China and the Yuan

The Chinese government announced that it will drop the yuan’s peg to the dollar. Overall, I think this is good. This shows further liberalization of markets by the Chinese. At the same time, I haven’t understood for the longest time why nearly everyone thinks the yuan will rise rapidly against the dollar. While I have a lot of positive things to say about the Chinese economy for the long run, the Chinese central bank has been inflating like crazy. China’s monetary inflation has exceeded the Fed’s inflation of the last few years.

Regardless of what happens to the yuan, the Chinese people are going to experience a deep recession/depression. This will be its first, since I guess you can’t really have a recession when you are living in total poverty as most of the people were before. The Chinese have made great progress over the last couple of decades. Unfortunately, some of what seems to be progress in the last few years has been artificial. There will be a real estate crash. China has a lot going for it, but don’t invest your money there in the short-term.

Gold and Silver

Gold has been setting record highs (in nominal terms) this past week. Gold and silver tend to move in the same direction. Silver also tends to be more volatile than gold. When there is a bear market in metals, silver usually does worse than gold. But in a bull market, silver often goes higher in percentage terms than gold.

This has not been the case lately. Silver has done well, but not as well as gold. While silver does have a history of being used as money, gold does even more so. Central banks around the world store gold, but not silver (at least that we are aware). The U.S. dollar has been strong lately compared to other currencies, particularly the Euro. But gold in terms of U.S. dollars has still done well. With uncertainty in the world, with massive debts, and with all of the other problems created by governments, some people are turning to gold. Central banks are also putting a floor under it. While there may be a pullback in the short-term, gold and gold related investments are still a good bet even at current prices.

House Hunters

There is a show on HGTV called House Hunters. Sometimes this show does another version called House Hunters International where someone shops for a house outside of the U.S. This may be where the person(s) lives or it may be a second home they are shopping for. The person or family will look at 3 homes and at the end of the show it is revealed which house they choose to buy.

It is always interesting to look at the real estate and the prices outside of the U.S. When someone is looking at beachfront property in the Caribbean, it is understandably expensive. But it is really amazing when they look in places like Western Europe. I’ve seen shows where they show places in Japan, Israel, and several countries in Western Europe. The prices are astronomical. This makes a couple of points for me. First, the standard of living is far lower in other places of the world. Of course we expect this in third world countries, but it is surprising looking at Europe. You will see these apartment/condos that are about 1,000 square feet going for 400,000 or 500,000 American dollars. It would be sub-standard living to most Americans.

The other relevant point is how expensive real estate is in a welfare state. If the U.S. is headed towards being a welfare state like much of Europe, then perhaps we can expect real estate prices to go up drastically in the long-term too.

Bonds

Interest rates are at or near historic lows, whether we are talking about the Fed Funds rate or the rate on treasury bonds. The question is, is this a bubble? The answer is probably “yes”, but it doesn’t mean you should be shorting bonds right now either. If and when it becomes more evident that the economy is in bad shape, there might continue to be a flight to safety. For many people, that means bonds. I am not saying that this is logically correct, but who can argue with the market?

If the stock market goes into free fall, there is a good chance that bonds will continue to do well in the short-term and may even increase significantly in value. An additional reason to not short bonds is because you will be fighting against the Fed. The Fed creates inflation which can ultimately hurt bonds, but the Fed creates inflation by buying assets, the biggest asset being bonds. I would not fight against the trend at this point. Interest rates will finally go up some day in the future, but I wouldn’t gamble a lot of money on that day being soon.

Inflation/Deflation

It seems there is a struggle in the economy between inflation and deflation. The Fed has created massive amounts of money, but most of that is sitting as excessive reserves with the banks. It is keeping us from massive price inflation. The economy is trying to get rid of all of the bad investments that happened during the previous boom, but the government is not letting it happen. There is a struggle between recession/depression and high price inflation (say 10% or more). The Fed can choose the latter at any time. It can essentially force the banks to stop holding excess reserves. The Fed can also buy any assets of its choosing.

In a speech that Bernanke made several years ago that earned him the nickname “Helicopter Ben”, he said that the Fed can prevent deflation/depression at any time by credibly threatening to create massive amounts of money. He is correct on this point. The Fed can cause massive inflation (monetary or price) at any time. Right now it is trying to walk a tight rope, but they are running out of room. We will eventually get a depression. Hopefully the Fed will choose that course soon. If not, we will get really high price inflation, and then we will get a depression.

Iran Update

Today there was a report that a ship, which was a U.S. Defense Department contractor, fired warning shots at Iranian boats. We don’t know the whole story yet, but it is evident that the Bush administration is trying to provoke a war with Iran. This would be awful as it would probably mean many innocent lives lost.

After this reported incident, oil shot up a couple of dollars. If there is war with Iran, it is hard to say how far up oil will go. It will depend on how extensive the war becomes. Most likely, oil will at least double in price within a short time frame. We should all hope that more war will not happen and we should do our best to speak out against it. But we can’t be certain what the U.S. government will do, so we should be prepared with our investments.

The best way to cover yourself is with an oil call option, but these are very expensive right now. If you are involved with options, then a call option with a long time horizon would work. You could buy something that expires at least a year out and don’t be afraid to get a high strike price because the reason you are getting it is in case there is a war with Iran and oil goes to 200 or 300 dollars a barrel. Think of it as an insurance policy.

If you don’t play the options market, you can buy an energy fund, but it will not respond nearly as much to a jump in oil prices.

Stocks and Financial Advisors

There is a general bias of financial advisors towards stocks. Most financial advisors will tell you that if you are young, the majority of your money should be in stocks because time is on your side. They say that stocks always go up in the long-term.

Financial advisors want you to buy stocks because that is what makes the most money for them and the companies they work for. Of course, this is a generalization and there are certainly some financial advisors that are better than others. But you don’t ask a divorce lawyer if you should get a divorce or a car salesman if you need a new car.

If you lived in Japan and bought stocks 20 years ago and held them, you would still be down today (and that doesn’t even factor in inflation). I am not totally opposed to stocks, but to have over half of your investments in traditional stocks is crazy, especially right now. There are a lot of warning signs in the U.S. economy like a weak dollar, high energy prices, high personal debts, extremely high government debts, and an out-of-control government that taxes, inflates, and regulates us like crazy.

During normal times, I would recommend about 25% of your investments be in regular stocks (not counting ETF’s or specialty stocks/mutual funds). If you are speculating right now, I wouldn’t recommend much at all in stocks unless you have some good and specific reasons that a particular stock is headed up.

Obama and Your Investments

Although Barack Obama lost the Pennsylvania primary yesterday, he only lost by a few delegates and it is looking likely that he will be the Democratic nominee. It is hard to see how he would lose to McCain, especially given the unpopularity of the Iraq War.

With the likelihood of an Obama presidency getting higher, what does this mean for our investments? He is tougher to predict than the other two establishment candidates. He definitely has plans to expand the welfare state at home, but it is hard to say what he will do with foreign policy. It is unlikely there would be a dramatic change in foreign policy, but it is possible that the Iraq War could end sooner.

I don’t recommend having much in the way of stocks these days, but if you are going to own stocks, I would recommend energy and defense stocks. With that said, a withdrawal from Iraq would hurt some defense stocks, particularly in the short-term.

Although an Obama presidency may not live up to its promise, particularly in troop withdrawals, it is a possibility. Therefore, you should not be too heavy in defense stocks now. Of course, with a recession likely, you shouldn’t be too heavy in any stocks right now anyway.

U.S. Dollar vs. Housing Prices

For the last couple of years, the U.S. dollar has gotten hammered along with housing prices. Of course there was a housing bubble that was created by the loose monetary policy of the Greenspan era at the Fed. The short-term could bring more downward pressure on both housing and the U.S. dollar, but the trend is unlikely to continue for long.

It doesn’t make sense long-term to have a weakening dollar along with falling prices in housing. Eventually the dollar will get low enough that buying property in the U.S. will be a complete bargain, especially for foreigners.

Let’s say that as of today the U.S. dollar and the Canadian dollar are at par. In other words, one U.S. dollar can be traded for one Canadian dollar (this is pretty close to reality right now). Let’s also say that the average U.S. house costs $200,000. Now let’s take an extreme example and say that over the next couple of years the average U.S. house drops to $100,000 and the Canadian dollar rises to $2.00 against the U.S. dollar. In other words, one Canadian dollar will then give you 2 U.S. dollars. It would then cost a Canadian just $50,000 to buy a house in the U.S., whereas before it cost $200,000. You would see Canadians trading in their dollars for U.S. currency and buying U.S. property like crazy. This would either drive up housing prices or drive up the U.S. dollar, or both.

We have seen a crash in the U.S. dollar and drop in housing prices at the same time due to some unique circumstances. The U.S. dollar is the main currency of the world and foreigners are starting to realize that they shouldn’t have so much holdings of U.S. currency. And although housing prices have dropped, they are still much higher than 5 years ago and the drop can be attributed to the housing bubble created by the Fed.

It is possible that the Federal Reserve could have a tight monetary policy (which it actually does right now) and see other central banks have an even tighter monetary policy. But this is highly unlikely in the long-term. Therefore, it is also highly unlikely that both the U.S. dollar and housing prices will continue to drop in the long-term. Nobody knows for sure what the Fed will do, but if history means anything, the Fed will most likely start inflating again and we will see housing prices pick back up in a couple of years.

Exchange Traded Funds

Exchange Traded Funds or ETF’s are a great tool in today’s world. Although the financial industry is highly regulated in many ways, there are also a lot of advantages to investors that weren’t available a short time ago.

First, transaction fees are often much lower with on-line brokerages. You can manage your own account without having to call a broker. The trades are cheap and market orders for heavily traded securities fill almost instantly.

Now you also have the luxury of ETF’s. As if mutual funds weren’t good enough, now we have ETF’s that track closely to a whole range of investments. ETF’s can be traded just like stocks. If you wanted to set up a diversified portfolio of stocks, bonds, and gold, it isn’t a problem now. You can buy an ETF that tracks the Dow, the S&P, the NASDAQ, or a number of other stock indexes. Then you can buy an ETF for long-term bonds like TLT. Then you can buy an ETF like GLD that traces the price of gold. You could buy $100,000 worth of these three things in minutes and you would pay less than $50 in commission with a decent on-line brokerage account.

There are many other ETF’s that are available now. You can buy foreign currencies or you can buy foreign stocks like EWH that invests in stocks from Hong Kong. Or you can short the market. Better yet, you can buy ultra-short funds like DXD that has approximately a double inverse relationship with the Dow. If the Dow goes down 2%, then DXD will go up approximately 4%. You can also buy silver with SLV. There are many choices that have come about in just the last few years.

These ETF’s are great tools. Study them and see what’s out there and then you can use them for your investing.

Combining Free Market Economics with Investing