Monday, January 15, 2007


A reply to Roubini bashers: investing at the precipice

As a regular reader of Nouriel Roubini's blog, I am dismayed by how rude people are toward his market forecasts. He believes that a recession will develop ca. this quarter and that investors should beware. Fourth quarter 2006 has been fairly strong, bringing the market up to where it was in summer 2000. Whoop de doo. Now, Nouriel may be wrong. Being premature in exiting the market is a good way to not make money. But... such is the nature of forecasting. The Hurricane Pam exercise predicted that New Orleans would be wiped out, and doubtless there were people sneering at them,too, right up until the Industrial Canal retaining wall broke. At any rate, I wrote a response regarding the detractors that I think proposes a good investment style. The basic idea is grading investments by their beta. A zero beta investment is like cash. It's value doesn't change with the market. A stock with a beta of 1 follows the market exactly. A stock with a beta greater than 1 goes up faster than the market. The right way to invest in times like this, in my opinion, is three-tiered beta. Hold enough quality low beta investments (including cash-like investments) to absolutely ensure that you can ride out or even exploit whatever happens. Have a certain amount in The Usual Suspects (near-unity beta) to get some dividend income and maybe a little growth. And include some risky high-beta investments so that you can skim some froth. This allows one to harvest gains on one's own schedule. Consider what happens to a portfolio which is, say, 40:40:20 in the face of a 30% downturn. Category 1 is unchanged. Category 2 drops to 27. Category 3. if we assume it's 2 beta goes to 8. The overall portfolio is now at 75 (40 x 1 + 40 x .7 + 20 x .4) and 40 percent of the assets are fully liquid. By contrast, a portfolio of unity-beta stocks is at 70% (100 x .7) but, worse, depressed stocks have to be sold to raise cash. Alternatively, suppose the market is good. The first portfolio earns 0%/7%/14% to give net growth of 6.6%. A portfolio of unity-beta stocks earns essentially the same (7%). As they say, never bet what you can't afford to lose. But don't be afraid to bet what you can. I actually think the greater risk is from currency. You can make money in dollars and still end up poorer if you aren't aware of what's going on internationally. Currency adjustments tend to be slow, but they can be rapid. And my guess is that the most expedient way for the world to deal with the dollar overhang is devaluation.
I'm in bonds and Europe, plus some Pacific Rim. Very little cash, because I don't really trust the dollar.
hmmm ... the dangers of fractional reserve banking indicates holding some local currency in physical form is always good strategy ... major question is what shall replace the dollar as the world currency ? ... euro won't do as china is the block ... south america still is working towards some sort of unified currency, same true with africa ... only leaves mideast and/or silver/gold ... silver is just an industrial metal in the west ... thus when usd crashes so will the price of silver/gold {then is the time to buy physical silver with local physical currency ... ... coins will emerge out of the mideast {golden dinar/silver dirham} ... bullion banks will stablize and accept iraqi dinar ... iraqi dinar takes on the form of mideast regional currency and eventually the world currency ... that is my story and i am sticking with it ... oneness,dh .... "It would be difficult to exaggerate the psychological and social impact of the anticipated replacement of the jumble of existing monetary systems--for many, the ultimate fortress of nationalist pride--by a single world currency operating largely through electronic impulses."
Well, Anonymous, that's certainly an original choice for a reserve currency. An Iraqi gold dinar that has yet to be minted.

It could be.

Shrimplate, bonds are cash-like enough to include those as low-beta investments. Granted, they are not risk-free.

I certainly understand your choices. But all countries carry risk. For example, China is very non-transparent, so we don't know what the risks are. If they go down, so will many Pacific Rim economies. And there's earthquakes, which can be devastating to places like Japan.

The reason not to place all one's bets against the dollar is that one may have to tap cash for living expenses, and that means converting to dollars. I think a reasonable proportion of investment based on market size is 40% US/60% foreign.
That's even a little more foreign than I'm in right now. Amazing. Not too long ago 10% foreign was recommended!

China will go down, because there's just no way there's enough petroleum left to sponsor their envy of U.S.-like growth. Then again, they can *walk* to the Middle East and Siberia to establish control over oil resources there.

I just don't think they can do it, and the same will happen in India and the southeast Asian "tigers."

We'll see what happens in the next 15 years or so.
Shrimplate, I based that estimate on a McKinsey&Co. graphic reproduced in the WSJ. It lists the following as the size of the debt+equity markets worldwide:

US: 47.6T
EU: 26.9T
JP: 17.3T
Other: 26.3T

The US has been a preferred destination because of the size of the market, fairly good transparency, and lower volatility. But these advantages are rapidly disappearing.

Ignoring currency risk, the ONLY advantages I see to investing in the US are that (a) one can pick individual stocks, either for reasons of socially conscious investing or for small cap investing purposes, (b) one can avoid some management expenses, and (c) geographic diversification. In fact, markets are so highly correlated, the latter advantage is disappearing.
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