This is an article that I hope will give people new insight into the very complex dilemma of investing for today’s income needs. I know that the answers you seek will not be found in this article in the manner that you would like to read, but this may be the only place that you will read what I feel to be the truth about this subject. I am not saying that I have the answers, but I do believe I see very serious problems on the horizon that could be very dangerous to the investment portfolios and cash needs that are so very important to investors who are retired or looking to retire.

The sad fact is; we work our whole lives in the hope that we can accumulate the wealth necessary to enjoy and survive, what is supposed to be, our “Golden Years.” The ultimate truth is recognizing the fact that many times we do not have enough of a nest egg to comfortably retire. This has forced so many people to invest their money in a manner that has placed them at great financial risk.

When working with traditional investment philosophies of diversification; there comes a time when the most prudent investment strategy is to simply take care of your money.  This means keeping your money liquid and safe. There are many times throughout history that funds are best kept in a parking place. Investors have been conditioned to believe that they should always seek a return on their money. This is not always the case and I believe that the current environment for stocks and bonds dictates that investors, thinking in the traditional manner, need to step back and place their funds in a vehicle that will protect them from losses in the event that my thinking comes to pass. Time and patience are your best friends and the end result will be an opportunity to take advantage of the mistakes of those who failed to recognize the warning signs. In a true bear market, under traditional investment philosophies, he who loses the least is the winner. This is the period of time that we have now entered. Rising interest rates and rising oil prices delegate traditional investments to a period where they are best forgotten.

As I have noted in prior articles; I believe interest rates are about to do a 180 degree turn. I believe interest rates are about to rise and rise dramatically as foreign bond holders lose faith in the American drug, excuse me I mean debt system; both are addictions. As the world sees the US economy faltering, again, in the short term, interest rates will fall in the tradition of falling interest rates in a recession. This will be the bait that attracts the fish to the hook for the fatal bite before the fish is reeled in and served up as a scrumptious meal for the smart money that dumped their bond holdings on the misguided investor.

Japan has already said that they will not support the dollar in the future. I think they have finally realized that a weaker dollar may be less damaging than an excess of US debt, whose repayment will not equal the purchase price of the original dollar investments. What do they really have to fear in the first place; we have outsourced all our manufacturing facilities and the only automobiles we know how to make get less than 20 miles to the gallon? Seems to me they could do well with either a rising or falling dollar. I don’t really believe that, but the possibility does exist.

In a nutshell; does it make sense to invest in bonds in a rising interest rate environment? The most investors can hope for is to have enough of a nest egg; if they were to buy bonds, to earn a return great enough to pay their monthly expenses. This is not a good enough reason to invest in a market where one is trapped, without an exit, in the event rising rates get out of control. The most one can hope to accomplish is a laddered bond portfolio where bonds are purchased over a five year period with bonds maturing each year so that the proceeds can be reinvested at the current rates of return. This will offer one the opportunity to have 20% of his or her money invested at current rates of return. This will enable the investor to slowly participate in greater income returns in a period of rising rates. The question an investor must ask and answer is the question of being able to survive a 25% to 50% loss of principal in the event a need arises and they have to cash in their bonds or bonds funds, at a time interest rates are higher than when they made their original investments. If rates are higher than when the original investment was made then a loss of principal will result as the bonds are sold back into the market to give the new buyer a current return that equals the market rate at the time of purchase.

I know for fact that losses of 50% on the principal were common back in 1980-81 as a result of rising rates; I had a client that sold an insured municipal bond trust where his current rate of return was 6.25% tax free; he received 50% of his investment back on the sale of the bond trust. Most people who invest in this manner do so as long term holders of the investments that they make. When making investments of this nature, the overriding motivation is maximizing current yield. This is not the investment philosophy that one should adopt when interest rates are at all-time lows. The biggest mistake that yield investors will make is the mistake of buying the maximum yield that they can find at what will eventually turn out to be the worst possible time. This search for extra yield will lead them to junk bond funds and Ginnie Maes. If history repeats itself, these categories of investments will turn out to be the most risky out there. I believe that if you can just postpone investments of this nature for the necessary time--which I feel will be four to six years--it is possible that the yields will be twice what they are today. That also equates into a savings of half your principal if a need arises where you have to sell in the event of an emergency. I know this is not what many of you would like to read, but don’t you think it is nice to know that you had the opportunity to read and learn before it is too late rather than being in a position that offers no flexibility after the fact? Think in terms of how far the extra income will go if you are able to survive and invest your money, down the road, at substantially higher rates of return! Another very important point to remember is the fact that the precious metals and natural resource stocks made phenomenal moves, while interest rates were rising back in the late 70’s and early 80’s. As I have stated in prior articles, I believe the massive amounts of debt that the consumer, corporations and the government have accumulated over the past twenty-five years; coupled with the fact that now we are accelerating the error of our ways, will guarantee that interest rates, in the end, will be substantially higher than they are today.

If you are still in a position where using a laddered approach does not get you the income necessary to comfortably retire, then don’t retire or maintain a separate job for cash flow to make up the difference. I have a real problem believing in our authorities when they have purposely used every means possible to destroy traditional savings. I believe this is an atrocity that will return to haunt investors in a manner that they cannot begin to understand in today’s financial world. The savings rate is one of the lowest in history, while the debt levels are at or approaching all time record highs. Record low interest rates have forced investors to flee the safety of bank CDs and traditional safe money returns for the high risk of alternative investments. I do not believe this switching of investment philosophies was an accidental outcome of the low interest rates; but rather I believe it was the planned design coupled with the objectives of allowing the home mortgage refinancing game to continue as long as possible, the consumer borrowing as much as possible and the forcing of as much money as possible into the stock market as a result of low yielding alternatives. The only outcome of this financial nightmare is an ending that will leave financial destruction for decades to come. I read very few articles dealing with the risk of owning long-term bonds in a period of rising interest rates. The biggest mistake an investor can make is the mistake of buying junk bonds or Ginnie Mae bond funds. Not only will you suffer an interest rate mark down, but a slowing economy could bring the additional risk of default to your investment. Yeah, I know Ginnie Maes are supposed to be guaranteed; go back and see how they held their value in the 1979-83 period. Where do you think the capital will come from to replace the foreign owners of our countries debt when the current owners refuse to roll their funds over or decide to sell before maturity? How do you think new funds will be lured into the trap of buying this questionable paper? Do you think rising interest will be the bait? Do you think the money will come from the stock market? I DO!

Incidentally, I feel rates may fall in the short-term as a result of the economy showing weakness, but I then feel rates will rise as the foreign owners of our bonds flee to greener pastures. I wonder what pastures those will be? Could it be spelled g-o-l-d? This is why I believe gold will not show the weakness that some people still feel is to come. As these foreign funds flee the traditional safety net of the US Bond, they will seek safety in some other form. I believe that a percentage of this money will have to find a home in the yellow metal. It seems to me that the same problems we are experiencing here in America are also found overseas. So why would the Euro offer any better safety net than the dollar?

The next trap is the traditional stock market mutual fund. If interest rates rise; what effect will this have on corporate earnings? How many of our major corporations have played the carry trade with their debt borrowings? How many corporations have huge amounts of debt borrowed in short term paper at the lowest rate they can pay while refusing to pay a little bit higher rate to lock in that debt, for what will be the least expensive borrowing cost they will ever have the opportunity to take advantage of? The answer is more than what we think and know. These people have loaned huge amounts of money at fixed long-term rates and borrowed at variable short-term rates. This works fine so long as rates do not rise. As rates rise, their borrowing costs will rise and the financial hit will go right to the bottom line. This stupidity will sink Fannie Mae and Freddie Mac. What does this type of financial suicide do to earnings in a rising interest rate environment? Most investors do not have a clue of the earnings which will evaporate as a result of rising rates down the road. In a period where interest rates are at historic all-time lows, corporations should be looking to lock their borrowing cost in for the long-term at rates they may never see again. The only reason they don’t lock the rates in is the fact that short-term earnings would suffer as a result of the extra 1%-2% increase in fixed rates. To not take advantage of the historic low rates is a grave mistake that the shareholders will pay for down the road.

An example of the ultimate stupidity in this market goes to our intelligent leaders who decided that the thirty year bond would come to an end. How can a government, with the debt problems we have, refuse to take advantage of the opportunity to lock in debt for thirty years at rates they will never see again? This is a mistake that we will pay for, in a big way, down the road.  I have no respect for the idiots who make decisions of this nature. Another point to this is the fact that if the debt is placed for thirty years, there will be no need to worry about the rolling of the debt as it does not come due on the short-term. The liquidation and refinancing of our debt are going to create a huge demand on outside capital to replace the foreign money that decides it wants to move elsewhere and seek a home somewhere other than in our paper. Interest rates will be forced to rise so that the new issues will be sold out. The major drawback to this is the source of funds; where will they come from? I believe the competition for the dwindling available funds to float our debt will eventually take its toll on the stock market. Where else can the necessary funds be found to supply the ever growing needs of our Federal Government? You have to be Larry Kudlow or Jim Cramer to think that these funds exist in ample supply outside of the stock market. The real cruncher comes into play with the exploding budget and trade deficits. There is an ever increasing need to raise more money because of the out of control debt loads. This is a suction of funds that will challenge alternative investments and I believe the necessity of the borrowing will outweigh the viability and the propaganda of the alternative investments. I would like to be able to come up with a different ending, but all my research is leading down the same path and that path does not have a happy ending for those who choose to be optimistic. It is a great thing to be an optimist; but be an optimist based on knowledge and fact rather than wishful thinking.

I am sure there are a lot of you asking the most important question of all “what am I supposed to do to keep above water?”  How do I buy and survive four to six years while rates are rising? The sad truth to this dilemma is the fact that you must make a choice. You must decide which path you are going to take. Do you follow the traditional path with the herd and accept your losses as market losses or do you step forward and break all the rules of diversification and invest your money in a manner that can allow you to participate or at least hope to keep you even in the event the things I have outlined in this article come to pass. The only way that you can make a decision is to gain knowledge. I do not believe the events I have outlined will be triggered overnight. In fact the possibility exists that there is still time to learn and come up with a game plan. As you read articles you should try to identify just what you believe and then concentrate on a strategy to incorporate investments into that game plan. It is very important to note that many market catastrophes happen in the month of October. I wish I had a crystal ball that could tell us exactly where we should be invested, but I don’t. I choose to put my faith in what I perceive as the direction of the economy, the market and the world. I also choose to put my faith in history as I know gold stocks and natural resource stocks performed very well in the thirties and the seventies. I see no reason to believe the results will be any different this time; in fact I believe that this time will be an extension of the past. It is possible my thinking will be wrong; but at least you had a chance to read about it before the fact rather than after the fact.

It is also very important to know that increasing precious metal prices and interest rate increases traditionally go hand in hand. This is a very sweet thing as when the time does come to take profits from our pm holdings; we can turn right around and invest the proceeds at much higher rates of return; to then be able to enjoy our “Golden Years.”  The question I find myself seeking an answer to now is the question of whether I will feel that investments in government bonds will be a prudent investment six years down the road. Kind of makes you think doesn’t it? I also know that when I begin to read about this in the common press, it will then be time to begin to take profits from my pm holdings. There is no need to worry about this now as I have every faith in our officials that they will turn to hyper-inflation before they put a lid on spending.

I have more to say on this subject and I hope to follow-up with a report to my e-mail list, for those who are interested. If you desire to know more of what I think, sign up for my e-mail list. I am going to Las Vegas for the conference and I am staying at the Mirage. I think this is an excellent opportunity to meet with the companies we read about all the time. I hope to write a report after the conference.

© 2004 Mike Hoy
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