Thursday, March 03, 2005


The Capital Spectator is a thought provoking site edited by James Picerno. James offers valuable information and insights to the markets; especially the bond markets. Few stock jocks follow the bond markets closely enough. Stocks and bonds are linked at the hip.

To maximize ones investment returns, one needs to invest heavily in stocks most of the time. One needs to keep as little in bonds as one can stomach. One can cut ones risks by keeping a relatively fixed percentage in stocks and in bonds all the time and rebalancing when ether position out-grows the assigned percentage. The total returns over time will be reduced in such a balanced portfolio but the account value will not hit extreme highs or extreme lows. Many an investor can sleep better at night knowing that in a recession bonds typically go up in value as stocks go down in value.

The investor who wants the highest probability of becoming very wealthy needs to invest all-in in the stock market and to stay all-in. Furthermore, he needs to automatically add the maximum investment he can afford every month. This investor will ride a very steep roller coaster and he is prohibited from seeing the bottom of the hills. It will be extremely hard for him to stay in his seat just before the bottom of the steepest hill is reached.

Relatively few investors are disciplined enough to truly stay with the balanced approach or the all-in approach. Many more balanced investors come close to maintaining their discipline. Of those, many are so risk averse that they leave piles of money on the table by routinely investing too heavily in fixed income vehicles.

Modern portfolio theory says that as the stock market reaches extremes, the sophisticated investor reduces or increases stock exposure as would be indicated by the direction of the extreme. The evidence consistently shows that when a really strong bull market comes along, investors of both persuasions over-commit late in the cycle and get burned. When a really bad bear arrives both types are likely to reduce stock exposure significantly near the bottom and they then miss the explosive move off the bottom.

The irony is that while research shows market timing is extremely hard, both investor types constantly work at timing the market. Like so many things in life, it is good to openly profess ones weaknesses and strengths. I work very hard trying to be a great market timer.

For many years, the concept that the market is too efficient for anyone to out-smart was believed by many a university professor. The concept first proposed by Burton Malkial was called the Efficient Market Hypothesis or EMH.

I have never believed in the EMH because there have always been at least a few investors around who regularly beat the market. I personally choose to move heavily into bonds when I believe bonds are the best place to be and into stocks when I believe they offer the advantage. In other words, I stay fully invested in stocks and bonds most of the time and in only one or the other at major extremes. The only time I raise significant amounts of cash is when I believe there is seriously high inflation ahead.

At the current time, I believe the over-all inflation rate will rise modestly over the next few years. The inflation rate should prove to be strong enough to significantly reduce bond returns but not enough to hurt stocks. At the current time, my stock-bond portfolio is 100% invested in stocks (I own significant amounts of real estate and a relatively small amount of gold and silver). My stock portfolio includes oil drilling stocks, "heavy" businesses such as railroads and one gold mining stock. I own many other positions but I point out the "commodity" positions to show that one can immunize ones stock portfolio to help off-set the inflation risks.

I plan to write an inflation--deflation piece over the weekend. Among other things, the article will say, if the price of oil is up strong and the price of electronic equipment is down strong, then the over-all rate might be quite modest. A strong economy with modest inflation is as good as it gets for stocks.

This started out to be a thank you note to James Picerno. I do appreciate the ideas and information he shares. His thoughts in regard to the on-going debate about the dollar helped me add two and two about the Euro-dollar strength. The following is a response that I wrote on his site.


My theory of Euro-dollar strength is simple. The French, Germans and probably other Euro countries have been trying to realign their employment laws. They have each had some recent success. Examples: the French finally changed laws restricting workers to 35 hours max per week. The Germans have scheduled reductions to ultra liberal unemployment insurance.

To bring about change, the administrations put their hammers down. The Germans accepted a recession as the cost to bring change. The central bankers kept short rates higher than US short rates. Naturally money has flowed to where rates are highest.

China is almost a red herring. Lots of talking heads make a lot of hay but China, an under-employed nation, which was allowed to join the WTO. Since then, China has sold goods freely and of course expanded rapidly. The fact that China is receiving many dollars and reinvesting many dollars is expected since the US economy is strong and re-inflating. Of course the US is buying heavily from the low cost producer.

With tight fiscal and monetary policies in place, the Europeans simply are not buying as much from China as is the US. Fewer Euro-dollars in--fewer Euro-dollars out!

What do you think?