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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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No matter what the investment or economic climate is, he mentally divides his portfolio in halfDefensive Investments that Allow You to Sleep Nights Gentlemen prefer bonds. Andrew Mellon, financier and secretary of the Treasury, 1921-1932 PERSONAL MEASURES YOU CAN TAKE Every asset you have, needs to be reevaluated in a bear market. This is because bear markets usually (not always) are bellwether indicators of recessions or depressions. Thus, not just your portfolio of stocks, but your real estate, deposited cash, business, government bonds, and other assets must be analyzed for safety. It may be that the defensive portion of your portfolio (non-stock holdings) simply needs to be increased. But, before you make a decision on how to change your portfolio, it is necessary to Take a View, as outlined in Chapter 3. You should examine political, economic, and monetary data to decide what sort of recession and/or bear market is likely to evolve over the next few months, or years: Will it be short and sharp a la 1987 or 1990, where the underlying economic and financial infrastructure wont be damaged very much if at all? Will it be an inflationary recession as we saw in the 1970s? A recession that may not be very deep, but will be protracted because it cannot end until inflation is squeezed out of the economy? Will it be deflationary, or just disinflationary? No matter what government does to create liquidity, if it is countered by businesses and consumers who spend less in an anxiety-ridden environment, government efforts will fail. For example, in the mid to late 1930s, in spite of Keynesian deficit spending, consumers were so worn down that nothing government did, stimulated the economy much, until war changed the mood of the consumer. Or will it be a combination of the above? Once you have made this assessment, you are ready to make changes to your portfolio. In Chapter 12, I explained how John Templeton structures his portfolio in bull and bear markets. It is worth repeating here. No matter what the investment or economic climate is, he mentally divides his portfolio in half, with 50% in long-term stock investments and the rest sometimes in stocks, sometimes in bonds, and sometimes in other defensive positions. That is a very sound principle, though the 50% rule would have to be adjusted depending on your level of overall wealth. The value of the stock part of your portfolio should never be more than three times what you can afford to lose and still maintain your lifestyle. Put another way, any security in this part of your portfolio could fall 30% before you decide to cut your losses, or maybe decide to ride out the storm no matter how long that storm is, without threatening your ability to fund your childrens college or your living standard during retirement. During a bull market, such as we saw in the 1990s, it is likely you had a far greater portion of your assets in stocks. But, following Templetons rule, even if you were 90% invested in stocks, you should have labeled 40% of those investments as short term, needing to be monitored daily, or at least three times weekly. And you should have been ready to move out of them via stops and into bonds or other cash-equivalent investments as soon as it became clear the market was in a bubble phase. It was no secret. This division of assets applies in bear markets as well, except what constitutes a defensive investment in a bear market depends on whether it is an inflationary or deflationary bear market. If you decide the bear market is going to be similar to 1987 or 1990, there is little you need to do except sell those stocks that are unlikely to participate in a new recovery. The rest of this chapter will deal with more retracted bear markets. BONDS AND CASH-EQUIVALENT INVESTMENTS Unless you believe that inflation will rapidly increase to 5% or more, having a major portion of your portfolio in bonds and bank accounts at interest is prudent. If bank interest rates are too low (e.g., 2%), you can substitute quality corporate bonds. Treasury or other government bonds with a 5-10 year maturity are the safest, because no matter how bad things get, it is unlikely that any government in the industrialized world will default on their bonds. In addition, in many countries there is a tax break on government (national, state, or local) bonds, which makes the real rate of interest higher than the actual rate. In an inflationary environment, bonds still have their place. During the 1970s, for example, while the dollar was suffering from high inflation, the Swiss franc and the German mark were not. Many Americans chose to put money into Swiss and German bonds and bank accounts at interest, and made considerable profits. It was, in fact, advice I gave my newsletter readers at the time! REAL ESTATE Unless high inflation occurs in a recession, investment real estate should be liquidated or cut back. The odds say it will not rise in value; thus, you risk it either going down or, at best, standing still. In a deflationary recession, if you hold rental property, the odds are high that rents will decline, and, if you want to sell the property later, there will be a dearth of buyers. Once you are satisfied that a protracted bear market exists on Wall Street, you must assume a business recession or depression will occur. With a business depression comes lack of spare cash by potential buyers of your real estate, so its better to get out before this happensat least real estate other than your residence. Most people want to keep their home for emotional reasons, regardless of how it fares as an investment. However, if we are headed for a depression and you arent married to your home, you could sell before property falls much. Also, it will be cheaper to rent than to own. In a deflationary recession, interest rates usually decline, so try to refinance any real estate you plan to hold at lower mortgage rates. Of course, by the time you make a decision to sellif you doprices will have dropped and real estate will be harder to sell. Its the same with stock values. But the loss of a top price, and perhaps a later actual loss from cost, is still better than risking holding property as it goes ever lower as the worst of a recession or depression bites. Moreover, your cash from a sale could be earning interest or be invested elsewhere. The worst that can happen after you sell real estate is that a business recession will not be very deep or that it will be short-lived. Its the same risk as when you sell a falling stock only to see it rise again. Nothing is certain. But the more you study markets, the better your decisions. But, if the rate of inflation suddenly speeds up while business is slowing down, real estate will become a way to preserve value. In an inflationary bear market, real estate is a major defensive investment. Dont sell. ARE BANKS SAFE IN A MAJOR BEAR MARKET? In 1929, the banks held gloriously for a number of months and everyone was proud of them. In November 1930 (a year after the crash), the Literary Digest said, There have been no important banking failures as a result of the shakeup, attesting to the strength of the banking system in the USA. But a year later, on December 5, 1931, they ran an editorial on what a good sign it was that banking failures were declining. Bank failures were down from 166 a week to 18 a week! It is true that many safeguards have been built into the system that were not there in 1929. And if the US banking system was insulated from the rest of the world, its possible there would be few banking problems. But we live in an interdependent world. As of 2002, were in a major global recession. The worlds banking system is only as strong as its weakest link(s). It is possible that there would not have been a banking crisis in the US in 1930 if a major Austrian bank, the Credit Anstalt, had not collapsed, which caused a ripple effect across a depressed Europe and the US. It is probable that, if the Austrian recession had been an isolated event and the rest of Europe and the US had enjoyed 1990s-type prosperity, the collapse of a minor European bank would not have become the straw that broke the back of European and US banking. The Asian banking crisis, which hit its peak in 1997, did not affect the rest of the world because Europe and the US were still enjoying unprecedented prosperity, and so were in a position, via the IMF, to support the shaky banking and finance systems in most of South-East Asia. Should a similar crisis occur in 2002, 2003, or 2004, with the world already in the throes of a recession, what was able to be isolated in 1997 could easily become the Credit Anstalt of the future just ahead. Let me hasten to add that, as of this writing, there is no rumor of any major bank in the US or Europe failing. But things change. Monitor the situation regularly, to make sure that a financial crisis somewhere else in the world doesnt escalate at a time when the West doesnt have the resources to contain its effects. Read an international newspaper daily for straws in the wind. You wont see them on TV! IF YOU OWN YOUR OWN BUSINESS What should the little or big businessman do about his business in a really bad deflationary bear market and recession? Big business just has to take it on the chin. They will do what they must do. They will slash payrolls, cut costs in every way, as they have been doing in 2000 and 2001. Small businesses can consider selling out, if they can find a buyer. It depends on whether they feel they can survive in an economic climate where they may lose, say, 30 to 40% of their gross income. If they can cut costs and still make a bare living, then they too can hang on, along with General Motors (whose car sales could fall to a trickle). Medium-sized businesses will probably gravitate toward mergers and downsizing to save overheads. This will result in fewer jobs, but many businesses will be saved. In an inflationary recession, owning your own business becomes a defensive investment. Your plant and equipment are tangible investments whose value increases as the currency depreciates. Generally, during inflationary times, consumer confidence remains high. So, though you may make less real profit (adjusted) in an inflationary recession than you would in low-inflation boom times, your business becomes a major defensive investment. TANGIBLE ASSETS In an inflationary recession, if you own a stamp or coin collection of value, jewelry, rare stones, antiques art, old cars, or a warehouse full of merchandise, hang on. Their value is likely to increase much more than the increase in inflation. But if the recession is deflationary, all the above would decrease in value. If the recession becomes a depression, probably much less. So, buy and sell accordingly. GOLD In times of uncertainty, gold bullion, gold mining shares, and gold coins rise in price. This is true whether the climate is deflationary or inflationary, though gold usually rises more during times of inflation than deflation. To those who claim that gold as a store of value is passe, I would point out that a large percentage of the worlds banking reserves is still held in gold. And hundreds of millions of people in Asia and the Middle East buy gold daily as their safe haven. Gold demand has exceeded supply for several years. A bull market in gold technically began in November 2000. For the year 2001, gold mining shares outperformed all stock averages. Every portfolio should have a survival gold holding. In an inflationary recession, gold becomes a major investment. In a deflationary recession, if the anxiety factor is high enough, gold is still attractive as an investment. But gold does not follow normal investment rules. During the 1930s, US gold ownership was forbidden, which enabled Roosevelt to raise the price of gold by government decree. It is significant that in a deflationary environment, even before the price of gold was officially raised, gold mining shares rose, and dramatically so during the depression. And, though Roosevelt decided on a new price for gold, it is significant that he raised the price almost 60%, from $20.67 to $35 an ouncea price that remained until the early 1970s. In the view of this author, another 60% rise could occur soon, but via the free market. This suggests that, even in a deflationary recession, gold is a good investment. During the inflationary 1970s, gold went from $35 to a record high of $850 an ounce on January 21, 1980. But gold is not an investment one only buys and holds, not even in a bear market. Its more of a buy, sell on run-ups, buy on sharp declines. Sell again. Buy again (while keeping a core holding). The reason is that governments recognize that gold stands, to a large extent, as judge and jury on their actions. Therefore, several governments (e.g., US and the UK) do whatever they can to keep the price of gold down. In the 1970s, during the first inflationary surge in 1974, government was able to talk the gold price down, while they dealt with inflation. Their continued propaganda campaign against gold was so successful that it was not until 1978, when it was clear to all that inflation was not going to be controlled, that the gold price exploded. Those who bought gold when it was $35 an ounce and sold it at around $800 an ounce made huge profits. I urged my readers to buy in this period. But it was not the sort of investment that just climbed a trend line calmly. Gold behaves more like a pressure cooker than a stock. When it begins to rise, governments do whatever they can to depress the price. Only when all their best efforts fail does gold rise to its true free-market price. There is strong circumstantial evidence that, for the last 12 years, the price of gold has been deliberately depressed via sales and hedging operations. Be that as it may, what is clear is that when economic conditions or the stock market get really bad, and the gold price begins to rise appreciably, certain governments do and will do all they can to hold the price down as long as they can. Greenspan said so before Congress. It also happened in the days of the London Gold Pool in the 1960s. Therefore, in the early stages of a bear market, whether it is inflationary or deflationary, I suggest a 10-15% investment in gold bars, gold bullion coins, and gold mining sharesall three. You can then add to your bullion and share holdings by increments, as the bear and gold markets evolve. CONCLUSION This book is designed to cover all types of bear markets. About half of them in our history have not been severe enough to require all the alternative actions listed herein. Each bear market must be judged on its own demerits. Their severity is never the same twice in a row. But an assessment of any bull or bear market is an evolving perspective. Learn to reexamine your perspectives on a regular basis, and ask yourself the hard questions as to whether your prior opinion, based on the new evidence, still applies. You can get help from quality investment letters, but not from TV or stockbrokers, due to their vested interest in bullishness. THE MARKET IS FOR EVERYONE The principles outlined in this chapter are the same for the man with $30,000 as for the man with three hundred million dollars. The same is true of all parts of this book. During the glory days of the late 1990s, most small investors saw the stock market as little more than a bank, and gains as simply a higher interest than their regular bank could offer. I remember seeing an investment club organizer interviewed on TV. He announced, with a perfectly straight face, that they were conservative, that they did not speculate in leading-edge technology firms even though potentially higher profits could be made. They were content and expected to make 20% per year, no more! Every year. Like an entitlement. The uniqueness of the dot com era is summed up in the assumption that the expectation of a guaranteed 20% profit per year was conservative! Most expected 30-35%. Even if the bear market and recession at hand end without a crash scene, we are never likely to see a market like the late 1990s again in our lifetimes. Henceforth, everybody, no matter how little money they have to invest, will need to be responsible for their own financial future, without help from a nobrainer bull market. And that takes work. All the work explained in this book, and beyond. DOING NOTHING IS STILL A DECISION Even if you decide to do nothing with your money, or want to get out of the market and park your money in government bonds or hide it under the mattress, the act of deciding to do nothing is an investment decision. You take a stand regardless of how you hold your assets. If you elect to leave them where they are, because you dont really know what to do, you have made a decision for which you should have weighed the evidence. There are people who were aware, as early as mid-2000, that markets were heading lower, but who allowed their stocks to lose even more value because they were not able to look reality in the face, take responsibility for their own financial future, and make portfolio adjustments based on the new conditions. After years of huge profits, though logically it appeared that era was over, emotionally many investors were not willing to accept the fact. Many of those same people are now saying it is too late to sell. If they are convinced, based on their best analysis and judgment, that the bear market of 2001-2002 will be so short and shallow that it really is too late to sell, then good luck to them. I am merely saying that its dangerous to base investment decisions on what you think/hope will happen and using data selectively to support a refusal to change course. It is never too late to do the right thing based on your best judgment, which you arrived at after doing the necessary study to form your conclusions. If you are wrong in selling, you can always buy back. But, if you ignore the signals, you cant go back to those higher prices and do it over differently. My suggestion, overall, is to do a bit of several things in case, even after you have worked hard to come to the right conclusion, you are wrong in your interpretations. Never be too radical in your solutions. The world, owing to ever more instant communications, moves faster. Some factors that affect longer-term trends can change overnight. But, overall, longer-term trends still evolve slowly. So, provided you stay alert, there is usually time to adjust your strategies to changing events. But spread your risks, and make haste in increments. Incorporate new information into your long-term view, and modify it and your portfolio mix accordingly. Those are the ingredients of defensive investing. |
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