Tuesday, July 28, 2009

understanding interest rate trends: contrarian history

who knew that the recent economic super-bubble was built on a empire of easy money?
a small number of people who can now claim 20/20 hindsight.
how did they make their observations?
who are they anyway?

After doing a lot of research (reading books, the news and talking to experienced investors) I came to see that the people who understood what interest rate trends say about the overall economy were the ones who were predicting an impending calamity.

Hardly anyone got the timing of when catastrophe would break out in the financial markets and spread into the real economy. In fact, the few people who did move out of the stock market right before the crash were usually just lucky to have cashed out at the right moment.

But all of these people, who understand interest rate trends, were relatively protected from losing great sums of money in the crash, largely because before the economic crisis they were considered highly conservative investors.

At one point, some people do make large bets on the stock market and perform well. But overall, their personal savings (and their recommendations for the average Canadian retail investor) were always conservative.

Why were they conservative if they were experienced and educated with respect to interest rates and finance in general?

because they understand that falling interest rates are generally related to easy money. If it's easy for corporations to borrow and for banks to lend, this generally inflates the economy and inflates the value of the stock market.

So why be highly conservative?
Because if you do the extra homework required to understand international trade and debt you would have seen all along, how deeper and deeper into debt the entire western world was becoming- excessive and increasing debt is never sustainable.
you would have therefore focused on protecting the majority of your capital by ensuring it is repaid to you in full and that you are earning an amount of interest that is safely above the current inflation rate (a spread of 5%- or 500 basis points- from the rate of inflation to the amount of interest paid is generally considered an optimum return for investment grade bonds).
you would have (if you were so inclined) still put some money in play in the stock market, to enjoy the upside, but also perhaps taken a greater risk because the majority of your money is guaranteed to be repaid- this could be more profitable or much less- depending on your choices.

My point is that I follow the wisdom of those who enjoyed success and longevity of their successes. I maybe don't understand the lessons when they're first taught. Who among us has ever been told we need to understand interest rate trends, and immediately forgotten to make it our top priority?

it is certain, with respect to understanding interest rate trends, that you will educate yourself and see the world in a different way once you do.

Monday, July 27, 2009

ladder your portfolio- a.k.a. bondage gear

We are likely witnessing a historic period in modern history.

Historic with respect to the movement of interest rates, inflation, exchange rates, employment, GDP growth, quality of life.

The key to outperforming market averages for the fixed-income investor comes down to preparation, discipline and execution.

preparation: this should be the easiest step

- plan 10 years into the future (this is the extreme long run, and should be the most flexible, least certain expectations)

- plan 5 years into the future (without the ability to plan and save with 100% certainty for at least 5 years you will not be able to meet or exceed the average market rates of return)

- once you have determined how much money you will be able to save and invest over the next five years (minimum), begin following the news related to interest rates, inflation and GDP

discipline: this requires the most concentration, understanding and synthesizing of information

- if you are living in a period of rising interest rates, it is to your advantage to avoid longer term and lower yielding bonds (you will not have sufficient cash on hand and will miss the chance to buy new issues at higher average rates)

- if you are living in a period of falling interest rates, it is to your advantage to buy and hold attractive medium to long term bonds ( you will already be outperforming new issues of similar duration),

i.e. if you buy a 5 year bond interest 6% and interest rates fall for 24 months (which they have in the past) , a newly issued 3 year bond may only yield 2.8%, buy you will already have a bond of similar duration (5 years minus 24 months) that pays more than double the new issue. even worse, new 5 year issues will yield only 4.5% interest

- credit ratings matter, you don't' need everything to be AAA, in fact you don't really need to be afraid of having nothing higher than AA (any provincial bond is rated AA).

-if you stick with AAA investments, you will be receiving the lowest yield for 'the most safety', but provinces in Canada will not go bankrupt either, fyi.

- you must avoid a high concentration of BBB, bbb issues and diversify among AA, A, BBB

execution: the most difficult step

- without an effective financial advisor, it is extremely difficult to be confident, informed, decisive, or savvy. An effective financial advisor confirms all of your expectations for how much money it is possible to safely earn, while occasionally exceeding those expectations to improve the quality of your life

- following through on the rules of creating a diversified ladder requires intuition and fact analysis eg. many thought that interest rates would never go lower than they were after 9/11. not only have they never returned to those levels, they have reached a point of essentially absolute zero- the central banks of the western world simply can't lower the interest rates any further. the point is, the investor needs to understand the way defeciet and debt affect the economy and what effect interest rates have on a debt situation (this is basic macro and micro economics)

-only through repeated experience or testing can an individual develop a savvy ability to understand the relationship between interest rates and the type of individual bond purchases they ought to make ( this doesn't mean you need to be a pro, but you will have to actually do homework to understand the nature of interest rate trends, and it's not the easiest, most entertaining topic)

Saturday, July 11, 2009

I'm in Asia! learning stuff!

granted there are lots of cost saving ways to travel in south east asia.

the downside? you have to travel for at least 24 hours and fly literally to the other side of the planet.

as well, depending on where you go, no one will understand english.

I'm in the philippines because it still is an undeveloped tourist destination: it's even cheaper than thailand or vietnam and many of the beaches and resorts are pristine.

the best part: everyone one here loves Americans (they don't distinguish between white people from north america) and everyone (even those with little or no education) can understand rudimentary english.

It's very easy to get around and no one will over-hustle you: they simply aren't used to a tourism industry like thailand or vietnam (depending on which city and region you choose).

So what am i doing here? well, i mentioned previously that i spend a lot of time looking for alternative investments since i left the world of traditional asset mixing. Just so happens that i have a personal connection with a fellow who is highly connectd with the asian development bank, head quartered in manila.

did i ask for a specific deal, strategy or investment opportunity? NO.
what i did is called networking. I took the effort and time to find this person and to simply have a conversation. In essence, it was a global cold call.

We talked at length about my personal background and i had the opportunity to seek his opinion on much of the global turmoil taking place. His views on what counts as stable, what counts as volatile and what counts as a bargain are all well informed and based in the real world of securing credit (from a multitude of central banks and global financial institutions) for medium to large size firms involved in import/export trade throughout all of asia.

What did i learn that i can relate to you?
a few basic opinions, with the caveat that my new friend admits even the most informed cannot predict the future.

but he did point out the long, protracted nature of the current recession.
he pointed out that there is still a great deal of bad debt that has not worked its way through the global financial system (credit card debt is now just starting to become a serious problem for global financial institutions).
when asked, he pointed out that automatically, the rest of the world has been moving away from the american dollar as the international currency.
a basket of international currencies used by large, global financial institutions for transactions, referred to commonly as "special drawing rights" (SDRs) are now gradually becoming the defacto world currency.
He also noted that among international central bankers, there already exists a consensus that the world will eventually eliminate free-floating currencies and create a single world currency.
THis is a very difficult thing to accomplish and will not be realized for years, perhaps decades (if ever- no guarantees on the future)

But he was very clear, the old currencies: the pound, the american dollar, even the euro are in for a very, very bleak future. If you hold investments in these currencies, if you attempt to trade with these currencies, you will be very stressed for a long, long time. you may even lose a great deal of money.

what does it mean for the canadian bondage freak?

a declining US dollar will destroy the majority of canadian exporters. this will completely overwhelm any short-term recovery efforts and likely drive up unemployment, drive down exports and delay any significant growth in the economy.

the consequence is lower earnings across the board. your mutual funds are not coming back. you will be lucky if they remain at their current levels.

your fixed-income? keep it 7 years max. and widely diversified

why? every central bank in the world is printing money. those who ignore history are doomed to repeat it. we're in for inflation (not a guarantee, but an educated guess). if you're strictly buy and hold, you have to avoid the long-term (even if it means taking a lower total yield). if you stick with a bond mutual fund or buy something 10-year, 20-year or god forbid 30-year, you could stand to underperform the market dramatically.

don't buy stocks, unless they are a totally dominant company that is having a down period, and don't overly invest in stocks.
keep buying bonds, but remember, inflation will be higher than people might expect and you need to be able to purchase new issues at higher interest rates, because interest rates will rise. the federal governments have done as much as they can to hold rates down for the time being, but if this really is the big bad unravelling of the empire of debt the West has built, it's going to be a long, slow, painful road to recovery