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Author: charliebonds Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35383  
Subject: Re: PenFed’s CD Offer, Again Date: 9/21/2010 7:38 PM
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Jack,

This is another attempt to respond to your question about what a value-investor should do in today’s market, especially in today’s bond market and its sub-zero yields (after taxes are paid and inflation is subtracted).

First, each investor’s situation is unique. So there can be no “one-size-fits-all” solutions. Some people have sufficient income-streams that they have no need to invest. So it can be a hobby for them or be avoided entirely. (I’ll plead mostly guilty to that.)

Second, many people don’t intend for their assets to survive them. They plan to spend down their money as they age, and they hope they will be out of life before they are out of money. (If I’m understanding Loki correctly, that is his plan.) Such people typically don’t worry about what the real-rate of inflation might be, and they make three further mistakes. They use some idealized number like 3.25% as their inflation-rate. They assume that TIPS will fully counteract inflation. They avoid all credit-risk.

You aren’t one of those people. Instead, you’re in the market, stock-side and bond-side, with both feet, and you’re sitting on some fat, unrealized profits that could be captured. What you’re essentially asking is a market-timing question, which is typically answered as “it can’t be done, and it should be attempted.” But that’s isn’t what Ben says, right? If something is over-priced, you don’t buy it. If you own something that is over-priced, it can easily be sold for a fat gain, with the intention to put the cash to work when prices become cheap again. So that’s the question facing us value-investors. How long can this market stay irrational? Obviously, as Keynes quipped, it can stay irrational (i.e., over-bought) longer than any of us can remain solvent (if we are betting against it) or we can stay on its sidelines (if we need income from investing.)

My response to having to time markets is two-fold. One, I don’t attempt to do so, and, two, I created a situation for myself where I don’t need to. Let me explain each part.

I have no idea how long sub-zero interest-rates will persist or whether they will go even lower. My suspicions are that they will as the economy continues to deteriorate, due to deficit-spending. But I’m not willing bet on it by positioning money to take advantage of that event if happens. I also suspect that the economy won’t blow up spectacularly. It will merely grind sidewards and downwards, following the same path that Japan has done. Some people describe that path as deflationary. But it isn’t at a householder’s level, as a quick trip to the grocery store or a sporting-goods store will suggest. E.g., 5x tippet material was $3.45 in mid-summer. Now it is running $3.95 a spool. In the course of a year’s fishing, one doesn’t buy much of it. But a 14.5% price increase here, and a 10-20% price increase there, on the items one does buy means that the CPI is nonsense better ignored in favor of one’s own numbers.

My numbers suggest that inflation can be expected to average 5-6% for the rest of my life. We already know that tax-rates will be going up for everyone except those already in the bread lines. Therefore, the retirement planning/investment game becomes a game of maneuvers (staying one jump ahead of them) or a game of attrition (outlasting them). Frankly, I suck at maneuvering. (That’s why I buy bonds, not stocks.) But, by temperament, I’ve got a lot of staying power, which is why, long ago, I simplified my lifestyle and took expenses to the bare bones, while at the same time, I beefed up income-streams so that they would never --under any likely scenario-- be overwhelmed by expenses. Therefore, my choice is to ride out the present over-boughtness of the market, fully able to outlast it even if it never returns to fair value again, much less the sort of discounts that should provoke widespread, renewed buying from value investors.

E.g., if I assume an immediate, 50% reduction in my current investment assets, a 5.5% inflation-rate, a life-long, zero COLA rate for SSI and pension benefits, a 2.5% pre-tax growth-rate for investments, the persistence of my already over-estimated projected tax-rates, and an 1 in 3 chance of living until age 84, my net-worth (excluding a paid-for house) will still be increasing each year. At age 102, when my chance of living another year has dwindled to one fifth of one percent, I’m still not out of money. I’m nearly bomb-proof. So I really don’t care what happens to the economy except for the social disruptions/class warfare that a Second Depression would cause, and I having no way of knowing for sure what the future will bring. So my choice, in the face of uncertainty, is to sit tight. When there was buying that should have been done, I did it. But that was then, and this is now.

Obviously, there is still buying that could be done, because markets are never monolithic. As Scott has argued, “If you’re the one closest to the bargain bin when something is put on sale, you get first look.” So the looking can’t, and won’t, stop. But my buying is going to slow down, if not screech to a halt, which is also the reason I’m not willing to cash in my current cap-gains. I can’t replace the current-yields and the yields-to-maturity I already have. Heck, I can’t even put to work the cash I already have, much less what I would get from taking profits. So cash is going to pile up, and my yield on that cash is going to plummet. But I’m willing to let it drift up to 20% or so before I go back to work again, scouring markets daily, trying to find a value-justified means reduce my cash.

And now I need to put together my gear for tomorrow's fishing trip.

Charlie
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