A Conundrum

Source: sxc.hu Photo: Pin-x-up

The US and the Global economy is slowly coming off one of the worst recessions in the memory. There are still multiple risks on the horizon, including high inflation, rising interest rates, declining dollar and the real possibility that Greece and some other nations might default on their sovereign debt. If you are like many other investors who has seen their portfolios decline in the past two years, you are probably wondering if this is a good time to come back to the market. You probably have your emergency fund funded, have worked hard over the last few years to get control of your debt. You may be wondering where should I invest now.

Asset Prices are Low

Stocks and other real assets are cheaper today than they have been in many many years. This means that this is a great time to buy these assets. Sure, there will be volatility in the short term and the high unemployment rate means that there may be more hiccups in the future as the country struggles to improve the employment situation. Still, if you have a little money to invest, this is the time to get in.

Inflation and High Interest Rates are on the Horizon

This is almost a given. The massive amount of federal debt that has been accumulated through the cycles of bailouts and stimulus mean that there has been an enormous increase in the amount of money that is circulating in the economy. This extra bit of money has not been matched with a corresponding increase in GDP, which means that unless the economy revs up really quickly the extra cash that is sloshing around will lead to higher inflation. Feds will likely try to control the inflation by soaking up the extra money supply and creating friction in how fast the money sloshes around by raising interest rates. Raising interest rate will also become necessary to maintain the interest of the investors in the US debt, such as China, as they are understandably becoming very nervous with the levels of debt that US has taken on.

Stocks and Real Estate are in and Bonds are out?

Cheap current asset values and the threat of inflation and rising interest rates have some profound implications for the investors today.

  • Stocks, Real Estate and tangible assets (such as commodities, art, primary metals, your broker’s yacht, etc) that are cheap today will rise in value with the inflation, as well as improving business fundamentals
  • Debt instruments such as Bonds of all flavors, mortgage securities, preferreds, will decline in value as the yields go up with the interest rate

So stay away from bonds where you can. Even treasuries, which even though could remain safe and high credit quality, are bound to decline in value as the interest rates rise. If you have to have an exposure to the bonds, possibly because your financial advisor told you so for your asset allocation needs, consider TIPS or very short term high grade bonds. I will go out on a limb here and even advise you to favor high quality short term corporate bonds issued by companies such as  Johnson and Johnson over the US Government bonds as it is possible that the credit of the US Government will deteriorate in the future. Read on for other possible ideas for investing in bonds.

Safer investments today are common stocks, real estates and commodities. I am assuming here that you are taking a long term view of the investments and are not looking to day trade.

Stocks that do Well in Inflation

Look for solid companies in consumer staples, food production, defense, energy and other sectors that produce goods and services that are essential. People will continue to buy these products (meaning demand will not drop much) even in the face of rising prices. Remember, inflation means prices go up but it also means that paychecks will go up. Even within these sectors you should look for companies that are more efficient and have better brands as they will be able to keep the costs down and raise prices more than their competitors.

There is Blood in the Streets for Real Estate

Real Estate, yes I said Real Estate, performs well in inflationary environments and can be bought at attractive valuations today (assuming there is a bank out there that is not scared to loan money, interest rates today are quite low as well). If so inclined, you may want to look at REITs as an option to purchasing real estate outright. Most real estate companies (and their stocks) are quite bloodied in the great rout and it may be difficult to choose the right ones, so buying a REIT provides safety and diversification. If real estate is your thing, be aware that the prices may stay low for some time as the demand picks up and the foreclosure pipeline empties out. Take a longer term perspective

And then there are Emerging Markets

Your search for international diversification should include emerging markets but not in the manner that most have been suggesting. Understand what is going on with the emerging markets:

  • Most emerging market economies did reasonable well during the great recession and they were first to start growing (many just slowed down but did not have recession). As a result assets may not be as cheap as you want for the risk
  • They are expected to continue to drive demand for commodities and other products to fuel their economic development for many years or decades to come
  • Demographics in many of the emerging market economies are more attractive than US or other developed economies

There may be reasons you may want to explore investing directly in emerging market countries. But what you need to focus on is what sort of products and services that these growing economies will need and which companies are best positioned to provide these products and services. Stuff like commodities, heavy machinery, junk food, energy, etc. In most cases, the companies most suited to supply these products are western companies. Find them and invest in them.

An Exception to the No Bond Rule

Most domestic and western bonds are risky due to the risk of higher interest rates. Emerging market bonds may not have the high interest rate risk but there is always the question of country risk. The ideal would be to find politically stable and credit worthy countries that may not be facing higher inflation and interest rates in the future. If you were to buy bonds, you may want to buy bonds issued by these countries. Canada and Australia come to mind.

Strategies to limit your risks

There are three strategies you can use to further limit your risk.

  1. Buy stock in companies that pay regular dividends. This ensures that some capital is returned to you regularly and there is less cash for the company to indulge in value destroying projects. If the company is paying regular dividends, it also implies that the company has real cash to pay dividends with and their books are less likely to be, let’s say, ‘mis-represented’. Easy way to do this is to use DRIPS.
  2. Look for value. Buy companies that are fundamentally sound but have distressed stock valuations for whatever reasons. Value investing helps find these stocks that are less likely to decline greatly (unless you have misjudged the company’s soundness) and will very likely bounce back with nice gains.
  3. Keep your emotions in check. You can be your worst enemy when investing. Do not invest if you cannot commit to an investment for a long term or if you are unsure of the soundness. Letting emotions rule your investments will lead to a disaster. Let a mutual fund manage your money or  buy index funds if you are sure of the sector or the economy but are unable to pick right stocks.

These are great days if you are a long term investor. Opportunities like this are rare.