, collectibles, consumables, and consumer durables."

The Report also defines Mid-tier millionaires as "HNWIs having US$5 million to US$30 million in investable assets."

Did the Ultra HNWIs do any better?

The Report stated that, "Ultra-HNWIs suffered more extensive losses in financial wealth than the HNWI population as a whole. The Ultra-HNWI population fell 24.6%, as the group’s wealth dropped 23.9%, pushing many down into the Mid-Tier Millionaire pool."

The Importance of Getting the Strategic Economic Direction Right

The above shows exactly how important it is, to get the Strategic Picture right. When an economy is in a Positive Sum Game, you can buy and hold good fundamental stocks, and even adopt a Dollar Averaging Periodic Timing Strategy.

However, once the economy moves into the rare, Negative Sum Game Climate of Asset Deflation, where High Uncertainties prevail, buying and holding assets can be very, very costly to your Overall Wealth. I have mentioned this way back in my emails in July 2007, and also in my previous blog article, but it is so important that it is worth mentioning again.

So, if you had left your money on fixed deposits, and was having a dissatisfied feeling that you have not optimized the ROI (Return on Investment), let it be known that your actual ROI for the year 2008, was 21%, assuming the Fixed Deposit Rate was 1%. Actually, it is less than that, because some of the Net Worth Losses were in 2nd Half of 2007, but hey, who's really counting?

Congratulations, you have managed to get ahead of 2 billion people with wealth, and have sneaked a march on the HNWIs, by getting a little richer compared to them.

Wealth is relative to what others own. If you had US$100,000 in 1930s, you would be a very, very rich man then. Today, you need to have US$1 million of Investable Assets, excluding your primary residence which you call home, to join the ranks of 8.6 million, Millionaires around the world. But, at least you are getting closer, by the day. :)

Where did the money go? How did Americans lose US$12.9 trillion?

As Property Prices fell, the value of Real Estate Assets held by Americans, dropped 15% or US$3.6 trillion, from US$24.1 trillion as at end of June 2007, to US$20.5 trillion as at end 2008.

The Stock Market wiped out a substantial portion of the Corporate Equities Assets held, with a decrease of US$ 5.9 trillion or 40%, from US$14.7 trillion as at 30 June 2007, to only US$ 8.8 trillion as at 31st December 2008.

The sad part is that many prudent, soon to be retired baby boomers are going to face a financial crisis, upon retirement in the next few years. Why? Because, their Pension Funds lost 22.6% or US$3 trillion, down from US$13.3 trillion as at 30th June 2007, to US$10.3 trillion as at 31st December 2008.

Were there Smart People who sold down their assets and moved their money into cash instruments? Yes. There was an increase of about US$600 billion, i.e. US$0.6 trillion, in Cash Instruments, since 30/6/07 (US$7.1 trillion) to 31/12/08 (US$7.7 trillion).

Is the American Financial System still Flushed with Cash?

Some people have argued that the American Financial System is still flushed with cash. Yes, this is true, and the amount as at the latest US Government statistics of 31st December 2008, is US7.7 trillion. This means that on average, Americans held 11.7 % (US$ 7.7 trillion divided by US$65.7 trillion) of their Total Assets in Cash as at 31st December 2008.

The problem is, the Wealthy holds a disproportionate amount of that cash, whilst the average American holds very little cash.

Another challenge is in getting the Americans with the cash, to spend. In the first place, these people are flushed with cash precisely because they don't need to spend this money. Secondly, there is a dislocation between asset demand and asset supply.

Quite a number of the properties for sale, (about 19 million properties actually) are in less desirable places, including Sub Prime Properties. The people with cash would not be drawn to buy such properties.

Even if the properties are in desirable locations, and look very attractive, as have been seen on Media Interviews, the Market Sentiment (Investor Confidence) and the Price still has to be right, to get the transaction done. However, this is not the case today, as 50% of the Property Transactions concluded are foreclosure sales. Furthermore, New Home Sales by Property Developers are competing with existing Home Sales for the limited investment capital.

If we value the average property at US$100,000, then, the value of the 19 million Existing Homes for Sale would require an Investment Capital of US$1.9 trillion. This is before New Home Sales for development projects to be launched.

Will this Cash be the Key Driving Force for America to grow out of this Economic Recession?

Since there is enough cash, i.e. US$7.7 trillion in the American Financial System, compared the value of properties in stock to be sold, it is possible for this Segment of Society to be the key driving force pushing America out of the current economic recession.

In fact, in most economic recessions, it is not those that are affected by the recession, i.e. the Unemployed, that will drive the economy; rather, it is the Unaffected that will eventually invest in New Home Sales, that moves the economic conditions out of its Vicious Cycle of Failure, into a more positive environment.

However, please note that it is Investments in NEW Home Sales, and not Existing Home Sales that is the driving force for an economic recovery. Why? Because Existing Homes are already built, and thus, has very minimal effect on Job Creation.

On the other hand, New Home Sales require construction workers to build the homes, and thus, is a key factor in driving the economy forward. Sustainable levels of New Home Sales is the Key to future Economic Recovery. This is the key economic indicator we will need to monitor, in ascertaining whether an Economic Recovery is really underway.

Is A Sustainable Economic Recovery Underway?

In the latest US Government Statistics published, American Household Wealth decreased another US$1.3 trillion in the 1st Quarter 0f 2009. The 2nd Quarter of 2009 may show a slight improvement in the Wealth of Americans, as there is a stock market rebound, off its lows set in February 2009, but this positive wealth effect is somewhat negated by the continued fall in property prices throughout the country.

Economic Activity did pick up in the 2nd Quarter of 2009, leading some Optimistic Analysts to argue that possibly an Economic Recovery is already underway. However, this phenomenon is merely due to a replenishment of business inventories, which were running low, and not due to increase in Consumer Demand.

New Home Sales did pick up for about two months, but then, it seemed to have fizzled out, and does not look SUSTAINABLE, which is the key to a Sustainable Economic Recovery.

In any case, the banking sector doesn't look like its about to go on a massive Credit Expansion Plan any time soon, and without Credit Expansion, there is limited upside to Economic Growth. Thus, any recovery will be lethargic at best; at least for the foreseeable future, until the recapitalization of the banks are resolved.

It is my belief that there are still a lot of banking losses to come. Credit Card Delinquencies and Home Mortgage Defaults are still rising rapidly, even as Home Prices continues to decline. The massive Job Losses, which is expected to persist till mid 2010, do not augur well for Investor Confidence as well.

Even if Investor Confidence is somewhat restored in the future, the market still lacks a very good reason to go out and buy properties. There may be a few occasional bump ups in prices, but the Property Market isn't going anywhere any time soon, when the economy continues to be lethargic at best, and the huge overhang in Property Inventories, coupled with increasing supply due to further Home Mortgage Defaults, with mean a stagnation of prices at best, and possibly, a further depression of prices.

It is obvious that this time around, the Supply of Properties far exceeds Demand. Also, with increasing pressure to sell due to the increasing inability to maintain mortgage installment payments, it is possible, and in fact, likely, in my opinion, that Distress Selling will depress prices significantly from current levels.

Can the US Government Policy Help Alleviate the Crisis of those in Financial Difficulty?

Here, it should be noted that the US Government's policy to help those in financial difficulties and in danger of losing their homes, have been criticized. Whilst everyone can understand why the Government would want to give a helping hand, more and more people are beginning to question whether this is a wise policy.

What is the Alternative? Some argue that perhaps the Government should be giving incentives to those that can afford the properties, to buy, rather than trying to help those that cannot afford it, to persist in keeping what they cannot pay for.

It is always sad to see someone losing their home. However, if one has overstretched one's finances, any Government help to pay a few months' mortgage installments, will not solve the longer term problem of continuing to pay for the next 10 to 20 years. Of course, in some cases, one may be able to tide over the few months, till one can find a job, but let's face it, the Trend is a Negative Sum Game, of even more, and more job losses to come, and for every job created, a number are lost. Thus, this is a losing battle where some question the wisdom to continue fighting.

Rather, if there is sufficient incentives for the Unaffected to buy properties, this may help to create demand, which will at least soften the persistent fall in prices, if not maintain the current level.

From a rational perspective, this makes sense. From an emotional perspective, how can you not help those in trouble? The key question is whether the US Government is throwing good money after a lost cause.

The Impact of Government Spending

The US Government has proposed to spend unprecedented amounts of money, and is expected to incur US$2 trillion in deficit. However, to date, there has been no noticeable traction effect from the Spending.

In a normal economic situation, Government Spending is supposed to result in a Multiplier Effect, i.e. US$1 of Government Spending will generate more than US$1 in economic growth. This is because the money flows from Government hands, into Businesses, which in turn, passes it on to Employees, who spend on Consumption Goods, and this in turn, stimulates job creation and employment income growth.

However, it has been argued that for the US, which has lost its Industrial Might, and is now Services and Consumer Spending Dependent, will require US$4 to generate US$1 of economic growth. If this is true, and so far, it looks like the case, then, it is extremely expensive economic growth; so expensive that some, including myself, would argue that it shouldn't be done.

High Impact Uncertainties of the Future

Nothing is working; at least not the real world stuff. Jobs continue to be lost; credit delinquencies continue to rise, banking loans are not forthcoming, asset prices continue to fall, and businesses continue to fail.

Adding to these woes, are the High Impact Uncertainties of Higher World Interest Rates and Devaluation of the US Dollar. By Uncertainties, I mean that the phenomenon may, or may not happen.

What is the Current Economic Situation?

Right now, we are in the midst of a GREAT RECESSION. Whether this Asset Deflation Environment will deteriorate into a much deeper economic crisis, i.e. an Economic Depression, will depend on whether the economy can recover before Unemployment hits 20%. As is, the official number is 9.5%, but if we take into account those that want to get a job but have given up looking for one, then, the figure is closer to 15%.

Can The Great Recession Worsen into an Economic Depression?

It is not difficult to see how the current Great Recession can turn into something worse. In fact, it is much harder to see a way out of the Unemployment Problem, as the trend of Job Losses is likely to persist in the foreseeable future, albeit, lower levels of losses with each passing month, after the 3rd Quarter.

I could be wrong, but my instincts and business judgment tells me that after the inventory build up, without an equal increase in consumer demand, businesses are bound to reduce their workforce even further. Thus, I expect 3rd Quarter of 2009, to experience significant job losses in the US.

Most people who are sharing their opinions that there will be an economic recovery at the end of 2009, or early 2010, is relying on mathematical economic growth, due to US Government Spending, i.e. one based on the Formula,

GDP = Consumption + Investment + Government Spending + Net Exports

Although Consumption and Investments are falling rapidly, if the Government Spending is large enough, it will increase the GDP, offsetting the fall in the other two areas. This is possible, and some people have called it a Jobless Economic Recovery.

However, Government Spending is not sustainable, if Unemployment persists, at least not, without increasingly higher funding costs to raise money to cover the Excess between Government Income and Expenditure.

In a normal economic recession situation, I would argue that Government Spending may work. However, in the present climate, with the banks languishing from a lack of capital adequacy, it is not likely to work, and job losses will persist.

Thus, it is not only probable but very likely that the current Great Recession will worsen into an Economic Depression.

What About Stagflation? Which is a More Likely Scenario, Depression or Stagflation?

If there is no further action from the US Government, then, I really believe that the US Economy will worsen into an Economic Depression. However, it is also clear that the US Government will do everything in its power (translated into more Government Spending), to bring forth an inflationary environment, rather than a Deflationary Environment, as will be encountered in an Economic Depression.

In an Economic Depression, Asset Prices will not only fall, but actually fall significantly. Why? Because Unemployment would have risen to levels that is extreme economic hardship to the majority of the population. Also, those with money would have lost a large portion of their wealth because they went in and bought assets thinking they were cheap, and the asset prices have deteriorated significantly since then.

At that point in time, most people, including the Rich, are cash strapped. What this means is that the Rich can still be owning quite a number of assets like properties and stocks, but most of these assets would have lost 50% to 80% of their values, and worst, they can't be sold because there are no buyers in this Cash Liquidity Crisis.

This Depression Scenario is not acceptable to the US Government, and it prefers, as far as I can see, to pump prime the economy with more and more Government Spending, at the risk of Inflation, possibly due to US Dollar Devaluation. This will bring forth a different Scenario, i.e. the Stagflation Scenario where Interest Rates and Inflation are high, but the economy is lethargic at best, and recessionary in nature.

However, due to the Inflationary Environment, Asset Prices may not fall as significantly as compared to a Depression Scenario. Nevertheless, in my previous blog article, it has been pointed out that a Stagflation Environment does not necessarily mean that Asset Prices will not fall.

What is worse is that Consumer Inflation will rise significantly, and this will give rise to more hardship for the People.

If this is the case, why should the US Government choose a Stagflation Environment compared to a Depression Environment?

The Lesser of Two Evils - Stagflation or Depression?

In my opinion, Stagflation is worse than a Depression. Why? Because the already hard hit Consumers will have less Purchasing Power for their Dollar. An Inflationary Environment does not necessarily mean that Job Creation will rise. If Job Creation does not rise, while Inflation erodes away at Declining Employment Income, the situation will be a lot worse than if the US Government had not done anything at all.

So why does the US Government persist on this choice?

Because it is trying to stimulate economic growth, in the hope that it can contain the Stagflation Pressures should it rear its ugly head.

We are in a poker game folks. If nothing is done, we are likely to face an Economic Depression. If something is done, it depends on the effectiveness of two subsequent events / activities First, whether the Government Spending will generate some economic growth and create some jobs. If these goals are achieved, then, we are on the way to an economic recovery.

On the other hand, if the current situation persist, i.e. where the Government Spending does not seem to produce any noticeable results, then, the US Government would have spent for nothing, but now face all the downside risks.

The 2nd Event / Activity is the effectiveness of the US Government in reigning in the excessive money supply, when inflationary pressures start to show. Theoretically, this is easy to say, but practically, the potential results to reign in Inflationary Pressures is unconvincing.

If the US Government is not able to reign in the Excessive Money Supply on time, then, a much more painful economic situation will arise, and it would be fair at that point in time to say, with hindsight, that the US Government had gambled big time and erred, and now the people must suffer the consequences.

Should the US Government Gamble for Stagflation?

Despite some opinions to the contrary, the degrees of freedom are limited. Interest Rate is already at 0.25%, and yet, it is not working. US$3.8 trillion is being thrown at the problem, and yet, there is no noticeable result.

It is also obvious that no US President can tell Americans that they just have to grit their teeth and take the pain like a man.

It is one of the greatest economic myths of all time that the public believes a competent Government can manage an economy in such a way, that there is no major economic recession. It is an even greater myth that the public believes that a Government, any Government, however competent, is capable of going against the Forces of Nature, and thus, is able to lead a country quickly out of a major economic recession.

"To be, or not to be, that is the question." If you want to be the US President, you have to show the Americans that you are doing something to alleviate their pain. This is despite the fact that you are human after all.

To be fair to President Obama, no US President would do any less than what he has done. My key issue with his policy is that he may have taken America a bridge too far, i.e. he has spent too much, too early.

I know that he argues that the earlier he spends, the earlier the economy will resume its path of positive growth. However, this is based on the Assumption that Government Spending will stimulate REAL Economic Growth and Create Jobs. Whether this premise is flawed, only time will tell.

In any case, for a Stagflation Environment, I would recommend buying enough shares in key consumer spending areas like Utilities, Transport, Telecommunications, Food & Beverages, to hedge against the increase in prices of consumer goods and services. However, I would maintain most of my Portfolio Capital in Cash Instruments, as the Interest Rate could be quite high.

What about the Hyper Inflation Scenario?

Yes, I have discussed the risks of the Hyper Inflation Scenario a number of times in my blog and email articles.

It is possible that the US Government fails to reign in the Excessive Money Supply when Stagflation Pressures set in. This will lead into a runaway inflation environment, where the US Dollar Devaluation will turn into a severe crisis of mammoth proportions, and then, we will know what it is like to experience Hell on Earth.

However, I believe that the Stagflation Scenario must arise first, before the Hyper Inflation Scenario can set in, and thus, we still have time to prepare and act, when necessary.

The Challenge is that the Hyper Inflation Scenario requires a completely opposite Investment Strategy to the Depression Scenario.

In the Depression Scenario, Cash is King. Hold cash, and earn at high interest rates, whilst enjoying great purchasing power because everything is cheap, due to a nationwide / worldwide cash liquidity squeeze.

On the other hand, in a Hyper Inflation Scenario, cash is the worst thing you can hold. When Purchasing Power is eroding at the rate of 50% per month, it is not enough to earn interest at 30% per annum. The way to hedge against Hyper Inflation is to buy Commodities, possibly in the form of Commodity ETFs (ETCs) or to own Plantation or Mining Stocks.

As you can see, it is very dicey / risky as the current economic situation is so uncertain, that either one of the scenarios, i.e. Depression or Hyper Inflation can happen in the future, and there is no way to ascertain which scenario will become the reality of tomorrow.

Thus, one way to hedge is to keep at least one property where you will stay, should either scenarios happen. In this case, in the event that Hyper Inflation sets in before you can do anything, you are at least hedged against one property.

The Window of Opportunity to hedge against Hyper Inflation will be very small, as it will occur like a Financial Tsunami, without much warning. By the time we realize what is happening, prices would have gone up by 30% to 50%, and then, we would be very hesitant to hedge because we could incur substantial losses should it turn out to be a false alarm.

It is easy to formulate a strategy to hedge, but in reality, the margin of error is so small that a slight mistake in timing could be fatal. Thus, it would be advisable to put on some defensive positions and risk some asset devaluation should the Hyper Inflation Risk rise from hereon.

CONCLUSION

At present, I see the Economic Environment as one of Negative Sum Game, i.e. Asset Deflation, although a continued Bear Market Rally is not only possible but likely in the Medium Term. However, in my opinion, in the Long Term of one or two years, the most likely scenario is an Economic Depression.

Depending on the subsequent action of the US Government and the ultimate impact of persistent massive Government Spending, there is a possibility that a Stagflation Scenario can play out in the later stages of the Depression.

Whether this leads to the Hyper Inflation Scenario will depend very much on the effectiveness of the US Government's efforts to reign in the Stagflationary Pressures when it rears its ugly head. Given that a Government, any Government, is more likely to fail than succeed in such a quest, it would be advisable to be hedged to a certain extent, through one or two properties, and exposure to Commodity ETFs and Commodity Related Stocks, when the Stagflation Scenario is underway.

Should the Hyper Inflation Scenario become a reality, it will be necessary to even borrow money rather than hold cash, to invest in Assets for Hedging, e.g. Physical Silver ETF or Physical Gold ETF.

In the meantime, hang in there. The Year 2009 might not result in such a great relative fund performance as was experienced in the year 2008, but I believe that it is still very much an Asset Deflation Environment, albeit a Prolonged Bear Market Rally before another big economic and financial markets crash.

Can you imagine what would happen if World Interest Rates were to soar significantly in the next two years? If the economy is in such a bad shape when World Interest Rate is so low, the World will be in a very desperate situation in a High Interest Regime. Can you imagine what Asset Prices would look like at that time?

Will this Scenario definitely come true? No. However, there is still time to jump on the bandwagon, should there be positive traction from the US Government Spending, and the US Economy unexpectedly turnaround into a Positive Economic Growth that is sustainable.

After all, if it is sustainable, it will last a few years, and thus, you can't miss a boat that will go on a journey for such a long time. This is why we don't focus much on the Positive Sum Game Scenario. It is the easiest to invest in, and doesn't require that much skill as the rest of the Scenarios, because the investment risk is reduced significantly, as the climate becomes much more predictable and manageable than the period experienced in the last two years. In a Positive Sum Game Scenario, the Warren Buffett Buy & Hold + Dollar Averaging Strategy would work well over the long term.

In the meantime, hang in there. Keep your investment capital safe.

In conclusion, "Not doing anything, is still doing something."

Best wishes,

Ooi