Financial Literacy

The normal financial theories for managing investments are becoming more perverse.

The stock and bond markets are at extremes: the world bond market yields are at 500-year lows and the U.S. stock market is well beyond “overpriced” territory.

The U.S. stock market is hitting new highs while this quarter’s corporate earnings are lower for the 5^th consecutive quarter.

How can this be?

To paraphrase analyst Max Keiser, “We haven’t had free financial markets since 2008. Since then, all we have are central bank interventions and manipulations. Central bankers are inflating unsustainable asset bubbles in stocks, real estate, bonds, and currencies. More bad economic news only means it is more likely there will be more central bank interventions and so markets launch even higher.”

More evidence of a crazy upside-down world:

• The Japanese central bank is buying stocks and corporate bonds every month to artificially prop them up.
• Several Keynesian economists are calling for a ban on cash so that central bankers can have more control over currency and the economy.
• 18 European nations have negative interest rates on their 2-year government bonds. 40% of all European government bonds have a negative interest rate.
• Britain, Europe, China, and the U.S. are taking turns, in concert, to actively lower their currency to stimulate exports; this is a race-to-the-bottom currency war. However, Japan’s currency has been manipulated so low now that anytime the government slows its interventions, the Japanese yen pops up in value.
• The central bank of England just started buying corporate bonds to artificially prop them up and reduced their interest rate to a grain of sand above zero %.
• One of Germany’s largest banks is going to put some of its reserves into gold rather than lend it at a negative interest rate to the central bank.
• Boring U.S. utility stocks are now trading at 3-standard deviations above their normal valuation. This means that investors trying to find a decent dividend yield on their money have pushed utility stocks into epic tulip-bulb bubble price levels. Steady dividend-paying stocks of all kinds are priced too high today.
• Large insurance companies and banks are becoming imperiled with zero-interest rate policies. MetLife announced their second quarter earnings fell by 90% because their bond portfolio earns much less.
• Bond insurance (called credit default swaps) can now be a profitable arbitrage. Shorting a bond with a negative yield produces an unnatural profit so now selling credit default swaps can make money three different ways (the insurance premiums, the dividends, plus any capital gain on shorting the bond).

Maybe we can get some calm clarity by listening to some of the most successful money managers about the current financial markets:

• Nassim Taleb, “You cannot cure a debt crisis with more debt. The markets will ultimately crash again and this time hurt a lot more people.” 8/8/2016
• Jeffry Gundlach, “Sell everything now, nothing looks good.” 7/29/2016
• Don Kaufman, “I’ve sold options for 30 years and I won’t sell any now, it is too risky.” 7/29/2016
• David Einhorn, “The Brexit vote will entice all the central banks to serve more jelly donuts.” (Meaning: print more currency from thin air) 7/26/2016
• Bill Gross, “Negative-yielding bonds is a supernova that will explode one day. Sovereign bonds are not worth the risk.” 6/10/2016
• Stan Druckenmiller, “What part of ‘Get Out of The Stock Market’ do you not understand?” 5/3/2016
• Carl Icahn, “I’m extremely cautious, the stock market will have a day of reckoning.” 4/28/2016
• Mitch Feierstein, “The world’s currencies are a Ponzi scheme and all Ponzi schemes collapse. This year, the insane financial markets are reflecting the unraveling of fiat currencies – and it is not going to end very well.” 3/11/2016
• Paul Singer, “Central banks have encouraged massive, concentrated investments in fantastically overpriced markets.” 2/3/2016

(Note that at least 4 of these money managers have large positions in gold and/or gold and silver mining stocks at this time.)

What to do with any of this information? As I’ve been advising:

1. Be extremely cautious with your investments.
2. Have an investing plan to accommodate a downturn:
   • Protect and preserve your portfolio if stock and bond prices fall from their recent price highs. Consider a trailing stop-loss order, perhaps 15% below any recent price high. Consider a married put option with several months before expiration.
   • Plus, a plan to profit from a long market decline. Consider an inverse ETF, short stock, or options strategy.
   • Develop a list of trophy stocks you’d like to purchase at a discount. Such as Hershey, Merck, Exxon, Amazon, and Google.
3. Hold some cash outside of a bank in case of a banking crisis, to cover a couple months of expenses. This is your personal liquidity insurance.
4. Hold some monetary metals, like gold and silver, outside of any financial system. This is your currency-devaluation insurance.

There is an obstacle for successful investing: it is difficult to find, access, vet, and invest in a successful small business. First, let’s review why it is important to find these investments. According to a study by Edward Wolff, an economist at NYU, the wealthiest 1% in the country has the majority of their net worth in small business equity. This does not refer to owning stocks or mutual funds, but a direct ownership stake in a business.

While the wealthiest Americans have a direct ownership in a business that pays them, the poorest have the highest percentage of personal debt and that costs them money. Which group do you want to move toward?

A direct investment is not as simple as buying shares in a company listed on a stock exchange. Publicly traded companies are audited and scrutinized by many different government agencies. When investing in a small privately-held company, you must perform these all of these functions yourself before you invest a penny. This process is called performing “due diligence” and you can find many checklists and ways to approach this online. But finding your own deal flow of businesses as potential investment candidates takes effort and personal interaction. And it is more difficult to find owners willing to accept modest investments under $25,000. Thankfully, recent regulation changes allow the less wealthy (non-Accredited investors whose net worth under $1 million) to invest in private companies.

There are now many investment platforms that screen investment candidates for new investors that are looking to invest $2,000 to $25,000 into a new venture. There are dozens of platforms for these investments – I just did a quick search and found a couple for businesses (EquityNet.com and Crowdability.com), or if you are more conservative, only professionally managed real estate investments (iFunding.com and AlphaFlow.com). Just like all investing, you also need to do homework on your potential investment website (they are called platforms) because not all investing platforms are equal; some have sterling reputations while some are mostly scams.

Any investment can be risky and all startups are extremely risky. However, if you are willing to learn about these types of investments before you invest, they could become the largest portion of your net worth over time, just like the top 1%.

Since January, there have been a few large swings in relative value, with much of that occurring in the last two weeks. Dependent upon which financial assets you were holding, you could be 78% richer or 12% poorer.

The British Pound Sterling has fallen from $1.47 to $1.29 against the U.S. dollar. Anyone holding British pounds since January has experienced a 12% drop in their purchasing power. When your home currency is weak or falling, you are better off holding some assets in any stronger currency or gold and silver.

Since January, gold has risen against the British pound by 47% and silver has risen by 66%. If you were a British resident and held a portion of your savings in gold and silver, then your savings would have increased in purchasing power by 57%. If you had kept all of your savings in British pounds, then you would have experienced a 12% loss in purchasing power. The difference between those two holdings, a 12% loss and a 57% gain, is a staggering 78% gap.

Trends and revaluations against gold and silver can occur overnight or over months and years. But sooner or later all paper currencies, which are backed by nothing, fall in value against gold and silver.

So which group of investors would you prefer to be in over the last 7 months:  the one 78% richer that hedged, or the one 12% poorer that didn’t hedge?  Two years ago, Russia lost +20% of their purchasing power to gold; last year Canadians lost 25% of their purchasing power to gold, this year it was Britain. Which currency will devalue next year? It could be yours.

In 1980, Ted Benna discovered a two-year old tax rule and came up with an idea: a deferred-tax retirement account. Benna was able to shepard his retirement plan idea through the IRS regulations and created the first 401(k) retirement accounts for his employer and fellow employees. These plans were originally called Salary Reduction Plans because you receive less income as part of it is added to your 401(k) account.

Two years later, there were less than 100 401(k) plans by corporations. That number has grown into +50 million plans today with +$3 trillion in assets.

It was Benna’s intention to turn spenders into savers, which he believes that he has helped accomplish. But as for his 401(k) plan, he says, “I’ve created a monster and it needs to be blown up. It is so over complicated and fraught with abuse and hidden fees; and opportunities for bad decisions. 401(k)s are better at enriching the financial industry than the actual savers.”

These are the same complaints that I have highlighted for years: That 401(k)s are a financial prison where your money is needlessly chewed up by fees. So much money is lost in fees even your employer match and tax deferral does not make up for all of the fees charged to your account. As such, it is a very poor location for your money, a Roth-IRA or regular IRA are a far superior location for your retirement savings.

I have noticed two groups of opinions from people with 401(k) plans, and their opinion is solely dependent upon when they started making contributions. From 1984 to 2000, there was a giant run-up in stocks. Anyone invested in stocks or mutual funds through a 401(k) believes that these are the best savings vehicle ever. These people attribute their financial success to the 401(k) account and not the stock market. Meanwhile, those who invested in 401(k)s after 1999 have seen their accounts struggle for nearly 20 years. Neither of these groups have compared what their money would have done outside of their 401(k), and what their income tax rate is likely to do over the next 25 years. Whenever I have gone through alternative scenarios, the 401(k) is the worst location for your retirement savings, by far, even with an employer providing a 50% matching contribution up to 6%.

There has been a turning point in the U.S. financial markets over the last two weeks. The U.S. Federal Reserve backed away from their promise to begin raising interest rates back up to normal levels. Instead, they revised their forecasts for:  a lower growth rate, lower inflation, lower interest rates, and Chairman Yellen stated, “I can’t specify a timetable for next interest-rate moves.” This occurred before Britain voted to leave the European Union and the uncertainty that it has created across the world’s financial markets over the last three days.

So what is going on? Two of our largest trading partners, Japan and Europe, are both using negative interest rates to try to grow their economies, and weak U.S. economic data is indicating that the U.S. may also have to join them.

If the Federal Reserve is not going to raise interest rates any higher, and it now appears that they are more likely to move rates down than up, this is a red-flag that the U.S. dollar may be at a medium-term peak. A primary driver of currency attractiveness is the interest-rates paid in that currency. When interest-rates fell below zero in Europe, money began flooding out of Europe to where it is treated better, with higher interest rates in the U.S. The Federal Reserve claimed in December that it would be raising interest rates all year, and this attracted additional money from overseas. But now, if the U.S. does not raise rates or rates begin declining, then money will flow away from the U.S. to another currency where it is treated better.

Since the 2008 financial crisis, the U.S. has been in terrible financial shape. But in spite of this, money has been flowing here because many other countries have been in relatively worse shape. This money flowing into the U.S. has pushed up real estate prices on the coasts and gone into the stock market and Treasury bond markets. If U.S. interest rates begin declining then some of that money will begin to flow elsewhere, bringing down the prices in those three markets, along with the U.S. dollar in general.

What are some ways to prepare for money flowing away from the U.S.?

• Be prepared to sell off some of your stocks and bonds with gains.
• Be prepared for real estate values to soften on the East and West coasts.
• Begin looking for a stronger currency/country to place your money.

(A potential candidate that I am considering is the Russian stock market, with the ETF ticker symbol “RSX.” The Russian stock market has already been beaten down to a very low price. The Russian stock market index is trading at a low Price/Earnings ratio of only 4.9 while the U.S. stock market is trading at a very high ratio of 24.6).

Whatever your financial situation, keeping abreast of macro-economic events is a way to anticipate price trends to protect yourself and possibly profit from these price moves.