Use 30% Rule For Risk-Bearing Securities

Dr. and Mrs. Millhalf just moved here full-time and had $500,000 to invest with the goal of leaving a million dollars to grandchildren. They made initial investments October 28th which are highlighted in the box below with prices as of January 3, 2006.

Dr. and Mrs. Millhalf’s Portfolio (1/3/06)
Security	Amount	Current Price	Value
BAC	1,125 shares	47.08	52,965
GLD	1,050 shares	53.12	55,776
UST	1,250 shares	41.40	51,750
Short term tax free bonds			$351,930
Total Portfolio			$512,421

Dr. Millhalf: Our account is up more than $12,000 in a little over two months. Wow!
Market Watch: Don’t get excited. That gain can disappear in a market like this in a heartbeat. That’s why it was suggested that only 30% of your portfolio be invested in risk-bearing securities

Mrs. Millhalf: Dr. Millhalf and I are concerned about inflation being a greater percent each year than the percent of income we can make on our investments. While it is stated that inflation is around 3%, I do the shopping, and filling up of gas tanks, and it is much, much more expensive this year to shop than it was even this time last year.
Market Watch: It’s important to remember that the government’s consumer price index (CPI) leaves out the cost of fuel and the cost of food, and it uses a formula for rent that undervalues “real world rents” significantly. The central banks of the world are using inflation as a strategy to counteract the deflationary forces of massive debt. Remember Japan’s debt in 1990 that resulted from outsized Japanese expenditures in the 1980s? Japan inflated their way out of that mess after some severe deflationary values in Japan’s real estate, banks and stock market. While Japanese debt continues to increase, Japan is currently able to carry those loan increases better than they did in the 1980s because Japanese corporations are successfully managed. The United States has well managed corporations, too, and our government is hoping the U. S. can inflate our way out of the current mess.

Dr. Millhalf: If we are trying to inflate our way out of this debt burden, won’t we have to stop borrowing like Japan did?
Market Watch: Japan never really quit borrowing. There were large write-offs, from which much news was created, but Japan continued to increase their debts annually almost every year since 1990. The structure of U. S. indebtedness differs from Japan in that such a large segment of our debt is consumer debt--$11 trillion of the $41 trillion U. S. debt load. U. S. consumer debt increased a record $531 billion in the 3rd quarter of this year according to Northern Trust economist Paul Kasriel. Mr. Kasriel points out in a recent article published in The New York Times that “we have a very accident-prone economy”. About $300 billion in that same quarter was extracted in loans by homeowners pledged by the equity from their properties. Mr. Kasriel calculates that the huge increase in mortgage debt as a percent of residential real estate values is like a cash machine in that “Real Estate has become the new asset to enable people to get rich without working, and when that slows down, it is going to have a ripple effect on the rest of the economy.” People with close to 100% loans in the value of their real estate are going to be in trouble. We have already learned in the last few weeks that the inventory of available housing for sale has now reached a 19 year high. Those enormous amounts of available inventory are held by many people who will have to decrease asking prices in order to meet their debt obligations. Mr. Kasriel says “if the price goes down, they are going to be tempted to leave the keys in the mailbox and let the lender know it’s his again”.

Dr. Millhalf: By my calculations, the U. S. consumer is spending, and therefore borrowing, roughly an additional $2 trillion each year on a roughly $13 trillion GDP. Is that close, and is it sustainable?
Market Watch: Yes and no. Four out of the last five years Americans have spent more than they’ve earned. For all but a few years between 1970 and 2000, Americans saved more than they earned. Corporate savings are improving, and corporate balance sheets are improving, while individuals are not saving and while individual’s balance sheets are deteriorating from increasing debt loads.

Mrs. Millhalf: I can see how consumers are not saving. How is it, though, that if consumers are not saving, corporations can be saving?
Market Watch: You really have to separate consumers and corporations into two groups. Some of the consumers work for our corporations, but many consumers used to work for those same corporations and no longer have jobs. Corporations have moved many jobs to lower cost labor markets. In realizing a huge savings in labor, U. S. corporations have been able to price their products competitively in world markets. Because U. S. corporations are the best managed in the world, they have been able to create profits from the transfer of those costs. Those profits are turning into savings. U. S. corporate balance sheets are in the best shape they have been in for many years.

Mrs. Millhalf: Is this an example of “the rich are getting richer while the poor are getting poorer”?
Market Watch: No. Most of the large corporations in the world are U. S. owned. As U. S. corporations become more competitive and lower their risk of debt, U. S. stockholders are holding securities in which the underlying value is improving annually. As the wealth of the country’s stockholders increases, like a boat in a rising tide, all of our country’s citizens will be better off. Do you remember President Kennedy’s Appalachian Program? In the ensuing forty years everybody in this country, on average, is better off than we were in the 1960s.

Dr. Millhalf: Market Watch keeps stressing that the road to wealth is compounding coupled with investing in undervalued stocks of corporations that are dominant in their industries. What about these hundreds of small growth companies?
Market Watch: One should be disciplined in how they “play” with these smaller companies. Who knows what they are really going to do? For every Microsoft, there are hundreds of failures. Most of us get caught in the failure end of that kind of stock picking and should, therefore, limit the percent of our assets in those investments to an amount of money we are willing to lose. In the long run one is likely to do better by purchasing General Electric, Bank of America, Proctor and Gamble, Dow Chemical, Pfizer, and so forth at a time when their values are greatest. Hold them, watch the dividends increase, and watch the value of the assets go up over time.

Dr. Millhalf: What’s the outlook for this year?
Market Watch: Last year the market went nowhere. Just like last year this time, all the “great” Wall Street analysts are projecting significant gains in the market. More than 90% of them are bullish, and when everybody is thinking the same way, nobody’s thinking very much. Stocks, bonds and real estate are all about 30% over-valued.

Personal debt, government deficits, surplus real estate on the market, high energy prices, a growing trade deficit, continued job displacement overseas, and the pending bankruptcy of large U. S. corporations like Ford and GM provide an anchor upon the market having any significant gains in 2006. There is as great of a chance the market will go down, rather than up, in 2006. The conservative investor will bide their time, be patient and pick off great stocks when their values return to high dividend yields and low price earnings ratios.

Caveat Emptor.
George Rauch
January 3, 2006

*In future months, we will track these investments to see how they are doing and to commit further amounts of capital to the stock market when good buys become available.

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