In Part 1 of this series, we covered why we believe U.S. Government debt closely resembles the subprime loans that sparked the financial crisis of 2008-09. In Part 2, we addressed the question of, "Who will finance this massive debt?" Now in this third and final part of the series, we will look at what investors can do to protect themselves against the potential consequences of this problem.
Before we discuss what we can do to protect ourselves, we must first understand the range of possible outcomes. In all of our research, we always begin with the idea that there is a range of possible outcomes and each of those outcomes has a probability of actually materializing. As an extreme example, there is a possibility that a giant meteor crashes into Earth tomorrow and causes worldwide destruction. However, we would assign a very low probability to that event. There is also a possibility that the sun will rise in the east and set in the west. We would assign a 99.9% probability to that event. We do not assign a 100% probability because there is a remote possibility that the magnetic polarity of Earth suddenly reverses.
The potential problems we see related to U.S. Government debt may never materialize. Maybe the United States will enter an age of unprecedented prosperity and we will easily manage all of our debts. While that is possible, we simply don't assign a very high probability to that scenario. And perhaps foreign countries will allow us to devalue our currency and continue to finance our deficits with no problems. This also has a very low probability. We also see a low, but slightly higher probability for historically low interest rates over an extended period.
We believe there are three main consequences to the U.S. Government debt problem, all of which are interrelated. These are a lower (devalued) U.S. dollar, higher inflation and higher interest rates. In our view, higher interest rates will be the most likely outcome for which we will have to prepare ourselves. However, let's go over some possible solutions to each of these problems. Remember that the consequences are interrelated, so these solutions could apply to multiple outcomes.
To protect ourselves from inflation, investors could buy hard assets such as gold, oil, other raw commodities and real estate. Investors could also purchase securities of companies that own these hard assets. However, there are a couple problems with buying hard assets. The first is that most hard assets don't produce any recurring cash flows (an exception being real estate), so how does an investor figure out what hard assets are worth (and subsequently, how does a value investor buy something at a discount which cannot be valued)? Secondly, if we experience high rates of inflation, how will we know which specific assets will be impacted, and by what degree? People usually think of inflation in a very broad sense, but inflation certainly impacts different assets at different rates over different periods of time. Just look at the market cycles of gold, oil, sugar, real estate and others.
Investors could also buy Treasury Inflation-Protected Securities (TIPS). There are a couple problems with TIPS, but the main issue we have is that TIPS are adjusted according to official CPI numbers, just as cost-of-living-adjustments on retirement benefits. We are highly skeptical of the inflation numbers reported by the government. And we are not alone on this issue (see ShadowStats.com).
To protect against a weak U.S. dollar, investors could buy foreign currencies, assets denominated in foreign currencies, securities of companies that own assets denominated in foreign currencies and securities of companies that earn profits in foreign currencies. However, we run into the same valuation problems with currencies that we do with hard assets. What is a currency worth? We could examine purchasing power parity data, but tells us nothing about the future of a currency. What if other countries have similar problems to those here in the U.S. (which many older, developed Western nations do, by the way)?
To protect against higher interest rates, investors could buy adjustable rate or floating rate debt, and short-term debt that can be reinvested at higher rates later. Adjustable rate or floating rate debt would be good choices as long as the issuer can support the higher interest payments. And holding short-term debt and cash is substantially similar to holding adjustable or floating debt as it is later reinvested.
We must admit that for the first time ever, we are seriously considering the possibility of owning hard assets for which we have no way of valuing. In doing so, we realize that we are, in part, speculating. Therefore, if we choose to go down that path, it would only be with a small portion of our capital, perhaps 10-20% at most. We have already, and will continue to look for opportunities to diversify our securities into companies that earn profits denominated in foreign currencies. But for the substantial majority of our investments, we will continue to do what we have always done. We will hold cash while we search for undervalued opportunities. We know of no better way to protect purchasing power than to buy significantly undervalued securities in companies that are able to pass higher input costs along to their customers. Finding such opportunities requires hard work and patience, both of which we have ample supply.
For more insight, research and sample portfolios, visit us at IgnoreTheMarket.com.
Before we discuss what we can do to protect ourselves, we must first understand the range of possible outcomes. In all of our research, we always begin with the idea that there is a range of possible outcomes and each of those outcomes has a probability of actually materializing. As an extreme example, there is a possibility that a giant meteor crashes into Earth tomorrow and causes worldwide destruction. However, we would assign a very low probability to that event. There is also a possibility that the sun will rise in the east and set in the west. We would assign a 99.9% probability to that event. We do not assign a 100% probability because there is a remote possibility that the magnetic polarity of Earth suddenly reverses.
The potential problems we see related to U.S. Government debt may never materialize. Maybe the United States will enter an age of unprecedented prosperity and we will easily manage all of our debts. While that is possible, we simply don't assign a very high probability to that scenario. And perhaps foreign countries will allow us to devalue our currency and continue to finance our deficits with no problems. This also has a very low probability. We also see a low, but slightly higher probability for historically low interest rates over an extended period.
We believe there are three main consequences to the U.S. Government debt problem, all of which are interrelated. These are a lower (devalued) U.S. dollar, higher inflation and higher interest rates. In our view, higher interest rates will be the most likely outcome for which we will have to prepare ourselves. However, let's go over some possible solutions to each of these problems. Remember that the consequences are interrelated, so these solutions could apply to multiple outcomes.
To protect ourselves from inflation, investors could buy hard assets such as gold, oil, other raw commodities and real estate. Investors could also purchase securities of companies that own these hard assets. However, there are a couple problems with buying hard assets. The first is that most hard assets don't produce any recurring cash flows (an exception being real estate), so how does an investor figure out what hard assets are worth (and subsequently, how does a value investor buy something at a discount which cannot be valued)? Secondly, if we experience high rates of inflation, how will we know which specific assets will be impacted, and by what degree? People usually think of inflation in a very broad sense, but inflation certainly impacts different assets at different rates over different periods of time. Just look at the market cycles of gold, oil, sugar, real estate and others.
Investors could also buy Treasury Inflation-Protected Securities (TIPS). There are a couple problems with TIPS, but the main issue we have is that TIPS are adjusted according to official CPI numbers, just as cost-of-living-adjustments on retirement benefits. We are highly skeptical of the inflation numbers reported by the government. And we are not alone on this issue (see ShadowStats.com).
To protect against a weak U.S. dollar, investors could buy foreign currencies, assets denominated in foreign currencies, securities of companies that own assets denominated in foreign currencies and securities of companies that earn profits in foreign currencies. However, we run into the same valuation problems with currencies that we do with hard assets. What is a currency worth? We could examine purchasing power parity data, but tells us nothing about the future of a currency. What if other countries have similar problems to those here in the U.S. (which many older, developed Western nations do, by the way)?
To protect against higher interest rates, investors could buy adjustable rate or floating rate debt, and short-term debt that can be reinvested at higher rates later. Adjustable rate or floating rate debt would be good choices as long as the issuer can support the higher interest payments. And holding short-term debt and cash is substantially similar to holding adjustable or floating debt as it is later reinvested.
We must admit that for the first time ever, we are seriously considering the possibility of owning hard assets for which we have no way of valuing. In doing so, we realize that we are, in part, speculating. Therefore, if we choose to go down that path, it would only be with a small portion of our capital, perhaps 10-20% at most. We have already, and will continue to look for opportunities to diversify our securities into companies that earn profits denominated in foreign currencies. But for the substantial majority of our investments, we will continue to do what we have always done. We will hold cash while we search for undervalued opportunities. We know of no better way to protect purchasing power than to buy significantly undervalued securities in companies that are able to pass higher input costs along to their customers. Finding such opportunities requires hard work and patience, both of which we have ample supply.
For more insight, research and sample portfolios, visit us at IgnoreTheMarket.com.
