About a year ago I wrote an article on derivatives based on a presentation by Satyajit Das. Patrick Cooney, CEO of Jory Capital in Winnipeg, found Das and his book Traders, Guns and Money, and brought him to Winnipeg one cold winter day early in 2008. I heard him twice that week and wrote an article on his discussion for you early last winter. (See page 45 of the March 3, 2008 Grainews.) I can e-mail it to you if you would like to read it again or for the first time.
Das said at the time that there were trillions, hundreds of trillions, of dollars of derivatives floating around the globe that were not backed by realistically priced assets. In other words many investors had investments that weren’t worth anything close to their original value and many lenders had lent out money using as collateral assets that weren’t worth anything close to the loans they were used for.
At that time the global economy was estimated to be around $53-$55 trillion and there was something like $800 trillion of these loans/assets floating around the world.
The whole thing started when banks asked the regulators of securities if they could change their business model from banks which could lend $8 to $10 for each dollar on deposit to “investment houses” which could lend $30 to $40 for each dollar on deposit. Permission was granted. Then the investment houses issued derivatives or options on those $30 to $1 loans so they actually had about $900 outstanding for each $1 on deposit.
Das also predicted that billions or trillions of those derivatives would have to be devalued or revalued down, down, down and as that happened lenders would have to write down loans, which would reduce their capital base so they would either have to raise capital by selling more shares, or selling parts of their business or be shut down because they did not meet the capitalization rules.
In 2008 all of the above has happened.
THIS IS NOT OVER
At a recent seminar that Jory Capital held in Winnipeg, Patrick Cooney discussed the derivatives still floating around in financial cyberspace. He estimates there is somewhere up to $700 trillion still out there. And the global economy has shrunk to around $50 trillion.
Even if only one per cent of those derivatives turn out to be bad, it means up to $7 trillion still has to be settled, paid off, rationalized, you pick the word, by an economy that is shrinking.
That’s over 10 per cent of the economy. That’s bad news. Worse yet, the $7 trillion that has to be written off will produce no financial benefit to anyone. It will be a total loss, a total writeoff of worthless, non-income-earning assets. Lenders who need to or want to keep up their capitalization margins will need to raise money from some other rich dude, take the loss out of earnings, reduce spending by cutting dividends, borrow from the U. S. government and sell more shares on the market, which will dilute earnings.
That is asking a lot of an economy that is $50 trillion and shrinking.
CHINA GOES SHOPPING
Now consider this: China holds about $2 trillion U. S. dollars. Treasury bills in the U. S. were earning zero interest at the end of 2008. It’s only a matter of time before China and other holders of U. S. dollars start to dump those dollars and buy other assets. That means the U. S. dollar has to drop due to the country’s weak economy. Finally, central banks around the world have brought interest rates down to or close to zero. In other words, monetary policies have pretty well run out of room.
Tours are being lined up to bring wealthy Chinese people to the U. S. to buy houses and other real estate. Word has it that China wants to buy 4,000 tonnes, yes tonnes, of gold worth about $95 billion when gold was around $800 per ounce. Money from China already is buying shares in uranium companies and I wouldn’t be surprised if Chinese money is buying shares in our oil and gas industries. They don’t seem to want to buy our farmland, maybe because it’s just too darn cold here and we only grow one crop per year.
The U. S. dollar has to drop as the U. S. economy slips into a deeper recession. The U. S. government under Obama already is promising to spend whatever it needs to get the economy going again. That will take a few months at least so we’re looking at the middle of 2009 or later. And I would think as the U. S. pumps out money, for a while the economic statistics will still be getting worse, which should or could or will get Obama to just spend more money.
THE 4 SCENARIOS
I personally think one of four things will happen in the years ahead. One is that the economy stays sluggish like a big L. It came down and then stays flat lined maybe for years. Second, it could improve slowly, which would be ideal and would give the administration time to prevent any massive inflation problems. Third, the economy takes off, and inflation becomes a real problem and then the U. S. and perhaps the whole world will need to slam the brakes on the global economy. Or fourth, the administration could let inflation run so the economy grows to say $70 trillion, reducing the ratio of bad debt.
Given these four financial pictures, what is the correct investment strategy to follow? Let’s look at each one by one.
If you think the economy is going to stay sluggish, then there likely isn’t much hope for most stocks. Then I would suggest we learn how to sell covered calls on a select group of stocks but the premiums could be quite small compared to premiums now because flat stocks don’t attract high premiums. But if the economy stays flat, many companies will cut dividends so really nothing much is safe.
If you think the economy is going to recover, then it would seem a balanced portfolio would be the way to go. That balanced investment strategy has worked for years for many and if the economy recovers slowly it might work in the years ahead.
If you think the economy is going to suddenly rise from the ground then we will have shortages of most resources because many mines, oil wells, and factories will be shut down before the economy rebounds. The economy would likely face sudden inflation so for a while we could own resource stocks and maybe make a “killing.”
If you think inflation will be allowed to run, then for sure owning resources and resource stocks would likely be the right choice.
I think the successful investment strategy for the next few (maybe many) years will be some combination of a couple of the scenarios. I personally will look for (and we likely already have some of these) stocks that are leaders in their business that I can buy on the cheap side and sell covered calls on them going forward. Something like 2,200 companies in the U. S. have more cash on account than their shares are worth on the stock market. Some of these may cut dividends because the yield is so far above normal that there would be room to cut. Some won’t cut dividends because they respect shareholders and have the money. Companies that provide NEEDS not WANTS likely fit that line of thinking.
Then I will use the rifle approach and buy shares in resource companies which include gold, silver, oil, eventually other metals and companies that will build infrastructure. If we can buy Canadian bank shares cheap enough, we might but they would have to be a bargain.
I have figured out how to make money four ways from one good stock. These are collecting dividends, managing covered calls so we collect premiums, capital gain, and on select stocks I will sell puts to bring in more cash. Most people cannot sell puts so don’t even think about it unless you’re an experienced investor.
I also will track the MACD on stocks we own. That indicator brings to us a picture of what big money is doing with a stock. Yes, I know I beat the bear by selling covered calls on stocks but that needs good timing and skill. It’s a lot more comfortable to own stocks with rising MACD than it is to own stocks with a falling MACD.
We might not sell stocks where the MACD has flattened on top and started to drop but we certainly would manage them differently than stocks with a rising MACD. I discuss all this stuff in great detail in my newsletter StocksTalk.
DO YOU NEED MORE CASH OR NET WORTH?
Quite honestly, in years to come it might be a lot harder to build net worth from stocks in the old traditional way. Returns from stocks usually come back to the mean. In the ‘90s stocks made 20 per cent. In this decade they made 10 per cent until 2008 when they lost 40 per cent.
The bear market of 2008 has whipped investors and brought many stocks down to their 2003 values. So this whole bull market has been erased except for money from a select group of stocks and dividends. Sadly anyone who averaged up as the years went by or didn’t get into the market until late in the bull market likely has seen his or her equity drop.
Even if returns from stocks reach the old 11 per cent per year, most investors are five years older, most have lost five years of growth and most are scared.
PetroCan stock is below its price of 2003, but Imperial Oil is up and so are many other energy stocks. Deere is flat and so are many other industrials. Utilities such as Fortis are up nicely and have paid a nice dividend. And Canadian banks are lucky to be flat, but they have paid a nice dividend. So I personally will own a basket of what I think will be good stocks for the economy I see coming. I will be selling covered calls on most of my stocks, but I will manage them so I collect capital gain on the rising stocks. The slow-growing stocks will offer a nice premium from covered calls, with little work. The faster-rising stocks will offer excellent premiums but we will have to work with them a bit so we don’t limit capital gain. And I won’t expect much from any financial stocks for a while but they might bring in nice premiums from selling covered calls.
Andy lives in Winnipeg. He manages his investments, plays with his granddaughter, does tax returns and publishes an investment newsletter called StocksTalk. And he spends quite a bit of time teaching his readers where to find information on how to sell covered calls. If you want to read StocksTalk free for a month send an email to [email protected]