Brainwaves

"The brain is wider than the sky for, put them side by side, the one the other will contain, with ease, and you, beside." - A Poem by Emily Dickinson

Over years of study, three chemical messengers have been found to influence a human's attraction to or avoidance of risky investments.  Altering these chemicals in the body has profound impacts on an investor and their beliefs.  I have mentioned one of them in a previous blog and that is testosterone.  As traders win their testosterone levels rise and this then drives them into ever more risky investments.  Lower the testosterone level and the risk of the trade is reduced.  The relationship therefore is not that men are better traders than women, on the contrary often times the elevated testosterone levels are what gets a male trader in over his head while his female counterpart reduces risk and avoids a blow up.  This is a very wide brush I am using as I am not suggesting that females never get crushed, but it does show why often times it is better to avoid the trader that is on a "hot" streak as they are running higher than normal levels of testosterone and could be about to blow up.

The next chemical is oxytocin which predominantly affects females.  This is the chemical that elevates itself at the time of giving birth, deadening the pain of the birthing process, allowing the female to bond with the child.  This bond is highlighted using a life or death scenario where a runaway train can be sent down one of two tracks.  Track One has 5 people that would die should the train be sent down that track while Track Two has only one person in peril.  Pretty much everyone chooses Track Two until you are told that the one person is someone that you know.  At this point most people switch the train to Track One.  Oxytocin is the reason for this change and it can affect your investment decisions.  This herd mentality can link people to groups and can sway a rational analysis to an irrational one when "everyone" is buying a stock.

Take Apple for example, it was hard to sit on the sidelines when it carried on climbing above $600 but with the recent bloodletting that it has done, falling below $450 from over $700 it is clear that it was the correct decision.  It would have been doubly hard to sit on the sidelines if I worked at a large corporation where the cheer leading reached a fever pitch.  For this reason the most successful investor of all time Warren Buffet lives away from the crowd in Omaha.  Another great investor, Nassim Taleb prefers to spend his time reading books on philosophy and sitting in coffee shops that do not have a television.  Nassim bets on the only sure thing in the market - it will crash again.  The problem is that as humans we are wired to win regularly and his investment strategy loses often but wins big every now and then.  Listening to the cheer leading section of CNBC disrupts his trading discipline so he does his best to avoid being sucked in by the crowd.

The final chemical is serotonin which regulates levels of anxiety.  Changing the serotonin levels can dramatically affect investment decisions.  In a study players were given a sum of money and were told to split it with another player.  With normal levels of serotonin about half rejected an offer of less than 30% of the money even though to refuse the offer was to receive nothing.  Reducing the serotonin levels increased the levels of non-cooperation enormously as now more than 80% of players refused to accept less than 30% of the money.  Taking this a step further shows that there is a direct link between the serotonin levels and risk aversion.  The lower the level the higher the risk aversion and vice versa.  For the low level serotonin people risk averse investments trump high return but risky investments and the opposite is true.

The take away of all of these studies to me is that we have to ensure that whatever investment decisions we make are made based on rational analysis rather than an emotional response.  This flies in the face of going with your gut instinct which as we all know can serve us well on many occasions.  Outside of gut instinct however we are far better served by investing based on our own sound investment analysis rather than those of others.  Switching off the TV and doing your own investment analysis will serve you well.  In addition be aware that when you are on a roll that it may be time to pare back rather than press the accelerator harder.  And finally while you may not want to risk your investment dollars too much sometimes stretching the band a little will serve you well as long as you have performed sound investment analysis.  So while the world of investments tests us at the best of times we need to understand that we can be our own worst enemy.  This is why often times it is best to sleep on a problem rather than jump right in; particularly when the investment decision would be made based on an anonymous tip!

The Impact of the Low Interest Rate Environment

"And he's up there, what's that? Hawaiian noises? Bangin' on the bongos like a chimpanzee
That ain't workin' that's the way you do it, Get your money for nothin' get your chicks for free" - Lyrics from the Dire Straits song Money for Nothing

The low interest rate environment continues on and it is having a large impact on your portfolio and most of you do not know it is happening or understand why and those that do are hoping for an end to this soon.  It is no secret that this low interest rate environment is here for a long time to come so be prepared and look outside the box. 

The idea behind low interest rates is that it stimulates the economy for the simple reason that it entices people and business to take on debt (as the interest rate is low) and invest their savings.  Both of these stimulate industry and consumer demand which results in GDP growth and a buoyant economy. 

Now what happens if this does not work (as is the case right now)?  After the initial success of staving off the next depression the continued low interest rate environment is now taking a large bite out of your portfolio returns.  A low interest rate environment will at first benefit most in that it reduces the monthly payments on your credit cards and mortgage payments.  Businesses are able to borrow at cheaper rates leading to higher profits.  In addition, investors seeking return pile into the stock market in order to lock in good yields and to take advantage of stock price appreciation as companies benefit from increased earnings due to lower debt payments. 

In a simple example assuming that an investor has a choice between bonds and stocks.  As an aside when I read Bloomberg magazine a few weeks ago, other than cash these were apparently the only two options to investors!  And for most investors these are the only three options for your investment dollars (sad but true).  So back to the example, if interest rates are high then an investor should choose the bond for two reasons; the risk reward profile is probably skewed to the bond, and if history is any gauge, interest rates will fall at some point in the future and the bond price will appreciate.  So you earn a good coupon payment and capture bond price appreciation.  The asme happens in the stock market.  When interest rates drop, the investor shuns bonds and moves the money into stocks to take advantage of the higher yields and the earnings growth.

Essentially this is what has happened to date.  Bond prices went through the roof and bond yields collapsed.  The stock market rallied and has continued to rally ever since.  Looking forward however, interest rates will remain low for years to come so now where to turn?  As I have said repeatedly before we are in a very high risk investment environment.  Taking a look at Japan you can see that in an environment where interest rates remain low for a long time (two decades and counting) it is normally due to a weak economic environment.  In a weakened economic environment there is no requirement for the price of stocks to continue to the moon.  At some point people wake up and look toward the safe play, shunning stocks and this is what is happening now.

Every month more and more money pours into money market and bank deposits.  Safety is being sought but inflation is eroding their portfolio faster than they realize.  Essentially the Federal Reserve is taxing the prudent and forcing investors to make irrational bets.  This is the big risk.  Do not let the idle money burn a hole in your pocket .  There are plenty of good investments out there that do not require you to rush in sight unseen in order to try to elicit a return.  Furthermore while inflation is a portfolio killer it is slow.  Rather take a 5% hit through inflation than a 25% hit by making an irrational mistake.  Do not get caught up in the hype and expand your investment horizon beyond these two investment classes as that is where the returns are coming from now and for the foreseeable future.

Out of my way - we are Printing!

"Don't stop me now I'm having such a good time, I'm having a ball.  If you want to have a good time, just give me a call." - Lyrics from the Queen song Don't Stop Me Now

The Queen song really sums up the state of the mess that is the United States government.  The song continues on:

"I'm a rocket ship on my way to Mars
On a collision course
I am a satellite I'm out of control
I am a sex machine ready to reload
Like an atom bomb about to
Oh oh oh oh oh explode"

Well as we are up against the debt ceiling and congress has once again spent the last year kicking the can down the road there is no doubt that they will once again procrastinate until the last minute.  Then they will once again pull an all night session to show the American people how diligent they are being and will make a snap decision about something as important and complex as the debt ceiling and the rest of the "Fiscal Cliff" both of which were deferred for a few months during the last all night session.

 

In the interim the Treasury has once again (I say once again as it was floated in 2010) brought forth the thought that they can print money without waiting for congress to get its act together.  The idea as we all know is to print a Trillion dollar coin.  The coin would not be huge as it would not contain a trillion dollars worth of platinum but would just be a platinum coin with a one and twelve zeros printed on it signifying debt owed to it by the buyer, the Federal Reserve.

 

Let's look at this in a little more detail.  If it were backed by a trillion dollars of actual platinum it would be worth something, however with platinum at $1,650 dollars an ounce you would need to buy over 600 billion ounces.  The price of platinum would spike through the roof.  It is hard to even imagine where it would settle but looking at the total open interest in platinum futures shows around 3 million ounces traded on a given month.  As the Treasury would need 600 billion ounces or 200,000 times the market it is not inconceivable that platinum prices would shoot to around $350,000 an ounce! 

 

By the way this is why the gold standard held inflation in check.  You could not print money unless you had the underlying asset to back the money.  Taking it a step further if we now backed the whole $17 trillion of debt with say platinum the price would reach well over a million dollars an ounce.  While this is nonsensical it should put it into perspective just how much a trillion dollars is and the bad news is that this would just be a short term solution as the United States is going to run another trillion dollar deficit this year and the next and the next. 

 

At present this is manageable as interest rates are still exceptionally low.  As long as interest rates remain at these low levels the debt service costs will remain a small part of the overall budget, but at some point in time like the song says interest rates will explode however as I have argued this will be years from now.

 

The first point I want to make is that this is not just a US problem but a global problem.  Europe is nowhere near to repairing their problems, China, while slowing has shown some hope with their latest economic data but these numbers always need to be discounted particularly with a new government taking over and the United States is hooked permanently to the printing machine for life support.

 

The second point is that these deficits and money printing will result in low interest rates for the foreseeable future.  Normally interest rates would rise but the shenanigans that the Treasury and the Federal Reserve are pulling (printing a trillion dollar coin being one) should give you an indication that they will stop at nothing to ensure that interest rates do not rise as then the game is definitely up.  This will have a large impact on the returns to your portfolio in the coming years so look to alternatives to repair the damage and protect your downside.

 

Finally, with all the money printing it is clear that asset values will start to rise creating inflation.  Inflation is good for hard assets such as gold and housing so skew your investment portfolio toward those asset classes and away from the cauldron that is the global stock market.

A Case for Precious Metals

"More gold has been mined from the hearts of men than has been taken from the earth." - Napoleon Hill

"Gold does not rust on the ground and rocks don't get soaked in the rain" - Turkish Proverb

Sentiment for gold has fallen precipitously over the last year as the price of gold has fallen close to 20% from its peak.  The issue is to decide whether this gold price move is a correction within a secular bull market or the start of something more serious.  The gold bull market has been intact for more than 12 years and to me it still has a long way to go.  Furthermore with the loss of favor among portfolio managers this is just the time when adding to a gold portfolio could make sense.

Gold began its meteoric rise in 2000 when the price of an ounce of gold was roughly $260.  Since then the gold price rose almost unabated to September 2011 when it peaked at just under $1,900 an ounce up roughly $1,300 an ounce or over 600%.  Many analysts and investors have called this rise a bubble and have shunned the investment.  So more than a year later the debate rages with the bulls saying that this is a great buying opportunity and the bears saying that the high in gold was the end of its era.

So who is right?  First off we need to understand what drives gold prices.  As gold is a commodity it is completely driven by the forces of demand and supply.  Let's look at supply first.  Means of extraction have remained relatively stable.  There have not been any major improvements to extracting the ore.  Unlike natural gas where fracking has changed the entire industry, gold ore has to be dug out often times at great depths and hauled to the surface for extraction from the mined ore.  You cannot magically blast a hole and have it rise to the surface. 

Gold reserves have not grown at all.  There have not been any major gold finds in the last decade even while exploration has intensified.  What has been discovered is either too remote to access, in countries that are liable to nationalize the mine if the find is too great or open to security risks.  For these reasons gold production has not risen even as the price has.  As there is really no improvement in terms of supply over the last decade all eyes shift to the demand side.

Demand for gold remains strong.  The governments of the world continue to add to their gold reserves and consumers the world over continue to buy gold for gifts, jewelry and as investments.  Furthermore the rise in the gold price is following the trajectory of the massive central government debt mountain.  The demand for gold therefore remains strong while the supply of gold is tepid so the price should rise but since September 2011 it has not. 

Looking at the movement in the price of gold and particularly gold related stocks it is clear that the gold bears are trying to take control of the market.  Gold spikes down on heavy volume only to recover later in the day.  On low volume days a sudden glut of sales orders push the prices of gold related stocks down where they languish but all of this comes on no significant news.  This is not the way that a seller owning a large gold position tries to exit a position.  You do not hit the sell button in a mass panic when there is nothing to report.  Normally you wait for a good spot to exit and then start to slowly unwind your position.

The problem that the gold bears have is that the price of gold and ultimately the gold related stocks is directly related to the demand for gold.  As demand for gold is strong it appears to me that momentum traders and high frequency traders are trying to manipulate the price of the metal and this has never worked for an extended period.  Remember how the Hunt brothers tried to corner the silver market?  They managed it for a while but ultimately could not control it for long.  The same will happen in the gold market.  It is just a matter of time before the order of supply and demand restores itself and the price of gold and gold related stocks rises once again.

So unless there is a magic wand to extract gold and wipe the massive mountains of debt clean from central government books in an instant, it is clear to me that this current market correction is a buying opportunity.