Tuesday, February 5, 2008

Cash Comforts, but the Fed has set off a scramble to find profitable yields.

I'm certainly not advocating a run for cash. If that is your thinking, read my previous couple of articles. But, I do advocate everyone having an emergency fund, and for us retirees, the fund needs to be considerably bigger to avoid the necessity of selling low to raise living expenses. And, while the recent market action has made the cash feel a lot more comfortable than before, the Fed's response has made it much more difficult to find a decent profit on the cash part of our portfolio.

On the off chance that others are struggling with this issue, I'm documenting what I'm doing and looking for suggestions from those who may have found a better solution.

Over the past couple of years, I've been relatively happy with CDs and money market funds that paid 5-6%, or 2-3% over inflation. Suddenly though, I'm faced with money market funds, and renewing CDs at a 2% lower rate.

Three to four years ago, when interest rates were also very low, I bought I-Savings Bonds. These generally guarantee 1-2% over inflation, and driven largely by energy inflation the 5-6% yield looked relatively attractive. The inflation guarantee and the tax deferral feature also suited my needs. I still hold those bonds, although over the past several months the 4.5-5% yield made me question the decision. Now, that looks relatively attractive again. These are easy to set up and fund on-line with Treasury Direct, but be aware they do have some holding limits and penalties for premature withdrawal. Annual purchases are also limited.

Outside of that, the best thing I've found is the Washington Mutual Savings for Success program. It guarantees 6.5% for accounts which are funded by regular withdrawals from your checking account and held for a year. It is essentially an inclining balance, 1 year CD. Unfortunately the structure of the program makes it difficult to invest significant sums and I'm sure they'll try to hang on to the deposits at a lower rate after the one year guarantee. Even so, it seems worthwhile for those who keep close tabs on how hard their money is working and are looking to place even modest amounts.

Another option I've been moving toward, although certainly not cash accounts, is high dividend blue chips. It is relatively easy these days to get 4-5% dividends on solid stocks like Dow or GE that also have some growth potential.

Once you get beyond these relatively modest proposals, ideas get pretty uninspiring. Stick with the money market and hope rates head upward soon? Invest in CDs, with the anticipation that even today's low rates may look good tomorrow? Maybe the best chance to do better is to look for short term, local, promotional deals, but read the fine print carefully.

Ok, here's the best part...where you, the reader, get to enlighten us with your research and ideas. Come on guys, here's your chance to publish. Just hit "comments" and let us know what you have.

Friday, February 1, 2008

Run for the Exits? Follow the herd at your peril!!!

I normally am reluctant to comment on the happenings on Wall Street and the Beltway. After all, the philosophy I preach doesn't require either following the daily market news and politics, or forecasting what is over the financial horizon. Besides, most people have access to far more financial information and prognostication than is good for their financial health. Even while I was in Artarctica for the past few weeks, CNN kept up the steady drumbeat...The market is crashing! The economy is slowing! Democrats and Republicans agree emergency stimulation is necessary! The Fed responds to the crisis! Financial companies make emergency deals to maintain liquidity!

Back in civilization, I picked up a newspaper in Buenos Aires, and though I don't really speak much spanish, I noticed the word "crisis" was used 14 times on the front page alone. Though I'll admit I can't predict the future, I can say with confidence that good companies were selling for 15% less than they were a few months earlier. So, by using some of the cash I accumulated during the fall upmarket, I was able to buy at a lower cost.

But, I admit I've had some surprises. I didn't expect either the Congress, the President or the Fed to capitulate as they have. I suspect they've been watching too much TV as well, but it has me trying to evaluate what it all means, so let's sort through what we know.

  • Obviously, we've been borrowing and spending too much and that has led to a dependency on cheap credit. The worst offenders are in some hot water.
  • The economy is slowing. How much and how long, nobody knows.
  • We've had a couple of bubbles inflate and burst...think dotcom and housing.
  • Oil and other commodities have been on a roll for the past few years, putting a damper on growth.
  • The U.S. has been driving the world economies.
  • It is an election year.

That's about it. There's nothing very surprising here. Everything on the list has been known for months. And if we want to understand what is likely to happen, these are the foundation. Even so, what we might reasonably assume may be more illuminative:

  • Eventually, we must be weaned from the addiction to credit. Based on this, one might theorize that the recent moves by Congress and the Fed are the reverse of what is needed. They seem designed to increase availability of credit and overspending, feeding the addiction. However, an aversion to discipline and pain, coupled with politics, are promoting giving drugs to the addict to minimize the worst effects of withdrawal. The big question is whether the process will result in a slow, less dramatic withdrawal or a feeding of the addiction leading to a Paul Volcker style, cold turkey approach. Until the last year, the former approach seemed to be in place and working, with slowingly increasing interest rates, but now I'm not so sure. Meanwhile, I'm hoping for the former, preparing for the latter, and trusting my investment system to manage the process.
  • The economy is slowing, but will that turn into a crash? And how will the outcome effect investments? This is a subject for a book, rather than an article, but let me take an abbreviated attempt. I anticipate more slowing and perhaps some reasonable contraction, but no crash. Housing will continue to fall, since prices are still 20-30% above the long term trend line, but I suspect the process will take several years and it will be very uneven geographically. This will limit the annual drag to less than the long term upward trend. Oil and commodity prices may continue upward for a while, but will eventually return lower to their long term trend lines. This will relieve some of the inflationary and budget pressures resulting from the credit and housing crunch. And, amazingly, traditional energy stocks are already priced for this scenario, so they shouldn't fall too far. Gold seems likely to follow the commodity trend, although the long term gold trend is not so clear. Bonds seem poised for poor performance, since interest rates will eventually return to their long term trend, significantly higher than today. Cash seems a poor bet, with the current low interest rates ( Particulary short term rates, which are more subject to government control. Interestingly, pun intended, artificially lowering short term rates may exert upward pressure on long term rates by raising the risk of inflation.). Meanwhile, stocks in general seem reasonably priced, perhaps even underpriced for today's low interest rates, and stock prices are near long term trends. I expect a relatively slow upward longer term trend in the markets, interrupted by significant volitility as the long term trends are exposed or impeded by daily events and stories.
  • In the long run, international markets will begin to take more leadership from the USA. Free trade is taking hold. Governments, on the whole, are becoming more democratic. These trends will allow billions of people to begin catching up, to the benefit of both themselves and the world economy. Progress will be uneven, but I believe the long term trend is unquestionable and positive for those not afraid to invest on a worldwide basis.
  • Politics will rule in the short term, but fade in the long term. This is not only true in the ebb and flow internationally, it applies perhaps even more to the USA. Election years yield increased uncertainty, and at the same time produce more quick fixes, such as tax rebates and mortgage modifications, resulting in increased volatility. Ultimately, though, these fixes succumb to the long term realities, ie, that the USA is tending to regulation and government interference rather than freedom.

Whew, now I'm much further out on a limb than I intended to be. There will be disagreement, of course, and I'd love to hear it. Will I be right, or will I be wrong? Either way, what can you do to prosper financially?

I was just reading, in a science magazine, no less, about a psychiatrist who is trying to build a model which plays reverse psychology with market emotion to predict investment movements. In other words, they search the internet for increases in "negative" or "positive" words and then bet against that trend. They didn't mention it, but I suspect the word "crisis" is one of the negative words. Apparently they are having considerable success, and, even though I suspect the models still need a lot of work, it all makes a lot of sense. As I've mentioned many times, and implied in the lead-in to this article, my experience is that following the emotions driven by the media is a key reason for underperformance of most investors. The herd mentality almost always leads to the worst decisions. And, while I didn't actually see it in print, the news could well be summarized by red, three inch letters screaming "Run for the Exits!!!". Most investors would be well served to avoid joining such stampedes.

Obviously, I believe that markets almost always return to long term trends, and that is the basis of my system, "Dollar cost Averaging on Steriods"...track long term trends and invest anticipating a return to the trend line. Use a mechanical system to avoid running with the herd, all with only a few minutes effort per month. Beat the markets without having to always be right about the future. Best of all, do something to take advantage of the volatility. Man, I'm glad I don't have to depend on my prognostication prowess to secure my financial future. Until the psychiatrists perfect their model, I'm convinced my process will get the job done. If you don't regularly follow this blog, go back to March 2007 for an outline of how the system works.