Sunday, September 28, 2008

A smart investor is informed about the investment and the economy: Don't just take Business Week's word for it

I was reading Business week this week – ha ha, no pun intended – and came across the type of article that drives me absolutely bazonkers! Safe Investing in a Troubled Economy was published on September 25, 2008 (free access, but you must register) and lists the types of assets that the average investor should be looking at in times of economic stress.
“Places to stash cash and hedge against risks like inflation and a weak dollar range from plain-vanilla Treasuries to certificates of deposit denominated in euros. All of the options below rely on the backing of the U.S. government rather than private-sector promises.”
RW: Why these types of articles drive me crazy is that the investment advice is laid out without any regard to the economics that underscore the rationale for purchasing each investment. For example, why would I want to hedge against a weak dollar (in the article, using currency hedges)?

As of 9/26/08, the U.S. dollar was 1.46 against the euro and 1.84 against the pound and trading above its 100-day averages of 1.52 and 1.92, respectively. Further, the U.S. dollar has held up quite nicely throughout September (the peak of the banking crisis), trading down when Lehman filed for bankruptcy, but up following Paulson’s and Bernanke’s testimonies to Congress.

What does this tell me? Longer term, the dollar is weak, but has gained some value on the economy’s resilience. Shorter-term, markets believe that Congress is nearing an agreement on the Troubled Asset Relief Program (TARP), which MAY (and I stress may) stabilize the financial system. What the markets obviously haven’t priced in yet, and certainly will if the bill is passed, is that TARP will cost big bucks and cause big deficits (see this post that cites the IMF article that posits that deficits rise substantially net of returns in response to banking crises), and foreign exchange markets don’t like either.

Chris Farrell, the author of the Business Week article, gives the following investing tips for the current economic backdrop (whatever that is because he doesn’t mention the state of the economy except in passing):

1) Short-term Treasury securities: “The allure of safety was so strong late in the week of Sept. 15 that the yield on the three-month T-bill went negative at one point.”

RW: I love how he really thinks that the average person is going to run out and buy a 3-month T bill on the open market. Or for that matter, that he/she even can. The yield on a 3-month T bill was negative because there was NO supply on the secondary market! Am I to understand that I could actually go out there and find a T bill to buy if Bank of America could not? If you want safety, buy into a money market fund backed by Treasuries, which Chris fails to mention. Hit Fidelity, or something similar, and they’ll help you out.

He goes on to say that one should not jump for the 10-yr or 30-yr Treasury bonds – both have a much higher yield due to their longer maturity lengths – because the record 5.1% annual inflation rate; the real return is less than zero. This is true, but one is not required to hold these bonds to maturity. Again, buy into a fund, and the manager will buy and sell the bonds as the price (yield) fluctuates to maximize the portfolio’s return. You will pay fees, but that sure beats trying to do this on your own.

2) Treasury Inflation-Protected Securities (TIPS) “The fear over rising prices is why more investors are flocking to U.S. Treasury Inflation-Protected Securities (TIPS).”… “TIPS offer a "deflation floor" that protects principal value if the fear of falling asset values turns into a deflationary episode.”

RW: Unless you really believe that a period of high inflation is in the pipeline, then TIPS really isn’t the way to go. However, TIPS is one of the only assets that yielded a positive real return (the nominal yield minus inflation) over the first half of 2008. If you had it then, that was a great investment! But going forward, it depends on how you think prices will move.

Inflation has abated over the second half of 2008, and will likely continue through 2009. Therefore, TIPS may not be the best way to go because you give up a lot to hedge against the risk of inflation. First, the yield is lower, but that is a real return. Over the last 100 days, the average yield on a 10-yr newly issued T bond is 2.3% higher than its inflation-adjusted (TIPS) counterpart, but the TIPS yield is real and the T bond is nominal. Second (and as Farrell states in his article), you pay taxes on both the yield net of the inflation adjustments. However, if you must buy TIPS, purchase shares of a mutual fund that holds TIPS since, as with the T bills/bonds, you will likely not be buying TIPS on the open market yourself.

And by the way, I would like to remind you that the U.S. has not experienced deflation since the great depression. I assure you that the Federal Reserve Bank is much more conditioned to act to promote price stabilization than it was in 1933. The Fed will do everything in its power to avoid deflation, including pawning an anti-deflationary scheme off onto taxpayers in the amount of $700 billion, which consequently, is much more likely to cause inflation rather than deflation. Deflation is a disaster scenario, one that I’m not willing to bet on right now.

3) I Bonds – don’t know much about this one, so I won’t address it.
4) Money Market Mutual Funds – this type of mutual fund is usually backed by short-term commercial paper. If you want a good article about the specifics of the money market, see the Wall Street Journal last week (if you don’t have access to the article, email me, and I will make sure that you do). The article details why this short-term source of funding, worth roughly $3.4 trillion, is so important in the following illustration:

Source: Wall Street Journal

I get really annoyed when reporters are flat-out wrong. According to Farrell (on September 25),

"Nearly $200 billion cascaded out of money funds before stopping on Sept. 18 when the Treasury Dept. put the full faith and credit of the U.S. taxpayer behind the implicit 'don't-break-the-buck' pledge at money funds. The principal value of money-market funds—including tax-exempt ones—is now guaranteed.”

RW: Yes, there was a run on money market funds. Yes, there was an announcement on Friday (09/19/08) that the Treasury will insure money market funds for a year, but that term length was repealed on Sunday (09/21/08). Now, the Treasury provides “coverage to shareholders for amounts held by them in such funds as of the close of business on September 19, 2008.” I hope that his readers did not run out and purchase shares in a non-insured money market fund thinking that it was insured.

5) Bank Savings Accounts – “Investors can earn a good yield and enjoy FDIC safety at online banks. At ING Direct (ING), for instance, a savings account pays 3% and a 12-month CD, 4%. No one with an account of $100,000 or less has lost a penny from a bank failure since the government's insurance fund was created in 1933.”

RW: Why in the heck is this listed on the second page of the article (you have to click on a link to get there)? Putting your money in a fully insured bank account (up to $100,000) is by far the safest way to go, especially in a banking crisis. It is easy to set up, totally insured, and the return is reasonable (around 3% for the online-only saving account, but adjusts according to short-term rates).

My Conclusions

People tend to get very risk averse when the uncertainty surrounding the state of the economy rises, so if you must be ultra safe, I would suggest the fully insured by the FDIC CD or online saving account (there is more information here). However, if you are a little more daring (my husband will not let me be, but he did buy Goldman), there are a lot of bargains out there in real estate, equities, and even high-yield corporate debt. The potential gains are much higher, but alas, the risk is, too. See this article at the Bubble Meter, Why You Should Probably Invest in Stocks Now.

Does anyone have investing advice for our readers?

Rebecca Wilder


  1. Thanks for the warning about insuance in Money Market funds not for funds after 9/19/08!! We also agree that CDs under $100,000 are the way to go for the present. Until things settle down, I don't think it is wise to invest any substantial money in anything else. Wait and see where this whole thing is headed. When the market goes up and down to the tune of 300 - 500 DJ points every day, you are gambling no matter which way you go.

  2. ps: the bargains will be there later and you will have greater piece of mind..