The Four Investment Risks You Can’t Avoid

by Alexander Green, Chief Investment Strategist
Monday, October 18, 2010: Issue #1368

We’re making money hand over fist – locking in significant double- and triple-digit gains – in our Oxford Trading Portfolio, Seven Deadly Sins Portfolio, Oxford All-Star Portfolio, Momentum Portfolio, Insider Portfolio and our New Frontier Portfolio.

Yet I still talk to investors every day who tell me they’re completely out of the market. When I ask them why, they always give me some variation of the same answer: They just can’t take the risk.

These investors need to wake up and smell the java. There has never been – and never will be – a time when stocks aren’t volatile and the economic outlook isn’t uncertain.

Yet nothing gives a better return over time than great stocks…

Four Wealth-Building Barriers

What these investors may not realize is that by sitting out the stock market rally, they’re taking four significantly greater risks:

• Purchasing Power Risk

Low inflation isn’t a problem now, but it’s like having a slow leak in your swimming pool. At some point, you’re likely to jump off the diving board and hit concrete.

Even low inflation is slowly draining your purchasing power. You may feel safe sitting in cash, but you’re virtually guaranteeing that inflation will outpace your asset growth. And thanks to our gargantuan budget deficit, we may face sharply higher inflation in the years ahead.

• Interest Rate Risk

Ben Bernanke and Co. took short-term interest rates to near zero. The average money market account now pays a microscopic .05%. (It will take your money more than 1,400 years to double at that rate.)

And if the Fed decides to raise rates by even one point, it will knock 3% off the value of your Treasury bonds, essentially erasing a year’s worth of returns. Bonds are not a great bet right now.

• Timing Risk

Every market timer would like to believe that he or she will be in the market for the rallies and out for the corrections. Never did the phrase “more easily said than done” ring truer.

I still talk to investors every week who are waiting for the market’s “final capitulation.” Final capitulation? The Dow is up 70% from the lows of last March. This is a bull market by any definition. Yes, it will end at some point. But if you didn’t catch the lows last year, what are the odds you’ll pick the top of this bull, which may last for years?

• Shortfall Risk

This is your single greatest investment risk – the possibility that you won’t have enough money to reach your financial goals or support yourself the way you’d like in retirement.

Talk to elderly investors who are counting nickels and the story is virtually always the same. They didn’t save enough and (depending on personality type) they were either too conservative or too aggressive with their money. It’s a sad thing when your golden years are tin-plated and it’s way too late for a do-over.

So what’s the solution?

Think Ahead and Grow Rich

In short, don’t let the perma-bears and the gloom-and-doomers talk you out of achieving your financial goals.

Yes, you should own some gold, some bonds, even some real estate. But if you don’t own stocks, where are you going to generate the returns you need to live the lifestyle you want?

No one can say where the stock market will be 15 days or 15 weeks from now. But think about your retirement. Fifteen years from now, the market will almost certainly be a lot higher.

So stop fretting over the short-term outlook and start putting money to work in great stocks to meet your long-term goals. Financial freedom is about managing investment risk… not avoiding it.

Good investing,

Alexander Green

Bond, Business/Finance, Economics, Finance, Financial economics, Financial markets, inflation, investment, investment risk, Mathematical finance, Portfolio, Retirement, Stock market

How The Oxford Club Beat The Financial Crisis… And What We See Now

by Alexander Green, Investment U’s Chief Investment Strategist
Thursday, September 23, 2010: Issue #1351

Investment forecasting is an inherently humbling business.

No matter how many good calls you make, there is always the possibility of getting it wrong the next time. Unexpected events happen. Markets turn on a dime. And an investment advisor often learns – in the cold reality of hindsight – that just when he felt like sticking his chest out he should have been covering his privates instead.

Yet there is a time for celebration too. And there is no denying that The Oxford Club and its members just came through the biggest financial crisis and the nastiest economic downturn in modern history with flying colors.

Perhaps the most surprising part is this: We can’t claim we foresaw how it would all unfold. If we had, we might have told readers to plow their money into bonds before the stock market meltdown and then switch back into stocks at the very bottom.

Unfortunately, there’s only one type of investor who does this consistently. You may have heard of them. They’re called liars.

So how did we succeed when tens of millions of investors stumbled?

Guesswork, Forecasting, Market Timing: Three Things You DON’T Need to Invest Successfully

Our investment system is built on the fundamental premise that to a large extent, the future is unknowable. Seasoned investors agree but then insist, “But of course you have to guess.”

No, you don’t.

We’ve taken the guesswork out of investing. For long-term investors, we use a proprietary asset allocation model, rebalance annually and keep taxes and investment costs to the absolute minimum.

No economic forecasting or market timing required.

Our short-term traders focus on buying great companies that are likely to beat consensus earnings estimates by a wide margin and run trailing stops behind them to protect both their principal and their profits.

How has this worked? You be the judge…

How We Notched a 28% Average Return Amid the Chaos of 2008

2008 was one of the worst years on record for the S&P 500. It posted a return of -38.5%. That caused us to stop out of 45 stocks in our Oxford Trading Portfolio. Here is the entire list. Nothing has been omitted. Although we took some lumps like everyone else that year, the average return on our closed positions was 28.6%.

With the financial crisis unfolding, we set aside our market neutral position. Why? Because you shouldn’t be afraid to aggressively buy or sell when market sentiment and valuations reach extremes. (That means either extreme optimism and sky-high valuations or extreme pessimism and rock-bottom valuations.)

Going into 2009, most investors were scared out of their pants. Stock market players were cashing in their chips. Bank depositors were running down to their local branch to withdraw their savings. The world seemed on the edge of financial collapse. And so did the markets.

Yet the headline on our annual forecast issue was: “Our No. 1 Prediction for 2009: Economic Disaster AND a Soaring Stock Market.”

Bear in mind, almost no one was saying this at the time. But that’s exactly what investors got. While the economic slump only deepened in 2009, the S&P 500 came roaring back – and our recommended stocks outperformed it handily.

If the Market Gives You Lemons… Don’t Get Sour, Just Suck Up Profits

This year we’ve maintained our optimistic stance on equities and have been rewarded with even more big profits.

While the S&P is only up 4% year-to-date, we’ve already realized gains of 229% on La-Z-Boy (NYSE: LZB), 103% on Tiffany & Co. (NYSE: TIF) and 54.7% on Emergency Medical Services (NYSE: EMS).

We’re also sitting on current gains of 321% on the Vanguard Emerging Markets Index (VEIEX), 299% on the Templeton Dragon Fund (NYSE: TDF) and 94% in Discovery Communications (Nasdaq: DISCA).

Yet over the past year and a half, at investment conferences around the world, I’ve heard almost nothing but talk of stagnation, double-dip recession and gallons of gloom and doom.

This week the National Bureau of Economic Research reported that the longest and most severe recession since the Great Depression is over. That doesn’t mean we’re out of the woods yet. We’re likely to have high unemployment and low economic growth for many months – and perhaps the next three years.

But we’re fully prepared for that, too. In fact, we’re already capitalizing on it. Perhaps that’s why the independent Hulbert Financial Digest ranks our Oxford Club Communiqué among the top investment letters in the nation for 10-year performance.

In short, we’ve taken the lemons the market handed out during the financial crisis and turned it into a Tom Collins with a fruit slice and a maraschino cherry.

If this sounds a little brash, I apologize. But we’ve enjoyed enormous success during the toughest economic period in more than 80 years.

And as Dizzy Dean famously said: “It ain’t bragging if you can do it.”

And if you want to do it, too, consider joining The Oxford Club and we’ll show you exactly how in our five model portfolios.

Good investing,

Alexander Green

Business/Finance, Crisis, Economic crisis, Economics, Finance, financial crisis, Financial economics, Financial markets, Futures contract, New York Stock Exchange, Oxford Club, P/E ratio, Short, Stock market

Investing in Stocks: Ignore the Negatives, Embrace Your Contrarian Side and Buy Stocks Now
by Alexander Green, Investment U’s Chief Investment Strategist
Tuesday, September 7, 2010: Issue #1338

When the Dow bottomed near 6,500 in the thick of last year’s financial crisis, few investors thought it was a good time to buy stocks. Sentiment was overwhelmingly bearish.

So when the market bounced higher, the consensus was that it was a “dead-cat bounce,” a bear-market trap. But it wasn’t.

As the rally gained speed, investors began to think that perhaps the worst of the financial crisis was indeed over and they would buy some stocks on a retracement or when the market tested its lows.

But that didn’t happen either. In fact, the Dow didn’t tire until it crossed 11,000 in May. By then, the market was up over 70% in just 14 months.

That was pretty depressing to investors sitting on the sidelines, earning microscopic yields on their cash. Many were so busy licking their wounds from the sell-off that they made little or no new investments during the rebound.

So what should you do now?

Investing in Stocks: Follow the Earnings

Since the market high four months ago, the Dow has lurched back and forth. But the primary direction has been down. No surprise here. After a rally of this magnitude, a correction is not unusual.

But don’t be like last year’s investors and miss the next rally. Now is a good time to put money to work in high-quality stocks.

In fact, the market is almost as cheap today as it was during the depths of despair in March 2009.

How is that possible when the Dow is more than 3,500 points higher?

Because a stock or index price doesn’t tell you anything about valuation. What matters are earnings and the multiple that the market puts on them.

Three Reasons Why You Should Buy Stocks Today

When measured by profits, the market is almost as cheap today – at 14.9 times trailing earnings and 12.2 times prospective earnings – as it was in March last year.

That’s because earnings are up. Way up. Second quarter profits at U.S. companies hit an all-time record.

A year and a half ago – when investors should have been buying stocks – the media was busy telling them about The Great Recession and how the world was coming apart at the seams.

Today, it provides saturation coverage of home foreclosures, personal bankruptcies and endless political carping. And because we’re blanketed with bad news, few investors see the positives. Consider, for example:

• The Fed has taken interest rates to near zero. That makes it cheaper for consumers and businesses to borrow. It also makes ultra-low-yielding cash a horrible investment.

• Inflation – the great bane of both stock and bond investors – is M.I.A. With the consumer price index showing virtually no increase, businesses don’t have to battle rising costs.

• Around the globe, most stocks are unloved and undervalued. Historically, when the P/E of the S&P 500 has dropped dramatically – as it has since the highs of May – it isn’t long before the market puts on a significant rally.

A Leaner Corporate America Could Drive the Next Rally

I know analysts are saying that earnings won’t be anything great. But they could be wrong – yet again – for two key reasons.

1. Businesses have tightened up their cost structure, laid off unnecessary personnel and refinanced debt at lower levels. Even a modest uptick in sales could deliver surprisingly good bottom-line growth.
2. It’s so cheap for businesses to borrow right now that I expect we’ll see many of them issuing debt to buy back their own shares. This could lead to robust growth in earnings per share, even if growth in gross earnings is less dramatic.

The bottom line?

Investing in Stocks: The Ultimate Contrarian Indicator Right Now

Stocks today are almost as cheap as they were when the Dow hit 6,500 18 months ago. And the macro-economic picture – while always cloudy – is a heck of a lot better now than it was then.

As an investor, look at your options. Cash pays next to nothing. Treasuries yield little more and could easily drop precipitously. Real estate is a non-starter, due to illiquidity, a flood of foreclosures and tough new lending rules.

But stocks offer excellent potential. And if you know anything about contrarian indicators, the fact that so few believe it only confirms it.

Good investing,

Alexander Green

Business/Finance, contrarian investing, Dow 30, Dow Jones Industrial Average, Economics, Equity securities, Finance, Financial economics, Financial markets, fundamental analysis, investment, Market trend, Short, Stock market

Long-Term Treasury Bonds: Consider Yourself Warned…

by Alexander Green, Chief Investment Strategist
Monday, July 26, 2010: Issue #1309

The brickbats are starting to pour in.

For months, I’ve warned readers about the bubble developing in long-term Treasury bonds.

Yet what was the top-performing asset class in the first half of 2010?

You guessed it: Long-term Treasury bonds, with a total return – price gains plus interest – of 13.2%.

Why is this happening? Two reasons…

• U.S. stocks performed poorly over the first six months of 2010 – down 5.6%. That’s driving many to the perceived safety of Treasuries.
• The anemic euro is making U.S.-dollar-denominated securities attractive to international investors. And Treasuries are the traditional choice for those fearful of equities.

So does this mean there isn’t a bubble after all? Hardly. In fact, the risk now is greater than ever…

1999: An Internet Odyssey

In the fall of 1999, I belonged to a ritzy tennis club – a time when Internet and technology stocks were all the rage.

My playing partners knew I was in the money management business, so there was plenty of chatter among them about “the New Era” and how “the Internet changes everything.”

Occasionally, one of my buddies would ask which Internet stocks I was buying.

“None,” I said. (I was early to get into the sector and early to get out.) The valuations were outrageous and I didn’t think it would end well.

They were surprised by this view, but kept enthusiastically buying and trading Internet stocks like almost everyone else. And, indeed, those stocks kept right on going up.

As the weeks went by, a familiar ritual developed. I’d walk up to the group and – knowing I didn’t own any – they’d ask how my Internet stocks were doing.

Laughs all around.

This went on week after week, month after month. And judging by the guffaws, the question was funnier each week than the week before.

Until one day it wasn’t funny at all.

2000: Nightmare on Wall Street

In March of 2000, the Nasdaq started coming apart and Internet stocks nosedived. As I approached their courtside table one morning, they abruptly stop talking.

“Morning, guys,” I said. “How are your Internet stocks doing?”

Funny… that line was hilarious before. Now it generated obscene gestures, as well as various suggestions for me and “the horse you rode in on.” Hmm.

What is the lesson here (other than that we shouldn’t laugh at the misfortunes of others)?

It’s that you cannot make a rational judgment about when irrational behavior will end.

The “Twin Demons in the Distance” For Treasury Bonds

Internet stocks went up longer than any logical analysis would predict. So did home prices a few years ago.

And the situation with long Treasury bonds right now also defies analysis. Unless, of course, we’re headed into a massive, deflationary period. But if that’s the case, why are gold and inflation-adjusted Treasuries (TIPS) moving up, too?

Either buyers of gold and TIPS are wrong – or buyers of long-term Treasuries are wrong. I think you know where I stand.

As The Wall Street Journal reported on July 6: “The huge stimulus the Federal Reserve and U.S. government have provided to the economy over the past few years will inevitably push up both interest rates and consumer prices. While the threat isn’t imminent, it’s not too early to take steps to protect the bond part of your portfolio from those twin demons in the distance.”

Consider yourself warned.

Good investing,

Alexander Green

Bonds, Business/Finance, Economics, Federal Reserve System, Finance, Government debt, United States Treasury security

Why Burton G. Malkiel is More Right Than Wrong

by Alexander Green, Chief Investment Strategist
Monday, July 12, 2010: Issue #1299

At FreedomFest in Las Vegas last week, I debated Burton G. Malkiel, author of the investment classic A Random Walk Down Wall Street.

Malkiel is one of just a few men alive who has profoundly affected modern investment thinking. And his position is straightforward.

He believes that rational, self-interested investors take all public information and immediately incorporate it into the price of stocks. (This is where we get the term “efficient market.”)

He therefore concludes that market timing and security analysis is foolhardy… that it’s simply not possible to beat the market over the long term… and that you’d be well advised to give up that dream and just own a broad selection of index funds.

I actually agree with much of what Malkiel says. Much… but certainly not all.

Irrational Exuberance

For starters, you can count on investors to be self-interested. But rational? Not always. Just take a look at recent history…

• How rational were investors 10 years ago when they bid Internet and technology stocks to the skies, forgoing sales and earnings for financial metrics like “eyeballs” and “web hits?”
• How rational were investors five years ago when they put themselves deeply in hock to flip land, rental properties, vacation homes and condos because “real estate always goes up?”
• How rational were investors when they dumped stocks en masse 16 months ago – with the Dow at 6,500 – and plunked the proceeds into money market funds just as yields reached an all-time low?

It’s true that most investors behave rationally most of the time.

But it’s certainly not true that all (or even most) investors behave rationally all the time. And that creates opportunity.

Let’s take a look at another flaw in the “random walk” argument…

Get the Insider Advantage

Malkiel mentions that investors incorporate all “public information” into the price of stocks. But how about non-public information?

Most investors don’t have access to non-public information, that’s true. But that doesn’t mean no one has access to it.

Some of the best trades I’ve ever made have resulted from visiting a retailer and asking the manager how regional and national sales are going. Are they supposed to talk about these things? Absolutely not. But do they?

Sometimes they do. Gaining a bit of key information by talking to customers, suppliers, competitors and employees can give you an edge.

And how about company insiders? Officers and directors have access to all manner of material, non-public information. That gives them an enormous advantage over ordinary investors. And that’s also why Uncle Sam requires them to file a Form 4 with the SEC, divulging the details of their buys and sells.

If you watch what the insiders are doing, you won’t access the non-public information that they possess. But you’ll certainly know whether they think their companies’ shares are overvalued or undervalued. And that’s crucial information.

A 10-Year Market-Beating Performance

In short, Malkiel is right that it’s difficult to beat the market. But does that mean it’s futile to try?

Not only have men like Warren Buffett and Peter Lynch put the lie to that line of thinking, so has our own Oxford Club Trading Portfolio. The independent Hulbert Financial Digest confirms that we’ve beaten the market by a wide margin over the past decade.

But while Malkiel is wrong on some crucial points, he is absolutely right on several others. For example…

• He believes it’s a fool’s errand to try to time the market. I agree.
• He insists that an index fund will outperform the vast majority of actively managed funds over time. He’s right. They have and almost certainly will.
• He argues that index funds provide a big performance boost due to cost-efficiency and tax-efficiency. Right again – and this is far more important over the long haul than most investors realize.

In short, I agree with Malkiel far more than I disagree with him. His research – and similar work by John Bogle, William Bernstein and others – has had a profound impact on the development of my own investment philosophy. In fact, our Gone Fishin’ Portfolio is the very embodiment of much of what he espouses.

And Malkiel may be surprised to learn that this portfolio has beaten the S&P 500 – with far less risk than being fully invested in stocks – every year for over a decade.

I’d call that a non-random success.

Good investing,

Alexander Green

Burton G. Malkiel, Burton Malkiel, Business/Finance, Economics, Economists, efficient market hypothesis, Finance, Financial economics, Financial markets, investment, market timing

The Japanese Stock Market: How to Play “The Land of Rising Stocks”

by Alexander Green, Chief Investment Strategist
Monday, June 28, 2010: Issue #1290

The Wall Street Journal reported last week that, for the first time in three years, foreign investors are increasing their holdings in the Japanese stock market.

Data released by the Tokyo Stock Exchange shows that foreign ownership of Japanese shares rose to 26% for the year that ended in March, up from 23.5% a year earlier.

The Journal suggests that a recovery in Japanese corporate earnings is tempting foreign investors back to the country’s equity markets.

But I think there’s more going on here. Perhaps hedge fund managers and other savvy global investors have paged back through their old, dog-eared copies of Dr. Jeremy Siegel’s Stocks for the Long Run.

If so, they may have recognized something significant…

Crunching the Numbers on Japan

Siegel notes that it’s rare for stocks to go 10 years without giving a positive return. Yet we’ve experienced just such a rarity over the last decade.

For stocks to go 20 years without giving a positive return is almost unheard of. And 30 years? That’s rarer than Big Foot, Nessie and the Abominable Snowman combined.

Which brings me back to Japan…

• In 1989, the Nikkei 225 – Japan’s equivalent of the S&P 500 – hit a new all-time high near 40,000. Today, more than 20 years later, it languishes near 10,000 – almost 75% lower.
• In other words, the Nikkei 225 would have to rise 300% just to get back where it was in 1989.

And it wouldn’t surprise me if it did just that by the end of the decade. After all, it’s happened before.

In the 1970s, the U.S. market returned just 0.34% a year – a 3.4% total return for the decade. Yet the Japanese market compounded at 16%, generating a 10-year return of 344%.

What other asset class offers that kind of potential return over the next decade? (Gold bugs, keep your seats.)

Don’t Chase the Bullet Train… Get on Board Now

The groundwork has been laid.

Last August, after more than 50 years, Japan’s opposition party trounced the Liberal Democratic Party in a landslide election.

The new government has promised to shrink the country’s massive bureaucracy and cut wasteful public spending. It also intends to end more than 20 years of economic stagnation by cutting taxes and focusing on small and mid-sized businesses.

Of course, we’re all skeptical of politicians’ promises, but there is evidence that they mean business this time. Twenty years is a long time to leave your economy in a funk.

It’s resulted in Japanese stocks being among the cheapest and most unloved in the world. Virtually no one is enthusiastic about the Tokyo market.

However, great opportunities are born when dirt-cheap valuations marry investor apathy. Plus, Japanese investors are flush with cash. They’ve largely ignored domestic stocks after two decades of sub-par returns. And as that money begins to find its way out of mattresses and back into Japanese equities, the Tokyo market should lift off.

This is doubly true when institutional money managers return to Japan in a serious way. For years, global fund managers have outperformed the world benchmark by simply underweighting Japan. But let the Shinkansen take off without them and they will be forced to dash after it.

So how do you play this?

Two Ways to Ride the Japanese Stock Market

There are dozens of worthwhile Japanese ADRs trading on Nasdaq and the Big Board.

But you can gain exposure to the Japanese stock market through two ETFs…

• iShares MSCI Japan Index (NYSE: EWJ), which invests in large-cap Japanese stocks.
• Wisdom Tree Japan Small-Cap Dividend Fund (NYSE: DFJ), which captures the best of the Japanese small-cap sector.

Or you can spread your bets and own both.

Incidentally, if you remain skeptical about Japanese stocks digging their way out of this 21-year hole, consider again how unlikely it is that Japanese stocks will earn a negative 30-year return.

As Dr. Siegel writes in Stocks For the Long Run:

“In the 12 years from 1948 to 1960, German stocks rose by over 30% per year in real terms. Indeed, from 1939, when the Germans began the war in Poland, through 1960, the real return on German stocks matched those in the United States and exceeded those in the U.K. Despite the total devastation that the war visited on Germany, the long-run investor made out as well in defeated Germany as in victorious Britain or the United States. The data powerfully attest to the resilience of stocks in the face of seemingly destructive political, social, and economic change.”

The story in Japan was similar. By the end of 1945, stock prices stood at about approximately one-third of their level just prior to the Empire’s surrender. Over the next 40 years, the Japanese market returned more than 20 times its American counterpart.

If 200 years of world stock market history is any guide, the current decade should be another barnburner for Japan.

Good investing,

Alexander Green

asset allocation, Business/Finance, Economics, Finance, Financial economics, Financial markets, Financial services, Funds, investment, Japan, jeremy siegel, Stock, Stock market, Stocks for the Long Run

Treasury Funds: Get These Time Bombs Out of Your Portfolio

by Alexander Green, Chief Investment Strategist
Monday, June 21, 2010: Issue #1285

Tens of millions of investors have a ticking time bomb in their fixed-income portfolios.

Are you one of them? If so, there’s still time to defuse it.

A few weeks ago, I wrote an Investment U column entitled, “Why the Safest Investment is Now One of the Riskiest.”

I noted that investors – frustrated by the microscopic yields on money market funds and certificates of deposit (CDs) – have poured money into longer-term Treasury funds.

Their thinking is simple. Too simple: “These funds yield over 5%, not bad in this environment, and the bonds they hold are guaranteed by the full faith and credit of Uncle Sam. What’s to worry about?”

Plenty…

Aren’t Treasury Funds Free of Risk?

Unlike individuals, corporations, and municipalities, the federal government can simply create money to meet any obligations. U.S. Treasuries are thus free of credit risk. But they aren’t free of interest-rate risk.

When interest rates go up, Treasury bond prices go down. Yet investors are comforting themselves that inflation isn’t currently a problem and that long-term rates remain near historic lows.

Don’t be fooled. There is a monster on the horizon – and he makes Beowulf’s Grindel look like Barney.

• Over the past 18 months, the federal debt has surged from $5.5 trillion to more than $8.6 trillion.
• Two years ago, it was 38% of GDP. Today, it’s 59% of GDP. And by the Congressional Budget Office’s own estimates, it’s going much higher still.

This is dangerous. Yet inflation has remained remarkably subdued so far. But understand that if the government opts to stimulate the economy further – especially if some emergency action is needed – short-term rates are already at zero.

Having already thrown the kitchen sink at the slowdown from a monetary standpoint, the federal government will almost certainly opt to spend even more dramatically.

The bond markets will not take this news well. Long-term rates are likely to spike. And when they do, it will get real ugly, real quick.

Investors always think they have time to move out of longer obligations before that happens. But that is not likely to be true…

The Triple Threat to Treasury Funds

Between early October 1979 and late February 1980, for example, the yield on the 10-year note rose almost four percentage points, driving a stake through most people’s bond portfolios.

Making matters worse, millions of Mom-and-Pop investors have unwittingly plunged into leveraged bond funds in recent years, often on their brokers’ recommendation.

Leveraged bond funds borrow money in the short-term to buy more longer-dated issues and enhance the funds’ yields. This is all well and good when rates are flat to lower. But when rates spike higher, look out below. The same thing will happen to these funds as to a margined stock portfolio in a correction.

In fact, leveraged closed-end bond fund investors could get hit with a triple-whammy…

• The bonds in the fund will drop when interest rates rise.
• The drop will be compounded by the fact that the portfolio is leveraged.
• The fund could plunge to a deep discount to its net asset value, too.

Become a Bomb Disposal Expert… On Your Portfolio

Not pretty. So what to do?

• First, check to see what percentage of your portfolio is in long-term bonds. It shouldn’t be more than 10% as a maximum (as protection against a deflationary scenario).
• Second, visit www.etfconnect.com and type in the symbols for your fixed-income ETFs or closed-end funds.

Then look at the number beside the fund’s “effective leverage.” Zero means the fund is unleveraged. But some may be leveraged up to 40% or more. (That’s how these funds are able to yield more than the bonds they invest in, even after expenses.)

In sum, this is a time to pare back your long-term bond holdings and eliminate most of your leveraged holdings.

Don’t take these words lightly. There is danger on the horizon. But if you act now, there’s still time to get that ticking time bomb out of your portfolio.

Good investing,

Alexander Green

Bonds, Business/Finance, Economics, Finance, Financial economics, Funds, Global Treasury Funds Plc - Sterling Fund, Interest, Interest rate, investment, Money fund, Portfolio, Subprime mortgage crisis, United States Treasury security

U.S. Treasury Bonds: Why the Safest Investment is Now One of the Riskiest

by Alexander Green, Chief Investment Strategist
Tuesday, June 1, 2010: Issue #1271

U.S. Treasury bonds are the safest investment in the world.

However, that doesn’t mean they can’t be dangerous. Far from it.

Yet a few days ago, The Wall Street Journal reported that, “Long-dated Treasury securities are now the most favored financial assets for global investors fleeing the eurozone’s debt crisis.”

Talk about jumping out of the frying pan and into the fire…

Don’t get me wrong. I’m not one of those end-of-the-worlders who expect the U.S. government to default on its sovereign obligations. That won’t happen.

It wouldn’t even be necessary. After all, history shows that governments always prefer to inflate their way out of a debt crisis by cranking up the printing presses instead. That way they can achieve a de facto debt reduction simply by devaluing the currency.

If you’ve seen the photographs of German citizens hauling wheelbarrows full of cash into the bank during the days of the Weimar Republic, you know what I’m talking about.

Of course, I don’t expect inflation like that. And neither should you.

But what kind of inflation does an investor expect who loans his money to the government for 30 years at a rate of just 4.1%?

Why U.S. Treasury Bonds Could Bulldoze Your Portfolio

That 4.1% figure is the current yield on the long end – and it’s a bet that has a little upside potential and a whole world of downside risk. Why?

Imagine a seesaw with interest rates and inflation on one end and bond prices on the other. If inflation goes down, bond prices go up. And vice-versa.

But how far down can rates go on the long end? Unless we have the sort of deflationary environment that Japan suffered in the 1990s, the appreciation potential here is minimal.

On the other hand, if inflation rears its ugly head, long bonds will get clobbered. And the worse inflation gets, the worse these bonds will do.

I realize that inflation is not an immediate threat. Technology and deregulation have brought costs down over the past decade. And even oil prices have moderated lately.

But if the bond market gets even a whiff of higher inflation, these bonds will drop like a stone. And I’m betting that investors who weren’t around during the early 1980s – and even many who were – don’t realize it.

They are so busy patting themselves on the back for eliminating default risk – and picking up a 4% yield versus next-to-nothing on the short end – that they are forgetting about interest rate risk: the risk that higher inflation will send long yields soaring and bond prices crashing.

Don’t Let the Government Trick You into Speculating

Seth Klarman, President of the Baupost Group, an investment firm in Boston that manages $22 billion, says the U.S. government is inadvertently provoking its citizens into taking very bad risks right now.

How?

“By holding short-term interest rates near zero, the government is basically tricking the population into going long on just about every security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

Of course, most people aren’t exactly in a speculating mood right now.

So what are they doing? They’re buying super safe long-term Treasuries and earning over 4%.

Except that’s not a safe investment – as many will eventually learn to their chagrin.

Good investing,

Alexander Green

Editor’s Note: Are you concerned about the direction in which America’s elected officials are taking the country? Worried about ever-increasing debt levels? Fearful of major inflation down the road?

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Bonds, Business/Finance, debt, Deflation, Economics, Finance, Fixed income market, Government debt, inflation, Interest, United States Treasury security, Yield, Yield curve

Gold: The Ultimate Salvation Investment

by Alexander Green, Chief Investment Strategist
Thursday, May 27, 2010: Issue #1269

There are a lot of reasons to buy gold.

Besides being lovely to behold, gold has an attractive combination of chemical and physical properties. It’s virtually immune to the effects of air, water and oxygen. It will not tarnish, rust, or corrode. And it is completely recyclable.

As Time magazine pointed out last week: “It is an amazing metal. It can be pounded into a sheet so thin that light passes through it, yet the sheet won’t crack. Gold can be stretched into wires thinner than a human hair, yet those wires will conduct electricity beautifully. Implant it in a human body in the form of a medical device, and it will resist the growth of bacteria. Gold is beautiful, pliable, ductile, strong. The Stone Age, Bronze Age, and Iron Age all came and went, but gold is forever.”

In short, gold is used in everything from wedding bands, to fillings, to optic lasers – and more…

• Thousands of mechanical devices require gold to ensure reliable performance over long periods.
• Billions of gold-coated electrical connectors are used throughout the computer, telecommunications and home appliance industries.
• Weather and communications satellites depend on gold-plated shields for protection from solar heat.
• Even the automobile industry depends on gold-coated contacts for sensors that activate air bag systems.

The price of “the barbarous relic” recently hit new all-time highs. But that has little to do with gold’s fabulous properties.

Gold is also the color of anxiety. And investors are fearful right now…

Why You Don’t Want to See $5,000 Gold

Like all sensible investors, I own gold and gold shares. But I truly do not want to see the metal soar to $5,000 as some are predicting. Why?

Because, in all likelihood, that will be bad news indeed for the economy and our standard of living, not to mention the rest of your investment portfolio.

By and large we are living in disinflationary times. Yes, the price of food and oil (and hence gas at the pump) have climbed over the past few years. But technology and deregulation have reduced the prices of many other things…

• Look at the computing power you get for the money today. (And look how those computers lower costs for business.)
• Deregulation has brought down the price of airline tickets 25% – in constant dollars – over the past 15 years.
• When I went to college out of state many years ago, I didn’t call home that often for one simple reason: I couldn’t afford it. But the break-up of Ma Bell has reduced the cost of long-distance calls to a pittance.

There is little threat of sharply higher inflation in the near term. But the longer term is a different story. And as the mess in Greece has proven, poor decision-making can cause long-term problems to suddenly show up on your doorstep.

Gold: Your No. 1 Economic Insurance Policy

Right now, gold is rising due to a lack of confidence in government and the reality that government bailouts don’t necessarily fix problems. Sometimes, they just kick the can down the road awhile.

All the European Union has done, for instance, is take the risk of owning Greek sovereign debt away from banks and other creditors and passed it on to taxpayers. Politicians often believe they can do magical things with other people’s money.

• We all know what happens when an individual exercises long-term irresponsibility in his financial affairs: personal bankruptcy.
• We’ve all seen what happens when a highly leveraged business can no longer service its debt: corporate bankruptcy.
• And in the years just ahead, Westerners may very well see what massive fiscal irresponsibility does to national governments, their debt ratings and their currencies.

No one can say exactly how and when this will play out. But there is a distinct possibility that gold will be your salvation investment.

That means – just like property and casualty insurance – that gold is something you really can’t afford not to own.

Good investing,

Alexander Green

Economics, Finance, gold, investment, Matter, Methods of investing in gold

Treasury Inflation-Protected Securities (TIPS): The Indispensable Investment

by Alexander Green, Chief Investment Strategist
Monday, May 10, 2010: Issue #1256

Two weeks ago, I wrote a column recommending Treasury Inflation-Protected Securities (TIPS) as protection against potential inflation down the road.

It prompted a flood of questions and challenges. I want to address those, but let me start by briefly re-stating my case:

1. Unprecedented government spending – including $108 trillion in unfunded liabilities for social security, Medicare and new universal healthcare benefits – is putting the nation at risk.
2. With interest rates near zero, the Federal Reserve cannot take one traditional step – lowering short-term rates – to revitalize a weakened economy.
3. In a severe economic downturn or double-dip recession, politicians – with the reluctant assistance of the Fed – could opt to spend even more massively to try to jump-start the economy.
4. The result could be stagflation: slow growth with higher inflation. (And although we haven’t seen it here in almost 30 years, perhaps even hyper-inflation.)

I don’t know what the odds of this happening are – and neither does anyone else. But I think investors would be foolish not to at least consider the possibility…

Inflation or Deflation? Hedge Your Bets This Way…

Respondents who disagreed generally fell into one of two camps…

• They either believed that deflation is more likely than inflation.
• They thought inflation was likely, but since Congress will almost certainly be the culprit, they don’t want to reward the mischief-makers by buying any kind of government securities.

Let me handle the former objection first: Is deflation more likely than inflation? Perhaps. No one can say. You should probably own a good slug of Triple-A insured municipal bonds just in case. (Because future tax rates are almost certainly going higher.)

By all means, make some plans for a deflationary scenario. But plan for the possibility of inflation, too. This is what diversification is all about. Hedge your bets.

But why use TIPS as your hedge, rather than a traditional inflation hedge like precious metals? In my view, you should use both. But remember, gold and silver are less than perfect hedges.

They have both performed exceptionally well over the last 10 years, for example. Gold has more than quadrupled. Silver has done even better. But the 20 years before that were an unmitigated disaster.

But no matter whether inflation is low or high, TIPS will protect you. How?

The Benefits of Buying Treasury Inflation-Protected Securities

• Regular Interest Payments: TIPS pay interest every six months, just like a regular Treasury bond. But unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation.
• Tax Benefits: The interest you receive is exempt from state and local income taxes (but not federal). TIPS are also less volatile than traditional bonds and are also excellent diversifiers.

There are three good ways to buy inflation-protected Treasuries:

1. Directly: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm
2. Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
3. Through its ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).

I recommend TIPS for two primary reasons…

1. I’m not a moralist trying to claim the high ground. I’m just trying to protect myself, my family and my heirs from potentially destructive hyper-inflation. I don’t want to remain true to my free-market principles only to see the net worth I’ve accumulated over a lifetime torpedoed.
2. There is no private-sector alternative here. For good reason, private and public companies don’t want to leave themselves vulnerable to sky-high interest and principal payments down the road if inflation takes off. So they don’t issue inflation-protected securities. That makes TIPS the only game in town.

I know that some libertarians and laissez-faire capitalists will refuse to buy Treasury securities, period. But as I’ve pointed out, other inflation hedges sometimes don’t work. So there is no small risk taking another approach.

In sum, there is only one investment that guarantees a return that exceeds inflation in the years ahead: TIPS.

And in my view, that makes them an indispensable part of your portfolio.

Good investing,

Alexander Green

Editor’s Note:It’s beaten the performance of the S&P 500 every year since 2003.

It’s churned out a remarkable 1,083% in cumulative gains over that time.

It’s been called a “superb, simple, smart, sophisticated strategy.”

It’s not risky or complicated… it’s a pragmatic, conservative approach to investing, based on a system that won a Nobel Prize for Economics.

And it could change the way you invest forever.

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Alexander Green, Bond, Business/Finance, Deflation, Economics, Finance, inflation, Real interest rate, Treasury Inflation-Protected Securities, United States Treasury security