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By washcomp
February 15, 2010

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I was tempted to scatter responses all over METAR and half of Georgia, but I thought it worthwhile to have a unified discussion about the risks and rewards likely to be seen over the next year. The posts have become interesting in the extreme.

There finally seems to be a general acceptance of the premise, that I've been pounding on for a year and a half, that the value of the US dollar index is a valid predictor of many macro movements (actually, per Wendy's observation, it's the 10 yr T note which is driving things, but I find the USD index more comfortable to follow).

The recent (possibly fatal) stresses in the Euro have made the US dollar the only obvious safe haven (at least for the time being). As long as there is adequate confidence in the greenback, gold will underperform expectations. US bond prices will stay high as long as there is a manic attempt to obtain dollars. This situation, of course will have to reverse for Treasuries to drop.

We have Doubtit touting TBT (short T bill ETF) for a winner by year's end. While some pundits might argue about his timing a bit, few will argue that our borrowing will not, at some future date, push interest rates higher. My projections are pointed to 2013, unless the Fed's back is to the wall, but of course I'm generally wrong.

DocO has pointed out that "high yield" muni bond funds are only spitting out 4%. In the face of compression of State and local budgets without the ability to fund through higher local taxes, this could make for some disappointed people in the near future.

The Mechanical Investing board, which favors a completely different approach from the BMW board has just had the current Feste Award holder (Mungofitch) post the following VERY BMW type list:

http://boards.fool.com/Message.asp?mid=28299664

For those to lazy to go there (but the whole thread bears re-reading a couple of times), the gist was:

So, here's the general idea:
- Start with the stocks rated in A++ or A+ for Financial Strength by Value Line (there are about 120 of them, usually).
- Of those, consider only the 75 biggest ones by market cap.
- Of those 75, buy equal dollar amounts of the few (anywhere from 3 to 15)
that have the highest current earnings yields (lowest P/E ratios).
- Hold them all for a while (a fixed number of months, 1 or more).
- When the hold period is over, find the new picks, sell anything no
longer top of the list, and buy the new top picks.

Results 1986 - 2009 inclusive
S&P 500, 9.8%/year compounded, no trading costs
This screen, 14.3%/year compounded holding 15 stocks, with trading costs
This screen, 17.0%/year compounded holding 10 stocks, with trading costs
This screen, 19.3%/year compounded holding 5 stocks, with trading costs
All figures include dividends but exclude inflation and taxes.

If you look at all 277 of the rolling years, this test beat the S&P 75%
of the time by an average of +15.6%. It underperformed the S&P in
25% of the rolling years, by an average of -8.1%.
So, that's 3-to-1 odds of winning, plus a 2-to-1 payout if you win.

To give an idea of the company size, at the moment the smallest
company with A+ or A++ financials that would be eligible has a market
cap of $18.2 billion. The current picks would be, in descending order:
Eli Lilly
BP
Chevron
Total
Lockheed Martin
Shell
ConocoPhilips
UnitedHealth
Raytheon
Marathon Oil
General Dynamics
AT&T
Amgen
Pfizer
Sanofi-Aventis

Mostly oil, drugs, and guns at the moment.

Anyway, the above is a portfolio of core holdings (and a procedure for rebalance the list) that I can appreciate. Interesting that a number of these companies (and some very similar one) are already represented in my portfolio, but I think enough of the above to be seriously considering simplifying my holdings substantially and favoring the above scheme (though, it's doubtful that I would soley depend on this list, the concept rings true and is similar to the way I look for value stocks).

Anyhow, with an increase in the dollar apparently under way for at least the next couple of months (as the Greek problem continues and is augmented by issues with the rest of the PIIGS), foreign currencies (and stocks denominated in them) will drop on a relative basis. So will profits of American multinational corporations due to adverse currency translations, lower competitive positioning and adverse tax proposals promoted by our presidential administration (if passed).

Cash pays little, and I expect that to be the case for some time.

So what constitutes safety and return in the above environment. Diversity (in the absence of black swans) in this environment, where everything is firmly pointed, generally takes the form of hedges. Hedges against the S&P will work well against the portfolio above. Australian accounts paying high interest rates will form a reasonable hedge against a drop in the dollar (while not being Euro linked). This specific currency also has been acting as a gold proxy and has an additional function of the Chinese economy built into its relationship.

While long bonds are likely to get hit at some point in the next few years, prudent use of high quality bonds (or associated funds) to add income over the next few years would be a reasonable balance.

In the deflationary environment defined by current events, cash that does not deteriorate in value trumps investments which do.

Real estate will be profitable at some time in the future, but the deleveraging is not over and I would only consider cash flow positive properties. While the US government (us, the taxpayers) are now explicitly backing Freddy Mac and Fanny Mae (as well as the government encouraging them to buy or back every piece of toxic waste in sight), there is just so much of it, that this will take a while. It will be interesting if the interpretation of the markets changes to "how can the existing tax base possibly foot the entire bill of the Americans who are defaulting on their mortgages (rather than the burden be shouldered by the banks).

It will be interesting to see if anyone realizes that someone forgot to turn off the switch again which turned GS and MS into banks.

Anyhow, this will be a year of questionable returns. If Doubtit is right, bonds will tank. If DocO is right, Munis will crumble. If I am right, gold will crack and foreign currencies wither. The lion is sleeping with the lamb (with Jim Mungofitch picking the same stocks as Mike Klien). We haven't heard a peep on how we (because, as taxpayers, we have begun to realize that it is always "we") are going to deal with this year's commercial real estate crisis. The skies are getting cloudy, there is lightning in the distance and the winds are picking up speed.

I am wondering what strategies others are using to batten down the hatches and maintain speed.

Trying to keep it on a light note :-)
Jeff