Financial Literacy

There is an inverse relationship between interest rates and the price of bonds. For example, when interest rates rise, then the price of bonds fall. Along with falling bond prices, stocks that are sensitive to interest rates fall as well. The most common interest-rate sensitive class of stocks are REITS, real-estate investment trusts. These are companies that pass-through their real estate rental income to stockholders. Over the last 8 years, interest rates have been low so that retirees looking to increase their income have been buying REITs for their high dividend payments. Now may be a good time to sell or hedge some of these securities.

Across the globe, interest rates have been rising for the last two months. Correspondingly, government bond prices have been falling in: France, Italy, Germany, Britain, Poland, Denmark, Sweden, Australia, Argentina, Mexico, Philippines, and the U.S. This downdraft of bond prices has also been pulling down the stock prices of REITs (the chart is a REIT index), and other interest-rate sensitive stocks such as: master-limited partnerships, preferred stocks, high-dividend yield stocks, and others.

So while the stock market has been bouncing around price highs for months, these interest-rate sensitive stocks have been falling across the board. Some investors bought these shares when they started to fall a month or two ago, only to see prices continue to fall. With global interest rates being severely low since 2009, interest rates could rise for a very, very long time, putting downward price pressure on all sorts of interest-rate sensitive securities. My advice is to be very cautious with your holdings in: bonds, REITs, preferred stocks, and anything else interest-rate sensitive by watching the direction of bond prices. You can do this by watching the price direction of a bond index on a price chart. While the terrain of interest rate securities varies (government, corporate, emerging market, short term, long term, etc.), the most widely followed interest rate instrument is the 10-year Treasury futures contract. An easier price chart to locate is an ETF (a security that trades like a stock) with similar characteristics which trades by the ticker symbol “IEF.”

When you have saved up a little money, it is tempting to get into private placement investments. These are investments that are direct – between you and a business operator. Common examples include real estate deals, business startups, raising cattle, oil wells, gold mines, and private loans. These investments are riskier and more difficult to exit than a regular stock, bond, or mutual fund.

While these investments are very risky, investors are attracted to them for their potential gains. Some of these investments offer high yields, say 8% interest plus the potential for capital gains. This is very enticing when bank CD rates are under 1%.

An acquaintance of mine lost $75,000 in a restaurant investment, 100% of the money he put into one of these private deals. To me, this was a predictable loss because he performed zero due-diligence on the investment before he gave them his money. He did no investigation beforehand, and was dying to get into his first “deal.” Let’s go over what he did wrong so we can learn from his mistakes.

1. No Education. His investment was made into a restaurant and he knew nothing about the restaurant industry, and made no effort to understand the business before he invested.
2. No Successful Mentor. Even if he had some education, he did not locate a proven, experienced, and successful mentor willing to help him. A mentor like this can help steer you away from bad investments and toward good investments.
3. No Independent Research. He made no effort to verify the claims made by the operators. He did not visit the site to see for himself if it was a good location and if their prior restaurant was successful.
4. Not Knowing the Partners. He made no effort to learn the backgrounds and reputations of the partners in the business making decisions. Do they have a successful track record or have they left a trail of ruin?
5. Not Understanding Value. The most important aspect of any investment is value. The investment may be great, but if you are paying too much, then it will be a bad investment for you. If it is a poor investment but you get in at a low price, you minimize any potential losses. You MUST know if you’re buying in at a good price or a bad price. You need to have valid reference points to make this evaluation and most investors make no effort to understand this.
6. No Analysis Experience. If you are unfamiliar with, let’s say investing in restaurants, then you need to examine 100 restaurant deals, in detail, to gain experience. This is how you’ll begin to be able to distinguish between a good investment and a bad investment. If you’re switching to gold mines, then you need to start analyzing 100 gold mining deals.

No matter which type of private investment you are making, these 6 points-of-protection are critical due diligence to make an educated decision. If you fail to thoroughly go through these steps before you make an investment, then I predict you will lose money on this investment. Learn from these hard-won lessons and go through the 6 steps before you hand a hard-won penny to anyone.

Several years ago, a relative invested $42,000 into a new business startup. A few years later, she began receiving dividends. After some more years, the business was sold. When the transaction closed she received a check for $97,000. Pretty good; her investment return is over 18% per year, and qualifies for lower capital-gains taxes.

So how was she able to do this?

She and her husband are steady savers. Since their first jobs, they would add $4 a week to their savings account. As their income increased, their small deposits grew larger in size. The continual and steady addition to savings allowed her to make a down payment on a rental property by the time she was 25. A couple decades later, she is now netting $2,100 a month from this rental. Note that her rental income from one little property is far more than the average social security retirement check! By making a routine of adding to savings, she and her husband have been able to make many similar investments through local networking. By becoming knowledgeable before they invest, these investments are usually profitable.

For example, a friend of theirs was opening a dry cleaners. As they are heavy savers, they were able to put up $17,000 to buy a share of the business. Their annual return, paid in dividends, is higher than private equity funds hope to achieve.

Their three-step plan:

1. Setup your living expenses so that you have a sustainable savings plan; or you cannot build up savings to get into investments like these.
2. Educate yourself before investing. Don’t succumb to the old proverb, “A fool and his money are soon parted”
3. Invest with knowledgeable, trustworthy, and profitable business operators.

Of course, not every investment is a grand slam or even a winner. But by continually employing these three steps, over and over, they have had enough large winners to vastly overcome any losses. This also allowed them to ratchet up their lifestyle spending from investment income, and they have the option of early retirement. So how are your investments growing?

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.

There is a common analogy used in financial matters about strong and weak hands. A strong-handed player refers to a participant that has deep pockets, conviction, and a sober long-term perspective. Contrarily, a weak-handed player refers to a participant with little or no money, fickle, and a desperate short-term perspective. When you are investing, which participant are you closer to?

When the price of crude oil remained above $100, many in the oil industry became accustomed to that high price. Starting 18-months ago, oil plummeted with increased production from fracking and recently touched $26 a barrel. The longer the price of crude oil remains under $40, the more oil companies will struggle when their business plan and loans require oil to be over $80 just to break-even.

As the price of oil has fallen, there have been 67 weak-handed oil companies that have gone bankrupt, and 150 more that cannot service their debts for much longer. Meanwhile, there are some strong-handed companies making preparations to buy competitors at low prices. First, Exxon-Mobil raised $12 billion in a bond sale to purchase competitors. Those oil firms with lots of debt and high costs will be weak-handed in those negotiations. Exxon also did this a few years ago when extraordinarily low natural gas prices imperiled many companies in that industry, and bought them up cheap. Marathon Oil has raised $7.5 billion in the last two months to both safeguard their credit rating and position themselves to acquire rivals. Hess Corp. also raised money this year for the same reasons. One successful shale-oil executive issued the largest IPO this year: $450 million on his plan to purchase bargains in the oil industry with his new company, Silver Run Acquisition Corp.

This pattern recurs in every industry as business cycles and price trends rise and fall. The strong vs. weak hands is an important question in many areas: how would you rate your employer? How would you rate your investments? How would you rate yourself as an investor? In any way that you can, you want to become a strong-handed investor and work for strong-handed employers that will continue to thrive in any kind of market environment.

Over the last 26 years, private equity investments have beaten the S&P 500 by 18%. This is a huge advantage over investing in a regular stock index fund. But private equity deals are only for millionaires aren’t they? Yes, to invest directly into deals, however, several large private equity firms are publicly traded and pay dividends as well. This may provide you an opportunity to add Private Equity as an asset-class to your investment portfolio.

A few private equity stock candidates for you to consider include The Blackstone Group (stock ticker symbol BX), Apollo Global Management (ticker APO), The Carlyle Group (ticker CG), and Triangle Capital Corp. (ticker TCAP). As a group, the average dividend yield for these four companies is over 9%, a decent-sized yield in today’s low-interest rate environment.