September 24, 2003
Plotting a Path Away From Equities
Despite difficult to find opportunities in equities, the investor nonetheless has some attractive alternatives for their capital.
By Brady Willett & Todd Alway

If it can be said that Enron woke up naïve investors to just how crooked some companies and Wall Street institutions are, then it is a safe bet that this year’s fantastic stock market rally has put many investors back to sleep.  To be sure, via mania like inflows into equity funds, retail investors have happily matched the new supply of stock coming from insider sales.  As overpriced companies double their nearly nonexistent dividend payouts (i.e. MSFT) investors applaud. And as other companies more than double their existing repurchase programs (i.e. CSCO), investors foam at the mouth in anticipation. Does it matter that once bitten fund chasers are no longer shy about chasing stock market gains?  Does it matter that seemingly positive dividend declarations are not enough to send the average yield on S&P 500 stocks above the lowly total of 2% (a lowly total even when considering Bush’s new tax plan)?  Does it matter that companies usually announce buy backs to thwart stock options dilution, to cover up insider sales, or to simply buy earnings?

Suffice it to say, there is not much hope for the value seeker in this momentum market because the applause – both from Wall Street and Joe investor - is deafening. Rather, if you want to purchase most stocks today using the argument that valuations are respectable you need to put on rose colored glasses, treat future operational earnings forecasts as the gospel, and take a dose of risk as if it were Viagra. Incidentally, and as evidenced by a dramatic uptick in Nasdaq margin debt, many tech dreamers have recently taken the plunge with abandon.  Apparently, stellar 3Q03 year-over-year earnings comparisons will assuage all fear; it doesn’t matter that stocks are pricing in a tomorrow that is unlikely to be achieved because everything and everyone feels comfortable playing the greater fool today.

Long-Term Options For The Long-Term Investor
 
Being safety minded we tend to shy away from some of the more risky/momentum driven alternatives to equities found in futures/derivatives, bearish funds/short selling, and gold stocks. However, using the two investment options below – perhaps in tandem - could prove as prosperous as a well timed momentum bet, minus the risk.

1) Treasury Inflation-Protected Securities (TIPS)

Because of the lack of ammo the Fed has available via interest rate reductions, Greenspan and Bernanke have, in no uncertain terms, assured the marketplace that their foot will stay on the printing press pedal until the U.S. economy revives. Thus, and if the Fed is not lying to the markets again, interest rates will have to head higher either because economic activity picks up and/or because the debased dollar stops attracting foreign investment (meaning that higher interest rates will be needed to attract such investment).

Given that basic Treasury bonds could be pummeled in an escalating interest rate environment, TIPS serve as an attractive alternative.  Indeed, TIPS, which carry a lower guaranteed coupon than comparable Treasury bonds, can make up the spread if consumer prices rise by more than the market is pricing in.  To overly simplify -- a guaranteed 2% yield in TIPS is 0.1% better than a guaranteed 4% yield in Treasuries if CPI registers a 2.1% advance.

Irregardless of Fed jawboning, another point to consider is that the U.S. (and now the G7) is placing pressure on countries like China and Japan to allow their currencies to appreciate.  Although a weaker dollar versus the Yen/Yuan would not be an absolute positive for the owner of U.S. assets, it does have the potential to import inflation rather than deflation from Asian countries. In such a case yields in TRIPS would rise proportionally.

The flipside to inflation is deflation, which is another possible future scenario. Although the holder of TIPS would not lose money in a deflationary environment (using the above example you would still get your 2%), the principle would not appreciate as it would with normal T-bonds. 

That said, the likelihood of Japanese style deflation in the United States is unlikely in the foreseeable future…unless the Fed is lying.

2) Gold/Silver

Gold is a unique investment in that it is likely to rise in value regardless of whether acute inflationary or deflationary pressures develop in the United States. To be sure, gold craves instability – something both the U.S. pricing environment and geopolitical climate are likely to offer plenty of in the coming years.

Given that the case for gold as an inflationary hedge is self-evident, the deflationary scenario is worth some chatter.  In our opinion, deflation is only possible if the Fed is currently lying to the markets. Put another way, if the Fed is unwilling to relentlessly inflate the money supply (perhaps for fear of producing a full fledged mania in the financial markets), then the deflationary scenario comes back into focus.

Suffice it to say, gold is likely to do well if the U.S. encounters Japanese style deflation because corporate profits would retrench (possibly also stock prices to a fabulous degree) and the ‘safe haven’ rush into bonds could prove short lived (how low can yields go?).

Purchasing, transporting, and storing precious metals can be both cumbersome and costly. Gold producers carry with them specific company dangers.  Buying/trading futures/options can be a potentially leveraged risk.  Suffice it to say, precious metal investors have long been in a quandary: what is the most appropriate investment option?

We continue to believe that buying gold/silver is the best alternative for the investor. And although we would be hesitant about adding gold/silver at current levels primarily because speculative long interest has risen in recent weeks (as has commercial short interest), calls for $400 - seemingly arriving on a daily basis from gold producers, fund managers, and investors – could ensure that another ‘pre-Iraq’ plunge does not transpire before $400 is reached.

The long awaited but little talked about American gold ETF (Symbol GLD) has not yet arrived. When this option is available to investors (and hopefully the derivatives on it soon afterwards) it could represent a better purchase opportunity than gold itself.  Alternatively, a Canadian Gold/Silver Fund, which also trades off the AMEX (CEF), is also worth a look (although a historical plot of price/NAV would suggest that the fund is expensive right now).

Conclusion

When talking about 2% - be it dividend yields on stocks and TIPS type investments – it is difficult to get very excited. However, TIPS offer the investor protection against inflation with little risk.  Moreover, the upside with TIPS is potentially handsome if inflation runs rampant or the U.S. says hello to hyperinflation (dollar devaluation).  On the other hand, gold – not patently a deflationary hedge but perhaps one of the few alternatives today - offers the investor peace of mind against currency upheavals and/or extreme pricing environments, as well as against geopolitical uncertainties.

As for the investor that is weary of being exposed to what could be a prolonged decline in the dollar via TIPS, many countries (including Real Return Bonds in Canada) have similar inflation protected bonds.

a