There has been a lot of volatility, fear and uncertainty in the stock market recently. Personally, I don’t think that there will be any changes in the near future and that the volatility will continue. I am still suspecting another recession in the next 12 months and a return of the Dow to 4 digits. Of course, I could be wrong but why take any chances? I will keep using protective puts on my retirement accounts. After all, they just saved me 9 percent of my portfolio. I am down about 4% since the downgrade.
Today is option expiration so those stocks that closed below the level of my puts yesterday will automatically be sold. I haven’t cared much that Akamai (AKAM) traded below $21 per share since I have puts that will be exercised at $27. They will sell today at $27 and I will have $6 per share extra in cash when I buy back on Monday. I will likely just sit on my current positions and wait for the carnage to end and a trend to re-establish. Then I can buy more shares with the cash that I have.
Avoiding Big Losses
I have become convinced that the best way to make money is to not lose big. Swinging for the fences makes for good stories, but winning is often times more about not making any forced errors. It is avoiding turnovers and protecting the ball. It is about controlling the game and not giving up a big play.
The same holds true for investing. I don’t want to lose 50% because it takes a 100% gain just to get back to even. I would much prefer to lose only 10% even if I have to give up a little bit of upside during bull markets. That is why I started using protective puts in 2007.
The timing couldn’t have been better since when the market was down big, I lost only 18%. It didn’t take long for me to get back to where I was before. You don’t necessarily have to use options to control your risk, but you should have a plan when investing whether it is “sell in May and go away” or dollar cost averaging or asset allocation.
For me, put options make the most sense. I have been trading options for over 10 years and have a good sense of how to use them. I have been sharing my trades on two of my stocks, SLW and ONXX, over at OptionsDude.com to give readers an idea of how I have been trading in my retirement. I actually thought my put options for both of these stocks would be exercised, but was surprised over the past week. The price of silver soared on Friday (and Silver Wheaton stock with it) such that I actually had one ray of sunshine in my portfolio.
This is a little shorter post than usual, but I wanted to share a little about how I am dealing with the volatility in the stock market especially now that options have expired, and results are in. I have been able to sit back and watch what is happening rather than worry too much about it.
Readers: What are your thoughts on recent market volatility? How have you been handling it? What are your plans going into the rest of the year?
I am sorry to interrupt my originally planned post, but felt that I simply had to comment to Andy’s post at Tight Fisted Miser who thinks inflation may not be as bad as perceived. Personally, I tend to disagree so I would like to expand upon my comment that I made. Andy does make a good point when raising the issue of hedonic regression, but I think the analysis needs to be taken further.
What is Hedonic Regression?
Of course, we should all be on the same page so that means we should understand hedonic regression prior to beginning further discussion. Hedonic regression is an economic theory that attempts to ascribe increased value to something of higher quality by breaking out component parts.
In Andy’s post, he cites the example that the average home size in 2009 was 2,700 square feet vs 1,400 square feet in 1970, and that is true. The larger sized home should cost more without the impact of inflation. That should be expected and is entirely justifiable.
Both Sides of the Equation
However, if you want to apply these mathematic adjustments to one side of the equation, you need to do it to both sides to avoid changing the equation (algebra 101). So, let’s look at salary hedonics.
Using Little House’s data from the inflation post that inspired this discussion, the average income in 1971 was $10,622 per year. In order to apply hedonics, I will use productivity data from the United States Bureau of Labor and Statistics (the increase is annualized).
- 1973-1979: 1.1%
- 1979-1990: 1.4%
- 1990-2000: 2.5%
- 2000-2007: 2.4%
So, I will take that average salary and starting in 1972 multiply by 1.1% for seven years, then 1.4% for eleven years and so on. The result? In 2007, I would expect the average salary to be $20,193 based upon the same rationale that a the worker in 2007 is more valuable due to improvements in productivity the same as the house is more value due to improvements in size and amenities.
Comparing Both Sides of the Equation
So we see that salaries have almost doubled due to hedonics as has the size and quality of homes. Thus the excess above a doubling could be ascribed to inflation. Is there any fault in this logic?
So you might expect the new house in 1971 which cost $25,200 to cost about $50,000 in 2011. And yet the data shows that the actual cost is $169,000 or just over 3 times expected.
Doing the same thing for salaries means that the salary of $40,000 in 2011 is only twice that which might be expected. This means that the average worker is in fact losing ground to inflation!
Granted the standard of living for homes have improved. I don’t think anyone would debate that fact. However, inflation is still ugly. Saying it is not as bad means the difference between being stabbed 30 times vs 20 times. Doesn’t mean much to me.
Items that Need No Hedonics
Of course, Super Saver brings up a good point in the commentary which is exactly why my mom thinks hedonics are crap. She uses the same gallon of gasoline in 2011 that she used in 1971. Granted the car is nicer, but she still needs to get from point A to point B.
She also drinks the same gallon of milk and the same diet Pepsi. The same head of lettuce is used to make her 7 layer salad. The stamp that she puts on the letter still gets to its destination in 2 or 3 days after putting it in the box and raising the little red flag.
Finally, she doesn’t really care if the latest iPod is better than the original version since my parents still have 8-tracks (but that’s another story).
The Good, Bad, and Ugly
It wouldn’t have been so bad for my parents if their salaries had kept pace with the cost of gasoline, food, and postage stamps but that wasn’t the case. Their salaries increased about 2.5 times from 1971-2005. The majority should have been explained by hedonics so they actually lost ground to inflation.
It is probably expected since once you hit a certain level, most people stop advancing. My mom taught in the same school for 30 years. She got her master’s degree in education, but didn’t go beyond that. So I can understand that she simply got some cost of living increases. Unfortunately, they didn’t keep pace with inflation. Ugly!
So inflation is ugly and salary growth has been bad, but what is good in all this?
My parents bought a house in 1973. They paid $5,000 for the lot and $25,000 to have the house built. It sold in 2005 for over $150,000. And it wasn’t even hedonized!
It had the same square footage when it sold in 2005 as it did in 1973. The size of the lot was the same. Nobody built a beach or ocean by the property. No mountain view was added. At least they did get rid of the green shag carpeting that was in my room before selling.
Even though no major improvements were made to that property, it still sold for more than 5 times what it cost in 1973. That is awesome! So at least they managed to be on the right side of the inflation equation by owning real estate.
The Moral of the Post
Inflation sucks! Don’t let anyone tell you otherwise. It is bad and is probably worse than you think. The only way to beat it is to own stuff. Own real estate, own gasoline, own food or farmland or stock in companies that own food or farmland or gasoline if you can’t own them outright.
You want to be able to maintain your purchasing power. Salaries won’t do it. Pensions and social security won’t do it. You have to do it yourself with investments designed to keep pace with inflation.
Not to pick on Andy, since he does make a great point. Standards of living have increased dramatically in the last 40 years. My flat screen HDTV is much better than the 19″ black and white I remember as a kid with the antenna with an aluminum foil hair-do to maximize reception.
But I would rather prepare for the worst and be pleasantly surprised if in 40 years, inflation isn’t so bad. And we haven’t even begun to talk about substitution bias in the CPI.
OK, readers. What are your thoughts? Inflation, hedonics, CPI, wealth gap, gold, fiat currency.
If you read my last post about K-waves, you know what to expect from this post. If not, then you really should read about Nickolai Kondratiev and K-waves for a better understanding regarding today’s topic. After all, Stalin had him killed for his work.
I will start out by outlining the characteristics of the various seasons: spring, summer, autumn, and winter. Then I will delve into the various investments that might be most appropriate for the expected conditions. Just like certain activities and clothing is more suitable for summer versus winter, the same holds true during these economic “seasons”.
Kondratiev actually proposed three phases to the cycle, but his work has been expanded to include a fourth phase to help it correspond to the seasons of the year. I think this is a great way to remember them as well.
The spring phase is all about gradual expansion and growth. It is characterized by mild inflation and technological innovation leading to new opportunities of entrepreneurship.
Interest rates start from historically low levels due to the previous winter economics. Credit slowly begins to build and expansion slowly begins to take hold. As a result, inflation slowly picks up as the money supply begins to expand following its contraction.
Optimism begins to fill the air and investment in this new technology begins to quicken. There is usually peace in the world and no major wartime efforts going on either so that countries can focus on the technology of the day.
Think about the period after World War II and the growth of communication technology from television to satellite to the internet. The most recent beginning of spring was identified in 1949.
Summer is a time of slowing growth and often even some economic recession. The recent spring has led to high consumer confidence and the bullishness leads to a stock market peak at the beginning of summer. Summer ushers in a period of stagnation.
Credit continues to expand primarily to companies and leads to high inflation that peaks at the end of summer. The stock market grinds lower to bottom at the end of summer. There is often a major conflict at the beginning of summer that corresponds with the stock market peak.
The most recent summer began in 1966 which saw the Vietnam War and the Nifty Fifty of the NYSE which were peaking in the late 60’s and early 70’s. Of course the 1970’s saw “stagflation” with no growth and high inflation. The stock market ground to a low in the early 80’s and gold peaked in 1980.
Autumn is a time for euphoria. Coming out of the summer doldrums, consumer confidence begins to build and credit to individuals begins to expand greatly. Inflation begins to fall along with interest rates and a massive bull market in stocks begins.
The falling inflation, bountiful credit, and plentiful jobs leads to higher levels of consumer confidence which develop into euphoria leading to asset bubbles. Also the declining interest rates results in massive expansion of debt such that by the end of autumn debt is at historic levels.
The euphoric peak in the stock markets announces the onset of winter as it did in 1929 and 2000. Autumn is usually a time of peace as well with no major armed conflicts which help to add to the euphoria.
Winter is characterized by the bursting of bubbles. Credit contracts and then virtually disappears as balance sheets require repair. Interest rates decline as does inflation such that fears of deflation begin to emerge.
Consumer confidence takes a major hit leading to concern, fear, and despair. Obviously, unemployment is high and jobs are scarce. Interest rates are lowered in an attempt to stimulate the economy.
There are often fiscal crises resulting in bankruptcies, banking crises, and even international currency crises like in 1931-1934. Repudiation of debt is significant. The bear market in stocks is on a parallel with the previous bull market. Armed conflict occurs.
Out of the ashes of the winter depression, a new technological advance begins, and the cycle begins anew.
When I first read about this eight years ago, I was utterly speechless. I couldn’t believe it. It seemed as if every period in history going back to the Revolutionary War could be outlined and placed into these various seasons. Of course, there were tables and graphs to do just that. I would encourage you to do some more research on your own but I have included one such table along with the link reference to begin that research. Then I will go into the investments for each season.
Reference: Institute for Practical Finance, Inc.
Investing for All Economic Seasons
As you can see from the table above, there are certain investments that might do well in each season, but let’s think logically about what may be worth investing in now that we know each season’s characteristics.
- Spring is a period of growth and optimism coming out of the bursting of stock market and real estate bubbles so it would make sense that investing in stocks and real estate at the lows would be a good choice. Interest rates are low so bonds would be a poor choice.
- Summer is characterized by inflation and so gold, commodities, and real estate are good choices. Stocks grind away for years at a time so decreasing allocation to stocks is a good idea. Gold usually peaks at the end of summer as do interest rates. The end of summer is a good time to purchase bonds or other interest rate investments.
- Autumn is the season for bubbles so real estate and stocks are a good place to be as long as you can sell at or near the top at the end of autumn. Gold is bottoming and going through its bear market so moving out of stocks and real estate over the years is a good idea.
- Winter is when the debt and financial crises hit as well as deflation. It is a good time to be in gold, commodities, and cash as investors are looking for tangible investments since confidence in paper is low. Cash is good because of the likelihood of deflation. Maintaining wealth is a good strategy for winter so that capital is ready for spring again.
Well this post has gotten a little bit long. I have more topics that I would like to cover in the same vein so I am going to pause right here and save it for my next post. In my next post, I want to cover my investing thoughts at this time.
In the meantime, I would love to hear your thoughts so far. Do you think that we are in Kondratiev’s winter? What implications might this have? Any idea when spring is coming? As always, thank you so much for reading!