Saturday, 22 May 2010

Investing During GFC II

A few years ago the world was plagued by the global financial crisis (GFC) that originated in the USA where out-of-control lending led to a property price bubble that eventually popped, leading to the destruction of private debt, which brought down property prices, stock prices, and commodity prices.

Today, what we are seeing is not really a private debt problem but a government debt problem. Instead of private banks needing to be bailed out, sovereign governments now need bailing out. The United States is in an interesting position because the stimulus and bailouts of the government have significantly increased government debt. These debts taken on by the banks are absorbed by the government, which means the average American pays for the mistakes of the banks via taxes.

The Greece economy is in tatters as it faces the likely scenario of defaulting on their debts. Worst yet, similar problems may also occur in many other countries, not just the PIGS--i.e. Portugal, Italy, Ireland, Greece, and Spain--but arguably also countries like the UK, France, Japan, and the US.

In my opinion, the debt problem in the world is so severe that we are likely to see the stock market go up and down but remain flat for maybe a whole decade. Here is the reason why. If governments are in debt then they have only three options: print, cut, or default. They can print money, cut spending and increase taxes (or both), or default on their debt. If they print money, there will be a bout of inflation, and stocks will rise. If they cut spending and increase taxes (or both) they will impede business and this will reduce stock prices. If government defaults on bonds, the cost of borrowing will be higher, which will lead to higher interest rates, which will prevent businesses from borrowing, which also leads to reduced stock prices. Some countries can print money and some cannot (e.g. Greece cannot print Euros). If we assume about half of countries in crisis will print money and half will default or increase taxes then the world economy should see saw back and forth for a long time.

To invest during GFC II, I believe you need to address both inflation and deflation. Protect yourself against deflationary recession by buying bonds or cash when you notice a rally in the stock market that you think is most likely the cause of irrational optimism or money printing. Any debt-fuelled growth should be looked upon with skepticism and you should accumulate cash or bonds. However, once the market pulls back and stock and commodity prices go down, try to acquire stocks and precious metals, probably biasing your stocks to resource and energy stocks.

I also feel that you should be a little bit optimistic and bias your portfolio a little more towards stocks rather then gold, bonds, or cash. This is because something may happen in the world that improves the economy. Technological improvement may result in a massive worldwide rally, so a stock/bond ratio or 2:1 seems good to me.

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