The Rush Report
The 2007 Market Rush Review
By
Mark Rush
redgroup2@
January 1st 2008
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Preface
It is once again time for my annual market review where I try to examine various world events that occurred in 2007 and understand their implications for the market in 2008. This is my time to reflect on my stock strategies, current events, portfolio performance, event scenarios, and the implications on the world equity markets.
In this distribution I have broken my review into two separate documents to better focus the point of each document. The 2007 Review will review 2007 and attempt to think about 2008. The second document is The 2008 Investing Guide is a collection of money and investment articles (some new, some recycled) and put into to a semi-logical sequence.
As you read through this review, even if you don’t agree with any of my thoughts, please take the time to think about your financial choices and think about ways to improve your returns. It is my goal in life to have my money working for me instead of me working for my money.
Please email me with your thoughts, questions, and insights on the opinion that I present. The purpose of my effort is to stimulate a dialogue around current events and their impacts on the markets.
This document may be distributed to anyone as long as it is in an unaltered form.
Regards,
Mark Rush
redgroup2@
Please read this important notice
Disclaimers
Keep in mind that I do not have any special insights into the markets nor do I have any type of training or experience in any kind of investments. I am not a financial advisor nor do I have a degree in economics or finance. Remember these facts as you read and ponder my unprofessional opinions.
This document should not be construed as investment advice; you and your financial advisor are responsible for making your investment decisions. The purpose if this document is for me to “think out loud” and stimulate thoughts regarding my investment ideas for my portfolio. I am asking you for your input about my ideas and strategies.
Nothing in this document should be construed as tax advice or estate planning. Tax laws are complicated and change often. I do not have the time to follow changes in tax codes at all therefore any thoughts I may have on the subject are very most likely to be obsolete or at the very least dated. Before you attempt to implement any tax strategies you should consult a tax professional or financial advisor.
All thoughts and strategies are based on the on the fact that I invest money from the United States using US dollars and pays US taxes. All comments and views are from my American investment perspective. Many of my strategies consider US tax implications and currency exchange rates which may not be valid when viewed from outside the US.
The views and opinions in this report are strictly my own based on publicly available information. I do not have any special perspective into the markets, just my own opinions which are often very wrong. Opinions stated are my own and do not reflect the opinions from any current, past or future employer.
I will/may change my strategies and investments ideas radically and suddenly between reports without notice to any receivers of this report. My own investment strategies can be extremely aggressive and my portfolio should not be replicated by anyone, including me.
I am an amateur investor and this document is a hobby for me. Any thoughts and concepts should be treated as such. Please consult a professional financial advisor before you make any investment decisions regarding your investment ideas, goals, and strategies. Continue reading this document at your own risk…
Introduction
Well it has been an interesting year for investing to say the least, at least twice in the past year the market panicked and it seemed like it was going to crash. The first time was in March when concerns that the Chinese stock market was overvalued and the second time was in the summer when the mortgage/real estate crisis came to center stage.
This summer the world credit markets almost came to a grinding halt for a few brief days, but thanks to swift movement by the European Central Band and then by our Federal Reserve a massive economic catastrophe was averted. I believe this was the most serious economic event since 9/11. This developing situation has certainly moved up on my list of things to watch.
Considering what transpired this year the stock market results weren’t that bad. For all of 2007, the Dow was up 6.4%, the S&P 500 rose 3.53% and the Nasdaq composite was up 9.8%. The international indexes did much better but check Chapter 5 for that breakdown.
The real estate bubble impacted me this year even though I don’t invest in the fixed income markets or even own a house. Due to E*Trade’s decision to offer mortgages and its subsequent meltdown, I reluctantly decided to change brokers after 10 year relationship with the firm. I along with a few hundred thousand other customers closed their accounts with E*Trade to prevent any exposure of my money to their bad business strategy. Even though no one lost any money (except shareholders) E*Trade’s customer asset base dropped by about 20% in the past year. In my opinion, E*Trade will be taken over sometime in 2008 and hopefully the current management will be fired.
With all that is going on in the world I regret to report that I was far more optimistic at this time last year for 2007 than I am going to be for 2008. I believe that we will have a couple of years of moderate growth in the US economy and stock markets but thankfully most people still have a optimistic vision for the emerging markets.
Clearly the US has several challenges ahead of it; current overvaluation of real estate, subprime debt, general consumer debt, federal debt, social security, war, stealth central planning, and inept policy makers (Legislative and Executive). On the other hand the rest of the world seems to be functioning more effective and efficient each year. Third world growth in the areas of economic activity, economic freedom, and rejection of failed Marxist philosophies are contributing to prosperity around the world with spillover back into the US. I believe that the world economy will help the US avoid recession this year.
Needless to say, I have been touting the benefits of overseas investment is this document since its inception and I expect to continue this philosophy until sometime around 2010-1012 for reasons to be discussed in the report. It sure would be great to discuss everything in the first couple of pages but lets move on to the core document and see what else I am thinking about for 2008…
-Mark
Chapter 1
2008 Forecasts
Economic Projections
It is time to review world events with my “opinion” of the probability of the event occurring (0-100%) with my “opinion” of the impact on markets on a 1 to 10 scale. A “1” represents little to no impact on the markets while a “10” indicates that if the event occurs I expect a widespread fundamental market directional change to occur. This is a totally unscientific based on my irrelevant opinions with absolutely no other basis other than my limited understanding of how the world works.
The purpose of this section is to highlight current risks in the market. I will attempt to quickly try to explain my thought process behind each rating.
US Economic Indicators (my view)
US Gross National Product (GDP) grows > 1.5% in 2008
Probability of Occurrence 50%
Impact 7
The housing market and consumer debt are beginning to hamper the economy and I believe that the trend will continue and accelerate in 2008. The rest of the economy seems relativity strong albeit weaker than last year at this time. On the down side, energy prices are raising again although seems to have paused somewhat for now.
Several economists are predicting a US based recession in 2008 and putting the odds for a recession somewhere around 40% give or take. I believe that we may flirt with recession but most likely still have 2% GDP growth in the first half of the year and near zero growth during the second half. If you are in the housing, construction, automotive, or lending industries this is of little reassurance for clearly times are bad. Economists’ consensus for the GDP growth in 2008 is 2.0%. I am a slight pessimist…
I believe the economy will be weaker in 2008 but not “horrible”
Slowing growth in economy is a negative for the market
Low unemployment of < 5%
Probability of Occurrence 50%
Impact 7
The housing market slowdown hasn’t seem to hit the unemployment numbers too bad as of yet. I don’t really foresee a massive unemployment explosion, but that could change. If employment stays strong (less than 5% unemployment), I believe this will get us though the current economic weakness. Something worth noting is that some believe that the downturn in the housing market is masking the real weakness in the job market. The thesis is that the construction workers are vastly overrepresented by illegal aliens and they don’t go the unemployment bureau when they are let go, therefore true unemployment is actually higher. This seems like a plausible scenario.
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Note the uptick in the unemployment rate… One must pay attention to this!
Low unemployment is a strong positive for the market, deteriorating is bad
Federal Reserve raises interest rates 2008
Probability of Occurrence 20%
Impact 7
This is a complete reversal from what I was thinking last year for I thought the Fed was going to raise rates in 2007 not lower them. I personally think that the Fed needs to resist lowering too much more and find another way to inject liquidity without causing inflation. My issue is that each time we lower the rates the dollar falls. Since capital is always in search of higher returns people will tend sell dollars making is worth less therefore the stuff that we like to buy (oil, BMW’s and Chinese goods) get more expensive causing inflation.
Keep in mind a lot of money is loaned to us from overseas, as the value of the dollar falls foreign investors will see poor returns compared to other global opportunities, therefore they will sell their US stocks and bonds and receive dollars; to repatriate their capital they will sell those dollars and buy foreign currencies, thereby causing the dollar to fall more, then we go back to the beginning of the cycle… To stop that cycle the US will have to compete for world capital by offering rates that are higher than the expected foreign exchange deprecation rate. This bodes for higher long term interest rates.
Lower rates are inflationary, and although good for the stock market (if nothing else changes, stocks should theoretically go with inflation) longer term it causes a flight of capital which is very bad for the US since it is a debtor nation.
Lower rates are good for the market short term…
Inflation exceeds 3%
Probability of Occurrence 60%
Impact 6
Three forces are at work on this question; World production is producing more goods and services at cheaper prices, strains on world raw materials and maintaining ample supply of raw material, and falling value of the US dollar therefore the vast amount of products imported will cost more… So two items for higher prices and one for lower, I am voting for inflation next year due to the falling dollar and low interest rates. Since we are a net importer it will take more dollars to purchase things that we buy from foreign markets therefore prices of these items go up in terms of the dollar, therefore inflation.
Low inflation in the US is a positive for the market
Continued strong spending by US consumer
Probability of Occurrence 30%
Impact 7
Clearly the consumer is still stronger than what I thought but is showing some signs of weakening. What I fear (and more importantly the data supports) is that as the sub prime mortgage fiasco is working its way through the lending system and all types of sub prime lending are being affected, especially credit cards. A great many American consumers are not prime borrows. This indicator is to be watched with vigilance!!
What I find the most ominous sign to me is the spread of credit concerns that are starting to roll into the credit card. Credit card accounts that are at least 30 days late jumped 26% to $17.3 billion from a year earlier, in my opinion, and this is an ominous sign.
This is the a very important indicator and I believe this indicator is weakening
Corporate profits exceed YoY growth of 5%
Probability of Occurrence 50%
Impact 6
It is general consensus on Wall St. that corporate profits will slow down in 2008 which seems reasonable to me. I believe that corporations will not drag on the economy but won’t add as much as it has in the past few years. Profits are not falling; they just aren’t growing as fast. Profits from corporation with significant overseas exposure are still doing well while the ones in banking and housing, not so much…
I expect earnings growth to be down; this is a negative indicator
Real Estate prices drop greater than 7.5% in 2008
Probability of Occurrence 50%
Impact 6
Last year I predicted 10% drop in home prices for 2007 and so far it seems to “only” fallen by 6.7% survey (the latest data is for October). I believe that I will get the rest of my 10% this year and then some so I am predicting another 7.5% dip in real estate prices in 2008.
Currently the 30 year mortgage rate is up to 6.25% which in the scheme of things rates is still attractive but still a full 1% higher than they were just two years ago. Currently I don’t own a house and plan to rent for at least one more year because I expect housing prices to come down more. I expect houses to stabilize in 2009 not because of intrinsic value but with the new tax and spend scheme in place, higher inflation, and voter bias to have the tax base subsidize home ownership, I believe that real estate at that time will be reasonable safe haven for capital especially if you borrow the money at a fixed rate.
Below is a chart of 30 year mortgage for the past 5 years. What is not reflected in this chart is what is going on in the jumbo mortgage market. Jumbo loans are larger loans that exceed $417,000 and are not backed by the government. The going rate for large loans for people with excellent credit and at least a 10% down payment is currently at 7.25%. Previously I thought the upper end of the market was going to be immune to this meltdown (after all the rich are getting richer) but without government backing no one wants to make these kind of large loans without significant compensation.
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Obviously this is a big negative for the investing since it is destroying equity.
$1,000,000,000,000.00 (Trillion Dollars) Trade deficit by 2010
Probability of Occurrence 35%
Impact 3(short term)
That is not a typo, T as in Trillion not B as in Billion. We imported $763.6B in 2006. The week dollar has stabilized this number for now and I have lowered my number to 40% chance down form 50%. A recession will likely reduce it more since we won’t be able to import as much stuff.
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Excessive imports are a bad thing…
International value of the US dollar declining >20% in next 5 years
Probability of Occurrence 75%
Impact 7
We need to watch to see if the dollar falls too much too fast. It may be good for our exports but let’s face it we import a lot more stuff than we export. A low dollar is inflationary since you will need to pay more for the things manufactured abroad.
If the dollar falls too much, foreign money will want leave the US and interest this will go up to convince that capital to stay.
Although the economy has grown over the past few years I don’t believe it can continue to support the current public and private debt burden. I believe that in the long term the dollar has no direction to go but down. The combination of poor education, poor fiscal discipline (public and private), and mass retirement only leads me to believe over the next 20 years it would be better to place a significant portion of your investments overseas to obtain better growth and to take advantage of the eventual currency devaluation and fall in local purchasing power.
As you can see from the chart on the next page, in 2001 it took about 85 cents to buy a Euro, today it takes over $1.46 (a 9% drop in the dollar in the past year) and I don’t foresee this trend changing anytime soon. You don’t like high gasoline prices, about $.25/gallon of the price increase this year in gas is due to the weak dollar. It is going to get worst…
Chart: How many dollars does is cost to buy 1 Euro?
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There was a time in my life when I thought I would move out of the US and leave my money invested here and live the life of a “rich American” overseas for pennies on the dollar. It looks more and more that I may have gotten this scenario backwards; I should send my money abroad now and get superior returns due to world economic expansion and the falling dollar. After the dollar falls I will bring it back into the US and then my foreign money will be worth much more. My new plan is to stay in the US and lead the lifestyle of a “wealthy foreigner” for cents on the Euro.
Weak Dollar = Bad for US investing.
CBOE Volatility Index (VIX)
Current value 22.5%
Impact N/A
One of the things that I like to look in market is the VIX, what is it and why should you occasionally look at it? Volatility is simply a measure how choppy the market is behaving; since the VIX is actually traded it reflects individuals and institutions views on what volatility expectation will be over the next 30 days. Some people have refer to this as the “fear index”, I don’t like that description, but it has some basis it true since the VIX does tend to peak in the middle of a market panics.
When the VIX is low this generally is a good time to buy those put options that I talk about for “insurance” and when it is high it is a good time to sell that insurance…
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From the chart above you can see that the “fear” peaked in March and has been coming an equilibrium somewhere around 22 1/2. I drew some trend lines in (the black line) to help show what I am thinking here. The market has come to a bouncing up and down off those lines I drew, and now it has run out of room.
Theoretically the market is at a point of decision, does the VIX go up from here (generally the market will go down) or will it break to the down side (generally the market would go up). If the VIX were to fall under 20 (and stay for a week or so) that would be a good time to start buying stocks. If it goes above 25 I would be inclined to sell. We will revisit this next quarter to see how my soothsaying is doing…
This indicator is, well indecisive… It may just predict the next market move
Liquidity
Probability of Occurrence 35%
Impact 8
Liquidity almost dried up this year and the lack of it could have caused a worldwide credit meltdown… I have stated that I felt that this was one of the most important indicators. I still believe that it is and it materially weaker than in the last report last year. This issue will be with us for a least another year or two.
This is still a big market negative
Global Health Issues:
Mutation of the Bird Flu to a Human form
Probability of Occurrence 10%
Impact 10
Bird Flu Virus (Avian form) reaching the U.S.
Probability of Occurrence 25% per year
Impact 4
Yes, avian flu still is on my most unwanted list it has the biggest and potentially largest impact to human kind at this point. It has the potential to be more devastating than Al-Qaeda, North Korea, Iran, and Britney Spears combined.
Probability of Occurrence: Until the flu mutates into a human transmittable form I am not overly concerned, if the flu does mutate to a human transmittable form I will be extremely concerned (I have never given a 10 rating to any other event). There have been cases in Europe where domestic birds have been infected and so far the outbreaks have been contained with low ramification to the human population and the broader stock markets.
The Spanish flu of 1918-19 was by far the most lethal influenza pandemic of the 20th century. It infected about one-quarter of the global population and killed more than 40 million people worldwide, roughly 2 percent of the world population at that time. With the world having 6.5 billion people now the number of deaths could easily be around 130 million people, nearly twice the number of deaths from WWII.
Nearly 50% of the people who have contracted bird flu have died from it. See the following link for more information.
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International / Foreign policy issues:
Economic crisis in China in next 5 years
Probability of Occurrence 15%
Impact 9
As with all rapid economic expansions we always have to be on the watch for a crash or in this case a recession. Once all the cheap labor is absorbed we will need to watch for economic efficiency improvements to fuel sustainable growth as with any modern economy. Once China becomes “fully employed” wage pressures will cause labor rationing therefore economic slowdown. This will be the challenge; it is easy to put untapped resources to work but it is very hard to efficiently allocate those resources.
Another thing to remember China plays by China’s rules, any investment that is placed in China runs the risk of being sacrificed for its own national interests. China is the economic engine that is powering the world economy currently and any mismanagement in the Chinese economy will affect all classes of investments worldwide. If you invest anywhere, you should familiar with the geo-economic conditions in China.
Al Qaeda attack in the US
Probability of Occurrence 10% in next 5 years
Impact 8
Unlikely but should be planned for… It is always wise to own some out of the money put options to protect against a sudden stock market collapse.
Every portfolio should always have long dated out of the money puts in it. Without these instruments, if something catastrophic were to occur 50% of your saving could be eliminated overnight. Government Bonds will protect to some degree.
I am really starting to become very unafraid of Al Qaeda these days, the more I think about it the more I am starting to think these guys are just of bunch of goat herder with AK-47s (rifles). They make a video; we launch a spy satellite. They buy bullets, we build supersonic jet fighters. Using goats and AK-47s to defend against a strike package is a really bad idea (don’t bring a knife to a gunfight)… If we choose to, we could make that entire part of the planet disappear without breaking a sweat… We haven’t gotten them yet because they are afraid of us, they are hiding, and we choose to “play” nice!
Destabilization of Pakistan in the next 3 years
Probability of Occurrence 40%
Impact 6 (8 for Indian investments)
With what has been going on over there as of late I have raised my rating on this one. My major concern is that the Islamic Republic of Pakistan has tested nuclear weapons and has between 25-50 nukes. Historically it has never gotten along with India who also happens to have ~50 nukes of its own. It is unlikely that a pro-western government would the come from a sudden change of the current situation.
I believe that Osama Bin Laden is hiding in northern Pakistan and him and his crew would benefit greatly from a coup. Of course if he actually wanted to do something, he might have to leave his cave with his goats and AK-47s to make a difference… What could possibly stop him from doing that? “Oscar Zulu Seven to Flight Command, satellite uplink confirmed and I have acquired the package… permission to engage…”
War in Iran
Probability of Occurrence 10% in next 3 years
Impact 9
This is a dangerous game of chicken that neither side should be playing… Iran has won
North Korea nuclear war
Removed from the list… (
International Economics:
Continued growth in China for next 5 years
Probability of Occurrence 80%
Impact 8
According to the CIA China is the second-largest economy in the world after the US, although in per capita terms the country is still poor. At current growth rates China could be the world largest economy by 2020 based upon purchasing power parity.
Continued growth in India
Probability of Occurrence 80%
Impact 6
Play: Purchase IIF or Indian mutual funds
Post Play: Retire rich…
Continued growth in Australia
Probability of Occurrence 70%
Impact 5
Despite recent pullbacks in the commodities markets I still believe that Australia is still a great lower risk way to benefit from the growth in Asia.
Play: EWA
Post Play: Retire and live well…
Continued moderate growth in Europe
Probability of Occurrence 40%
Impact 5
Europe is actually seeing some growth these days; the more progressive economies are doing better… I would now consider putting some money in Ireland, France, and Germany.
Domestic Macroeconomic factors:
Baby Boomers Retirements and Social Insecurity
Probability of Occurrence 99%
Impact 9 (long term)
This policy has the potential for massive socioeconomic upheavals over the next 30 years and I am not sure we are prudent enough as a culture to take the “medicine” that is required to solve the Social Security problem. Currently Social Security and Medicare consume 30% of all federal revenues which equates to 7% of GDP. This is projected to go to 14% of GDP by 2040. Take a look at my 2008 Savings Guide for a complete write up on the subject, it starts somewhere around page 9… It is a real eye opener!!!
The three easy (unpopular) fixes is to either; raise Social Security taxes now, cut everyone’s benefit by 15%, or raise everyone retirement age by 5 years. Implementation of these ideas can shave Trillions, yes with a “T”, off of the payments over the next 75 years
Out of all the issues that I am covering this is certainly the one issue that is most likely to occur and have the largest impact to Americans outside of a major war (Iraq is not a major war). The Social Security problem is so large and the problem will come to fruition so slowly that I am not sure we will have the foresight or the guts to deal with it in time to prevent massive widespread pain.
Budget Deficits >$250 Billion
Probability of Occurrence 60%
Impact 3 (short term)
I find it disturbing that our federal government taxes then spends nearly 20% of our economy activity; add state and local government to the mix and you will find nearly 25% of our entire output is government spending… For the past couple of years the deficit has always come in smaller than expected, I believe that we will go the other way and tax receipts will not grow as fast because I suspect the economy has weakened more than it appears. This will show up in the tax receipts.
Estimated receipts for fiscal year 2008 were $2.66 trillion
$1.25 trillion - Individual income tax
$927.2 billion - Social Security and other payroll taxes
$314.9 billion - Corporate income tax
$68.1 billion - Excise taxes
$29.2 billion - Customs duties
$25.7 billion - Estate and gift taxes
$50.7 billion - Other
The budget for 2008 totals $2.9 trillion
$608 billion (+4.5%) - Social Security
$481.4 billion (+12.1%) - United States Department of Defense
$386 billion (+5.2%) - Medicare
$324.0 billion (+1.8%) - Unemployment/Welfare/Other mandatory spending
$261 billion (+9.2%) Net interest on debt
$209 billion (+5.6%) - Medicaid and SCHIP
$145.2 billion (+45.8%) - Global War on Terror
$69.3 billion (+0.3%) - Health and Human Services
$56.0 billion (+0.0%) - United States Department of Education
$51.8 billion (+9.7%) - Other On-budget Discretionary Spending
$39.4 billion (+18.7%) - United States Department of Veterans Affairs
$39.0 billion - Other Off-budget Discretionary Spending
$35.2 billion (+1.4%) - US Department of Housing and Urban Development
$35.0 billion (+22.0%) - State and Other International Programs
$34.3 billion (+7.2%) - Department of Homeland Security
$24.3 billion (+6.6%) - Energy
$20.2 billion (+4.1%) - Administration of justice
$20.2 billion (+3.1%) - Department of Agriculture
$17.3 billion (+6.8%) - National Aeronautics and Space Administration
$12.1 billion (+13.1%) - Department of Transportation
$12.1 billion (+6.1%) - Department of Treasury
$10.6 billion (+2.9%) - United States Department of the Interior
$10.6 billion (-9.4%) - United States Department of Labor
Over the past 7 years the revenues of the US government has skyrocket… but not as fast as our spending. Whatever happened to the battles to reduce government expenditures?
Democrats in charge of both White House and Congress in 2009
Probability of Occurrence 60%
Impact 8
The democrats have been waiting 28 years to control the legislative and executive agenda and will likely get their wish though at least 2010, after that time the populous will turn back to the center (as has always happened in recent history). Now given the blue states clamoring for power, it won’t be long before the legislative agenda begins, with a supportive President ready to sign all bills into law. As with any political association it will run amuck and I believe create great harm to the long term health of the US dollar, US investment and our economic wellbeing.
Chapter 2
The Plan
Every trader reserves the right to make a more intelligent decision today than he made yesterday.
- Sheldon Natenberg
Positives
• Economic growth in the developing world continues to expand at an unprecedented rate and it is contributing to a massive increase in world wealth
• I believe that some US stocks are starting to get cheap
• So far the housing bubble unwind isn’t affecting the economy as much as I feared
• Interest rates remain relatively low
• Unemployment is still reasonably low
• We have a semi-competent Federal Reserve
Negatives
• A potential reduction in global liquidity due to stains on credit markets
• Slow to no economic growth in the US is expected this year
• The unwinding of the housing market
• Higher energy, metals and grain prices
• Congress seems tempted to fiddle with the economy in unproductive ways
• Emerging markets are getting bid up on speculation
• Lower corporate profits growth rate this year
• Dollar is weakening
• Trade imbalance
• Budget deficit
• Potential of consumer credit crunch due to multiple factors
• War on Terror/global instability
So… What is the Plan?
The short and honest answer is “I don’t know”! Here is what we have, we could be coming upon a recession and at the same time we have sever liquidity issues in the credit markets, this sounds like you should dump your stock and run for the hills. But at the same time you have a new world order macroeconomics (globalization) in play and international growth that is unheard of in the history of mankind.
These two very large and fundamentally opposite thoughts lead me to believe either argument for the market direction in 2008 could be valid. The problem is which will win? In the very long run, say five years from now, without a hesitation globalization and the new world economic order will win, in the short run the credit market has a very real potential to trigger a credit meltdown causing a worldwide recession and severely constraining the world banking system and causing markets to sell off violently.
So… Given that thesis I have no choice but to play a very conservative strategy and continue to play the foreign markets and limit my US investments especially banking, housing, and consumer cyclicals. Things like Target, Bank America, and Home Despot should be avoided because they rely on the consumer, credit, and the housing industry. You should ask this simple question “does this investment depend on Americans spending money they don’t have?” before you invest.
Now, for those of long range investing or nerves of steal, a lot of money can be made in the next few years on these names. In the long run this crisis will solve itself, these stocks will come back with a vengeance, but I don’t plan to be the first to jump in to test the waters nor do I plan to be the last. I will invest after the water has cleared, I won’t have picked the bottom but plenty of money can be made later without gambling now.
Even now I am taking positions in things like Goldman Sacks and Lloyds (British bank with little subprime exposure) because these are solid companies that are continuing to perform but have been sold off with the entire banking group. Owning some energy, natural recourse, base materials and some gold is not a bad defensive play. I plan to keep some of my gas trusts (SJT), the Australian ETF (EWA) and continue to buy gold (GLD) with my idle money. If a recession were to occur these stocks will get hit, if a global recession occurs these stocks will get creamed.
I have been rewarded quite well with my Indian investments again this year and will continue to keep money parked in that country also. As for China, it has been a nice run and I have been reducing my positions in that country and will continue to do so. Long term it is a great place to invest but these stocks will get crushed if the economy goes bad in either the US or China (bad in China means GDP growth of less than 10%).
Bottom line: The next few years are going to be tricky for most investors, we are at a massive turning point of either much higher or much lower and no one knows the outcome. I am afraid to invest because I don’t want to loose money but at the same time this could be the cheapest stocks will be for the next 10 years. This is the classic “fear and greed” dilemma for me.
I don’t believe that we are at a bottom of the market at this point but I am still going to have money in the market during 2008, if things get worst I will have no hesitation to liquidate everything and put my money in a short term European money market bond (FXE). If things look better, I will have no hesitation selling my conservative investments and buying those beaten down names.
The Housing Market, how did we get here and where are we going?
I have been pointing out the flaws on the real estate market for almost two years now and I did expect a large correction (hence me not owning a house) but what I did underestimate was the extent of the damage to the credit markets.
In my simplistic estimation, some of the rise in the housing market was legitimate. Upper end households have been doing well, increasing land prices, new loan products and new methods of bundling loans and managing risk. But other factors contributed to a bubble including the Fed lowering short term interest rate, Bush tax cuts, poor credit standards, China running trading surpluses and investing money in the US thus keeping long term rates low.
I am afraid that we still will see a lot worst ahead of us; we are still only in ACT Two
The three “acts” of the housing bear market are:
Act One: Build and they will come!
Act Two: I have to repay this loan?
Act Three: Banks liquidate and crush housing prices…
At this time we were only finishing ACT One; we are just now just beginning of Act Two. Act Two will play out for about another year or so, and I now expect Act Three to take another year or after that. Bottom line is that I expect the housing slump to go on for at least two more years.
Why I will buy a house in 2009
Now believe it or not I am convinced that the housing market will bottom sometime in 2009 and I plan to buy a house in a year or two. I plan to buy a house larger than I need and I plan take out the largest loan that is allowed.
Why? I expect long term interest to increase starting in a few years due to deficit spending and social programs. I also expect these problems to weaken the value of the dollar and cause inflation and I do not ever expect that trend to reverse.
My investment in housing is a two fold strategy, I will buy a house which is an investment should at least keep pace with inflation and I will borrow a lot of current dollars and pay back the loan in the future with presumably significantly less valuable future dollars. I hope to have very little out of pocket money involved in my transaction, my expectation is that the asset (house) will rise due to inflation, and the “real” value of my fixed rate loan will fall due to increasing interest rates.
The key to this “spread” or inflation arbitrage is getting a long term fixed interest rate loan. When inflation kicks in assets increase in value and debt decrease in value therefore you would want to own assets (houses) and be short debt (take out loans). I have been preaching the fall of the housing market and now I will be preaching (in a year or two) the value of having a house with lots of fixed debt against it. Oh yeah, the tax breaks on the loan and the fact that you don’t pay taxes on the capital gains on a house make it that much more enticing. When everyone else is zigging you should be zagging.
My thoughts on the next few years investment climate due to politics
I would like to state again that this is a by its nature not a political blog, but an investment essay. I am not trying to convince anyone how to vote nor how to invest, I am trying to foresee the future and guess what the likely outcomes will be. Based on my guess, I want to develop an investment strategy based on the politics outcomes. No one should modify their long term investment strategies (especially me) based on the opinions of an unqualified market/political soothsayer.
My hypothesis will start with some basic assumptions that I believe are completely reasonable. Looking at the polls, candidates, money raised, and the political atmosphere I believe that Hillary Clinton will win the White house in 2008 and more importantly the democrats sweep both the house and Senate. What this will mean, for the first time in almost 28 years, the Democrats will control the White House and Congress.
The long waited for and hard earned victory means the Democrats will completely control the agenda. The lists of things on the agenda are plentiful and expensive just at a time when the government needs to really cut spending to fund social security in the upcoming decades.
The first item on the agenda will be easy, it will be to increase taxes and start new programs. This in itself is an honorable goal and if money were a physical object opening up the coffers would help those in need to achieve its desired effect. The problem is that it isn’t money just something sitting a bank vault waiting for someone to emancipate someone else’s money to a put it to a good use. Money is more like grain in a silo, you can eat it today or you can plant it for more grain in the future… Money will be diverted from investing and use for current consumption. Our country already consumes too much and invests too little and the value of our dollar shows this.
I suspect that the economy will react and it will all go very wrong as money is diverted from private sector to the government. The problem is once a program or entitlement is in place it is nearly impossible to rescind no mater how bad it is or how costly it becomes. This will have its impact on the longer term greater socioeconomic well being of the US.
We only have to look a Social Security; this was the best of intentioned government program that has greatly benefitted many people. In the beginning many people received benefits without contributing much to the program. The problem is the people who got something for nearly nothing owe it to those who will get nearly nothing for a great deal of something. Most of the early recipients who benefited the most have since past on and the program will burden the future of the grandchildren of people who have not been born yet. Tens of millions have indeed benefited while hundreds of millions will have lost.
I agree that I am bias on the subject since the majority of my resources are geared toward investment and not towards consumption. Since any new tax plan will divert these resources form being invested in the future reducing my future income and the governments (after all if I make a bunch of money by investing they get a not such an insignificant cut of my gains). I am opposed to any program that is only purpose is to divert resources from our future to encourage more consumption in our present. The vaults of the wealthy can be raided indefinitely, the grain silos of our society cannot.
On another political note I believe that the US will pullout of Iraq at the end of 2009 and this should hurt the economy (a recession in the “defense” industry) in the short term but help interest rates marginally (by not borrowing lots of money to buy bullets). I expect the next administration will limit defense spending (positive for the economy as long as we don’t get attacked) so stay away from defense stocks.
No doubt that I will be writing more about and more about this subject as the elections comes to fruition, then I most likely I will be writing about it until 2012…
Chapter 3
Domestic Investment Ideas for 2008
I am trying to avoid individual stocks and I am emphasizing more focus on ETF and indexes. As I start to follow my own advice, my portfolio should start to look more like the advice that I dispense.
Gold
Symbol GLD
Price $82.46
Target $100 (end of 2010)
Sector Precious Metal
Risk Moderate +
Return Moderate
Complexity Simple
Time Horizon Medium term (3 months – 60 months)
Tax implications Long term capital gain rate of 15% does not apply to this ETF.
Long term capital gains rate for this security is 28%
Account(s) IRA and Taxed
What this ETF does is allows you to buy gold as if were a stock. Each share that you hold is equivalent to owning a 1/10th of an ounce of gold. The gold is stored in a bank vault in Great Britain. Gold has always been a currency of safety and I believe world demand for this metal is only going to go up as the world gets richer. Also as the US dollar falls gold will tend to go up. I believe that gold will be $1000 per ounce within the next few years.
San Juan Trust
Symbol SJT
Price $33.80
Target $45 (end of 2010)
Sector Natural Gas Trust
Risk Moderate +
Return Moderate
Complexity Simple
Time Horizon Long Term (12 months – 24 months)
Tax implications Dividend tax rate of 15% does not apply to this ETF.
Dividends are taxed at your normal incremental tax rate.
Account(s) IRA only
Basically with this trust you own some of the natural gas in the San Juan basin in the western US. They sell it and give you the money each quarter. Currently the yield is about 10% but longer term natural gas could go much higher (due to high oil prices) and the yield could go much higher and/or the stock price will increase. Be aware that trusts do not pay corporate taxes therefore dividends are at your normal marginal rate.
Deere & Co
Symbol DE
Sector Farm Equipment
Risk Moderate
Return Moderate
Complexity Simple
Time Horizon Long term (6 - 36 months +)
Tax implications Dividends are taxed 15% rate
Account(s) IRA and Taxed
So you want to grow some corn or wheat? These are the guys you are going to have to call to get this job done. Deere & Company manufactures and distributes agricultural and commercial equipment worldwide. As the grain prices have risen getting more out of each acre has become more and more important. That’s where these guys come in. Also as the world becomes richer, more third world countries can afford and will need farm machinery.
Valero Energy
Symbol VLO
Sector Oil Refining
Risk Moderate
Tax implications Dividends are taxed 15% rate
Account(s) IRA and Taxed
Valero is large US based refiner and getting slammed by the drop in oil and gasoline prices. Longer term the US isn’t building anymore refining capacity and I think it’s a good idea to own a little oil and some gasoline refining (VLO). At this time I am only suggesting a very small position but gasoline continues to go up this is something to own.
Diamond Offshore Drilling
Symbol DO
Sector Oil and natural gas drilling company
Risk High
Return High+
Complexity Simple
Time Horizon Medium term (6-18 months)
Tax implications Dividends are taxed 15% rate
Account(s) IRA and Taxed
About once a year I stumble across a company that I find a hard time believing the forecasts and this is one of those companies. This company’s earnings are expected to grow this year by 50% and again its profits are likely to go up another 50% in 2009!!
So you want to find some oil out in the middle of the ocean? These are the guys you are going to have to call to get the job done. This company is deepwater oil and gas drilling contractor. The company owns and operates a fleet of 44 offshore rigs. Its customers primarily include oil and natural gas companies and business is darn good.
I picked this stock last year but never actually bought some and now it’s much more expensive… (
This phenomenon is not only limited to Diamond Offshore, it is affecting the entire sector. Other stocks to research are Transocean (RIG) Noble (NE) and GlobalSantaFe (GSF). The Oil Services HOLDRs (OIH) ETF is a good diversified way to play these names and along with others in this sector. Diamond Offshore is my stock of the year…
Security Name Goldman Sacks
Symbol GS
Sector Investment Banking
Risk Moderate +
Return Medium
Complexity Simple
Time Horizon Long term (36 months +)
Tax implications Dividends are taxed 15% rate
Account(s) IRA and Taxed
Why do I like Goldman Sacs? That is easy; it has a low Price to Earnings ratio (< 9) and has great growth. How does it make money? I don’t know and most people don’t know either, it is best described as a black box of investment, banking and global trading. It has some of the best financial minds in the world working for it and I think owning some of this company for the long run is a good idea. It doesn’t pay a high dividend because it has better uses for your money. It has been hit with concerns about credit and such but THIS is the time to buy at least some of this stock.
Chapter 4
International Ideas for 2008
2008 Economic Growth Forecast by Country
|China |9.9% |Poland |5.2% |Brazil |
|US Large Cap: |20% |30% |40% |30% |
|US Small Cap: |10% |10% |20% |30% |
|International: |10% |20% |30% |40% |
|Fixed Income: |50% |35% |10% |0% |
|Cash: |10% |5% |0% |0% |
| |Risk |Balanced |Growth |Aggressive |
| |Adverse | | | |
|2007 Return |7.82% |9.40% |10.04% |10.45% |
US Large Cap:
SPDR S&P Depository Receipts (SPY)
NASDAQ 100 Trust Shares (QQQQ)
Vanguard Value VIPERs (VTV)
US Small Cap:
iShares Russell 2000 Index (IWM)
International:
iShares MSCI “EAFA” Europe, Australia and Far East Index Fund (EFA)
iShares MSCI Emerging Markets Index (EEM)
Fixed Income (Bonds):
iShares Lehman 20+ Year Treasury Bond (TLT)
iShares Lehman 7-10 Year Treasury Bond (IEF)
iShares Lehman Aggregate Bond (AGG)
iShares GS $ InvesTop Corp Bond (LQD)
Cash:
iShares Lehman 1-3 Year Treasury bond (SHY)
2007 Returns of the Model Portfolio
|Name | |12/31/06 Price |12/31/07Price |YTD Gain % |YTD Gain % w/ |
| |Symbol | | |w/o Div |Div |
| S&P 500 Depository Receipts |SPY |$141.62 |$146.21 |3.24% |5.15% |
|NASDAQ 100 Trust Shares |QQQQ |$43.16 |$51.22 |18.67% |19.78% |
|DIAMONDS Trust (Dow) |DIA |$120.90 |$132.55 |6.54% |8.56% |
|Vanguard Value VIPERs |VTV |$68.23 |$66.39 |-2.70% |-0.59% |
|iShares Russell 2000 Index |IWM |$78.03 |$75.92 |-2.70% |-2.26% |
|iShares MSCI “EAFA” |EFA |$73.22 |$78.50 |7.21% |9.94% |
|iShares MSCI Emerging Markets |EEM |$114.17 |$150.30 |31.65% |33.35% |
|iShares Lehman 20+ Year Treasury |TLT |$88.43 |$93.04 |5.21% |9.54% |
|iShares Lehman 7-10 Year Treasury |IEF |$82.44 |$87.01 |5.54% |9.69% |
|iShares Lehman Aggregate Bond |AGG |$99.70 |$101.17 |1.47% |5.99% |
|iShares GS $ InvesTop Corp |LQD |$106.68 |$104.84 |-1.72% |3.19% |
|iShares Lehman 1-3 Year Treasury |SHY |$79.96 |$82.19 |2.79% |6.82% |
The above chart shows the Q1 results of the various “core” ETFs that I recommend for each individual, these returns are with and without dividend and including all fees.
The “market” averages are as follows for 2007 without dividends, the Dow was up 6.4%, the S&P 500 rose 3.53% and the NASDAQ composite was up 9.8%.
As you can see most of the indexes did reasonably well with the outstanding investments being the Nasdaq 100 and the Emerging Markets ETF. The lagers were the Russell 2000 small cap stock index and Vanguard Value index. I would be leery of the longer term bonds at this point since they had a good gain this year.
| |Risk |Balanced |Growth |Aggressive |
| |Adverse | | | |
|2007 Return |7.82% |9.40% |10.04% |10.45% |
Above are the results for the various “no brainer” portfolios using the suggested investment ratios including dividends. What amazes me is how easy it is to get a decent return with doing very little work using these 12 simple investments, no hassles, no worries, something seems to always go wrong in the portfolio but other things always seem to go right. I use the S&P 500 as my index and each portfolio beat that objective. I spend a lot of time and effort and this portfolio continues to perform with out much effort. Maybe some day I will follow my own advice and simply make these investments?
Chapter 6
My Performance and Holdings
I am unable to calculate my performance this time since I felt it necessary to change brokers suddenly this quarter. After I moved my assets E*trade locked me out of all my historical data so it is impossible to access any of my 10 year history of my accounts. April 15th is going to suck for me this year (yes, I do my own taxes) since my only records are online at E*trade which I have no access to the data.
Anyhow this is my good faith estimate of my returns based on my total dollars in the account: In my taxable (conservative) account my gain is a dismal 1% gain but on my IRA account (aggressive) I had a very respectable 19% gain. I have about an equal sum in each of my accounts therefore my entire gain this year was ~10% vs. the S&P 500 rose 3.53% this year so overall I beat the index by 6.5%.
For all of 2007, the Dow was up 6.4%, the S&P 500 rose 3.53% and the Nasdaq composite was up 9.8%. These numbers are all without dividends.
I would love to break it down on what won and what lost, where the gains were and what I paid for stuff but I can’t… E*Trade you piss me off and I hope you go under…
Chapter 7
Final Thoughts
The Good
• The world is experiencing unprecedented economic growth due to globalization
• The world is becoming more productive and more people are living better
• Growth in the developing world continues to grow at an exceptional rate that is contributing to a massive increase in wealth in third world countries
• US Interest rates remain relatively low
• Unemployment is still low
• Inflation is still low
• We have a competent Federal Reserve
• The US economy is strong and being supported by international development
The Bad
• Possible recession next year in the US
• The unwinding of the housing market
• Higher energy, metals and grain prices
• Democrats in control of economy in 2009
• Long term US investment climate 2010 due to tax cuts expiring
• Chinese markets are getting bid up on speculation
• Lower US corporate profits growth rate this year
• Dollar is weakening
• Trade imbalance
• Budget deficit
The Ugly
• Social Security will eventually cause a hyperinflation sometime within 20 years
• The US Government borrows too much money and its citizens don’t save
• Current consumption in the US is being financed by foreign governments
• Potential of consumer credit crunch due to multiple factors
• Potential for national debt spiral
• War! What is it good for? Absolutely nothing.
Things to know
• Short-term interest rates have dropped long term rates should go up
• The investment world looks much riskier than it was during the last report.
• Oil prices have gone up and food prices are setting new highs
• China!
Final thoughts:
The housing market is a $1 trillion dollar problem in a $13 trillion US economy and $45 trillion world economy. When Japan started to unwind at the end of the 80’s nearly $20 trillion was lost between real estate market and the Japanese stock market. Japan is still there… When all is said and done, all the houses will still be there and someone will be living in them. What is going on is nothing more than the transfer of wealth from current owner and lenders to future owner and lender. No intrinsic wealth has been destroyed…
China will be the world’s largest economy by the year 2040. On a purchasing power parity basis it will very likely overtake the US as early as 2015. This will have significant world geopolitical and socioeconomic consequences for everyone on the planet and I have given in and have some investments in China. Learn what you can about China and India it will be very important for your long term financial well being.
I have been watching for a fall in imports, tax receipts, and/or reduced sales at retailer. Some of that has already happened and I am very leery investor at this point.
Globalization helps the economy. Cheaper goods and services appear on our shores everyday and despite the common misconceptions globalization stealing jobs on net it benefits the US and feeds the poor around the world. The world is getting richer, more and more consumers of goods and services that can afford to buy things… China is a big new customer for BMW’s.
This is the conclusion of my report, I hope to get the next report out April 1st 2008 and entertain you with my new thoughts and reflections. Please send any questions, comments or new topic ideas for future issues to me via email. GOOD LUCK and good investing!!!
Regards,
Mark Rush
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