Investing: Bad News, Good News, and What’s Next

The manic depressive market wildly swings up and down on each new news story: The Fed is meeting at Jackson Hole possibly to discuss QE3 (or not), and that news may pump up the stock market. But China’s banks seem to be using Enron’s accounting manual, Europe’s banks need liquidity and are loaded with bad debt, and U.S. banks only temporarily TARPed over trouble. Gaddafi’s regime in Libya appears over, but Libya’s oil output may not fully recover for years. Venezuela wants banks to open their vaults and send back its gold, but Wells Fargo says gold is a bubble. Pundits say gold is a barbarous relic, but exchanges and banks are now using gold as money. The U.S. is headed for hyperinflation with skyrocketing stock prices, but on the other hand, we seem to be deflating like Japan and doomed to a deflating stock market for another decade. Whom do you trust and what should you do?

No one knows where the stock market or U.S. Treasury bonds are headed tomorrow, but in my opinion, here are some fundamentals to consider.

The Bad News Isn’t Going Away

Until we have real global financial reform and restrain the banks, we won’t have sustained growth. The stock market hasn’t hit bottom. There’s a crisis of confidence in banks and all currencies. We haven’t taken effective steps to tackle the U.S. deficit through productivity. We haven’t examined spending to eliminate fraud and waste, and we haven’t addressed our need for more tax revenues by eliminating the Bush tax cuts (for starters).

Savers are punished by “stranguflation:” negative real returns on “safe” assets, declining housing prices, and rising costs of food, energy and health care. The Fed touts the falling cost of I-Pads, but how often do you buy one of those, and how often do you eat?

Good News (for Now)

The USD is still the world’s reserve currency. Even though we devalued the USD, there has been a global flight to US Treasuries pushing down our borrowing costs (yields). No one in the global financial community feels the U.S. has done its best to correct our problems, but severe problems in Europe, China’s inflation, and Middle East unrest has money running to the U.S. Since we’ve devalued the dollar, we appear to be a bargain for foreign investors, even though they are terrified by our money printing presses and the potential for inflating commodity prices in the long run.

How did I play this? My own portfolio is currently more than 20% gold with some silver, and I bought out-of-the-money call options on the VIX when it was in the teens with maturities of 4-6 months. This is “short” stock market strategy, one could have also done well buying puts on the S&P a few months ago. In the first big stock market downdraft in August, I sold the options when the VIX hit the high 30’s, and I’ll buy more options again if the VIX falls again. Many investors are not comfortable with options, and this strategy isn’t appropriate for everyone. The rest of my portfolio is chiefly in cash or deep value opportunities.

What Happens Next?

No one knows for sure, and anyone who tells you he or she does is selling snake oil. The situation is fluid. We tried to reflate our deflating economy. Our massive dollar devaluation may encourage investment, because it’s protectionist. It reduces our cost of labor, among a few other “benefits.” The problem is that the Fed has printed money, and we haven’t done anything to position the U.S. for greater productivity. We’re trying to inflate our way out of a problem without investing in productivity. This is a very dangerous way of attacking this problem. Even more “stimulus” would just be an attempt to inflate our way out of our long-standing deep recession. That’s the foolish and unsuccessful strategy we’ve adopted so far. That could lead to runaway budget deficits (our deficit already looks intractable) and bring us to double-digit inflation. Even the European flight to US Treasuries may not save us from a deeper recession in that scenario.

If we don’t overreact—and we may have already overreacted—our dollar devaluation results in our foreign trade situation first getting worse (as it has now) before it gets better. Now is the time (actually, we should have started years ago) to spend capital to increase U.S. productivity. The dollar’s plunge relative to other currencies will eventually make us more competitive. This will be good for blue chip companies, in particular those that own real assets and manufacture items. The Fed and Washington may do anything, however, so one must watch the news.

What does this mean for the U.S. stock market? In my opinion, it is currently not good value and feels like the 1970’s when we experienced a recession followed by inflation. One should consider staying mostly in cash and expect stocks become cheaper. One might miss an interim rally, especially if the Fed announces QE3 (more “stimulus” and money printing or more bank bailouts, but that is like using Kleenex laced with sneezing powder. We will see stock prices even lower than they are today. The old paradigm dictated that stocks were a buy when P/E ratios were 13 or less (and many are well above that), dividends at 4%, and book values at 1.3 or less. (This excludes oil companies which tend to trade at lower P/E ratios in general.) I believe we’ll see much better deals in coming months. In 1978/79 P/E ratios sank below 7 for blue chip companies.

Should one buy U.S. Treasuries with long maturities? The long end of the bond market doesn’t reward investors due to the potential of rising interest rates. If interest rates spike to double digits, then one can reassess the situation.

Long term investors should consider buying commodities or companies that own physical commodities. We’re running out of key commodities especially related to agriculture and fertilizer. Washington’s brand of the latter isn’t the type we need.

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago’s Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).
About Janet Tavakoli 34 Articles

Affiliation: Tavakoli Structured Finance, Inc.

Janet Tavakoli is the founder and president of Tavakoli Structured Finance, Inc. (TSF), a Chicago based consulting firm providing expert experience and knowledge about maximizing value in the capital markets in the face of complexity and uncertainty. TSF provides consulting services to financial institutions, institutional investors, and hedge funds.

Ms. Tavakoli was years ahead of the financial industry predicting lax underwriting and misrating of structured financial products would result in the collapse of the global credit bubble. She also predicted the collapse of the thrift industry, Long Term Capital Management, and First Alliance Mortgage prompting Business Week to profile her as "The Cassandra of Credit Derivatives." [2008].

Ms. Tavakoli pointed out grave flaws in the methodology for rating structured financial products in her books, Structured Finance & Collateralized Debt Obligations (2003, 2008), and Credit Derivatives (1998, 2001). She wrote the first letter the SEC posted in February 2007 in response to its proposed rules for the credit rating agencies; she made the case that the NRSRO designation for the rating agencies should be revoked for structured financial products.

Ms. Tavakoli is frequently published and quoted in financial journals including The Wall Street Journal, The Financial Times, Business Week, Fortune, Global Risk Review, RISK, IDD, Chicago Tribune, Los Angeles Times, LIPPER HedgeWorld, Asset Securitization Report, Journal of Structured Finance, Investor Dealers' Digest, International Securitization Report, Bloomberg News, Bloomberg Magazine, Credit, Derivatives Week,, Finance World, and others.

Frequent television appearances include CNN, CNBC, BNN, CBS Evening News, Bloomberg TV, First Business Morning News, Fox, ABC, and BBC.

Tavakoli is a former adjunct associate professor of finance at Chicago Booth (the University of Chicago's Graduate School of Business) where she taught "Derivatives: Futures, Forwards, Options and Swaps".

Janet Tavakoli is the former Executive Director, Head of Financial Engineering in the Global Financial Markets Division at Westdeutsche Landesbank in London. She headed market risk management for the capital markets group for Bank One in Chicago. Tavakoli headed the asset swap trading desk at Merrill Lynch in New York, headed mortgage backed securities marketing for Merrill Lynch in New York, and headed mortgage backed securities marketing to Japanese clients for PaineWebber in New York. She also worked for Bear Stearns heading marketing for quantitative research.

She is the author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008), and Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (Wiley, 2009).

During her career, she has been registered and licensed with the SFA, NASD, ASE, CBOE, NYSE, PSE and the NFA and has passed the series 7, 63 and 3 qualifying exams.

Ms. Tavakoli has a B.S. in Chemical Engineering from Illinois Institute of Technology and an MBA in Finance from University of Chicago Graduate School of Business.

Visit: Tavakoli Structured Finance

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