Friday, September 05, 2008


The most important investment "secret" is a simple concept. Follow the concept in a disciplined manner and you are on your way to being a billionaire. The concept is easy, the discipline to follow it is the hard part.

The value of rents has risen and continues to rise relative to "safe" returns. In July 2007, the 10-year "safe" return of US Treasury Notes was 5.3%. Today, the 10-year "safe" return from Treasury Notes is 3.59%. The regular receipt of a 6% net rent in 2007 was just barely above the "safe" return; collecting rent instead of treasury interest was a lot of work for a minor gain and not worth the risk. The low return for high risk indicated that rents had to go up, safe returns had to go up or both. Both has been the result. The market price of rent houses went down while the value of the T-Note went up. The cash flow spread increased by 47% if we measure the T-Note rate against the 6% rental rates. The cash flow spread jumped 67% if we assume a 10% decline in the value of a rent house with no change in the rental income. ($6,000 divided by $100,000 is 6% but $6,000 divided by $90,000 is 6.7%.) Most importantly, lower construction combined with population growth will gradually lower the supply of rent houses and increase the demand for rent houses and thus lead to rent increases.

Investing well is not much more than the process of comparing returns to the "safe" rate.

The facts are clear, the guaranteed 10-year rate of return has been going down, which is making the relative value of rents, dividends and other cash flows go up. Stocks are a better investment today than they were in 2007 for several reasons, but the key reason is that they do not have to make as much to beat the "safe" rates.


Back in July 2007, there were sharks in the "cash flow water". Short term rates (sharks) sticking their dorsal fins out of the water. The safe 90 day treasury rate was just as high or higher than the "safe" two-year treasury rate, the "safe" 5-year treasury rate and so on. I regret that I temporarily lost discipline and took my eye off the sharks. I sold bonds to keep stocks when I should have sold stocks to buy more bonds. Mistakes are good, if we learn from them.

One of the traps that caught me was the focus on stock market earnings yields, by smart people such as Ed Yardini and Don Hayes. Short rates reached long rates by June 2006 but the market continued to do well. The explanation provided by Yardini, Hayes and others was that there was a wide positive gap between the earnings yield and the 10-year T-Note yield. Because "safe" rates were already near historical lows, it was tempting to believe that "this time was different".

The earnings yield is the upside down of the PE ratio. I have read in at least 10,000 books, news letters and articles that one should buy stocks when PE ratios are low (or when earnings yields are high). On the other hand, for more than 30 years, I have been well aware of the fact that one can easily get burned by "PE ratio investing". I have long know that the derivatives of "PE ratio investing", such as "PEG ratio investing" and "GARP Investing" can lead to disaster. It should have been obvious that what is true for individual stocks or groups is true for the market as a whole.

Long ago, I understood that the time to buy a stock or industry group is at its earnings trough, not at its earnings peak. Any investment system that relies on "good" earnings, is a dangerous system because stock prices lead earnings by many months.

Let's compare oil to high tech as an illustration. Back in 1999, a barrel of oil was selling for $10 to $12 while high tech companies were approaching peak earnings and oil drilling companies were struggling to stay in business. Suddenly, there were sharks in the water. Short rates reached long rates and even exceeded them for a time. The people who bought bonds avoided the collapse in the high tech market. By October of 2002, long rates had fallen dramatically and the broad market averages soared. Bond rates continued to fall until the ten-year rate reached 3.1% in June 2003 (the thirty-year reached 3.3%).

The investor who keeps 100% of his money in stocks all the time should have sold all of his tech stocks by March of 2000 and put some of the money into energy stocks. Today, we are looking at the flip side of the same coin. The peak in bond rates in February 2000, when the 10-year hit 6.8%, rhymes with the peak in bond rates in July 2007, when the 10-year rate hit 5.3%. Bonds had rallied and the market was set up for a big turn by September 2011, just when the terrorist hit.

The current huge bond market rally is not confined to the USA. The rally is even stronger in England, Australia and Canada. The most visible evidence of this is the collapse of their currencies relative to ours. These countries are our closest international friends. The EU is falling relative to the dollar but not as fast.

The bond market rally and the collapse of commodities will not be over until central bankers force the local sharks deep. Sell gold, oil and interest rates and buy consumers of these, such as financial stocks, consumer cyclical stocks and technology stocks (in that