Outputs
Successful investing is 'avoiding' emotion (you can't control emotion) while waiting for 'late' instability (selling) or 'early' stability (buying).
Leading Indicators...Updated Feb'08
Short-Term (all 4 must turn)
Credit (MZM Money Velocity) ↓
Leading Economic Indicators ↓
SP500 Operating Earnings ↓
Yr/Yr Change in Delinquency Rates ↑
Longer-Term
Total Credit Decelerating
Credit Standards Tightening
Spreads Widening
Total money velocity Declining now 16%...danger being too low before a recession
Mean Market P/E and other stocks above mean, gov't bonds neg correlated
Co-incident Indicators...Updated Mar'08
Price Changes (45 week) ↓
[Social Mood: Negative on Real Estate, Economy, & Stocks] ↓
Payroll Growth (12mo) ↓
Portfolio Bias
The inflation charts show forces of inflation falling fast. Delinquency rates are now running at 7%.
A decelerating credit market favors government bonds and "flight to quality" investments. Although you will see large price swings in various markets (end of a bull market).
Bias: Deflationary
Buy Value At Recovery Turn and Use Portfolio Bias....VCU
(Value, Credit, Up-trend)
1) Value or under the mean
2) Credit Accelerating. Bias Inflationary.
3) Up-trend...beginning of market positive percent change
( Ideally Long Term Dependence as well)
At this time, the ultimate chart showing long term dependence and VCU is the US treasury bonds 30 year.
Value- Reversion to the Mean: Yes as they haven't participated in recent market advances
(below the mean - negatively correlated asset).
Credit: 'Flight to Safety'
Long Term Dependence: Yes, chart shows long term up-trend.
Up-trend: Yes since 1982.
As for stocks, there's no compelling value. I say wait for a crash/opportunity.
Portfolio: US Gov't Long Bonds or TLT
Buy Value...Industry Watch
Market PE 17
Home Construction $HGX < 8
Mortgage Issuers ?
Banks ?
Oil & Gas Integrated 10.4
Iron & Steel 10.5
Construction Services 16.4
Construction & Agricultural Machinery 17.4
Electric Utilities 17.4
Aerospace and Defense 18.8
Major Drugs 21.7
Health Care 22.7
Gold & Silver 23.6
Advertising 39.9
No Bargain Industries. If after recession there is no private credit growth, candidates are: infrastructure, and food. Otherwise, construction services and other oversold industries...possibly Robot (more later) is the best...April each year.
As stocks sell off some industries will become bargains. The chart should show a significant sell off with a down period.
I watch for the major bargain industry and buy its dogs when the chart shows a turn. The longer the down market the better the upside.
The gold and oil stocks showed a long term dependence ... down for 20 years, 1982-2002. So they were primed for a good rally. Unfortunately, there are no major indexes like these showing a long term downtrend. "Bargain sectors" have disappeared. However, construction services is looking better. I would also look for the housing market index to be above 50. Although the future rebound won't be as good as 2002-2007 in steel, metals, or oil, they are the most promising candidates.
Sell Over-valued and Use Portfolio Bias....VCU
1) Over-valued way above mean
2) Credit is decelerating. Bias deflationary.
3) Chart is 'choppy' high % change moves. Sell 'hype'.
Hedged Position
There is always a chance that I am being fooled by randomness. I believe the portfolio should still have a bias such as deflationary or inflationary. Right now it's deflationary. As such, the portfolio should always have a hedge in the opposite direction, possibly leveraged, in case an earthquake comes out of nowhere.
If your hedge is to be leveraged, it should be thought of as insurance. The investment for the most part is a throw away. I have a small position in gold at this time.
Hedge: 10% GLD increase to 20% if CPI rises above 5% and gold price rises when the Euro drops rates.
Background
"Be fooled in small matters, not in the large." p. 203 The Black Swan
Liquidity tends to flow to "dry" areas. When liquidity is withdrawn, markets drop except "flight to quality" investments. With liquidity, returns will be best in areas that have been dry. The flow here will raise these boats faster than any others.
You use the deflationary/inflationary bias to select the type of investments. But you keep in mind that in a credit driven system, the catastrophic event will be deflationary followed by a currency devaluation or hyperinflation. As the economy gets closer to this threshold, it will oscillate between the deflationary and inflationary biases.
The Fed knows this problem and so over-reacts when the threat of deflation is apparent and makes credit available very cheaply. On the other hand, they live with the legacy of the 1970s and want to also fight inflation. When the CPI and core CPI meet their thresholds (ie. 3%), they raise rates and attempt to limit credit availability. They are in a delicate balancing act which is a losing game in the end as you can't grow your debt faster than your spending or income forever.
Unfortunately, there is a delay from the time the Fed starts to raise rates and a credit deceleration. In fact, as the Fed starts to raise rates, credit will actually accelerate as people are afraid of being locked out of the market. At some point, the rates will rise high enough for the credit fever to break. The credit fever can break abruptly or slowly.
If I believe the economy has a deflationary bias, I put 80-90% into treasury bonds. Once credit starts to flow again, I look for an investment class or classes that have been beaten down during the credit deceleration phase. Within this group, I then select the industry charts that show long term dependence (ideally) and an obvious breakout recovery (up-trend). You find these sectors by analyzing the stocks first then working back to their industry charts. For example, sort for stocks that have been dropping for a few years showing a breakout of 40% in the last year. Unfortunately, there are no major industries with losses at this time. I briefly check the stock charts of this industry for the obvious up-trends. By watching for some kind of up-trend, you avoid the 'value trap' which occurs when buying a low-priced stock only to have it remain low priced, either because the stock deserves the low price or because the market never catches on to the mispricing.
After I own these stocks for a while, I switch to the bottom 1/3 of the sector/index or its dogs after they show up-trends. These stocks tend to do better than the index during the recovery phase. If you wish to replicate the index, choose the top stocks (1/6 of total) and the bottom stocks (1/6) in the index. I place 50% of my portfolio in the VCU sector. I expect that these sectors will be commodity related in the 2007-2008 period. Although I will only invest in those sectors if the USD starts to show weakness and there is negative real rates in the US.
With 50% in VCU, I keep the other 50% in treasury bonds of the highest real rate currency. Some of this bond portfolio may be invested in GLD if the major currencies EUR and USD fall to negative real rates. Up-trend means the chart shows some sign of life. Strip the chart to its bare minimum and look at it over the past 3-5 years. Ideally you want a 3-6 month breakout. At the beginning of a bull market, charts are more reliable in showing an up-trend. %change is also a good indicator. They aren't very useful at the end of the bull market as price swings are large/wild.
Alternate Strategy - Permanent Portfolio
As investors, we have to admit that quite often the simplest approach works best. It's hard to realize sometimes that all the effort put into analysis can go for naught.
Taking a simple method, why not construct a permanent portfolio consisting of the best investments in the two environments of debt deflation and hyperinflation? If a black swan occurs in either direction, you are covered.
The proportion is according to your risk tolerance. GLD is more volatile than bonds about 3:1.
75% US Bonds 30 year or TLT if you don't want to purchase bonds (Best Investment in a Deflation)
25% GLD (Best Investment in a Hyperinflation)
Why US Bonds? In a deflation, Americans will consume less and shrink their trade deficit. They will also favour local producers again shrinking their deficit. These events will be bullish to the USD.
GLD is a stock proxy for gold. You can always buy the real stuff instead. If the stock market were to shut down as it did in 1914 for 6 months, the pure stuff would obviously do much better.
OR
This strategy pays interest on both deflation and inflation protected components.
50% TLT (gov't long bond )
50% TIP (gov't inflation protected)
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