The Terrible, Horrible, No Good, Very Bad Economy - Part Deux
Stocks/Bonds, Commodities and Crypto, Oh My!
It’s a nervous time for many people as they watch their nest eggs shrink by 20 to 30% and wonder how much further they can fall. I wish I had an answer, but honestly, I don’t. But this highlights the problem with following the retirement plans the IRS and your employer have made the path of least resistance: hoping that the money you put into the plan will grow and be there at the time you are ready to retire. But what if it doesn’t? What if it drops by half in the last year of working? Too often, retirement savings accounts tied entirely to stocks and bonds fail to achieve the promises made.
That, by the way, is why they call 401k plans and others like them “defined contribution” plans. The only thing you know is what you put into it. What comes out? Well, that won’t be known until you get to retirement age. Until then, they cannot produce an income for you unless you pull the money with steep penalties or borrow against it, which is not income because you have to pay it back.
Where 401k’s are concerned, save to receive your match where offered, but after that, divert the rest of your savings/investing efforts to things that can earn you an income now.
So let’s continue looking at the various asset classes and where outstanding opportunities might be found in our Terrible, Horrible, No Good, Bad Economy:
Real Estate (continued)
I did not mention this in part one of this post: For rental real estate, when the math works (i.e., positive cash flow) in a distressed economy with higher interest rate loans, the math will work even better once exiting the crisis.
Why? Because interest rates move lower as downturns take hold. This is due to government interventions and supply-demand pressures working in tandem. Suppose you’ve projected the cash-on-cash returns (as a reminder, that being the net cash after rents minus expenses, divided by the cash you put into the deal, typically your downpayment) to be 20% when you do the deal. In that case, they can improve substantially when the opportunity to refi comes later in the economic cycle. So year one might be a 20% return, but by year 4, after a refi to a lower rate, those returns may jump to 30% or better.
Stocks
In this category, my focus is on stocks purchased outside of retirement accounts that can create income for you today. My Grandmother used dividend stocks as part of her income when she was no longer working, and they have been a tried and true solution for generations of well-to-do investors. Were they well-to-do before they had these stocks, or did investing in these stocks make them that way? I’d suggest the answer is a little of both.
There are many ways to create an income for yourself, and dividend stocks are low-hanging fruit in the orchard of opportunity. Real estate can easily yield 20% cash on cash returns. Doing the same with a portfolio of dividend stocks is unlikely. A good return on a portfolio of low to moderate-risk dividend stocks would be closer to 6-8%.
The attraction of dividend stocks amid a bear market comes from (1) shares of many dividend stocks discounts from the recent valuations and (2) the ease of entering and exiting the portfolio. You can step in or out of them in a matter of hours, so the liquidity is very high. And, while 6-8% is not comparable to potential real estate returns, the investing risks can be lower. Buying in an already bear market offers more potential upside when the market turns, and that can often happen faster than most expect in the depths of the fear storm. And remember, any income is better than no income. So, let’s say you invest $50,000 in a dividend stock portfolio that pays a projected 8% return. That would provide $4,000 a year in additional pre-tax income to your pocket, or over $300 a month. Could you use another $4,000 a year of income? I certainly could.
In a declining market, finding higher dividend stocks is easier, but be aware current dividends will likely decline to some degree in this environment. When selecting dividend stocks heading into a likely recession, apart from finding one with the dividend yield you desire, look for the following:
Companies that provide staple products people need even when money is tight. Communications, electric, water, gas, and grocery providers remain in demand when economies are down. Non-public electric generators that can sell their power to the highest bidders are likely to see higher profits in the near term. This is because power prices purchased in the open market are increasing, meaning more profit for operators that sell into that market.
Price-to-book ratios close to or below 1. This can be an indicator of an undervalued company. It can also mean a company is in trouble, so look at all the items I outline here to ensure you’ve got a healthy cash cow.
Look at the earnings history of the company. It should be stable and preferably show a record of increases over time.
Debt ratios below 1, although this can vary widely by industry, lower ratios speak to less leverage, which can be a good thing in tightening credit markets.
A quick ratio of 1 or better. Liquidity matters in tight credit markets like we are seeing now.
Compare the company to its closest competitors. Do their metrics look as good or better than the competition? The brokerage company you sign up with to acquire the stocks will have good screening and comparison tools for you to complete such comparisons.
Search any recent news on the company or industry that could have a significant impact, positively or negatively, on the company.
For example: in the semiconductor industry, the Biden administration's ban on selling advanced semiconductor manufacturing equipment to China (expect Taiwan to eventually be at risk as well, given China’s reunification efforts) will severely exacerbate the existing chip shortage in Western nations. Those companies with chip manufacturing capabilities outside of China and Taiwan stand to see increased demand for their products.
Another example: Changes in policy around oil and gas extraction paired with the Ukraine conflict, have resulted in European oil and petroleum products shortages. Companies with O&P production assets outside the conflict zones are in a solid position to see outsized profits. The dividends paid by these companies are amongst the most attractive in the markets today and should have staying power for some time. Investing in these stocks is an excellent way to put some of the extra money you are paying at the pump back into your pocket.
One more example: The ironically named Inflation Reduction Act is pumping almost 400 billion dollars into the “clean” energy economy. That means funding for more solar, wind, electric vehicles, energy storage (batteries being foremost in this segment), and hydrogen use in electric generation. A savvy contrarian investor will research the materials currently going into these technologies and invest in companies in the supply chain (miners, refiners, and companies with scalable, more efficient solutions) for these products. Invest a small portion of your savings here - remember these will more likely be speculative investments, not income-producing, so keep it to a small percentage of your portfolio, but these have the potential to be moonshot opportunities in the next 5-10 years.
Bonds
Like dividend stocks, bonds can pay you a regular income, and that’s good. They are also near the front of the line to get repaid if a company should declare bankruptcy, which is also good. The downside of bonds compared to stocks is the absence of more upside than the stated interest rate paid on the bond (called the coupon rate), but you can’t have it all. Generally, bonds are considered a less risky choice to invest in than stocks.
For the investor looking for cash flow, bonds can be a good low-risk solution, generating rates between 4-6% with no potential for appreciation but less risk of loss to your principal investment. But if I’m being honest, I’ve struggled to get excited about bonds because of the looming specter of inflation for most of my investing career. Now that we’ve arrived at a period of high inflation, most bonds' yields are still well below the actual inflation rate (north of 15%), so I am hard-pressed to recommend them as an investment in this cycle. If we find a way to resolve the national debt problem (some kind of reset, the likes of which I cannot see happening short of total economic collapse), bonds might be a more attractive investment opportunity. If you want to go this route, consider US Government I bonds. They are “inflation” indexed (offering about a rate 2/3rds the actual inflation rate), but at the moment, are paying 9.62%, which is better than most anything else in the investment grade bond segment.
Cryptocurrency
The cryptocurrency segment continues to be received with great skepticism by many Wall Street types. One of the main problems they’ve had with crypto, but won’t admit to, is the difficulty in making easy money in trading this asset class. However, since the creation of the derivatives markets for Bitcoin and other leading cryptocurrencies, opportunities for rigging investments in crypto have become easier, so more Wall Street types have warmed up to them. The creation of the derivatives markets for crypto was done at the insistence of the SEC, which claimed that only being able to bet long (i.e., for cryptos to increase in value) made them unsuitable for investment-grade ETFs and the like. Thank goodness the SEC hasn’t been overseeing real estate all these years!
In this economy, cryptocurrencies are not likely to see appreciation - and more likely depreciation - until the Fed gives up on their dollar-strengthening rate hikes and reducing their balance sheet. In the case of Bitcoin, limited in how much can be created, it has a significant long-term advantage over fiat currencies. It also does not require a central corruptible entity to manage its ability to trade, which is the case for almost every other financial market asset. I am bullish on Bitcoin long-term and would take a small position (5% of portfolio max) in this asset for diversity in your overall investment portfolio. It won’t pay you and is speculative, but it may remain the best non-leveraged moonshot investing opportunity in the financial markets.
One risk is western banks banding together to no longer allow the conversion of Bitcoin into fiat currencies. If that happens, all transactions with Bitcoin would have to be entirely outside the traditional banking system. I think the risk of this event remains low as long as institutional investors and some governments hold Bitcoin. You can monitor their holdings (at least those publicly announced) at this site.
Commodities
Commodities are one of the more challenging areas to invest in. Certain commodities can crash when financial markets are going great, and others soar when financial markets are crashing. The key to success in investing in commodities can be finding a way to cut through the perception to get to reality. It also helps to read how changes in products and industries that need specific materials will impact supply and demand. The futures markets add a layer of complexity to this process.
I expect there are contrarian investors who do very well in the commodities space. Still, because it is speculative, leveraged, and does not pay you, I haven’t devoted time to learning all the dynamics at play with the different commodities. I am not a fan of using leverage (apart from fixed-rate bank loans) to gain an advantage in investing. The commodities futures markets are highly leveraged and a risky game, best left to speculators and those inside the rigged system to invest in. The only investment I’d recommend in commodities at present is a small (less than 10% - unless close to retirement age) non-leveraged position using vehicles like commodity-specific miner ETFs and investment in physical precious metals, mainly as a defensive play against inflation.
Until next time, may peace and prosperity be with you.
The Natural Economist
Next up: A Bitcoin story