Quick tactical note of how I see things panning out in the US.
Having been an options trader and having invested for a while, I have a healthy appreciation and fear of the path of an investment’s returns. AIPC which was a great investment for me by any measure promptly lost half its value before eventually assuming a path that would result in it’s being purchased for over 6 times my first buy print on the stock. Great return, tricky path. At one point the “investment” showed a -50% return. Sticking with it yielded an awesome IRR.
Which brings me to the first half subject of this note…. Do we invest thinking that this is a deflationary envrionement (forget equities and stick to fixed income) or an inflationary environment (the opposite)? Indeed, I find valid arguments from both the deflationists and the inflationists and believe both are right. How is this possible? I suspect that we will have relatively bad deflation in the US before the currency finally weakens and then leads to inflation.
Why won’t we have inflation in the short term? The quick answer is that it would solve too many problems and make life too easy. Following the principal of maximum pain, then this scenario is unlikely. What problems would inflation solve? While I am worried about the budget deficit of the US, I think there are bigger problems in the short term with the various public pensions and entitlements – social security, medicare, state and local workers – as well as a debt overhang from the housing bubble with its associated overhang on banks balance sheets. In short everyone would benefit in a situation where pensions, benefits, and debt obligations are held constant in nominal terms while we experienced a large dose of inflation. The debt load would be alleviated, and everything would strengthen.
But isn’t the US operating like Zimbabwe, you might ask? Isn’t hyperinfation just around the corner due to a currency collapse? In short no. Zimbabwe had a number of things against it. First is that the state actively destroyed production capacity by breaking up and redistributing productive farmland. Second is that it was a small component of the global export market so its sudden competitiveness due to a currency devaluation would not be noticed. Third is that there was little history of rule of law. Forth is that it has no military. Fifth is that it has a limited population base and what it does have is limited in terms of global competitiveness. There are more, but you get the idea. The US, with a currency collapse, would suddenly become a force to be reckoned with. It was once a manufacturing powerhouse, and that can indeed return with the right forces. Furthermore, all its debts are local currency denominated. Yes the US is extremely dependent on oil and would suffer greatly in the short term with a currency crash, but it’s also resilient and would eventually adapt and compete. So bottom line is that while that may eventually happen, it’s just too convenient to happen in the very short term.
So what is likely in the short term? Deflation. The exact opposite of all of the above. Possibly with global competitive currency debasement leading to very little relative devaluation perhaps. States and local municipalities finding ways to cut pensions or perhaps even worse raising taxes on others to continue paying pensions. Either way someone is going to lose purchasing power. Same deal with entitlement programs. It doesn’t look good.
This brings me to the second half of the subject. In an environment like this, where you expect things to continue to deteriorate, there are no great passive investment returns to be made. Shorting (an inherently levered strategy) will get you killed in the long term as the market experiences increased volatility and periodic rallies for whatever sane or insane reason. In the meantime the general trend will be down. To get a feel for what this looks like, look at the graph of SDS: UltraShort S&P500 ProShares (SDS) via wikiinvest:
Flash Player 9 or higher is required to view the chart Click here to download Flash Player nowYou got the direction right but still lost money. So what’s the answer? It’s actually not so surprising or depressing. The best thing to invest in when faced with these issues is in whatever is real that you can do to keep employed, keep relavent, and keep producing something of value (which should be rewarded with money if the product is in demand).
With declining per-capita productivity (which is what you get with increasing unemployment), it’s not going to be easy. And I expect the returns for purely passive investments to decline – after all capacity utilization should decline in an environment like this, so what will “investing” pay? What investments are needed when there is steadily increasing capacity due to decline in demand? Bottom line is that it’s going to be tricky.
There’s always money to be made in dealing with short term capital crunches and by making markets where you are matching buyers and sellers, but it’s hard to make a living at that unless you are devoted to it full time. If that’s not your calling or edge, then find something that is your calling or edge that you can become an expert on and trade/get paid for other goods. Invest in yourself – your skills – and try to keep acquiring productive assets and growing your productive skill set.
This is the time for active investing – doing things like building businesses, streamlining production, and anticipating demand and meeting it.
Try not to lose money.
Arthur O’Keefe, São Paulo Value
