When the market turns nasty people typically look to uncorrelate their holdings, but it looks like building an uncorrelated portfolio is harder than ever these days. I made 6 month correlations matrixes for international equity markets, the bond market and US sector ETF’s. Diversification gains looks to be scarce outside of the bond markets…
The (main) problem with the US economy is not cyclical but structural. Yes the US (and the rest of the world) is currently in a cyclical downturn, this cyclical downturn is part of a much larger structural collapse of the US economy. Worst of all, no one is talking about this structural collapse and the stimulus plan does not address the real problems that underlay the US economy.
Simply put, the US economy is structured in an unsustainable way.
Trade Deficits
Since the late 70’s the US has imported more goods than it has exported. This trade deficit has led to many nations around the world holding large reserves of US dollars. Other countries have been willing to hold US denominated currency, and US denominated debt, because the US is seen as the pinnacle of financial stability. In my opinion, the large military budget is largely responsible for this perceived stability. The problem with running constant trade deficits is that it creates a constantly increasing supply of US dollars throughout the world. In the past demand for US currency has kept up with supply, and the US dollar has remained (relatively) strong. The dollar’s strength and willingness of other nations to accept our paper currency in exchange for hard goods was bolstered by such financial crisis’ as the Russian debt default in 1998, the Asian Contagion crisis 1997-1998, and the Latin American economic crisis in the early 2000’s. But this party cannot go on forever. With the world awash with dollars, it is only a matter of time before the dollar, and consequently all dollar denominated assets, realized a huge devaluation.
Figure 2 US Trade Deficit (in Billions USD)
The World’s Oldest Profession
We are literally selling ourselves to pay for our immediate consumption. Everyone knows the paradigm of the exotic dancer who is selling her body to put herself though medical/law school . At least she is selling herself to make an investment in her future, we are selling off parts of our country in order to consume more goods in the near term. Our current account(balance of trade + net factor income from abroad + net unilateral transfers from abroad) balance is dismal . This quote from the BEA accurately portrays our situation:
“The U.S. net international investment position at year end 2007 was -$2,441.8 billion (preliminary), as the value of foreign investments in the United States exceeded the value of U.S. investments abroad.”
Figure 1 Us Current Account Deficit (in Billions USD)
Dollar as A Reserve Currency
Don’t get me wrong, it’s good that other countries want to invest in the US, buy dollar denominated assets and are willing to take on our debt. It shows that the world has a great confidence in the US economy. But I think people need to realize that the current system is unsustainable, the US cannot go on trading pieces of paper for hard goods forever. We can’t keep selling off parts of our house to buy a new TV and a new car. At some point we need to start making things again. At some point we need to stop worrying about the US consumer and start worrying about the US producer. Protectionism greatly exacerbated the Great Depression, and I don’t think now is an appropriate time to be thinking about trying to force more egalitarian trade terms on the rest of the world. After all, we need someone to buy our debt just as the developing world needs someone to buy their hard goods. But I think US economic policymakers should take a long look at our trade policies in more “normal times” and formulate a reasonable plan to preserve the integrity of the dollar. Import vouchers are one good solution proposed by Warren Buffet.
So What Who Cares
The not unlikely scenario of a run on the dollar in the next decade has profound investment implications for anyone with a long term investment horizon. It is my belief that long term investors should diversify their net worth across the globe. Just as someone who works at Lehman Brothers should not hold Lehman Brothers stock, American investors should not keep all of their money tied up in the US markets. I suggest putting some money in broadly based international ETF’s and hard commodities that are traded all throughout the world(such as oil and soybeans). These commodities can also be easily purchased through ETF’s. The home biased is tempting, and well documented, but I suggest you avoid it. Until these monkey politicians wrap their heads around fixing the American producer and stop focusing narrowly on the American consumer, I suggest global diversification.
Reasons to buy
Microsoft is a cash generating powerhouse. The company prints over a billion dollars of cash flow per month. Moreover, Microsoft has a ttm profit margin of 28 %, an operating margin of 39%, and a return on equity of 54%.
In addition to those very attractive profitability ratios, Microsoft has very little chance of declaring bankruptcy in the foreseeable future – zero chance in my option – which is very important given current market conditions. With a debt/equity ratio of .06 and a current ratio of 1.52, Microsoft is about as solvent as water! This software giant also has 20 billion in cash and only 2 billion in debt. The large cash position is great because it gives Microsoft the option to acquire other companies or buyback their stock at depressed levels. You Always Have Other Options right?* Tell that to Jerry Yang!
In addition to sound solvency ratios Microsoft is currently yielding 2.7%, and sports a trailing twelve-month price/earnings multiple of 10.1 compared to an industry average multiple of 14.1.
Aside from strong fundamentals Microsoft also has a several interesting prospects. Firstly, Microsfot has signed a deal with major health insurer Aetna that will allow patients to access their health record via Microsoft’s HealthVault platform. Microsoft is also looking to expand their exposure to the rapidly growing search advertising field – either organically with Live or by the acquisition of a search platform such as Yahoo’s.
Reasons to be wary
A large portion of Microsoft’s revenues come from selling software such as the Windows OS and Office suite. This software is typically sold when someone buys a new PC. The global slowdown will indubitably mean slowing PC sales growth even when we consider emerging market growth. Moreover, piracy is a huge risk for Microsoft going forward. In China, Most Windows OS’s (90% according to one study) are pirated. Everyone knows the Chinese do not fully grasp the concept of intellectual property rights. If you want evidence of this just take a stroll down Canal Street - “Gucci!, Prada!, Gucci!, Prada!”. I foresee the relative ease at which programs can be pirated as becoming a bigger and bigger problem as Microsoft expands its software business into the poorer emerging markets.
Another risk is that posed by search giant Google. Not only does the GOOG control about 70% of the search market but it is also starting to infringe upon Microsoft’s territory via browser based applications such as Google Spreadsheet (which is like Microsoft’s Excel). Though these browser based applications are not a real threat yet, they could become one in the future.
Despite the risks I like MSFT because of its strong cash position, ability to generate additional cash, and strong product pipeline.
*Yahoo! Is commonly mistaken to be an acronym for You Always Have Other Options – when really it is an acronym for Yet Another Hierarchical Officious Oracle.
Disclosures - None
