Rational Advice for the Emotional Investor

On your markets. Get set. Reflate.

Yes the reflation rally's away. But does it have legs? We keep waiting for the big bounce. It looks like it might finally be here. Stocks were up in New York. So were gold and oil.

We grapple again with bubbles this Tuesday. If you are now seeing the vaunted 50% retracement rally in stocks-one that looks a lot like the rally in the first four months of 1930-how broad and deep will it be? And what will it mean for the massive bond bubble?

A lot depends on your state of mind. If you have a sense that this crisis really isn't that different or worse than the bear market of 1974, then you may be casual about it. The same investors who've driven bond yields down into the dust in an orgy of safe haven buying may decide to switch asset classes.

Everyone out of the bond market and back into stocks! One more into the breach dear friends...'till we fill up our portfolios with half-off blue chips.

Your investment state of mind has a lot to do with the security of your employment and your income. When people start to worry about having a job, they cut expenses. One of the first places that cut backs show up is retail spending. Just ask Gerry Harvey.

Pre-tax profits at Harvey Norman stores fell by 32% in the quarter ended in September. Shame on you Australia. Kevin Rudd has mailed you $10.4 billion. You're supposed to spend it. Not save it. Get with the program!

The current, ongoing, and interminable financial crisis has been compared to a lot of things. One of them is Hurricane Katrina. You remember that one in 1995. The U.S. Federal government made a meal of the emergency response, eventually distributing debit cards to displaced residents of the Gulf Coast.

This strategy, we reckon, is a sure bet to be revived in the global battle against asset deflation and a collapse in the consumer economy. If lower taxes won't do it, and lower interest rates can't get much lower, and more government spending fails to produce the desired effect, the big helicopter drop becomes a direct infusion of credit-based capital right on to the consumer balance sheet. What we really need is some precision guided reflation.

You may recall that the debit card strategy kicked off a huge bull market in televisions and hookers. It probably won't be much different this time around, which would be good for Gerry Harvey and the licensed professional ladies of the night we pass on our way home each night (with a polite nod). Bread and circuses...TV and hookers...time's change but the human heart remains corruptible.

Still, is this a rally you can trade? Trade, yes. Invest in? Well that depends on your time horizon. We reckon that every investor needs a sort of five year plan at this point. It sounds a little Stalinist. But while central planning is impossible without perfect knowledge, a little personal planning is possible. It is possible.

But the events you're watching in the financial markets simply can't be interpreted in the context of short-term market moves. There are larger story lines taking shape; the bond bubble, the irrational rally in the U.S. dollar, and the question of when the rest of the world will come to its senses and begin investing in its own growth rather than American debt.

How about some reader mail?

Dear Dan,

What happens when the bond bubble bursts? I am serious.

Anthony T.

Dear Anthony. You definitely have your serious face on. We have no idea. But we reckon you'll see a move out of bonds and into stocks and probably some recovery in commodity prices. All that stimulation is bound to create a little false surge in final global demand. After that? Good question.

In a rational monetary world, each new unit of supply coming on stream would generally decrease the value of all the other units. Or, each new Treasury obligation borrowed into existence would gradually diminish the fiscal credibility of the U.S. government. Diminishing marginal credibility.

But even gradual trends must reach the proverbial tipping point, where they obtain a momentum of their own and begin to accelerate. This will happen in the bond market. It may already be happening, in fact. Yields moved up yesterday.

You can be sure that the bond yields are not so low because the rest of the world really thinks U.S. bonds are the single best investment on the planet for scarce capital. This notion reassures Americans (and your editor is one) who have come to believe their prosperity is perpetual AND a birthright.

But the bubble in U.S. bonds is not an endorsement of the superiority of American capital markets. It's just the opposite. It's a massive fear trade. And sooner or later, that fear will be turned on the bond market itself. A calamity ensues for the U.S. government, forced to refinance existing debt and much higher rates just as the O-Team is asking the world for even more money.

G'day Dan,

I have two words for your mate who gave you an earful. And no they are not...*%#@ off!

Stop Loss...had your friend employed them and stuck to them, he'd have been laughing at your misfortune this year, instead of giving you a serve.

Easy to give this advice, and certainly wish I'd taken it sometimes this year as well! So no matter what happens in 2009, maybe those two words could form a part of everyone's investment strategy.

Another two words for your friend...Buy Gold.

Luke

Cheers Luke. The stop loss or the trailing stop is certainly worth a look for any serious investor. It takes the emotion out of your decision to sell, which is often much more difficult than your decision to buy.

For smaller stocks where the price swings are more severe, using a tight trailing-stop can get you stopped out of a position during a volatile day. This raises your transaction costs over time.

On the other hand, if you decide on a pre-set level of capital which you're willing to put at risk in any given trade or investment, you should definitely stick with it. It gives you peace of mind. But it takes discipline too.

Dear Dan,

When you dig a hole you can fill it up with one of two things:

1) Concrete, thus converting it from a hole ( with all its negative connotations) into a rock solid foundation upon which you can build an edifice that will stand the test of time. Or alternatively

2) You could fill it with Fiat money (the modern day equivalent of quick sand).

My dear departed Dad always said, "When you find yourself at the bottom of a deep holeSTOP DIGGING, or in this case inflating."

Love your work.

Kevin H.

Thanks Kevin. One of the best ways to tell if a politician is stupider than average is his use of this digging metaphor. The really dumb ones will say, "We've got to dig ourselves out of this hole."

Your dad was right. If you're in a hole, the first thing to do is stop digging, especially if it's your own financial grave, and the government is about to pour a ton of money over your head in a kind of monetary baptism by liquidity.

The only people that should still be digging are gold companies, who may find something of value, like, say, gold.

Dan Denning
for The Daily Reckoning Australia

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