At the end of each year I take some time out to assess how my investments are performing and make some changes based on the latest outlook. Writing this down helps me understand what I did right and wrong and see if the arguments for new investment positions ring true. In the past I've exchanged these opinion pieces via email with friends who also invest, but this year I thought I'll blog it so everyone can see each other's comments. Most of the ideas below are derived from friends and well known investors such as Jim Rogers, Barry Rithotz, and others. Check out Barry's blog for a great source of data.
This year has been full of some well anticipated drama in the financial and housing sectors. I began shorting builder stocks in late 2005, building supply in 2006, and financials in early 2007. I was too early on the builder stocks and experienced a good deal of pain initially - most of these positions hit the stop losses I put in place on all shorts and the positions were undone. In 2006 I put in place a new set of builder shorts, this time concentrating on the weaker builders - those with poor momentum, profitability and high debt such as SPF. This worked out well because the weaker builders didn't rise with the pack and started their decline early. The two main building related shorts I put in place declined 80% and 50% respectively. Unfortunately I didn't replicate the size of the initial position. The lesson is that I need to increase the size of my positions generally, particularly when the outcome is so certain. I've found that I'm usually right about the long term direction of macroeconomic outcomes but usually early on the timing. To actually make substantive money shorting, this means I need to wait until both the sector and the stocks themselves are in decline before shorting. Since its hard to spot a trend in the first few weeks, I have to expect to place the bet several times after being undone by a stop loss without losing confidence and decreasing the size of the position. In fact I need to do the opposite - increase the size of the position with time as with time I know I'm closer to the expected outcome. Nothing new here - this short technique is well covered in the 1923 classic Reminiscences of a Stock Operator by Edwin Lefevre.
My long positions have done somewhat better. The energy and emerging market positions I took in the last few years did really well. Some of the best were Eastern Europe fund EUROX, Indian banks IBN and HDB (thanks to Gary Bhatia for those picks), Indian fund IIF, and in energy XOM and KMP. I was underexposed to China - my one China related fund WBIGX returned 23% annually over the last 5 years but underperformed the Chinese indexes substantially. Given how predictably poor the performance of US stock markets has been over the last years relative to most international markets, I should have taken larger international positions and reduced the size of my US long positions.
In late 2004 I put a good deal of money into the Yen and the Japanese Nikkie Index on the theory that the fundamentals in Japan were turning around after a 20 year slump. This investment did well for about a year and then flatlined. Some of the fundamentals still look good - the financial sector is deregulating, Toyota, Honda, and others are doing well, and the saving rate is so high that a slight shift in domestic sentiment in favor of stocks could easily double the market there. Most Japanese savings are in cash and government bonds earning very low yields. On the negative side, the population is much older than emerging markets and continues to get older, which can preclude aggressive investment. What's lacking is the "animal spirits" to revive domestic interest in the market - it may take another 5-10 years before a new generation that doesn't remember the debacle of 1992-2000 takes over. I'm interested in what you guys think on this one - I may be early, or just wrong.
Long Term Outlook (10 years)
Viewed both from a fundamental and a technical standpoint, I believe the outlook for most US based asset classes (stock, bond, residential real estate) is bleak and rapidly worsening. The dollar is dramatically overvalued given our gigantic current account deficits. Foreign governments control the US exchange rate, and they are slowly but surely diversifying away from the dollar. The dollar is in the middle of a multi year decline against virtually all other currencies, so this is merely an observation of well established trend. In a recent Bloomberg interview, Jim Rogers who made a bundle predicting earlier currency and commodity trends, said he is moving all his assets out of the US dollar into yen, renminbi and swiss francs. To quote "The US dollar is and has been the world's reserve currency. That's in the process of changing. The pound sterling, which used to be the world's reserve currency, lost 80% of its value as it went through the process of losing its status as the world's reserve currency." Rogers expects the renminbi to triple or quadruple over the next decade.
The historical engine of US growth - government investment in academia and places like Bell Labs, has lagged GDP growth and real inflation over the last 15 years. Note that in the link, official BLS inflation figures are used to compute constant dollar outlay. As discussed elsewhere in this post, these numbers significantly understate real inflation. Many people assume this slack will be taken up by private investors like VCs, but if you've ever raised money for a startup you know that VCs don't knowingly invest in anything that has a payout of longer than 5 years. Most technologies have payouts in the 10-20 year range. If you took a look at where the innovation is happening in key fields like software, biotech, and energy most of it was US based 10 years ago, now I'd say more than half is outside the US. Silicon Valley remains the best place in the world for productizing technology but its only a matter of time before other parts of the world build the investment infrastructure to replicate it.
US based assets like residential real estate and stocks are overvalued when compared to fundamentals and international comparables. In hot markets, the full cost buying a house is almost double the cost of renting one, and home ownership rates are well above historical averages. We now know why this occurred - lose lending standards and investment driven buying. Both these underlying causes have reversed themselves.
Looking at stocks, P/Es for US stocks may seem low compared to Chinese or Indian stocks. China and India together have population about 6x that of the US. Yes they're mostly poor, but that's changing fast - if only 30% of their population moves into the middle class they will each equal the whole population of the US. In the next 10-20 years we should expect that each of these economies by themselves will be bigger in GDP terms than the US. This may seem like a shocking prediction, but if we compare China to say Taiwan, Korea, or Japan of 1946 there are many similarities - an educated and motivated population, a government committed to building economic advantage, and lots of cheap labor. Those economies grew several thousand percent in GDP and stock index terms in 20 years. The difference is that China has 10x the population of the current #2 GDP country - Japan. So most Chinese and Indian stocks should be viewed as growth stocks, with 1000%+ growth likely over the next decades. Taking up the issue of comparative P/E again, when evaluating a growth stock, P/E is largely irrelevant. PEG, Sales growth, competitive advantage, and size of market are better indicators. Throw in the likelyhood of a 20% or more dollar decline over the next few years and there's no likely scenario where US stock indices outperform China or Indian stock indices over the next 20 years. All the verbiage above is just reason to expect the trend over the last 5 years to continue - see this chart at the bottom of the page to compare what various international sectors have done.
Looking at US bonds, the decision is even easier - who wants to get a 5-10% return in a currency that is declining and an inflation rate that is well above the yield? For those of you that believe that inflation is low, read this - the CPI numbers you hear about in the news are just plain wrong. Its tough to get an accurate number since the government misreports it, but just think about how much the major components of what you buy - housing, gas, food have gone up and its easy to see that holding a bond at 6% is losing money, even before you factor in the likelyhood of higher future inflation and thus a decline in the price of the bond.
Based on the above, I've sold most of my US based stock and all my bond investments in favor of investing primarily in stocks and currencies in China, India, Brazil, and Eastern Europe. I'm holding the stocks and funds listed earlier and waiting for a dip before loading up on more Chinese and Indian investments. When the dip occurs, I'm considering financial sector investments in these countries that benefit from protectionism and gain from overall GDP growth. China Life (LFC), a major insurer is one idea, I'm looking for more. The recent concentration of miners in the commodities markets also make for monopoly profit potential - BHP and Rio Tinto. I'd also like to find some good agricultural commodity plays, but haven't found any yet - let me know if you have any ideas. There's RJA but its not very liquid. I will also buy into the major indexes of each country when the dip occurs using ETFs.
In addition to the now well known Chinese and Indian growth stories, there are other smaller and riskier countries whose indexes have gotten hot recently - Vietnam, Turkey, Saudi Arabia, etc. Several of these smaller markets have experience big run ups in the last year. I'm less optimistic about the long term prospects for these markets because they lack the vast supply of cheap labor and economies of scale that can accrue to large economies. However since some of them are rising from tiny bases, there may be some good short term opportunities among them. Frankly I just don't know enough to warrant placing any bets. Any ideas readers?
The few US based long positions I hold are stocks that do well in high inflation environments, have big technology advantages, have substantial foreign revenue, and/or gain with commodity prices. XOM, GOOG, Apple, and KMP fit the bill.
Near Term Outlook (1 year)
Volatility can be your friend or your enemy. Many US based investment pundits still position emerging market stocks as risky investments. From the above you can probably see that in the long term, I think US based stocks are much more risky. The volatility of Chinese and Indian stocks is what you want to get big gains. However in the short term, 10% daily swings in price can be unnerving. For money you want to use for other purposes inside of 7-10 years, the hot markets of India and China are risky. I have a bucket of money, about half my portfolio in various tax exempt and foreign accounts that I have no plans to use before retirement, at least 20 years away. 100% of that is going into long positions in foreign markets and currencies. However the other half of my portfolio which I plan to use to buy a house in the next year is mostly in cash and US based short positions. Why? Because there's high likelyhood of a significant decline in global markets in the next year. The US is at the end of the typical 4 year investment cycle, and foreign markets have seen huge gains in the last few years - the probability of a pullback is increasing. If the US goes into recession there will be a mild global short term pullback, probably a good buying opportunity internationally.
So what about those shorts? The banks, the builders, the building suppliers, the mortgage bankers have all seen dramatic declines already. I've closed out shorts on SPF, RSTO, and CFC after 50-80% declines. I'm considering shorting Citi and maybe some of the mortgage insurers, even though they are all well down already. The bet is that the housing market will continue to decline (likely) and there are some real bankruptcy potentials for the financials that have big exposure (less likely but possible). A better bet might be to identify areas that are lagging correlates to housing, like consumer retail spending, but I haven't had a chance to determine what the best areas are. Any ideas would be appreciated.
An area I'm currently shorting is the NASDAQ. In past US downturns we've seen the NASDAQ take a big hit, because corporate technology purchases are partially discretionary spending, and partly due to P/E compression on the many high tech story stocks. This time the NASDAQ is less overheated than last time, however the contraction in spending will still occur. There's also another force at work that may damage the major tech companies like Oracle, Microsoft, NTAP, EMC, IBM and others. That force is open source software and a new architecture for web based software. A survey I recently completed of 30 top Web companies like Google and Facebook shows that web companies have largely abandoned the hardware and software sold by the US tech majors in favor of internally built software based on open source software and commodity hardware. In addition, I'm seeing the leading edge of small business - startups - begin to adopt web based software instead of Microsoft's desktop and server software - think Google (and Yahoo) apps for small business. For the last few months I've been using Google Apps for small biz side by side with Microsoft's latest desktop apps and OS and find that the Google stuff is dramatically superior in most respects. Eventually this new architecture will spill over the early adopter parts in the enterprise, cutting off the major's primary source of profits. A recession just might be the trigger to force a architecture reevaluation, particularly in the hard hit banking/investment sector that have been tech early adopters.
I'm looking forward to hearing what you think.