Where the Smart Money is Going: And Why Yours Shouldn't

We live in interesting times, to say the least. During the economic collapse of the last four months, if you're not too squeamish to watch, there have been some fascinating things going on. First of all, as virtually everyone with a brain can see, the stock markets in the U.S. have dropped, losing close to a third of their value. I'm not going to rehash all the details on that; you can read all about it here, as well as many other places. Suffice it to say that stock markets around the world, whether in the developing world or in the developed world, have been on a roller coaster of instability that we haven't seen since the 1930's. If you want to put your money there (presuming Bernie Madoff hasn't made off with your nest egg), be my guest. Just don't come back to me in two or three years and complain. I'll just say, "I told you so!"

So what are your alternatives? A friend of mine asked me this exact question a few days ago. I told him what I thought and I haven't changed my mind, but I've been thinking about it ever since. One of the rather interesting things that's been happening recently is that, for government bonds -- and, in particular, for U.S. Treasuries, traditionally the safest bets in the capital markets -- yields have dried up. Basically, if you want to lend money to the U.S. Government, its an "even up" deal. In exchange for the chance to put your cash in Uncle Sam's pocket, he's promising to give it back whenever that bond or T-Bill matures. Interest? Fugetaboutit! Your return, for the duration, is being able to sleep at night. The risk is low and everybody knows it. So the U.S. Treasury has no shortage of willing lenders. This is nothing new, by the way. Whenever the markets for stocks & other marketable financial instruments gets rocky, investors stream out of those markets in something called a "flight to quality", namely U.S. treasury obligations. And that's where the Smart Money is going now. They're not getting much for their bonds & bills, though. Here are the yields as of close of business at 2008 Year End:

Treasury Bills, Notes and Bonds

Most recent issues
Maturity	% yield	Change
At close 12/31/2008
3-month	0.112%	0.00
6-month	0.249%	0.00
2-year	0.75%	0.00
5-year	1.55%	0.00
10-year	2.22%	0.00
30-year	2.68%	0.00

So that's what the Smart Money Pros are getting as a return on their investments. If that 2.68% yield on a hypothetical 30 year Treasury looks good to you, have at it. I'm sure, come the market's opening after the holiday, yields will still be there. With the bailouts of the banks & auto companies, and the big stimulus package being designed by Obama's troops, there'll be no shortage of treasuries around. Everyone can get as much as they'd like. Here's the problem, though: Excluding any correction for inflation (or, as the case may be, for deflation), 2.68% seems pretty measly to me. Especially given the risk. And, yes, treasuries have risk. Not credit risk (i.e., the possibility of default); I trust that the U.S. Government will still be in business when this whole thing is over -- altho other governments may not. Treasuries are, though, vulnerable to market risk. Their price fluctuates. As interest rates go up and down, the prices of Treasuries go up and down. Or, more exactly, they go down and up. If interest rates in general go down, bonds go up. And if interest rates go up, bonds go down. U.S. Treasuries obligations (Bills, Bonds, & Notes, technically speaking) are not at all immune to this. They go up and down, too. So, class . . . think about our current situation a bit. Treasury rates are unlikely to go down. There's no place to go. They are just about as low as they could possibly go. They could stay the same. But, as I hinted up above, in my own, always humble, opinion, even 2.68% is hardly worth the trouble. At these levels (especially considering the transaction costs of buying & selling modest amounts of bonds) there's basically no yield here to speak of. You might as well hold cash (more later on this brilliant plan). But there's another alternative: Interest rates could go up. Of course, they won't do that very soon. But, eventually, they will certainly go up. And, when interest rates go up, all those safe-as-can-be Treasuries will drop like a rock. The short term ones -- less than a year will drop like pebbles. The medium term ones (as in 2, 3 or 5 years) will drop like rocks. And the longer term ones will drop like big ol' boulders. The longer the maturity, the bigger the fall will be. It's a financial law, folks. There's no escape from the mathematical certainty of this basic principle

So, what I told my friend was to put extra cash into, well . . . cash. No commissions, no market risk, no credit risk (or, at least, no more -- or less -- credit risk than Treasuries). Kinda simple, actually. In fact, maybe not just U.S. dollars. There are also Euros, the Chinese Renminbi, Japanese Yen . . . A caution, tho: currency markets are also not without risk. Don't say I didn't warn you!

Creative Bankers

I happened on this column by Thomas Friedman in the New York Times, titled "Time to Reboot America". I was struck by a number of things. First of all, Friedman's point, that the U.S. is essentially in the same shape as GM and that the country needs a fresh start and, furthermore , that the next 3 months or so present an historic opportunity, albeit an expensive one, to start anew, is spot on.

This is something that many American expats can see with a clarity that seems to get muddier the more time one spends in the U.S. these days.

Then a few other thoughts popped up. I saw an article here in China where a chinese banker was intent on defending the value of the many "innovations" the capital markets have been witness to in the last ten years. Quickly on the heels of that was a memory, long dormant but still clear, of the late great Peter Drucker telling me that the field of finance, as he put it, was not a place that encouraged creativity. What he was referring to wasn't management creativity, nor was it the creativity financial pros bring to solving organizational financial problems. He was talking about the kind of financial engineering that became the hallmark of the modern Wall Street; the kind of "creativity" that used smoke & mirrors to create financial instruments so far removed from anything of underlying real value that they had worth only in that someone thought they could be bought or sold, sort of like the mythical emperor's new clothes (which, of course, never really existed). At the time Drucker made that comment, to call a banker creative would have been an insult. People wanted their bankers conservative, even stodgy. That's an attitude that, today, seems rather refreshing.

How ironic it would be if the Chinese, in their efforts to bring innovation to the modern Chinese world, buy that myth from Wall Street: that financial creativity (of the third kind) is the kind of innovation that China needs. Its not. As the U.S. has learned, to its horror.