Stocks and Bonds, Shun These Two Bad Investments
Stock-Markets / Investing 2010 Jul 12, 2010 - 03:37 AM GMTBy: Gary_North
The public has been told that the way to wealth is investing. The way to invest, Ph.D. economists tell the public, is to allocate your portfolio between stocks and bonds. Which stocks? An index of American stocks, preferably the S&P 500. Buy a no-load fund. Same with bonds: a mix of mid-term and long-term AAA-rated corporate and Treasury bonds.
Don't try to beat the index, modern portfolio theory warns us. Buy and hold. All will be well.
For fund managers, yes. For investors, no.
STOCKS
On 29 December 1989, Japan's Nikkei stock index rose to just shy of 39,000. Today, it is under 10,000. Yet for over two decades, the productivity of Japanese workers has risen. They have better televisions, better cars, and better food. They have the World Wide Web. We all do. Our lifestyles are better. Few people would go back to 1989, knowing what they do today – except to short the Nikkei. Our productivity is greater.
Here is an anomaly. The stock market is regarded as a proxy for wealth. Yet it is a lousy proxy for wealth. No stock market in history better reveals this fact than Japan's over the last two decades. A person who sold all of his stocks on December 29, 1989, and put his money into a Japanese savings account paying basically zero interest for two decades is better off by four to one than the professional who left his money in stocks on the assumption that rising Japanese productivity would raise the Japanese stock market.
The standard defense of stocks is that ownership of those companies that are adding to national productivity will enable investors to ride the wealth curve. This is utter nonsense. While investing in shares creates a liquid market for firms to raise capital, most firms fail to deliver consistently. Most projects fail. Most plans fail.
Investors like Warren Buffett – there are few – who invest in the right companies do get rich. But Buffett is not a man to invest in innovative firms. He invests in old firms with good management, like See's Candies and the Burlington Northern Railroad.
The free market is not about getting rich by owning a broad index of companies. The free market is about bearing uncertainty in the quest for profit. How? By serving the desires of customers. The customer is king in a free market society. The businessman is his profit-seeking servant.
The way to great wealth is effective service to customers. But few firms prove capable of doing this, decade after decade. Few firms make major breakthroughs more than once. If you invest in such a firm when no one sees the breakthrough coming, then you can get rich. But don't expect to do this more than twice in your life.
Problem: modern portfolio theory tells you not to put all of your eggs in one basket. You must diversify. So, you will never hit the big score.
When you think "diversification," think "Nikkei, 1990–2010."
Is modern portfolio theory wrong? Statistically, no. Most people do not beat the market. Most people are average investors. But some are better than others. Modern portfolio theory says that you cannot beat the market. Maybe you can. Maybe you have a better theory of how markets operate.
First, what if the market is a loser? The Nikkei has been for 20 years. The S&P 500 has been for a decade. If you stick with a loser, you lose.
Second, what if all the smart investors are wrong about investing? How could so many of them be wrong? Because they are Keynesians.
Economists say that you cannot beat the market's index. They mean that they can't, and they think the market is smarter than they are. So, they think it is smarter than you are.
Problem: Keynesian theory makes smart people functionally stupid. You don't have to be smarter than they are. You just have to avoid Keynesianism.
Has anything worked better than a stock market index? Yes: Warren Buffett. How does modern portfolio theory explain Warren Buffett? It says that what he did was sheer luck – a run of luck like no other in history. Then we are told: "Forget about Warren Buffett. You will not be lucky enough to find the next one." This is probably true, if you limit yourself to Keynesians.
Who are the developers of modern portfolio theory? Academic economists who got tenure early, who could not be fired, and whose only good investment in their careers was a heavily mortgaged house purchased in 1965.
Then why invest in the American stock market? If you cannot beat the market, and if the market's movement goes the opposite of the increase in productivity, which it has been the case of the United States for a decade, then why invest in an American stock market index?
The answer is: "You shouldn't."
THEY TELL YOU THE OPPOSITE
The experts tell you that the American stock market has been the best place for your money over the last 50 years, or 70 years. Then where are all the retired people who live in luxury because they bought and held an index of American stocks?
Do you know one? I don't. I used to move in circles of very successful people. (Now I stay home.) I cannot think of anyone I know who made his fortune exclusively by investing in stocks. The richest ones I know who went from rags to riches made it in real estate.
The best place for your money is in yourself. If you invest in a career by serving customers, and you invest your profits in your own business, you will beat the stock market. Even if you don't, you will not be significantly worse off. You will have a shot at wealth. You don't with the stock market.
Entrepreneurs do this. They invest. They may go bankrupt. Then they do it again. This is the common theme of the book, The Millionaire Next Door. The secret is frugal personal spending, efficient service of customers, and reinvesting your profits in the business.
Not everyone can do this. That's the problem. Few people have the stomach for entrepreneurship. They fear failure. They are not sensitive to customers' future demands. They are not fit for the career.
Should they invest in stocks? Not if the last decade in the United States has a lesson. Not if the last two decades in Japan has a lesson.
BONDS
The goal here, we are told, is to balance income (bonds) with capital appreciation (stocks). Go lighter on bonds the younger you are, we are told.
There is a handy formula for this. Subtract your age from 100. Whatever figure you get, that is the percentage to put into stocks. If you are 46, put 54% of your portfolio into stocks. If you are 95, put 5% in stocks.
There are two problems with bonds. Think "heads" and "tails." Heads, the investor loses. Tails, the company wins.
Here's how it works. The investor buys a corporate bond. Let's say that it pays 5% per annum for 30 years. It is AAA-rated. (Note: there are hardly any AAA-rated American corporate bonds.) The bond is for $1,000 face value, meaning at the maturity date, the investor will be paid $1,000.
His $1,000 earns him $50 a year in interest. Let us say that the Federal Reserve starts inflating. Prices start rising at 5% per annum. Now investors want a higher rate of interest to compensate them for the loss in purchasing power. They demand 10% per annum. Companies comply. They need the money.
To earn $50 a year, an investor need only pay $500 for a bond. So, the $1,000 face value bond that pays 5% is now worth only $500. No one will pay more. Why should he?
Bonds are vulnerable to unforeseen price inflation. The central bank can wipe out bond investors. It did this, 1940 to 1980. It was a generation of losses in bonds. The companies won. The investors lost. This is "heads, investors lose."
Let us look at the other possibility. The Federal Reserve stops creating new money. Prices stabilize. They may even fall by 2%. Investors are willing to settle for less than 5%. Maybe they will take 2.5%. The bond that pays 5% is now a winner. To buy $50 a year, the investor must now pay $2,000. So, the 5% bond is now worth $2,000. The investor has made a capital gain of 100%.
The managers of the corporation, not being idiots, now go into the bond market and sell a $1,000 bond at 2.5%. They take that $1,000 and send a check to the holder of the 5% bond. "Sorry, Charlie: we are recalling the bond. We're paying you off." Presto: the company has reduced its cost of indebtedness by 50%. "Tails, the company wins."
If a bond can be recalled, it becomes what economists call an asymmetric risk. That's a fancy phrase for "Heads, the investor loses; tails, the company wins."
Then there is the risk premium. The corporation may go bankrupt. Sorry, Charlie.
It may have its credit rating reduced by a ratings agency. The market value of the outstanding bonds immediately falls, meaning the interest rate discount increases. Sorry, Charlie.
Income taxes may be increased. Sorry, Charlie.
Conclusions: corporate bonds are not a good investment.
What about U.S. Treasury bonds? They have this advantage: they are not callable. Yet. So, if rates fall, investors keep their capital gains.
They have an AAA rating. It is unlikely that any American private credit rating firm will be the first to lower the AAA rating of a US Treasury bond.
But the US government is running a $1.6 trillion deficit this year. It will run something comparable for the next decade, government budget agencies predict: at least $1 trillion a year. This will place pressure on the present market for Treasury debt. Rates are likely to rise.
If the Main Street economy revives, which will be good for stocks (we are told), then banks will start lending. When they do, the doubling of the monetary base in October 2008 will produce a doubling of M1. This will raise long-term interest rates. That will be bad for holders of 30-year T-bonds.
T-bonds pay under 4%. For this rate of return, the investor puts his capital at risk as a result of rising long-term interest rates.
The investor is predicting low or zero price inflation, low-rate government financing of a national debt that must be rolled over every five years, and no increase in income taxes. On all three assumptions, I believe the investor is terminally naïve.
THE AVERAGE MAN HAS NOT BEEN SUCKED IN
Most people have no money in stocks or bonds. Most of those who do have their money in a pension program run by their employers. The funds invest in stocks. What has been the result of this delegation of responsibility to expert investors? Losses.
The average American has no pension. He has Social Security: a political claim against the future wages of people just like he is, only younger. His security is no better than Federal Reserve monetary policy, Congress's ability to persuade younger workers not to revolt, and his children's willingness to bail him out when the first two prove to have been false hopes.
The median net worth of Americans 55 and older is around $200,000. That was before the housing decline. You can see the estimate for your age bracket by using the CNN net worth calculator. You can also discover what someone in your income bracket is worth.
Think about this number. If a man is worth $200,000 at age 60 or thereabouts, or maybe $230,000 at 65, how much passive income will this generate at today's bank CD interest rate? Under $2,000 a year. So, he will have to sell his equity. But wait! The bulk of that $200,000 is the equity in his home – or was. So, he will have to sign up for a reverse mortgage. He will sell his house in stages.
The point is, if he lives for 20 more years, and his wife outlives him, they will be in poverty at death. He will have to sell at least $10,000 in assets each year to supplement Social Security. Inflation will speed up this process as the dollar depreciates.
His medical bills cost the government about $1,000 a month. Can you see why people hold placards at political rallies: "Don't touch my Medicare"? They are trapped. If they had to pay for their own medical care, they would be in poverty within a decade of retirement.
This is the reality of pensions and retirement. Yet the people on Tout TV do not tell listeners, "Sell your stocks. Start a home business. There is no way that you can retire in comfort with money in the stock market."
People want to believe that they can write a check each month and forget about the future. They delegate responsibility for their future to experts who get paid whether or not their investments pan out.
This is madness. It is universal.
PARTICIPATION IN PROSPERITY
The basis of prosperity is economic growth and increasing personal liberty. We are clearly living in an era of decreasing personal liberty. Is increased growth likely to offset or even overcome the decline in liberty?
In the West, probably not. The West is dependent on imports from Asia to defend its lifestyle. The West is running a balance-of-payments deficit with Asia. That is to say, individuals in the West are living high on the hog due to the kindness of strangers: Asian central bankers who are pursuing mercantilism. These central bankers buy the government bonds of Western nations, thereby holding down domestic interest rates in the West. Western consumers can afford to take on more debt to buy more Asian-made goods. They can meet monthly payments, since rates are low.
We can see who the winners are: Western governments, Western consumers of Asian imports, and Asian political officials, who tell their people that exports are improving the economy.
Who are the losers? Asian consumers, who have less to buy. Western manufacturers who face increased competition from Asia.
Why invest in the West? The West is on life-support from Asian central banks. It is facing an ever-growing degree of taxation and intervention. The governments cannot fulfill their welfare promises to voters. When the deficits no longer can be sold at low rates, the day of reckoning in Western nations will arrive.
If we invest in Asia, we are investing in these good things: a good work ethic, high rates of thrift, competitive industries in a world market, optimism, a reduction of government regulations, an increasing division labor due to increased per capita investment, educated people who are skilled in math and engineering, and a still youthful work force.
Here are the bad things: high rates of central bank inflation, a mercantilist economy that shortchanges workers, nations with unproven political stability, antidemocratic attitudes toward criticism of the government, legal codes that have only recently honored private property, a gambling mentality, resistance to foreign firms and ownership in domestic retail markets, and capital markets without a long tradition of common law.
On the whole, Asia is better prepared to benefit from technological innovation. This does not mean that its organized capital markets are ready to soar. Asia must get through a reduction in the rate of monetary inflation. Asian real estate is a bubble. That bubble will pop. On the far side of that popped bubble there will be great profit opportunities.
CONCLUSION
The promoters of wealth through investing in American stocks and bonds have faced for a decade what promoters of Japanese stocks and bonds have faced for two decades. The markets have proven them wrong. "Buy and hold" was good advice for gold in 2000, but not for stocks and bonds.
So, what do these same investment experts recommend? "Don't buy gold; its run is over. Buy a portfolio of stocks and bonds. The next decade won't repeat what the last one did. Trust us. We know what we're talking about." Right: just like Bear Stearns knew, Lehman Brothers knew, and Merrill Lynch knew.
The governments and central banks have intervened again and again to repair the system. Each intervention creates new problems. This was what Ludwig von Mises observed in 1950. The interventions escalate because the problems caused by the previous interventions escalate.
The nation's economic reserves have been tapped increasingly by the Federal Reserve.
The government's shearing of the sheep is becoming more expensive. But the shearing process is never rolled back for long. The sheep think they are being helped by the shearing process. They think the other sheep are being sheared even more. They are content with this. They resist any reduction of shearing whenever they believe that the other sheep will be being sheared even less.
Find a country where sheep are being sheared less. Invest there. After the next crash.
Gary North [send him mail ] is the author of Mises on Money . Visit http://www.garynorth.com . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .
© 2010 Copyright Gary North - All Rights Reserved
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