Discovery Investing: The Barbell
By Michael Berry --------------------------------->
Coming downturn is ideal environment for the barbell
It is becoming clear that economic growth is slowing in the U.S. and Canada. On Friday the PMI (Purchasing Manager’s Index) in the U.S. came in below 50, the level at which the economy is neither expanding nor shrinking. It fell to 49.5 in November, from 51.2 in October -- the first time in 3 1/2 years it has been negative. Such an event is evidence that the U.S. economy is slowing.
The Canadian economy is following suit. It grew at a modest 1.7% in the third quarter down from 2%. This was the slowest growth in three years. The difference, of course, is that Canada is running a budget surplus. She has “turned the corner” with her great commodity wealth and fiscal policies since 1995. She may be able to achieve the soft landing that we hear about in the recent Greenspan speech on the U.S. housing market.
The U.S., however, has a significant budget deficit. She is the largest debtor in the world and the largest consumer. This means that the U.S. runs a tremendous trade deficit.
In spite of clairvoyance from bond yields in both the U.S. and Canadian markets with inverted yield curves to boot, Federal Reserve Chief Bernanke sounded an inflation alarm in a speech last week. I believe that the Fed will be forced to cut short term interest rates, rather than raise them – and sooner than most expect.
Monday AM Bloomberg reported that mutual fund dealer Putnam and fixed income giant PIMCO are betting on a 5% decline in the U.S. dollar. These firms reckon that lower growth, and then lowered interest rates, will drive the dollars (Greenback and Loonie) lower. Such thinking can turn from prophecy into reality as the crowd follows suit. Both Putnam and PIMCO think Treasury yields could fall to 3.5% in 2007.
China’s gold consumption will rise 17% this year to 350 tons. This is becoming a trend in China as it may in India. Some of this investment must come at the expense of the US dollar (although not the Loonie). Support of the dollar requires a substantial capital inflow. It will lessen as other countries choose to diversify their dollar exposure. The outlook for gold is therefore bright.
What about bonds? I have been wrong on bonds. I believed, through the summer, that the bond vigilantes would recognize nascent inflation. Early in the year they did so, but in May the “worm turned.” Bond markets became more concerned with declining economic growth. U.S. Treasury yields have fallen dramatically since May. The good news is that lower rates may save the over-levered, over-mortgaged and “under-equitied” U.S. consumer. Economist Gary Shilling, however, believes that within months the housing market will be staggered by dramatically lower selling prices, which could catalyze the hard economic landing some have been predicting.
Four years ago Don Peters, President of Central Plains Advisors in Wichita, Kansas, and I developed a portfolio we called “The Barbell.” Don has been one of the best bond managers in the country. It was not a traditional bond barbell portfolio, which is a bond investment strategy that concentrates holdings in very short-term and extremely long-term maturities. Instead, we hypothesized that if the economy fell into recession, or worse: a serious deflation, bonds and gold would be assets of choice. I wrote about the Barbell several times in 2004 and once in 2005. While I have been bullish on gold since 2001 I gave up on the bond market in 2005. Last week Chicago Fed President Michael Moskow suggested a rate increase was more likely than a decline. Perhaps the strategy is to place dagger in the heart of inflation and then cut rates. However it seems likely that the Fed has already tightened far too much. Can they really tighten further? It appears, in spite of Dr. Bernanke's recent inflation concerns, that the Barbell might work exceedingly well in the next 12 to 18 months.
Alternatives. The US stock market will face tough sledding in general. Analysts are beginning to revise earnings estimates down. La Cucaracha may begin to appear in the form of negative earnings surprises. Discovery stocks are, as always, a very good place to be because great discoveries will create great wealth. Dollars are flowing out of US stocks to foreign stocks. $100 billion has found the foreign market this year, an increase of 40% over last year.
May I suggest that you consider the barbell portfolio? This should include gold and precious metals and the long term US and Canadian Treasury bonds. The gold exposure should be partly in the metal itself – which probably means coins. Discovery investments and energy assets will be complementary to the barbell. As you can see we have been steadfastly correct on gold. It bottomed at $240 in 2001. However, we had expected to see bond yields rise. They did rise between July of 2005 and May of 2006. The recent decline in bond yields (and corresponding increase in bond prices) looks convincing in light of evidence for an economic slowdown and an unlikely rate increase from the Fed. Barbell anyone?
Inexorably downward. Is a 3.5% yield now in the cards for the 30-yearTreasury?
Gold has been good to us since 2001.
Michael Berry has been a portfolio manager for both Heartland Advisors and Kemper Scudder, where he successfully managed small and mid-cap value portfolios. He was a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia and has also held the Wheat First Endowed Chair at James Madison University. Dr. Berry is now a proponent of what he calls "discovery investing."
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