Sunday, April 27

Week 147 - Food & Fuel Costs since 1969 vs. Gold, Treasuries, and Stocks

Situation: As an investor, there are several categories (or “classes”) of assets that you can choose for investment. These include: stocks, stock options, bonds, gold, real estate, annuities, life insurance, and commodity futures & options. New sales pitches for each particular asset class are made available with remarkable frequency. However, you will seldom hear or read much about the downside of owning those types of assets. In truth, investing in each asset class supports a different purpose from the others. Aside from stock ownership, if you build a position in an asset class you’re usually engaging in what is referred to as “forced savings.” Why? Because transaction costs, inflation, and taxes will probably eat up all the profit. Home ownership is perhaps the best example of forced savings because the Federal Government makes sure that you’ll come out ahead if you persevere. This is accomplished over the life of a “conforming” 30-yr mortgage. The “price appreciation” of your home is unlikely to beat inflation (recall that over 40% of the Consumer Price Index reflects housing costs) but you will benefit from forced savings (paying the mortgage each month). Why? Because a bank bought 80% of the house with its initial loan, and the Federal Government then guaranteed that mortgage while granting you a big tax break on interest payments. You end up with all the equity, even though others assumed most of the risk. If you bought the house when you were 30, you’ll get to live there mortgage-free and rent-free after you turn 60. If you live to 75, that’s a 45-yr period of building equity in real estate. 

Now let’s examine how other investment choices played out play out over the same 45 year period (see Table). First of all, no bank is going to loan you 80% of the money you need to buy stocks or gold, so cross that right off the list. Nor is the Federal Government going to waive taxes on the interest you pay for any money that a bank loans you. You might get an 80% loan to buy Treasury Notes but you would most likely need to post those Notes as collateral. Even at that, the interest you pay on the loan will likely consume the interest you earn from the Notes. You also can get a 50% loan from your stockbroker to buy stocks but you’ll pay twice as much interest as you would buying Treasury Notes but are you sure you’ll make twice as much?  

What about buying gold? Gold looks attractive to own because it is a currency that can’t lose value (i.e., there’s just enough gold mined each year to keep ounces/person stable). But gold pays no interest, it has high transaction costs, it must be insured, and your capital gains will be taxed the same as ordinary income when you sell it. Gold does go up in value during times of inflation but your transaction and insurance costs will also increase. At that point, you really notice that you’re earning zero income from holding gold. In a deflation, gold falls in value and not by a trivial amount. It’s decrease will be at approximately the same rate as any other commodity. Being a stable-value currency, gold will naturally fall in value whenever the dollar rises in value. From all of this, we conclude that gold is nice to own during a recession (when transaction and insurance costs are low) but the moment the economy starts to turn around you’ll want to sell it. This will also be the same moment when gold begins to fall rapidly in value. Unfortunately, that sudden drop in the price of gold is also the first clear sign that the economy has turned the corner.

Let’s examine Treasury Notes and Bonds next. This asset class is yet another story when compared to the others. It is the only asset class that rises in value during a bad recession or persistent deflation, but with one exception. That exception is ownership of stock in food purveyors like McDonald’s or Wal-Mart; those stocks will also rise. But when the economy does turn the corner and start expanding, interest rates will rise and bond prices will fall. 

Stocks are the asset you want to hold in an expanding economy. Stocks will even keep up with the rare event of hyperinflation. The problem, however, with stock ownership is found in the Beta statistic. The Beta statistic is pegged to the price quote for the S&P 500 Index, which always has a Beta of 1. What this means is that if a stock climbs in value faster than the S&P 500 Index, it will have a Beta higher than 1. But that also means it will fall faster than the S&P 500 Index in a bear market, and to about the same degree. So, you’ll have to judge your stock purchases from the 3- or 5-yr Beta and keep the 5-yr Beta for your stock portfolio under 0.7 (Warren Buffett’s recommendation).

The Table has total returns for 18 stocks obtained from a screen of Dividend Achievers (10+ yrs dividend growth) among the 65 companies in the Dow Jones Composite Average that have data going back to ~1970 on the Buyupside website. Performance of the S&P 500 Index is given for comparison, as is a 60/40 mix of the S&P 500 Index and Treasury Notes. Stocks clearly outperformed Treasury Notes and Gold over that long-term period and over the past 5 yrs. Gold still managed to beat inflation over both periods, keeping its reputation as an inflation-fighter (before accounting for the costs of ownership). Treasury Notes are vulnerable to the “Financial Repression” that central banks worldwide use to drive down interest rates during a bad recession. That makes any T-Notes (or especially T-Bonds) that you already own very valuable if you want to sell them. But the downside is that any new Notes that you buy during a Financial Repression will pay very little interest. NOTE: metrics in the Table that underperform the mix of 60% stocks and 40% T-Notes (line 19) are highlighted in red. 

Bottom Line: Buy stock in 10 or more companies as your main long-term investing strategy. Our recommendation is that you make your purchases online and in small increments using a dividend reinvestment plan (DRIP). That keeps costs down and allows you to benefit from dollar-cost averaging. Try to pick stocks with a 5-yr Beta under 0.9, and keep the aggregate 5-yr Beta of your stock portfolio under 0.7 (that being yet another pearl of wisdom from the Oracle of Omaha, Warren Buffett). Since you’ll retire someday, stick to stock in companies that have a long history of growing their dividend. The advantage to this strategy is that you’ll have a retirement asset (quarterly dividend checks arriving in the mail) that grows quite a bit faster than inflation (see Column H in the Table).

Risk Rating for the aggregate of 18 stocks listed in the Table: 5

Full Disclosure of my current investment activity relative to assets listed in the Table: I dollar average into inflation-protected 10-yr US Treasury Notes, as well as DRIPs for WMT, JNJ, IBM, KO, XOM, and PG.

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