Tactical Change to Portfolios

In the post immediately below this one, I offered some thoughts about a potential dollar decline. In the interim, I've done some more thinkin' and analyzin' about our current state of affairs, including the imminent stimulus package. As has often been the case over the past several years, I found in the writings of Jeremy Grantham the crystalized message that had been foggily drifting around in my head. I couldn't quite get my hands on that fog, but Grantham managed to present me with a "That's it!" moment.

We are in the midst of a great write-down of asset values -- real estate and equity in businesses for the most part. Prior to this value destruction, total private debt was about half of the asset values. As the values come down, so too must the debt. We are headed for a debt reduction in the $10 to $12 trillion range. That reduction needs to occur before we can return to our long-term GDP trend line.

There are three ways to reduce debt.

One: The old fashioned way -- pay it down. Stop consuming and investing and instead use cash wages and earnings to pay down debt. This translates into a drawn-out period of suppressed economic activity. And it takes a long time.

Two: Default. If you don't pay it back, and the lender can't collect, the debt kinda disappears. This is problematic for you, to be sure, but it's happening right now on a grand scale.

Three: Inflation. If you can pay back a dollar of debt incurred in 2005 with a dollar-fifty of money earned (for the same work) in 2012, your debt has effectively been reduced by a third.

The first of these is modestly underway at present. Consumer saving rates rose sharply in late 2008, and much of that saving is going to pay down debt. But, this is a slow, slow process. For historic precedent, you can look to Japan's economy post-1989. It took the better part of 15 years, but this is how Japan largely managed its debt reduction. We have bet on this trend by continuing our underweighting of stocks and real estate.

The second of these is emphatically underway and we're not the only ones to realize it. Default rates are exploding upwards. In fact, we expect to profit from a probable over-reaction in some sectors. We've purchased debt at discounts of 20%-30% on which we expect to incur loss rates of only 0%-15%.

The last debt-reduction method (inflation) is not yet in full swing. However, it's coming and we want to be ahead of the curve. The stimulus package, together with the Fed's continuing commitment to create (ie, "print") money with a vengeance, all but ensures an above-trend period of inflation sometime over the next X years. How long is X? We cannot know for sure, but we think the cost of being early is low.

Our principal current investment positions that provide insulation from a weakening dollar and rising inflation are energy and natural resource stocks. We have also kept our bond maturities short, but that's more of a defensive posture than a profit-seeking one.

This week, we have added positions in developed-market foreign bonds. We owned such positions for several years and gradually eliminated them throughout 2008. We are buying those same positions back now, but at about ~20% lower prices. The exposure to foreign bonds is a hedge against a weakening dollar -- if the dollar weakens, the bonds rise in value. If we are right, we profit nicely. If we are wrong, we earn about the same interest rate we could earn on domestic bonds. We think the odds of the dollar strongly strengthening from here are low.

This is my favorite type of investment scenario -- one where the payoff probabilities are asymmetrical. The downside is low or improbable; the upside is high or probable.

We will continue to watch carefully for opportunities to shift gradually toward an inflation-defensive posture.