By 2 Cents on July 31st, 2010 | Category: BJ News |  I’d like to thank the editors at Seeking Alpha for inviting me to become a contributing author. That just means that they can republish any investing or market-related articles I write here on Balance Junkie over on Seeking Alpha. If you’re not familiar with Seeking Alpha, but are interested in the markets, investing, or economics, it’s a great way to gain access to a lot of information and opinions all at once. I like it because I can quickly find both sides of any debate articulated very nicely.
Whether you’re new to investing, you’re an avid market-watcher, or you just want to take a more active role in managing your money, you may want to browse through the articles and see what you can learn. I’m new to Seeking Alpha, both as a contributor and a user, so I’m still learning about all that the site has to offer. There are tons of articles for you to read, comment on, or retweet if you so desire. You can choose to follow any contributors that you like and you can customize the information you see according to your investing interests. It’s free to use and free to join.
I will continue to write on a variety of topics here at Balance Junkie. You’ll still find articles on basic personal finance, investing and life balance as well as more in depth market analysis. I hope you enjoy the variety of information. If you want to follow me on Seeking Alpha, you can click on the logo and it will take you to my author page. (For the record, I don’t receive any compensation from SA for my contributions, other than the exposure it provides for Balance Junkie.)
As always, I welcome your comments. I would also be curious to know if any of you already frequent SA and have any thoughts you want to share.
By 2 Cents on July 30th, 2010 | Category: Investing | A nickel ain’t worth a dime anymore.
~ Yogi Berra
 When we looked at the current pros and cons of investing in commodities and real estate, it became quite apparent that there are some pretty good arguments on both sides of the debate. We often hear contradictory truisms. Cash is trash. Cash is king. Which is it?
The correct answer is likely “it depends”. There are times when it’s prudent to hold more cash, and there are times when it makes sense to move more money into riskier assets like the ones we’ve been discussing this week. Today, we’ll take a look at the case for each and hopefully help you decide where you want to be on the cash spectrum.
As in most debates, there’s a little truth in each extreme, but the greatest knowledge lies in the middle. Further, the best cash allocation for me may not be the best for you. A lot will depend on your unique financial situation and your views on the macroeconomic climate. With those disclaimers out of the way, let’s get right into the Trash vs. King debate.
Cash Is Trash
Here are the most common arguments for holding less cash, as opposed to other assets like stocks, bonds, real estate, or commodities:
- By far the most frequent (and valid) argument is that returns on cash may not outperform inflation, leading to negative real returns.
- You can achieve a much higher return on your money in just about any other asset class as long as the economy is performing reasonably well.
- Cash yields (especially in money market funds) are particularly pathetic right now, running anywhere from a fraction of a percent to 2% for some high interest savings accounts.
- If inflation spikes, the purchasing power of your cash will fall, so you will be able to buy less stuff for the same amount of cash.
Cash Is King
Here are the most common arguments for holding more cash:
- Cash is the safest investment, and often comes with a CDIC (or FDIC) guarantee. (Money market mutual funds are not guaranteed.)
- If deflation is the order of the day, cash is the place to be.
- Economic slowdowns and volatility can lead investors to reduce risk by selling other asset classes, thereby driving their prices down significantly. Cash doesn’t usually experience these big swings.
- If you don’t hold a decent amount of cash, you won’t be ready to buy when other asset classes get hit.
Royalty or Rubbish?
In the end, how much cash you choose to hold will depend on a few main decisions:
- Your view on inflation vs. deflation.
- Your views on economic growth.
- Your risk tolerance.
There have been a number of good arguments put forth on the first two issues, with some arguing that the stock market is about to rally again, and others firmly staking their tents in the Japanese deflation camp. Your position on these pivotal issues will likely determine the percentage of cash that you will hold. But perhaps more important is your position on number 3.
Which is more important to you: preservation of capital or higher return on your investments? If we’re all honest with ourselves, we would probably unanimously agree that we really want both. Unfortunately, that’s not how it works. By determining your cash allocation, you’re really putting a number on each. Obviously, the older you are, the higher your cash allocation should be.
Regular readers already know that I favour capital preservation right now. I tend to be in the deflation now, inflation later crowd. I see the problems presented by high sovereign and consumer debt levels as a threat to the global economy and financial stability. I think it will take some time before we can work off the excess capacity and leverage in the financial system. While I definitely see the potential for reflex rallies in the markets, I still believe that capital preservation should be the order of the day until a) we understand the length and depth of the current deflationary turn and b) the global deleveraging process is closer to being completed.
The Ultimate Diversifier
I recently wrote that these markets currently offer no respite in diversification because of the increasing correlations within and between asset classes. That’s another reason I favour cash at the moment. It’s the ultimate diversifier. (I know that’s not a word, but if the President of the United States can say “decider”, I can coin the term “diversifier”.) The one certain way to reduce risk in your investments is to simply increase your cash allocation. Stocks, bonds, commodities and real estate can suffer large capital losses relatively quickly when risk levels are elevated, as I believe they are now.
I’ve heard the argument before that holding high levels of cash is actually riskier than holding a diversified portfolio of high quality stocks and bonds, but I’ve never been able to make myself believe it. Even if inflation rises, reducing the purchasing power of my cash, interest rates will rise to compensate for that. The interest rate-inflation differential would have to be pretty huge to compare with the 20% plus drop in stocks or other asset classes that is possible.
Now I’m not advocating a 100% cash position for everyone, although my personal accounts are close to that level at the moment. I’m just saying that there are some pretty substantial risks out there right now, so shuffling your mix of equities and bonds probably won’t offer the same risk reduction bang you can get by shifting more bucks into cash.
(Disclosure: I hold more than 90% of my money in cash at the time of writing.)
What’s your view on cash? Trash or king?
By 2 Cents on July 28th, 2010 | Category: Investing | No man acquires property without acquiring a little arithmetic also.
~ Ralph Waldo Emerson
 We continue our look at the prospects for various asset classes in the current market environment today with a survey of the commodities and real estate landscape. Both of these are usually considered hard assets. As Dennis Gartman always says, “if you drop them on your foot, they hurt”.
Generally speaking, hard assets like commodities and real estate tend to appreciate during inflationary times and depreciate during deflationary climates. So your view on whether to allocate money to these two may hinge on your position in the inflation vs. deflation debate. I tend to be in the camp that says we are currently in a deflationary environment, and likely will be for some time. But there is definitely the potential for inflation to rear its head down the road depending on the actions taken by monetary authorities.
Commodities: Will It Be the Elevator or the Stairs?
There’s an old saying on the trading floors that commodities take the stairs up, but the elevator down. Uptrends are usually gradual and orderly, whereas corrections can be fast and steep. Over the past decade or so, however, it seems like commodities markets are a lot more volatile in both directions. I’m not sure if it’s the number and complexity of ways to gain exposure to commodities or not, but the rise in volatility does seem to coincide with the proliferation of ETFs and derivatives.
Your choice of investment vehicle for your commodity exposure may determine your success as well. You can buy stocks in companies that mine or harvest various commodities like oil, gold, copper, or grains, or you can trade futures on the individual commodities. You can buy ETFs that can track a basket of commodity-producing companies, or a single commodity like gold itself. Just be aware that funds that track commodities don’t always track them as closely as you might like.
Here are some reasons that you may (or may not) want to put money into commodities right now:
Pros
- Growth in emerging markets like China and India may fuel demand for everything from oil to potash.
- If central banks monetize debt in order to avert a sovereign debt crisis, inflation could spike, taking commodities with it.
- If the U.S. dollar (in which all commodities are currently denominated) falls, commodities usually rise.
- If investors lose confidence in fiat currencies, they may flock to commodities, especially gold.
Cons
- Commodities can be very volatile, and it’s easy to get shaken out of your positions.
- If deflation takes hold for an extended period of time and the economy fails to recover sufficiently, commodity prices will fall.
- If the U.S. dollar rallies because traders lose confidence in other currencies like the Euro, the Pound, or the Yen, commodities will likely suffer.
- If there’s even a hint of growth slowing in China or other emerging markets, traders tend to sell commodities first and ask questions later.
It would be easy to spill a lot more pixels on each commodity individually, as each one has unique characteristics. These are meant to be generic guidelines for investing in commodities. Given my view that deflation is the main worry right now, I favour a cautious approach to commodities. Still, the longer term growth story for commodities is undeniable. The supply of most commodities is, after all, finite.
If you don’t mind volatility and are a pretty agile trader, you might consider a small core position in your favourite commodity companies or ETF (bought on a pullback, of course). You can always allocate some cash to trade the swings as well, but there’s no shame in sitting out for a while if you don’t have a trader’s disposition, or can’t afford the increased risk.
Real Estate: Location, Location, Location
It’s hard to talk about real estate as a single asset class, as prices can behave very differently depending on the specific market you’re discussing. As we all know, the real estate markets in Canada and Australia did not take the hit that the U.S. market sustained over the past few years. Whether those two commodity-rich countries will be able to escape unscathed or are merely trailing their American counterparts remains to be seen. (Update: Interesting article asking Just How Risky Are China’s Housing Markets?)
We can also make a distinction between the residential housing market and the commercial real estate market. I’ve always been of the opinion that my home is just that: home. It’s not an investment to be gamed. It’s literally the roof over our heads, and should be treated differently than a commercial property or even a vacation cottage.
Of course, there are numerous ways to gain exposure to the real estate market without moving every two years. You can buy rental properties, invest in commercial real estate, buy the stocks of home builders and related industries, or simply buy a REIT (Real Estate Investment Trust) or two and collect the distributions.
Here are a few reasons why you may (or may not) want to invest in real estate right now:
Pros
- Home prices in the U.S. have already fallen so much that they may be ready to bottom.
- Canadian home prices may correct a little, but won’t fall off a cliff.
- Increased foreclosures may mean that you could find your dream home for a bargain.
- If inflation takes hold, real estate prices usually rise.
- Commercial real estate isn’t in as dire straits as some think. Securitization and financing are available.
Cons
- U.S. home prices have further to fall and it may take another 5-10 years before they experience a meaningful bounce.
- Canadian home prices are in a bubble and are due for a serious correction.
- Many commercial real estate loans are coming due over the next couple of years and they may not be able to roll that debt into new loans.
- The glut of homes on the U.S. market will only get worse as banks foreclose on more homes, driving prices down further.
- The expiration of the stimulative home buyers’ programs that have supported the market will mean lower U.S. home prices.
- If deflation really takes hold, prices in the U.S. could remain depressed for some time, and those in stronger markets could experience deeper corrections than many currently expect.
If you think it sounds like these two camps are looking at two different markets, you’re not alone. I’ve read articles and seen various interviews with pundits who have argued each of these conflicting points persuasively. Maybe the recent market gyrations actually make sense when you look at the cross-currents that seem to be present. So what’s an investor with available cash to do?
I tend to be very cautious, and there are enough concerns out there right now that I prefer to sit on the sidelines. As a result, I might miss the train as it leaves the station. But one thing I’ve learned about markets over the years is that there will always be another train and I’d rather catch the second than get run over by the first.
What are your thoughts on the current state of the commodities and real estate markets? Are you putting money to work, staying the course, or sitting on the sidelines?
(Disclosure: I don’t own any of the securities or investment vehicles mentioned in this article at the time of writing.)
By 2 Cents on July 26th, 2010 | Category: Investing | A dollar picked up in the road is more satisfaction to us than the 99 which we had to work for, and the money won at Faro or in the stock market snuggles into our hearts in the same way.
~ Mark Twain
 I was going to do a single article on the pros and cons of investing in different asset classes right now, but I decided that there was too much information there, so I’m going to break it up into 3 articles which I’ll post this week. Today, we’ll take a look at the two asset classes you probably hear the most about: stocks and bonds.
The idea of this series is not to provide recommendations about which asset allocation is correct, but to provide you with some information you can use to make the determination that’s right for your situation based on the current state of the markets and the economy. If you are in your 20s, your choices will be different than those in their 40s or 50s. The amount of income you earn, your risk tolerance, your market knowledge and opinions will also affect your choices.
Stocks
Before I get into the pros and cons of putting your money in various types of stocks right now, let me just reiterate some facts about stocks in general:
- Money in stocks is money at risk.
- Stocks can go up or down by a little or a lot at any moment for any reason or for no apparent reason.
- Stocks can trade sideways for long periods of time too.
- No one knows for sure what stocks will do in any given time period.
- History is a guide, but you can crash and burn if you’re always looking in the rear view mirror.
For a more general look at the pros and cons of investing in stocks in general, see Should You Invest in Stocks?
Dividend-Paying Stocks
We discussed this a bit in Friday’s post on No Respite in Diversification, but I’ll try to make the pros and cons clearer here:
Pros
- Companies that pay dividends are usually larger, more successful enterprises that have been around for a while.
- You can earn anywhere from a fraction of a percentage point to 6% or more from dividends, depending on the type of business.
- Because they are usually relatively stable companies, these stocks sometimes fall less during bear markets.
Cons
- As discussed on Friday, markets can sometimes become highly correlated (as they are now). During these types of bear markets, dividend stocks can get hit just as hard as all the others.
- Companies sometimes cut their dividends. This can happen if an individual company encounters problems, or if we enter a vicious bear market and/or a very poor economy. If the dividend is cut, you will lose some or all of your dividend income and the share price will likely get clobbered to boot. (The clobbering usually happens before the dividend cut is announced, and the stock price sometimes recovers after the actual announcement.)
- Companies with very high dividend yields should be avoided as that’s often a warning sign of pending trouble.
Other Types of Stock Allocations
I don’t have the space here to go into a great deal of detail on all of the different ways you can split your equity (stock) allocation, so I’ll just go through some of the basics and a few pros and cons for each:
- Large Caps vs. Small Caps: Some investors like to diversify their stock holdings by market capitalization (ie. how big the company is). Large caps have the advantage of a proven track record and more stable stock price, but sometimes lack the growth boost that you can get from small cap stocks. You may find the next Apple in the small cap basket, but you’re more likely to go through a few companies that don’t pan out or even go bankrupt before you find that diamond in the rough.
- Growth vs. Value: Some investors like to buy stock in companies experiencing very high growth rates, expecting the share price to increase quickly. The trouble with growth stocks is that, by the time everyone realizes they are growing quickly, that growth is already reflected in the share price. If you’re a little late to the party, you can get hurt. Other investors prefer to invest in stocks that they perceive as undervalued according to whatever metric they might use. The problem with this approach is that companies sometimes trade at low valuations for very good reasons. Perhaps growth is slowing, or they are encountering an operational problem.
- Sector Allocations: Some investors like to diversify according to sectors like energy, utilities, consumer staples, consumer discretionary, etc.. This can be an effective way to spread risk, unless markets become very highly correlated. The key to this strategy is to remember that diversification within equities isn’t total diversification: you still need to hold other asset classes like bonds, cash, etc. to be truly diversified.
- Geographic Allocations: Some investors believe they can achieve diversity by allocating capital to different regions like North America, Europe, or emerging markets. While it’s true that investing in fast-growing markets like the BRICs (Brazil, Russia, India, China) can add a little kick to your portfolio, you also need to be aware that they can fall quite precipitously as well. You may not like where you get kicked if that happens.
These are just a few of the ways you can split up your equity allocation. But, as I mentioned on Friday, stocks are becoming more correlated lately, and it’s something to note if you’re looking to put money to work right now. Diversification within your equity allocation may be quite elusive until that correlation eases. You may want to lower your exposure to stocks for a while to reduce your overall risk.
Bonds
There are many ways to diversify within your bond allocation as well. Here are some general considerations in the current environment for bonds:
Pros
- Currently, deflationary forces seem to be more prevalent, so there is still some room for bond prices to climb.
- Bond prices tend to fluctuate less than stock prices.
- Bonds provide interest income that is guaranteed, but only if the issuer doesn’t default and you hold the bond to maturity.
- Even if bond prices are at or near a top, bond tops can last 2 – 14 years.
- Inflation-protected bonds like Real Return Bonds in Canada, or TIPS in the U.S. can provide a good inflation hedge.
- Although corporate bonds are often seen as more risky, some corporate balance sheets look a lot healthier than many sovereign balance sheets right now.
Cons
- Bond prices have been rising steadily since the early 1980s, so the bull market may be getting a little long in the tooth. There may not be a whole lot left in the way of capital appreciation.
- With very low yields, new bond purchases are not going to offer much income.
- If inflation rears its head, bond prices may fall precipitously, causing significant capital losses.
- The capital protection provided by buying individual bonds is at least partially lost if you buy a mutual fund or ETF.
- Bond supply is huge right now, with sovereign and corporate entities vying for investors’ money. If bond traders start to demand more yield for their money, that would cause bond yields to rise and prices to fall. This idea of sovereign issuers crowding out banks and corporations that depend on the bond market to finance their operations has been a worry for quite some time. It hasn’t happened yet, as investors have become disenchanted with equities and can’t seem to get enough bonds. That may change at some point, and it could happen abruptly.
I’m sure I must have missed some of the pros or cons for stocks and bonds that are relevant in today’s market. Can you think of any others?
By 2 Cents on July 23rd, 2010 | Category: Investing | Invest a few moments in thinking. It will pay good interest.
~ Author Unknown
 We’ve been talking about bubbles all week. So far, we’ve outlined 5 financial bubbles and 5 socioeconomic bubbles that could affect your money and your quality of life. It looks like we may have a bubble of bubbles on our hands. Does that have to be a bad thing? How can we prepare for the popping of these bubbles? What does all of this mean for your investment strategy?
Traditional Advice
One perennial piece of advice is that diversification can smooth out fluctuations in your investment returns. Don’t put all your eggs in one basket. That way, if you have 3 baskets and one is dropped or otherwise damaged, you’ll still have the eggs in the other two.
There are a couple of “defensive” investment strategies that are often recommended for long term investors, especially during trying economic times:
- Invest in High Quality Dividend-Paying Stocks: The idea here is that you will “get paid to wait”. So if we hit an air pocket in the economy and the stock market, at least you’ll be able to collect 1% – 5% in dividend income. The assumption here is that the value of these stocks will not fall as much during a bear market because they tend to be of higher quality. You should just wait it out because stocks always rebound eventually.
- Stick to Your Asset Allocation & Rebalancing Plan: This approach is often used by passive index investors. They simply choose a stock allocation and a bond allocation, and periodically rebalance by buying some of the asset class that has fallen and selling some of the one that has risen. The assumption here is that stocks and bonds are usually not highly correlated, so if stocks are going up, bonds are probably going down. This is how diversification is supposed to help you spread out your risk.
Why Diversification Will Be Less Effective in This Environment
So the idea of diversification is to spread your money among asset classes that are not highly correlated. In many cases, putting your eggs in different baskets may be a good strategy. But what if all 3 baskets fall off the truck at once? That can happen to your money too.
The strategies above would have worked pretty well during the secular bull market of 1982-2000. During that time period, stocks largely moved higher, and cyclical bear markets were buying opportunities. Many believe (myself included) that a secular bear market began in 2000. For that reason (and few others) the strategies mentioned above won’t work as well, if at all. Danielle Park, money manager and author of Juggling Dynamite, recently offered some very good reasons why we need to sell to avoid losses. I’ve incorporated many of those here:
- Contracting PE Multiples: One hallmark of a secular bear market is that price to earnings ratios tend to contract. That means that investors are willing to pay less for $1 of earnings. So even if your favourite dividend-paying company manages to maintain or increase its earnings, the stock price could still fall – perhaps by quite a bit. The same goes for the stock indices. A 3% dividend is cold comfort if your capital has depreciated by 40% or more.
- Increasing Correlations Within Asset Classes: If stocks of various sectors, geographies, and capitalizations trade up or down together, the argument for diversification within asset classes falls apart pretty quickly. In fact, there has been a lot of noise made lately about how the stocks in the S&P 500 are now 81% correlated with the index. When everything trades in the same direction at once, diversification doesn’t work. Another article asks What Is Correlation Telling Us? This one discusses the role of government backing of certain bonds and rates being held very low as factors that have lead to higher correlations among certain types of credit in the bond market.
- Increasing Correlations Between Asset Classes: Historically, stocks are not highly correlated with bonds. In fact, they are usually inversely correlated. But since the middle of the 1980s, stock and bond prices have moved in the same direction – mostly up. We would normally expect that, as stocks rose from 1982 – 2000, bond yields would have risen too.(Remember that bond prices and yields move in opposite directions.) A chart comparing the 10 year U.S. treasury yield to the S&P 500 shows the opposite. In fact, bond yields fell as stocks rose. That means that bond prices rose in tandem with stock prices. That would have made a traditional rebalancing approach much less effective.
- HFT (High Frequency Trading): Many large trading and investment firms now use computer algorithms to execute trades. A lot of these computer models are based on similar technical patterns, so the market can sometimes look like a herd of cattle stampeding in one direction and then the opposite one. We’ve definitely seen a lot more of that lately. (If you’re interested in more particulars on the effects of HFT on markets, read this article on Correlations Among Asset Classes.)
I should say that recently, bond prices have actually been rising as investors have reverted to their traditional view of bonds as a safe haven in falling stock markets. My point was simply that hearing someone say that stocks and bonds always move in opposite directions and investing your money according to that historical precedent may not always be a great idea. You still need to look at each asset class individually. Where is it trading relative to its own unique cycle and relative to the overall economic cycle? Stock cycles tend to be shorter than bond cycles, so it’s possible that the secular bull market in equities ended in 2000, but the bull market in bonds could keep going for a while longer.
The Dangers of History & Tradition
A lot of the investment guidance out there is based on historical precedent and clichés that may not be effective in the current market environment. That’s not to say that there’s no place for the tried and true. But there’s no substitute for independent thinking and due diligence. (See Ignorance Makes You a Better Investor and Other Money Losing Fallacies.)
There are so many aspects of today’s financial markets that are unprecedented, including the interference of governments and central banks, that it would be foolhardy not to at least review your investment approach. (See Today’s Markets: Not Business as Usual.) Although it’s less likely that all 3 of your baskets will fall off the truck at once, that doesn’t mean it won’t happen. And if the weather’s bad and the truck driver is intoxicated, you might want to keep more cash instead of investing in so many eggs.
If asset classes are becoming more highly correlated, and those in the economic driver’s seat may need a driver’s ed refresher, where can you put your money? On Monday, we’ll take a look at the different asset classes and the pros and cons of putting money into each of them right now.
Do you think diversification will always provide better or safer returns?
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