Nine Secrets for Successful Speculation

By Louis James, Chief Metals & Mining Investment Strategist

When I started working for Doug Casey almost 10 years ago, I probably knew as much about investing as the average Joe, but I now know that I knew absolutely nothing then about successful speculation.
Learning from the international speculator himself—and from his business partner, David Galland, to give credit where due—was like taking the proverbial drink from a fire hose. Fortunately, I was quite thirsty.

You see, just before Doug and David hired me in 2004, I’d had something of an epiphany. As a writer, most of what I was doing at the time was grant-proposal writing, asking wealthy philanthropists to support causes I believed in. After some years of meeting wealthy people and asking them for money, it suddenly dawned on me that they were nothing like the mean, greedy stereotypes the average American envisions.

It’s quite embarrassing, but I have to admit that I was surprised how much I liked these “rich” people—not for what they could do for me, but for what they had done with their own lives. Most of them started with nothing and created financial empires. Even the ones who were born into wealthy families took what fortune gave them and turned it into much more. And though I’m sure the sample was biased, since I was meeting libertarian millionaires, these people accumulated wealth by creating real value that benefited those they did business with. My key observation was they were all very serious about money—not obsessed with it, but conscious of using it wisely and putting it to most efficient use. I greatly admired this; it’s what I strive for myself now.

But I’m getting ahead of myself. The reason for my embarrassment is that my surprise told me something about myself; I discovered that I’d had a bad attitude about money.

This may seem like a philosophical digression, but it’s an absolutely critical point. Without realizing that I’d adopted a cultural norm without conscious choice, I was like many others who believe that it is unseemly to care too much about money. I was working on saving the world, which was reward enough for me, and wanted only enough money to provide for my family.

And at the same instant my surprise at liking my rich donors made me realize that—despite my decades of pro-market activism—I had been prejudiced against successful capitalists, I realized that people who thought the way I did never had very much money.

It seems painfully obvious in hindsight. If thinking about money and exerting yourself to earn more of it makes you pinch your nose in disgust, how can you possibly be effective at doing so?

Well, you can’t. I’m convinced that while almost nobody intends to be poor, this is why so many people are. They may want the benefits of being rich, but they actually don’t want to be rich and have a great mental aversion to thinking about money and acting in ways that will bring more of it into their lives.

So, in May of 2004, I decided to get serious about money. I liked my rich friends and admired them all greatly, but I didn’t see any of them as superhuman. There was no reason I could not have done what any of them had done, if I’d had the same willingness to do the work they did to achieve success.

Lo and behold, it was two months later that Doug and David offered me a job at Casey Research. That’s not magic, nor coincidence; if it hadn’t been Casey, I would have found someone else to learn from. The important thing is that had the offer come two months sooner, being a champion of noble causes and not a money-grubbing financier, I would have turned it down.

I’m still a champion of noble causes, but how things have changed since I enrolled in “Casey U” and got serious about learning how to put my money to work for me, instead of me having to always work for money!

Instead of asking people for donations, I’m now the one writing checks (which I believe will get much larger in the not-too-distant future). I can tell you this is much more fun.

How did I do it? I followed Doug’s advice, speculated alongside him—and took profits with him. Without getting into the details, I can say I had some winning investments early on. I went long during the crash of 2008 and used the proceeds to buy property in 2010. I took profits on the property last year and bought the same stocks I was recommending in the International Speculator last fall, close to what now appears to have been another bottom.

In the interim, I’ve gone from renting to being a homeowner. I’ve gone from being an investment virgin to being one of those expert investors you occasionally see on TV. I’ve gone from a significant negative net worth to a significant nest egg… which I am happily working on increasing.

And I want to help all our readers do the same. Not because all we here at Casey Research care about is money, but because accumulating wealth creates value, as Doug teaches us.

It’s impossible, of course, to communicate all I’ve learned over my years with Doug in a simple article like this. I’m sure I’ll write a book on it someday—perhaps after the current gold cycle passes its coming manic peak.

Still, I can boil what I’ve learned from Doug down to a few “secrets” that can help you as they have me. I urge you to think of these as a study guide, if you will, not a complete set of instructions.

As you read the list below, think about how you can learn more about each secret and adapt it to your own most effective use.

Secret #1: Contrarianism takes courage.

Everyone knows the essential investment formula: “Buy low, sell high,” but it is so much easier said than done, it might as well be a secret formula.

The way to really make it work is to invest in an asset or commodity that people want and need but that for reasons of market cyclicality or other temporary factors, no one else is buying. When the vast majority thinks something necessary is a bad investment, you want to be a buyer—that’s what it means to be a contrarian.

Obviously, if this were easy, everyone would do it, and there would be no such thing as a contrarian opportunity. But it is very hard for most people to think independently enough to risk hard-won cash in ways others think is mistaken or too dangerous. Hence, fortune favors the bold.

Secret #2: Success takes discipline.

It’s not just a matter of courage, of course; you can bravely follow a path right off a cliff if you’re not careful. So you have to have a game plan for risk mitigation. You have to expect market volatility and turn it to your advantage. And you’ll need an exit strategy.

The ways a successful speculator needs discipline are endless, but the most critical of all is to employ smart buying and selling tactics, so you don’t get goaded into paying too much or spooked into selling for too little.

Secret #3: Analysis over emotion.

This may seem like an obvious corollary to the above, but it’s a point well worth stressing on its own. To be a successful speculator does not require being an emotionless robot, but it does require abiding by reason at times when either fear or euphoria tempt us to veer from our game plans.

When a substantial investment in a speculative pick tanks—for no company-specific reason—the sense of gut-wrenching fear is very real. Panic often causes investors to sell at the very time they should be backing up the truck for more.

Similarly, when a stock is on a tear and friends are congratulating you on what a genius you are, the temptation to remain fully exposed—or even take on more risk in a play that is no longer undervalued—can be irresistible. But to ignore the numbers because of how you feel is extremely risky and leads to realizing unnecessary losses and letting terrific gains slip through your fingers.

Secret #4: Trust your gut.

Trusting a gut feeling sounds contradictory to the above, but it’s really not. The point is not to put feelings over logic, but to listen to what your feelings tell you—particularly about company people you meet and their words in press releases.

“People” is the first of Doug Casey’s famous Eight Ps of Resource Stock Evaluation, and if a CEO comes across like a used-car salesman, that is telling you something. If a press release omits critical numbers or seems to be gilding the lily, that, too, tells you something.

The more experience you accumulate in whatever sector you focus on, the more acute your intuitive “radar” becomes: listen to it. There’s nothing more frustrating than to take a chance on a story that looked good on paper but that your gut was warning you about, and then the investment disappoints. Kicking yourself is bad for your knees.

Secret #5: Assume Bulshytt.

As a speculator, investor, or really anyone who buys anything, you have to assume that everyone in business has an angle. Their interests may coincide with your own, but you can’t assume that.

It’s vital to keep in mind whom you are speaking with and what their interest might be. This applies to even the most honest people in mining, which is such a difficult business, no mine would ever get built if company CEOs put out a press release every time they ran into a problem.

A mine, from exploration to production to reclamation, is a nonstop flow of problems that need solving. But your brokers want to make commissions, your conference organizers want excitement, your bullion dealers want volume, etc. And, yes, your newsletter writers want to eat as well; ask yourself who pays them and whether their interests are aligned with yours or the companies they cover.

(Bulshytt is not a typo, but a reference to Neal Stephenson's brilliant novel, Anathem, which defines the term, briefly, as words, phrases, or even entire books or speeches that are misleading or empty of meaning.)

Secret #6: The trend is your friend.

No one can predict the future, but anyone who applies him- or herself diligently enough can identify trends in the world that will have predictable consequences and outcomes.

If you identify a trend that is real—or that at least has an overwhelming amount of evidence in its favor—it can serve as both compass and chart, keeping you on course regardless of market chaos, irrational investors, and the ever-present flood of bulshytt.

Knowing that you are betting on a trend that makes great sense and is backed by hard data also helps maintain your courage. Remember; prices may fluctuate, but price and value are not the same thing. If you are right about the trend, it will be your friend. Also, remember that it’s easier to be right about the direction of a trend than its timing.

Secret #7: Only speculate with money you can afford to lose.

This is a logical corollary to the above. If you bet the farm or gamble away your children’s college tuition on risky speculations—and only relatively risky investments have the potential to generate the extraordinary returns that justify speculating in the first place—it will be almost impossible to maintain your cool and discipline when you need it.

As Doug likes to say; it’s better to risk 10% of your capital shooting for 100% gains than to risk 100% of your capital shooting for 10% gains.

Secret #8: Stack the odds in your favor.

Given the risks inherent in speculating for extraordinary gains, you have to stack the odds in your favor. If you can’t, don’t play.

There are several ways to do this, including betting on People with proven track records, buying when market corrections put companies on sale way below any objective valuation, and participating in private placements. The most critical may be to either conduct the due diligence most investors are too busy to be bothered with, or find someone you can trust to do it for you.

Secret #9: You can’t kiss all the girls.

This is one of Doug’s favorite sayings, and though seemingly obvious, it’s one of the main pitfalls for unwary speculators.

When you encounter a fantastic story or a stock going vertical and it feels like it’s getting away from you, it can be very, very difficult to do all the things I mention above. I can tell you from firsthand experience, it’s agonizing to identify a good bet, arrive too late, and see the ship sail off to great fortune—without you.
But if you let that push you into paying too much for your speculative picks, you can wipe out your own gains, even if you’re betting on the right trends.

You can’t kiss all the girls, and it only leads to trouble if you try. Fortunately, the universe of possible speculations is so vast, it simply doesn’t matter if someone else beats you to any particular one; there will always be another to ask for the next dance. Bide your time, and make your move only when all of the above is on your side.

Final Point

These are the principles I live and breathe every day as a speculator. The devil, of course, is in the details, which is why I’m happy to be the editor of the Casey International Speculator, where I can cover the ins and outs of all of the above in depth.

Right now, we’re looking at an opportunity the likes of which we haven’t seen in years: thanks to the downturn in gold—which now appears to have subsided—junior gold stocks are still drastically undervalued.

My team and I recently identified a set of junior mining companies that we believe have what it takes to potentially become 10 baggers, generating 1,000%+ gains. If you don’t yet subscribe, I encourage you to try the International Speculator risk-free today and get our detailed 10-Bagger List for 2014 that tells you exactly why we think these companies will be winners. Click here to learn more about the 10-Bagger List for 2014.

Whatever you do, the above distillation of Doug’s experience and wisdom should help you in your own quest.

The article Doug Casey’s 9 Secrets for Successful Speculation was originally published at Casey Research

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Hedge Fund Trader Seth Klarman: QE Stimulus Bubble Will Burst

Major hedge fund trader says the QE stimulus bubble will burst.... at some point

In his letter to investors, Seth Klarman noted that “most” investors are downplaying risk and this “never turns out well,” noting that most people are not prepared for anything bad to happen. “No one can know what the future holds, but any year in which the S&P 500 jumps 32% and the NASDAQ Composite 40% while corporate earnings barely increase should be cause for concern, not further exuberance,” Seth Klarman’s investor letter said. “It might not look like it now, but markets don’t exist simply to enrich people.”

Noting that stock markets have risk and are not guaranteed investments may seem like an obvious notation, but against today’s backdrop of never before witnessed manipulated markets Seth Klarman sagely notes “Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.”

When will this happen? “Maybe not today or tomorrow, but someday,” he writes, then starts to consider what a collapse might look like. “When the markets reverse, everything investors thought they knew will be turned upside down and inside out. ‘Buy the dips’ will be replaced with ‘what was I thinking?’ Just when investors become convinced that it can’t get any worse, it will. They will be painfully reminded of why it’s always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain. They will be reminded that it’s easier to buy than to sell, and that in bear markets, all to many investments turn into roach motels: ‘You can get in but you can’t get out.’ Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill prepared will find there’s a long way to fall. Few, if any, will escape unscathed.”

Seth Klarman’s focus on Fed

Seth Klarman then once again turned his sharp rhetorical knife to the academics that run the US Federal Reserve who seem to think that controlling free markets is a matter of communications policy.

“The Fed, in its ongoing attempt to tamp down market volatility as much as possible decided in 2013 that its real problem was communication,” Seth Klarman dryly wrote. “If only it could find a way to communicate to the financial markets the clarity and predictability of policy actions, it could be even more effective in its machinations. No longer would markets react abruptly to Fed pronouncements. Investors and markets would be tamed.” The Fed has been harshly criticized by professional traders for its lack of understanding of real world market mechanics.

This lack of understanding is a concern given that the Fed is taking the economy into uncharted territory with unprecedented stimulus. “As experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that the Fed’s itinerary is bound to be exceptional, each stop more exciting than the one before,” Seth Klarman wrote, sounding a common theme among professional market watchers. “Weather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly.”

While the mainstream media is loaded with flattering articles of the Fed’s brilliance in quantitative easing and its stimulus program, the real beneficiaries of such a policy are the largest banks. Here Seth Klarman notes they have placed the economy at great risk without achieving much reward. “Before 2009, the Fed had never bought a single mortgage bond in its nearly 100-year history,” Seth Klarman writes of the key component of the Fed’s policy that took risky assets off the bank’s balance sheets. “By 2013, the Fed was by far the largest holder of those bonds, holding over $4 trillion and counting. For that hefty sum, GDP was apparently raised as little as 25 basis points in the aggregate. In other words, the policy has been a near-total failure. Bernanke is left arguing that some action was better than none. QE in effect, had become Wall Street’s new ‘too big to fail’ policy.”

Seth Klarman: What do economists know?

There has been considerable discussion that the academic side of the economics profession has little clue how markets really work. Economic academics, who now make up the majority of the Fed governors, often look at the world from the standpoint of a game of chess, where one can explore different options and there is now a “right” or “wrong” approach to market manipulation.

“The 2013 Nobel Memorial Prize in economics was shared by three academics: two were proponents of the efficient market hypothesis and the third was a behavioral economist, who believes in market inefficiency,” Seth Klarman wrote. “We suppose that could be considered a hedged position for the awards committee, one that would never occur in the hard sciences such as physics and chemistry, where a prize shared among three with divergent views would be an embarrassing mistake or a bad joke. While a Nobel Prize might well be the culmination of a life’s work, shouldn’t the work accurately describe the real world?”

Another interesting insight on the topic was to come from David Rosenberg, Chief Economist and Strategist at GluskinSheff, who recently wondered “[A]m I the only one to find some humour, if not irony, in the fact that the three U.S. economists who won the Nobel Prize for Economics did so because they ‘laid the foundation for the current understanding of asset prices’ at the same time that these asset prices are being determined less today by market-determined forces but rather by the distorting effects of the unprecedented central bank manipulation?”

Seth Klarman: Fed Created Truman Show Style Faux Economy

Baupost Group, among the largest hedge funds in the world, returned $4 billion in assets to clients at the end of 2013 because it didn’t want to grow too quickly and dilute performance. Klarman’s fund, which in 2013 had a high of 50% of his portfolio in cash, up from 36% in 2012, posted 2013 returns in the mid-teens consistent with the fund’s nearly 22 year track record.

Seth Klarman on Baupost’s returns

Saying the fund “drew a line in the sand” when it decided to return roughly $4 billion to clients at year end, Seth Klarman reflected on the decision, saying he wanted to control the fund’s head count, noting “we could not allow the firm to grow without limit. We are wise enough to know a good thing when we see it, and cautious enough to want to cherish, protect and nurture it so that we might maintain its essential qualities for a very long time.” A 50% cash position for a hedge fund might be construed as an indication the fund has grown to the point it was having difficulty allocating all the capital in appropriate trades.

He noted the 2013 performance occurred “despite the drag of large, zero yielding cash balances throughout the year.” Klarman, author of Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, said the performance resulted from “considerable progress in event driven and private situations, and at least some uplift from the strong equity rally. Distressed debt, public equities, structured products, and real estate led the gains.” Tail risk hedges, the only material area of loss in the portfolio, cost approximately 0.2% as the fund reduced exposure to distressed debt, structured products, and private investments while public equity exposure increased modestly.

Market bifurcation {the basis for being bullish on equities}

In 2013 Seth Klarman noted the market bifurcation, which he describes as “a momentum environment of market haves (which we avoid spending time on) and have-nots (which receive our undivided attention) – coupled with our energetic sourcing efforts and valued long-term relationships,” and he expressed optimism for the fund in 2014 amidst what might be a stock market subject to individual interpretation. “In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test,” he wrote. “What investors see in the inkblots says considerably more about them than it does about the market.”

Seth Klarman noted that those “born bullish,” those who “never met a stock market they didn’t like” and those with “a consistently short memory,” might look to the positives and ignore the negatives. “Price-earnings ratios, while elevated, are not in the stratosphere,” he wrote, stating the bull case. “Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn’t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December’s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.

Seth Klarman’s market analysis

Like many of the best market analysts, Seth Klarman looks at both sides of the issue, the bull and bear case, in depth. “If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about,” he wrote. Citing a policy of near-zero short-term interest rates that continues to distort reality and will have long term consequences, he ominously noted “we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences,” a thought pervasive among many top fund managers. “Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings?”

As he outlined the bear case, he started to divulge his own analysis that “on almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix, Inc. and Tesla Motors Inc.

As it turns out he was just warming up. “There is a growing gap between the financial markets and the real economy,” Seth Klarman wrote, noting that even as the Fed promised that interest rates would stay low, they did get out of control to some degree across the yield curve in 2013. “Medium and long­term bond funds got hammered in 2013. Meanwhile, corporate earnings sputtered to a mid-single digit gain last year even as stocks drove relentlessly higher, without even a 10% correction in the last two and a half years,” a concern among many professional traders.

When it comes to stock market speculation and jumping on the bull market happy talk, Seth Klarman notes it’s never hard to build a “coalition of willing” who are willing to climb on the bandwagon. “A flash mob of day traders, momentum investors, and the usual hot money crowd drove one of the best years in decades for U.S., Japanese, and European equities,” he wrote. “Even with the ranks of the unemployed and underemployed still bloated and the economy barely improved from a year ago, the S&P 500 , Dow Jones Industrial Average 2 Minute, and Russell 2000 regularly posted new record highs.”

Seth Klarman noted that whether you see today’s investment glass as half full or half empty depends on your age and personality type, as well as your “lifetime” of experiences. “Our assessment is that the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth,” while citing numerous examples of overvalued internet stocks that defied value investing logic.

“In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987,” he wrote. “A paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people’s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does. Frankly, wouldn’t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?” he said in a somewhat hilarious moment that bears a degree of truth.

Seth Klarman on Europe

Seth Klarman still isn’t much of a bull in Europe, as we noted in a previous ValueWalk. “Europe isn’t fixed either, but you wouldn’t be able to tell that from investor sentiment,” he noted. “One sell-side analyst recently declared that ‘the recovery is here,’ a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013. Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008,” he said, noting a growing concern among fund managers regarding the government debt crisis getting out of hand.

Seth Klarman noted that Germany’s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008, and said “That doesn’t look fixed to us.” The EU credit rating was recently reduced by S&P, he noted, while European unemployment remains stubbornly above 12%. “Not fixed,” he said. “Various other risks lurk on the periphery: bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and social unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural imbalances. As Angela Merkel recently noted, Europe has 7% of the world’s population, 25% of its output, and 50% of its social spending.” While he notes the problems in Europe, Seth Klarman did not rule out that opportunity might be found in the region.

Seth Klarman on Bitcoin

Seth Klarman also weighed in on Bitcoin, noting that “Only in a bull market could an online ‘currency’ dubbed bitcoin surge 100-fold in one year, as it did in 2013. Now most sell-side firms are rushing to provide research on this latest fad,” he also noted that while “bitcoin funds” are being formed, the fund is “happy to let pass us by, the thinking behind cryptocurrencies may contain a kernel of rationality. If paper currencies – dollars and yen – can be printed in essentially unlimited volumes, and just as with all currencies are only worth what recipients on any given day will exchange in goods or services, then what makes them any better than the “crypto” kind of money?”

Comparing the economy and the Federal Reserve’s management of it to the movie The Truman Show, where the lead character lived in a false, highly-orchestrated environment, Seth Klarman notes with insight, “Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.” Then he quotes Jim Grant who recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.”

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The article Outside the Box: Seth Klarman: Investors Downplaying Risk “Never Turns Out Well” was originally published at Mauldin Economics.

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And the Band Plays On

By Dennis Miller 

Quantitative Easing (QE) is no longer a surprise, but the fact that it's continued for so long is. Like many Miller’s Money readers, I believe the government cannot continue to pay its bills by having the Federal Reserve buy debt with newly created money forever. This has gone on much longer than I'd have ever dreamed possible.

Unemployment numbers dropped in December and the Federal Reserve tapered their money creation from $85 billion to $75 billion per month. Why did the unemployment rate drop? Primarily because people whose benefits have expired are no longer considered unemployed. The government classifies them as merely discouraged, but the fact remains that they don't have jobs.

So, what is the problem? Let's start with the magnitude of money creation. Tim Price sums it up well in an article on Sovereign Man:

"Last year, the U.S. Federal Reserve enjoyed its 100th anniversary, having been founded in a blaze of secrecy in 1913. By 2007, the Fed's balance sheet had grown to $800 billion. Under its current QE program (which may or may not get tapered according to the Fed's current intentions), the Fed is printing $1 trillion a year.

To put it another way, the Fed is printing roughly 100 years' worth of money every 12 months. (Now that's inflation.)"

As Doug Casey likes to remind us: Just because something is inevitable, does not mean it is imminent. Well, sooner or later imminent and inevitable are going to meet. Interest rates are depressed because the Federal Reserve is holding our debt. Eventually those creditors outside the Federal Reserve will demand much higher interest rates.

Currently, 30 year Treasuries are paying 3.59%. If interest rates rose by 2%—still below what was considered "normal" a decade ago—the interest cost to our government would jump by 30% or more. It's hard to imagine the huge budget cuts or tax increases it would take to pay for that.

In the meantime, investors are caught between the proverbial rock and hard place. We cannot invest in long- or medium-term, "safe," fixed income investments because they are no longer safe. They could easily destroy your buying power through inflation.

At the same time, the stock market is not trading on fundamentals. It is on thin ice. Just how thin is that ice? Take a look at what happened when the Federal Reserve stopped propping up the economy with money printing.

Each time they stopped with their stimulus the market dropped. In the summer of 2013, Bernanke made his famous "taper" remark and the market reacted negatively, immediately. The Fed has had to introduce more money into the system to stop the slide.

Investors who need yield know they have virtually no place else to go but the stock market. Most realize it is a huge bubble; they only hope to get out ahead of everyone else when the time comes. And we can't hold cash; inflation would clobber us. So, we've been forced into the market to protect and grow our nest eggs.
It reminds me of playing musical chairs as a kid. The piano player would slow down the tempo. We would all grab the back of a chair and get ready to sit. No one wanted to be the one left standing.

Today the band is playing the "Limbo Rock." Investors are in limbo, knowing the music will stop eventually. We're all going to have to grab a chair quickly—and the stakes are much higher now.

The chart below on margin debt comes courtesy of my friend and colleague at Casey Research, Bud Conrad.

Investors now have a dangerous amount of money invested on margin—meaning they borrowed money from their brokers to buy even more stock. There are strict margin requirements on how much one can borrow as a percentage of their holdings. If the stock price drops, the investor receives a margin call from his broker. That has to take place quickly under SEC requirements. The broker can also sell the holding at market to bring the client's account back into compliance.

Record margin debt, coupled with the thought of traders using computers to read the trend and automatically place orders in fractions of a second, paints an uneasy picture. The unemotional computers will not only sell their holdings, they may well initiate short sales to drive the market down even further.

As the lyrics from the "Limbo Rock" ask, "How low can you go?" When the market limbos down, it will likely be faster and further than we've imagined.

Why is 2014 different? I've been taking stock of 2013 as I prepare our tax filings. Our portfolio did very well last year, thanks in great measure to the analysts at Casey Research. With our Bulletproof Income strategy in place, I am very comfortable with our plans going forward.

At the same time, I am as jittery as a 9-year-old walking slowly around a circle of chairs, knowing that sooner or later the music will stop. The music has played for years now and we are in the game, whether we like it or not. Pundits have gone from saying "this is the year" to more tempered remarks like "this can't go on forever." They place their bets on inevitable, but hedge them on imminent.

What can we do? One of the mantras behind our Bulletproof Income strategy is: "Avoid catastrophic losses." Doug Casey has warned us that in a drastic correction most everyone gets hurt, so our goal is to minimize that damage and its impact on our retirement plans.

Here are a few things you can do to protect yourself.

• Diversify. Not all sectors rise and fall at the same speed. Optimal diversification requires more than just various stock picks across various sectors. Limit your overall stock market exposure according to your age. You don't have to be all in the market. There are still other ways to earn good, safe returns. International diversification will give you an added margin of safety, too, not only from a market downturn but also from inflation.
• Apply strict position limits. No more than 5% of your overall portfolio should be in any single investment. When I look at the record margin debt, I wonder how so many investors can go hog wild on a single investment. Planning for retirement demands a more measured approach.
• Set trailing stop losses. If you set trailing stop losses on your positions at no more than 20%, the most you could lose on any single trade is 1% of your overall portfolio. The beauty of trailing stops is the maximum loss seldom happens. As the stock rises the trailing stop rises with it, which will lock in some additional profits.
• Monitor regularly. As part of my regular annual review, I go over each one of my stop-loss positions. I use an online trading platform to keep track of them. Depending on the stock, you may want to place a stop-loss sell order or use an alert service that will notify you if the stock drops below your set point. Other investors prefer to use a third party for notification.
  
  So, why do I check my stop losses? My particular trading platform accepts the orders "GTC," meaning "good 'til cancelled." But GTC really means "Good for 60 days and then you have to re-enter the notification." Just read the small print.
  
  Also, sometimes stop losses need adjusting. As a stock gets closer to the projected target price, you may want to reduce the trailing stop loss to 15%, or maybe even 10%, to lock in more profits.

We all want to enjoy our retirement years and have some fun. I sleep well knowing we have several good circuit breakers in place. We may get stopped out of several positions and stuck temporarily holding more cash than we'd like. But that means we've avoided catastrophic loss and have cash to take advantage of the real bargains that are bound to appear.

And so the band plays on as baby boomers and retirees continue to limbo.

From the very first issue of Money Forever our goal—my mission­­—has been to help those who truly want to take control of their retirement finances. I want our subscribers to have more wealth, a better understanding of how to create a Bulletproof portfolio, and confidence their money will last throughout retirement.

With that in mind, I’d like to invite you to give Money Forever a try. The current the subscription rate is affordable – less than that of your daily senior vitamin supplements. The best part is you can take advantage of our 90-day, no-risk offer. You can cancel for any reason or even no reason at all, no questions asked, within the first 90 days and receive a full, immediate refund. As you might expect, our cancellation rates are very low, and we aim to keep it that way. Click here to find out more.

The article And the Band Plays On was originally published at Millers Money

Buffett’s annual letter: What you can learn from my real estate investments

By John Mauldin

It does not hurt to be reminded once in a while about what it means to be a “true investor,” and who better to remind us than Warren Buffett? Today’s Outside the Box comes to us from the pages of Fortune magazine (hat tip to my good friend Tom Romero of Capital Research Partners, who is a pretty fair investor in his own right).

Fortune seems to have had the inside scoop on Mr. Buffett’s pronouncements over the years. I still keep some old Fortune magazines with interviews of Mr. Buffett to remind myself about the basics. For whatever reason I was up at 5 o’clock this morning and began reading this piece, and it functioned just as well as coffee as a wake up call.

Warren starts off by telling us the stories of two relatively minor real estate investments he made, one in the ’80s and the other in the ’90s, but where he’s going is straight to the heart of some fundamental investing principles.

Most of us get all wrapped up, from time to time, in the daily or weekly movements of our investments; but Warren wants us to remember that “Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

Easier said than done; but he’s right, of course. Now, it’s certainly OK dwell at length on the macroeconomic big picture, right? I mean, that’s half my fun most days! No, says Warren,

Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: “You don't know how easy this game is until you get into that broadcasting booth.”)

So Warren wants our feet planted squarely on the field of play; he doesn’t want us up in the stands or, heaven forbid, watching the game on TV. And forget reading some commentator’s analysis of yesterday’s game or his take on the rest of the season!

Well, OK. So if this is the last Outside the Box or Thoughts from the Frontline you ever read, at least I got you this far, right?

But read on, and be sure not to miss Warren’s very pithy (and timely!) quotation from the late Barton Biggs.
And let me point out that when Warren suggests a future portfolio of 90% S&P index funds, he is talking about very, very long-term portfolio design and not something that retirees who need income or have a shorter-term focus (less than multiple decades) should be thinking about.

And to be fair, Buffet’s process of choosing which investments to put into his portfolio would not allow him to end up with very many components of the S&P 500. So I don’t share his bias against active management, though I have to agree that most of what passes for active management is problematic. But there is a lot we need to remember and ponder in Buffett’s Benjamin Graham old-style value investing.

I have never met the man, but I would like to. I think we might have more in common than some readers would imagine. Including hamburgers.

Today I’m flying to Los Angeles, where I will speak tonight and tomorrow for my partners at Altegris Investments. I am particularly looking forward to spending time with Jack Rivkin. I always learn a lot. Then I get on a plane to fly all the way across the country to Miami. I will be speaking for my close friend Darrell Cain at his annual conference as well as spending time with Pat Cox, who is going to come over from the West Coast of Florida. I hope to get a good part of this weekend’s letter done on the flight.

Then it’s on to Washington DC for a series of meetings. George Gilder is flying down from Boston and has offered to introduce me to a few of his friends, and I will do the same for him. We will hopefully be sitting down for a video in which we’ll discuss some mutually interesting ideas, as well as share a dinner or two where we’ll talk about a variety of policies with a few people who are perhaps in positions to do something about them.

Packing for a week in a variety of different climates is always an interesting process. And keeping up with my reading and writing and gym time and, most importantly, friend time will make for a very busy next seven days. You make sure you enjoy yourself. Now let’s see what Warren has to tell us about investing.

Your thinking a lot about portfolio strategy lately analyst,

John Mauldin, Editor

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Buffett’s annual letter: What you can learn from my real estate investments

This story is from the March 17, 2014 issue of Fortune.
February 24, 2014: 5:00 AM ET

In an exclusive excerpt from his upcoming shareholder letter, Warren Buffett looks back at a pair of real estate purchases and the lessons they offer for equity investors.
By Warren Buffett

“Investment is most intelligent when it is most businesslike.”
–Benjamin Graham, The Intelligent Investor

It is fitting to have a Ben Graham quote open this essay because I owe so much of what I know about investing to him. I will talk more about Ben a bit later, and I will even sooner talk about common stocks. But let me first tell you about two small non-stock investments that I made long ago. Though neither changed my net worth by much, they are instructive.

This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath as in our recent Great Recession.

In 1986, I purchased a 400 acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.

I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop, and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.

In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to New York University that the Resolution Trust Corp. was selling. Again, a bubble had popped – this one involving commercial real estate – and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.

Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant – who occupied around 20% of the project’s space – was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.

I joined a small group – including Larry and my friend Fred Rose – in purchasing the building. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
Income from both the farm and the NYU real estate will probably increase in decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.

I tell these tales to illustrate certain fundamentals of investing:

•You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”

•Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.

•If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.

•With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

•Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)

My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in determining the success of those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.
There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings, whereas I have yet to see a quotation for either my farm or the New York real estate.

It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

Owners of stocks, however, too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there – do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.

A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.

During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?

When Charlie Munger and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decision.

It’s vital, however, that we recognize the perimeter of our “circle of competence” and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.

Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.
I have good news for these nonprofessionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th century, the Dow Jones industrial index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial. The goal of the nonprofessional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

That’s the “what” of investing for the nonprofessional. The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’s observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

If “investors” frenetically bought and sold farmland to one another, neither the yields nor the prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.

Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire Hathaway (BRKA) shares will be fully distributed to certain philanthropic organizations over the 10 years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s. (VFINX)) I believe the trust’s long term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, or individuals – who employ high-fee managers.

And now back to Ben Graham. I learned most of the thoughts in this investment discussion from Ben’s book The Intelligent Investor, which I bought in 1949. My financial life changed with that purchase.

Before reading Ben’s book, I had wandered around the investing landscape, devouring everything written on the subject. Much of what I read fascinated me: I tried my hand at charting and at using market indicia to predict stock movements. I sat in brokerage offices watching the tape roll by, and I listened to commentators. All of this was fun, but I couldn’t shake the feeling that I wasn’t getting anywhere.

In contrast, Ben’s ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. These points guide my investing decisions today.

A couple of interesting sidelights about the book: Later editions included a postscript describing an unnamed investment that was a bonanza for Ben. Ben made the purchase in 1948 when he was writing the first edition and – brace yourself – the mystery company was Geico. If Ben had not recognized the special qualities of Geico when it was still in its infancy, my future and Berkshire’s would have been far different.

The 1949 edition of the book also recommended a railroad stock that was then selling for $17 and earning about $10 per share. (One of the reasons I admired Ben was that he had the guts to use current examples, leaving himself open to sneers if he stumbled.) In part, that low valuation resulted from an accounting rule of the time that required the railroad to exclude from its reported earnings the substantial retained earnings of affiliates.

The recommended stock was Northern Pacific, and its most important affiliate was Chicago, Burlington & Quincy. These railroads are now important parts of BNSF (Burlington Northern Santa Fe), which is today fully owned by Berkshire. When I read the book, Northern Pacific had a market value of about $40 million. Now its successor (having added a great many properties, to be sure) earns that amount every four days.

I can’t remember what I paid for that first copy of The Intelligent Investor. Whatever the cost, it would underscore the truth of Ben’s adage: Price is what you pay; value is what you get. Of all the investments I ever made, buying Ben’s book was the best (except for my purchase of two marriage licenses).

Warren Buffett is the CEO of Berkshire Hathaway. This essay is an edited excerpt from his annual letter to shareholders.

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The article Outside the Box: Buffett’s annual letter: What you can learn from my real estate investments was originally published at Mauldin Economics.

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Why the Resource Supercycle Is Still Intact

By Rick Rule, Chairman and Founder, Sprott Global Resource Investments

Natural resource based industries are very capital intensive, and hence extremely cyclical. It is not unreasonable to say that as a natural resource investor, you are either contrarian or you will be a victim.

These markets are risky and volatile!

Why Cyclicality?

 

Let's talk about cyclicality first. Some of the cyclicality of these industries is a function of their being extraordinarily capital intensive. This lengthens the companies' response times to market cycles.

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Strengthening copper prices, for example, do not immediately result in increased copper production in many market cycles, because the production cycle requires new deposits to be discovered, financed, and constructed......a process that can consume a decade.

Price declines—even declines below the industry's total production costs—do not immediately cause massive production cuts. The "sunk capital" involved in discovery and construction of mining projects and attendant infrastructure (such as smelters, railways, and ports) causes the industry to produce down to, and sometimes below, their cash costs of production.

Producers often engage in a "last man standing" contest, to drive others to mothball productive assets, citing the high cost of shutdown and restart. They fail to mention their conflicts of interest as managers, whose compensation is linked to running operational mines.

Interest-rate cycles can raise or lower the cost and availability of capital, and the accompanying business cycles certainly influence demand. Given the "trapped" nature of the industry's productive assets, local political and fiscal cycles can also influence outcomes in natural-resource investments.

Today, I believe that we are still in a resource "supercycle," a long-term period of increasing commodity prices in both nominal and real terms. The market conditions of the past two years have made many observers doubt this assertion. But I believe the current cyclical decline is a normal and healthy part of the ongoing secular bull market.

Has this happened in the past?

 

The most striking analogy to the current situation occurred in the epic gold bull market in the 1970s. Many of you will recall that in that bull market, gold prices advanced from US$35 per ounce to $850 per ounce over the course of a decade. Fewer of you will recall that in the middle of that bull market, in 1975 and 1976, a cyclical decline saw the price of gold decline by 50%, from about $200 per ounce down to about $100 per ounce. It then rebounded over the next six years to $850 per ounce.

Investors who lacked the conviction to maintain their positions missed an 850% move over six short years. The current gold bull market, since its inception in 2000, has experienced eight declines of 10% or greater, and three declines—including the present one—of more than 20%.

This volatility need not threaten the investor who has the intellectual and financial resources to exploit it.

The natural-resources bull market lives…

 

The supercycle is a direct result of several factors. The most important of these is, ironically, the deep resource bear markets which lasted for almost two decades, commencing in 1982.

This period critically constrained investment in a capital-intensive industry where assets are depleted over time.

Productive capacity declined in every category; very little exploration took place; few new mines or oilfields replenished reserves; infrastructure and processing assets deteriorated. Critical human-resource capabilities suffered as well; as workers retired or got laid off, replacements were neither trained nor hired.

National oil companies (NOCs) exacerbated this decline in many nations by milking their oil and gas industries to subsidize domestic spending programs for political gain. This was done at the expense of sustaining capital investments. The worst examples are Mexico, Venezuela, Ecuador, Peru, Indonesia, and Iran. I believe 25% of world export crude capacity may be at risk from failure of NOCs to maintain and expand their productive assets.

Demands for social contributions in the form of taxes, royalties, carried equity interests, social or infrastructure contributions, and the like have increased. Voters are not concerned that producers need real returns to recover from two decades of underinvestment or to fund capital investments to offset depletion. Today this is actively constraining investment, and hence supply.

Poor people getting richer…

 

The supercycle is also driven by globalization and the social and political liberalization of emerging and frontier markets. As people become freer, they tend to become richer.

As poor countries become less poor, their purchases tend to be very commodity centric, especially compared to Western consumers. For the 3.5 billion people at the bottom of the economic pyramid, the goods that provide the most utility are material goods and consumables, rather than the information services or "high value-added" goods.

A poor or very poor household is likely to increase its aggregate calorie consumption—both by eating more food and more energy-dense food like meat. They will likely consume more electrical power and motor fuel and upgrade their home from adobe or thatch to higher-quality building materials. As people's incomes increase in developing and frontier markets, the goods they buy are commodity-intensive, which drives up demand per capita. And we are talking billions of "capitas."

Rising incomes and savings among certain cultures in the Middle East, South Asia, and East Asia—places with a strong cultural affinity for bullion—have increased the demand for gold, silver, platinum, and palladium bullion. Bullion has been a store of value in these regions for generations, and rising incomes have generated physical bullion demand that has surprised many Western-centric analysts.

Competitive devaluation

 

The third important driver in this cycle has been the depreciation of currencies and the impact that has had on nominal pricing for resources and precious metals.

Most developed economies have consumed and borrowed at worrying levels. The United States federal government has on-balance-sheet liabilities of over $16 trillion, and off-balance-sheet liabilities estimated at around $70 trillion.

These numbers do not include state and local government liabilities, nor the likely liabilities from underfunded private pensions. Not to mention increased costs associated with more comprehensive health care and an aging population!

Many analysts are even more concerned about the debts and liabilities of other developed economies—Europe and Japan. In both places, debt-to-GDP ratios are greater than in the US. Europe and Japan are financing themselves through a combination of artificially low interest rates and more borrowing and money printing. This drives down the value of their currencies, helping their exports.

But which nations' leaders will stand firm and allow their export industries to wither as their domestic producers suffer from cheap competing foreign goods? If Japan's Abe is successful at increasing his country's exports at the expense of its competitors like Taiwan, Korea, or China, then his policies could lead to competitive devaluation. And how will the European community react, for that matter?

Loss of purchasing power in fiat currencies increases the nominal pricing of commodities and drives demand for bullion as a preferred savings vehicle.

The factors that have driven this resource supercycle have not changed. Demand is increasing. Supplies are constrained. Currencies are weakening. Thus I believe we remain in a secular bull market for natural resources and precious metals.

With that in mind, I would call the current market for bullion and resource equities a sale.

Where to invest?

 

Let's talk about a type of company most of us follow: mineral exploration companies, or "juniors." We often confuse the minerals exploration business with an asset-based business. I would argue that is a mistake.

Entities that explore for minerals are actually more similar to "the research and development" space of the mining industry. They are knowledge based businesses.

When I was in university, I learned that one in 3,000 "mineralized anomalies" (exploration targets) ended up becoming a mine. I doubt those odds have improved much in 40 years. So investors take a 1-in-3,000 chance in order to receive a 10-to-1 return.

These are not good odds. But understanding the industry improves them substantially.

Exploration companies are similar to outsourcing companies. Major mining companies today conduct relatively little exploration. Their competitive advantage lies in scale, financial stability, and engineering and construction expertise. Similar to how big companies in other sectors outsource certain tasks to smaller, more specialized shops, the big miners let the juniors take on exploration risk and reward the successful ones via acquisitions.

Major companies are punished rather than rewarded for exploration activities in the short term. Majors therefore tend to focus on the acquisition of successful juniors as a growth strategy.

Today, the junior model is broken. Many public exploration companies spend a majority of their capital on general and administrative expenses, including fundraising. Overlay a hefty administrative load on an activity with a slim probability of success, and these challenges become even more severe.

One response from the exploration and financial community has been to put less emphasis on exploration success and focus instead on "market success." In this model, rather than "turning rocks into money," the process becomes "turning rocks into paper, and paper into money."

One manifestation of that is the juniors' habit of recycling exploration targets that have failed repeatedly in the past but can be counted on to yield decent confirmation holes, and the tendency to acquire hyper-marginal deposits and promote the value of resources underground without mentioning the cost of actually extracting them.

The industry has been quite successful, during bull markets, at causing "sophisticated" investors to focus on exciting but meaningless criteria.

Being successful in natural resource investing requires you to make choices. If your broker convinces you to buy the sector as a whole, they will have lived up to their moniker—you will become "broker" and "broker."
We have already said that exploration is a knowledge-based business. The truth is that a small number of people involved in the sector generate the overwhelming majority of the successes. This realization is key to improving our odds of success.

"Pareto's law" is the social scientists' term for the so-called "80-20 rule," which holds that 80% of the work is accomplished by 20% of the participants.

A substantial body of evidence exists that it is roughly true across a variety of disciplines. In a large enough sample, this remains true within that top 20%—meaning 20% of the top 20%, or 4% of the population, contributes in excess of 60% of the utility.

The key as investors is to judge management teams by their past success. I believe this is usually much more relevant than their current exploration project.

It is important as well that their past successes are directly relevant to the task at hand. A mining entrepreneur might have past success operating a gold mine in French speaking Quebec. Very impressive, except that this same promoter now proposes to explore for copper, in young volcanic rocks, in Peru!

In my experience, more than half of the management teams you interview will have no history of success that shows that they are apt at executing their current project.

Management must be able to identify the most important unanswered question that can make or break the project. They must be able to say how that question or thesis was identified, explain the process by which the question will be answered, the time required to answer the question, how much money it will take. They also need to know how to recognize when they have answered the question. Many of the management teams you interview will be unable to address this sequence of questions, and therefore will have a very difficult time adding value.

The resource sector is capital intensive and highly cyclical, and we expect that the current pullback is a cyclical decline from an overheated bull market. The fundamental reasons to own natural resource and precious metals have not changed. Warren Buffett says, "Be brave when others are afraid, be afraid when others are brave." We are still "gold bugs." And even "gold bulls."

Rick Rule is the chairman and founder of Sprott Global Resource Investments Ltd., a full-service brokerage firm located in Carlsbad, CA. He has dedicated his entire adult life to different aspects of natural-resource investing and has a worldwide network of contacts in the natural-resource and finance worlds.

Watch Rick and an all-star cast of natural-resource and investment experts—including Frank Giustra, Doug Casey, John Mauldin, and Ross Beaty—in the must-see video "Upturn Millionaires," and discover how to play the turning tides in junior mining stocks, for potentially life changing gains. Click here to watch.

The article Why the Resource Supercycle Is Still Intact was originally published at Casey Research.com.

Don't miss this weeks free webinar "The Big Trade with John Carter"....Just Click Here

 

What are Business Development Companies?

By Andrey Dashkov

Business Development Companies (BDCs) are publicly traded private debt and equity funds. I know that description isn’t terribly sexy, but keep reading and you’ll find there’s a lot to be excited about.


BDCs provide financing to firms too small to seek traditional bank financing or to do an IPO, but at the same time are too advanced to interest the earliest-stage venture capitalist. These companies are often near or at profitability and just need extra cash to reach the next milestone. Filling this void, BDCs provide funds to target companies in exchange for interest payments and/or an equity stake.

BDCs earn their living by lending at interest rates higher than those at which they borrow. Conceptually, they act like banks or bond funds, but with access to yields unlike any you’ll see from a traditional bond fund. The interest rate spread—meaning the difference between their capital costs and interest they charge their clients—is a major component of their business.

Oftentimes, a BDC will increase its dividend when market interest rates have not changed. Like a bank, the more loans it has in force, the more it profits. Increasing its dividend payout will generally have a very positive effect on its share price.

Unlike banks or many other traditional financial institutions, however, BDCs are structured to pay out more than 90% of their net profits to the shareholders. In return, BDCs don’t pay any income tax. In essence, their profits flow through to the owners. Many investors like to own BDCs in an IRA to create tax deferred or tax free income. The opportunity to use them for tax planning purposes, access to diversified early stage financing, and the impressive dividend yields they deliver make them a perfect fit for the Bulletproof Income strategy we employ at Miller's Money Forever.

The Clients

 

As a business model, BDCs emerged in response to a particular need: early-stage companies needed funding but couldn’t do it publicly due to their small size. At the same time, these companies didn’t match the investment criteria of so-called angel investors or venture capital providers. Enter the Business Development Company.

BDC teams, through expertise and connections, select the most promising companies in their fields and provide funds in return for a debt or equity stake, expecting gains from a potential acquisition scenario and a flow of interest payments in the meantime. The ability to selectively lend money to the right startup companies is paramount. It makes little difference how much interest they charge if the client defaults on the loan.

With limited financing options, BDCs’ clients may incur strict terms regarding their debt arrangements. The debt often comes with a high interest rate, has senior level status, and is often accompanied by deal sweeteners like warrants which add to the upside potential for those with a stake in the borrowing company.

In return for these stringent terms, the borrower can use the funds to:

•  Increase its cash reserve for added security;

•  Accelerate product development;

•  Hire staff and purchase licenses necessary to advance R&D, etc.

•  Invest in property, plant, and equipment to produce its product and bring it to market.

Turning to a BDC for funds allows a company to finance its development and minimize dilution of equity investors while reaching key value adding milestones in the process.

What’s in It for Investors?

 

In addition to the unique opportunity to access early-stage financing, we like BDCs for their dividend policy and high yield. The Investment Act of 1940 requires vehicles such as BDCs to pay out a minimum of 90% of their earnings. In practice, they tend to pay out more than that, plus their short term capital gains.

This often results in a high yield. Yields of 7-12% are common, which makes this vehicle unique in today’s low yield environment. The risk is minimized by diversification—like a good bond fund, they spread their assets over many sectors. This rational approach and the resulting income make the right BDC(s) a great addition to our Bulletproof Income strategy.

BDCs and the Bulletproof Income Strategy

 

In short, BDCs serve our strategy by:

• Providing inflation protection in the form of high yields and dividend growth;

• Limiting our exposure to interest rate risk, thereby adding a level of security (some BDCs borrow funds at variable rates, but not the ones we like);

• Maintaining low leverage, which BDCs are legally required to do;

• Distributing the vast majority of their income to shareholders, thereby creating an immediate link between the company’s operating success and the shareholders’ wellbeing… in other words, to keep their shareholders happy, BDCs have to perform well.

How Should You Pick a BDC?

 

Not every BDC out there qualifies as a sound investment. Here’s a list of qualities that make a BDC attractive.

• Dividend distributions come from earnings. This may sound like common sense, but it’s worth reiterating. A successful BDC should generate enough quarterly income to pay off its dividend obligations. If it doesn’t, it will have to go to the market for funds and either issue equity or borrow, or deplete cash reserves it would otherwise use to fund future investments. An equity issuance would result in share dilution; debt would increase leverage with no imminent potential to generate gains; and a lower cash reserve is no good either. We prefer stocks that balance their commitments to the shareholders with a long term growth strategy.

• The dividends are growing. This is another characteristic of a solid income pick, BDC or otherwise. Ideally, the dividend growth would outpace inflation, in addition to the yield itself being higher than the official CPI numbers. This growth can come from increasing the interest rate spread and also having more loans on the books.

• Yields should be realistic. We’d be cautious about a BDC that pays more than 12% of its income in dividends. Remember, gains come from the interest it receives from the borrowers. Higher interest indicates higher risk debt on a BDC’s balance sheet, which should be monitored regularly.

• Fixed-rate liabilities are preferred. We need our BDC to be able to cover its obligations if interest rates rise. Fixed rates are more predictable than floating rates; we like the more conservative approach.

• Their betas should be (way) below 1. We don’t want our investment to move together with the broad market or be too interest-rate sensitive. Keeping our betas as low as possible provides additional opportunities to reduce risk, which is a critical part of our strategy.

• They are diversified across many sectors. A BDC that has 100 tech companies in its portfolio is not as well diversified as a one with 50 firms scattered across a dozen sectors, including aerospace, defense, packaging, pharmaceuticals, and others. Review a company’s SEC filings to see how many baskets its eggs are in.

Wrap up......

 

Right now, BDCs look very interesting to income-seeking investors. They provide excellent yields, diversification opportunities, and access to early-stage companies that previously only institutions enjoyed. They also fit in with Miller Money Forever's Bulletproof Income strategy, the purpose of which is to provide seniors and savers with real returns, while offering maximum safety and diversification.

Catching a peek our Bulletproof portfolio is risk-free if you try today. Access it now by subscribing to Miller's Money Forever, with a 90-day money-back guarantee. If you don't like it, simply return the subscription within those first three months and we'll refund your payment, no questions asked. And the knowledge you gain in those months will be yours to keep forever.


Posted courtesy of our trading partners at Casey Research

How Fed Policy Has Devastated Three Generations of Retirees

By Dennis Miller

One aspect of the American Dream has always been the prospect of enjoying one's golden years in retired bliss. And while everyone knows that the rules of the game have been subject to change over the years, the recent, unprecedented changes in fiscal policy have proved to be a virtual wrecking ball to Americans' retirement dreams.

Over the past few years, the Federal Reserve has moved from simple interest rate manipulation to wholesale market interference with the goal of maintaining bank solvency and equity prices. This steamroller style interference in the markets has had massive consequences. And not just for the Baby Boomers who are now hitting retirement age, but also for their children and children's children—three American generations whose retirement hopes have been left to swing in the wind on a string of broken promises.

Baby Boomers Get Their Risk On

 

The Baby Boomer generation (born 1946 – 1964) is quite used to adjusting to ever-changing conditions when it comes to retirement.

For decades, receiving a pension was what one looked forward to for their old age. But as you can see in the chart below, at least in the private sector that idea has become as extinct as a T-rex.



Its replacement became the 401(k) and the IRA—tax-deferred vehicles that let savers take control of their own retirement, for better or worse.

Granted, Americans have built up a sizable nest egg in these defined-contribution retirement accounts—more than $5.4 trillion in IRAs alone—but the cumulative savings fail to tell the larger story. The dire truth is that Baby Boomers are caught in a trap, simultaneously trying to preserve capital and generate yield through wild market swings like 2000's massive crash, 2008's 30% correction, and 2010's flash crash.

The market's frequent large "corrections" have had a sobering effect on Boomers' investment behavior. In an attempt to avoid the swings while still making money to live off, Boomers have flooded the bond market with money and significantly reduced their stock market exposure.

As you can see in the right-most bars on the graph above, Boomers who are in their sixties today have significantly reduced the weighting of equities in their portfolios over the last decade—much more so than their peers of just 10 years earlier.

It's true that since the bursting of the housing bubble in 2007, major indexes have recovered to a point where anyone who stayed put after the crash should have been made whole again. Yet the actual market participation by the Boomers has been considerably lower—thrice bitten, twice shy—meaning many missed out on the equity market's recovery.

Instead, hundreds of billions of dollars flowed into the bond markets over the past five years, as evidenced by the $50 billion upswing in bond ETF assets in 2012, and the $125 billion in bond-based mutual fund net inflows over the same period.



Following a protective instinct, conservative investors shifted their money from stocks to bonds… at exactly the time interest rates were rapidly falling for most classes of income investments.

Boomers have suffered more losses and settled for lower income than ever before. The double whammy took a serious toll on the retirement dreams of many. But that was OK, because there was always Social Security as a backstop.

It's become increasingly obvious, though, that Social Security is not keeping up with the times.

By tying its payouts to the Consumer Price Index (CPI)—a measure as flawed at predicting actual consumer prices as a groundhog at predicting the weather (a consumer price that doesn't include fuel or food?)—as a net effect, the real value of Social Security payouts has shrunk dramatically.

Here's a chart of official consumer inflation vs. the real numbers calculated by economist John Williams of ShadowStats (he uses the US government's unadulterated accounting methods of the 1980s). While the official number is 2%, real inflation is in the 9% range.



Washington has been cutting Social Security payments for years, just in a way that wasn't obvious to most newscasters and taxpayers—at least not until it was time to collect, as increasing numbers of Boomers now are.

Between the downfall of the pension, Boomers' eschewing of the stock market, and the government's zero interest rate policy, for many Americans retiring in their sixties has become little more than wishful thinking—and a financially comfortable retirement now requires taking significantly more risk than most are willing or able to handle.

Generation X Strikes Out

 

Traditionally, the 45-55 age group has been the most fervent retirement savers, but that has changed drastically in the last 25 years. As you can see in this chart, the most rapid declines in participation rate for the black line (age 45-54) coincide with major dips in the market, such as in 2001 and 2007.



To make matters worse, Gen-Xers (born 1965 – 1980) are also the most debt-ridden generation of the past century.

According to the Pew Research Center, Gen-Xers and Baby Boomers alike have much lower asset-to-debt ratios than older groups. Whereas War and Depression babies got rid of debt over the past 20 years, Boomers and Gen-Xers were adding to their load:

• War babies: 27x more assets than debt
• Late Boomers: 4x more assets than debt
• Gen-Xers: 2x more assets than debt

That situation deteriorated further in the last six years; while all groups lost money in the Great Recession, the Gen-Xers were the hardest-hit.

As Early and Late Boomers struggled with asset depreciation of 28% and 25%, respectively, Gen-Xers lost almost half (45%) of their already smaller wealth. They also lost 27% of home equity during the crisis, the largest percentage loss of the groups studied by Pew.

 

Millennials: Down a Well and Refusing the Rope

 

The effects of a prolonged period of low interest rates on current and near-term retirees are obvious. But the long-term effects on those now in their early years of working and saving may be much greater.

We've all been taught about the power of compound interest. Put away $10,000 today, compounding at 7%, and in 20 years you have about $40,000 and in 30 years nearly $80,000.

As powerful a tool as long-term compounding is, though, nothing can cut the legs out from under it more than saving less early on or earning less in the first few years. Any small change to the input has a drastic effect on what comes out the far end.

The Millennials—those born between 1981 and 2000—are suffering from both right now. It's no secret that interest rates are low, and there is little that their generation, whose oldest members are now in their early thirties, can do about it.

Shrinking interest rates are wreaking real havoc on the Boomers' children, extending the time to retirement for that generation by nearly a decade.

Why would any politician pass legislation to change Social Security eligibility, a measure that usually doesn't bode well for reelection, if they can simply rely on fiscal policy to accomplish the same net effect?
To make matters worse, the years of financial turmoil, a tough post-college job market, high levels of student loans, and numerous other factors have kept most Millennials out of the stock markets.

Millennials are far less likely to open a retirement savings account than previous generations.  According to a recent Wells Fargo survey, "In companies that do not automatically enroll eligible employees, just 13.4% of Millennials participate in the plan."

This is worse even than the number EBRI collected in the graph presented earlier, which still pegged retirement plan participation rates at all-time lows for the 20-something set. Only a small percentage of Millennials are taking even the most basic step toward taking charge of their own retirement.

With their parents and grandparents showing them the failure of the pension system and Social Security first-hand, one would think the opposite might be true. But the numbers clearly show that Millennials are less interested in saving for their future retirement than their parents were.
Having seen it happen to their own grandparents, maybe they are just resigned to the idea that they'll have to work well into their golden years anyway. And who could blame their generation for not trusting the stock markets with their capital after seeing what happened to their parents’ nest eggs so many times during their own childhoods?

The youngest working generation is eschewing investment, at what might be a great cost down the road.

Adapt to Survive

 

Multiple years of shrinking interest rates, thanks to heavy bond buying by the Federal Reserve in its Quantitative Easing program, have taken an immense toll on generations of savers. The increased risk that current and future retirees have to take on to meet their income needs has left many shaken and financially insecure.

As a result, many are now looking to new strategies to make up for the shortfall the Fed's zero interest rate policy has created—shifting their focus from bonds to dividend-paying stocks and adapting as they go along.
Dennis Miller is a noted financial author and “retirement mentor,” a columnist for CBS Market Watch, and editor of Miller’s Money Forever (www.millersmoney.com), an independent guide for investors of all ages on the ins and outs of retirement finance—from building an income portfolio to evaluating financial advisors, annuities, insurance options, and more.  He also recently participated alongside John Stossel and David Walker in America’s Broken Promise, an online video event that premieres Thursday, September 5^th.
 
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