Don't Fear The Reaper

A good thread busted out in the comments on yesterday's post. A reader asked me to weigh in on my concerns about inflation (hyper or otherwise) and the status of the dollar. Another reader asked for my take on financial stocks and REITs.

So let's roll 'em up and dive in.

The current event has been surprising to me in its magnitude. The things I relied on to be underweight financials (the sector's weighting in the SPX and the inversion of the yield curve) warn of problems they don't say anything about magnitude. Simply heeding those warnings means not having to be correct about magnitude. I only held one REIT across the board, Equity Residential (EQR), which I sold in late 2007. Other trades in the sector included a swap out of Barclays (BCS) and into Santander de Chile (SAN) in December 2007 and then I bought Chicago Mercantile (CME) very far into the bear market but it still went down a lot after I bought but has come way back. I still have one Australian bank and one Canadian bank that are bull market holdovers that I hope to hold forever but if they do something like buy a Merrill Lynch I wouldn't hesitate to sell it right away as was the case with BAC.


So that is the background for anyone new. Going forward I have given up on REITs as diversifiers. While it is true that correlations across the board went higher during the bear the correlation of REITs to financials seemed to go up very early on as opposed to closer to the end like a lot of things did. Not that I will never buy one, just that I have lost faith in their ability to offer diversification.

I am a couple of percentage points underweight versus the index. Domestic financial stocks have roared back price wise to be sure but I don't think the massive run is justified fundamentally. After going down a ton they came screaming back that is a normal market reaction but I don't really want to put client money into stocks that have no, IMO, fundamental basis for being bought. I have a stock picked out that I expect to buy in the sector that would take me close to equal weight that while clearly a financial is not a bank, brokerage or insurance company--beyond that I'm not going to front run it. I am also open to buying something like Hong Kong Exchanges (HKXCY) for certain accounts down the road but that would be a long way down the road if ever. About all I can say about that name now is that it makes a good first impression (please, do not add 1+1 and get eleven here).

As far as the fate of the US dollar and so on. I have had the same big picture thoughts about all of this for years and they have not changed much because of the crisis. I have felt that the US would have to share its role of world economic superpower. Other countries are growing faster and becoming more relevant in the world economic order; China for all its issues is more relevant than it used to be. This would cause there to be a little less demand for the greenback which puts some upward pressure on US interest rates and maybe gooses up inflation some.

As for inflation I think hyperinflation is off the table. The dollar is likely to have to share the role of world reserve currency. This means that plenty of countries will still need, want and use USD. Allowing it to hyperinflate hurts everyone so it is in everyone's interest to prevent it. That is not to say that inflation can't go up to a point of being quite uncomfortable but hyper seems very unlikely.

Since first putting this together in the early days of this site we have seen rates panic lower as the financial system came closer to a meltdown than people thought possible. My idea for interest rates was something close to 6-7% for long rates but we now have further to travel to that point which means the discomfort of that adjustment could be more uncomfortable.

I would point out that all of these things are likely to play out over many years. Indeed I believe this entire decade will be viewed as part of one massive but slow moving adjustment.

Regardless of the particulars I think the outcome will be similar. This not doomsday but more of a headwind the result of which, IMO, will be below normal returns for US equity markets which isn't that horrible because we've already been living with that for ten years. I've been saying we need to increase foreign exposure for years and I think that will continue to be the case. While this has been correct thus far it has also been a very obvious conclusion to draw and I believe no less obvious now.