THE QUANDARY OF SAFETY

Gold Eagle ^ | 8/28/02 | Robert B. Gordon Sc.D.

[Free Fire Zone]

THE QUANDARY OF SAFETY

My dictionary defines this fascinating word with two other words, perplexity and uncertainty. It almost sounds like an enigma within an enigma. For this essay, safety is defined as the state of being safe from the risk of experiencing loss.

Is cash under the mattress safe? It is from some hazards but not others. It has the advantage that the owner can check it as often as necessary. Unfortunately there are few other places for your assets that are so accessible.

One of the major problems that exists today is that some former means of insuring assets against loss may no longer be adequate to cover future losses. Property, casualty and life insurance companies invest the premiums they receive into stocks and bonds, which can be decimated by bear markets or a weak economy or both. The better companies have a long record of meeting their obligations. They attempt to reduce their risk of a catastrophic loss by sharing large risks with other insurers.

The huge loss of the Trade Center towers was presumably managed in this way. This type of risk sharing also occurs for natural disasters like fire and flood. There is historic data available to estimate the risk and set the premiums for each policy. It is much more difficult to do this for insuring risks in the global financial services area. In the final half of the last century, our leaders laughed at the possibility of another Great Depression. We now know that many insurance company assets were poorly invested and lost in the bear market to date. With this sad record, they may be totally inadequate to deal with a second Great Depression? We will discuss several potential problem areas next.

There is an insurance fund to repay losses of investors when a brokerage company fails. So far it has handled relatively small failures amounting to several hundred millions of dollars per year. To my limited knowledge of this area, there is no way to guess the ability of this insurance pool to handle several large failures of brokerages at the same time. In another area, of interest to millions of retired investors, there are insurers who guarantee the principal and revenue of tax-free bonds supported by the tax income of states or the revenue of designated agencies. It is presumed that the insurers are capitalized to assume the risk of a small number of bond issues. But, right now, there is a likelihood that all 50 states may be in serious trouble in a nationwide depression that is predicted by some observers. This could literally overwhelm the assets of the insurance companies. There is another insurance company to take over the pension plans of bankrupt employers. With the current surge in corporate bankruptcies, it is unlikely that the available insurance assets can handle more than a small part of the losses.

THE SAFETY OF AAA ASSETS

After the 1929 Crash, a few highly rated bonds were still in existence but a much larger number, rated as investment grade before the crash, had disappeared in one way or another as the company issuing them disappeared. This situation is almost certainly occurring again because of the serious corporate failure levels.

A triple A rating is currently given to a small and shrinking group of U.S. business firms. It is also given, questionably in my view, to the 3 GSE's (Government Supported Enterprises) that hold or guarantee most of the nation's mortgage loans. The little known fact is that the Federal act, setting them up, guaranteed only a few billions of dollars of support for 2 trillions of mortgages. Whether the Federal government can cough up more if needed will depend on their other problems at the time. In my considered judgment, nothing approaches the safety of direct ownership of U.S. Treasury securities. Other sovereign governments also share, with the U.S., the ability to pay debts by printing money as a last resort.

Very serious misconceptions can arise from the use of any statistics that are generated by Wall Street to facilitate their sale of stocks and bonds. Every listing of investment grade securities and their price indices excludes the companies that went out of business. It is never wise to put your faith only in a bond rating from Standard & Poors or Moody's who are paid by the companies they rate. This confusing situation sort of puts all serious investors in a quandary, so to speak.

BEWARE OF CREDIT ENHANCED SECURITIES

During the recent stock market bubble, there has been a much less well-known credit bubble. Wall Street bankers and lawyers have been burning the midnight oil creating new ways to dump low-grade investments on unwary buyers. I am aware of their existence and have for quite some time been reading strong warnings of trouble ahead by Doug Noland on the Prudent Bear web site.

Many hundreds of billions of dollars of very low-grade debt such as credit card receivables, etc. have been packaged into high-grade vehicles called CDO's for Collateralized Debt Obligations and ABS for Asset Backed Securities. In recent years, huge quantities of these "safe" securities have been sold to millions of unsuspecting Americans seeking secure income. In my opinion, this "security" will last until the national credit bubble bursts, causing a major catastrophe. This problem is quite analogous to the insured tax-free bonds described earlier where the insurance features will prove inadequate in a nation-wide downturn.

OBJECTIVE RATINGS OF BANKS, BROKERS, HMOs AND INSURERS

A very valuable resource for all investors is the new on-line safety rating service available at Weiss Ratings. I have recently checked my banks and brokers and received satisfactory ratings which I intend to obtain on a quarterly basis for just $7.95 each. They give overall ratings from A+ to F based on five criteria: Capital adequacy, asset quality, profitability, liquidity and stability, each of which is given a numerical rating on a 0 to 10 scale.

The Weiss service is possible by having a battery of accountants poring over the quarterly Q-10 reports sent to the SEC by all major U.S. companies. The Weiss firm receives no revenue from the companies, just from their subscribers.

WHO CAN YOU BELIEVE ON THE INTERNET?

In sharp contrast to the incredibly bad commentators seen hourly on CNBC, there are a very few writers with vision and integrity I can recommend. One of my all time favorites, Bill Fleckenstein, a brilliant writer and hedge fund manager, writes a daily piece, but has recently started a weekly piece available on the MSN network. Among many other great calls, he predicted all the many accounting shenanigans long before anyone else blew the whistle.

The Prudent Bear organization www.prudentbear.com publishes a valuable daily market report plus articles from outside experts. I read it daily. Another daily read is the humorous, historical and sometimes hysterical comments and articles available on www.dailyreckoning.com from Bill Bonner's publishing empire.

Last by not least, there are very many excellent writers whose works can be accessed daily on http://www.gold-eagle.com .

THE SAFEST MUTUAL FUNDS

First let me say, I hold no stock in mutual fund management companies. I have no inside knowledge of what goes on in the executive suites of leading fund management companies. However, I have owned hundreds of different mutual funds of nearly every conceivable type. I have witnessed many good things and many very bad things over the past 50-some years.

Although the entire mutual fund industry may be a disaster ready to happen, I am aware of no one who has publicly taken either side of this issue. However as I write, John Bogle, founder and ex-head of Vanguard, was quoted on CNBC as predicting that 4800 mutual funds will close operations. That is about half of the present total.

Rather than join this guessing game, I will try to use my experience and judgment to rate various types of mutual funds by survivability based on their type, size and ownership characteristics. There is absolutely no way to do this except on a relative, not absolute, basis.

Fund size, fund type and fund age are most critical. Funds with assets too low to be profitable will be the first to go by closure or merger. Hybrid stock/bond funds may be more survivable than equity and bond funds but there are more important variables. Load funds may do better than no-load funds since the investor may feel locked in. Once the fund size is above the profitability minimum, other factors come into play. For example, recently formed funds are in special danger of heavy redemptions. Funds with a long lifetime and superior relative performance will be favored for survival, irrespective of their asset size or load.

Those relatively few funds with high survivability ratings are readily seen on my computer screen using FastTrack software that can chart the past 13 year performance of 4500 funds, 6 funds at a time. I can assure you that they do not look like the chart of the Nasdaq index over those years. They show steady growth over the bull years and a rise or modest drop in the bear market to date. All of the favored fund types mentioned in essays over the past year passed a screen test on my computer.

PROBABLE FUND SURVIVORS

My view is that very large funds with long histories that did not change their philosophy and become momentum players in the Mania should survive in the absence of major blunders by their management. At the other end of the spectrum, the precious metals funds and the short funds should be intact and growing, again barring management mistakes. Bond funds of profitable size specializing in U.S. Treasuries and/or sovereign Foreign Government debt will almost certainly do well and grow. But we never concentrate our holdings in a single fund regardless of its asset class. We always diversify broadly and suggest that you do the same.

OTHER ASSETS

It is nearly impossible for me to say anything useful about other asset classes. I am very worried about the current housing bubble, which is causing some investors to rush into housing as others did earlier in the stock bubble. I have vivid memories of the real estate disaster in the Great Depression. It was so bad that, when I started college in 1931, I changed my initial life goal of becoming an architect. And four years later, in the midst of the depression, I changed my career major again to accept a teaching fellowship paying $600 per annum on which I lived till I received my degree. Those tough times may return again.

Our youngest readers may, in the future, have a once in a lifetime opportunity to buy real estate for 10 cents on each dollar of cost. In the early 1950's, my wife and I had a fabulous vacation in a palatial mansion on the Miami Beach Gold Coast just north of a luxury hotel. This residence was built in the 1920 boom period for well over a million dollars by the Ford family of Libby-Owens-Ford. Some years later this property, with 1000 feet of ocean frontage, was purchased by my wife's relative for $85,000. When we were there, the ocean frontage, alone, was valued at $1000 per foot.

I am concerned when readers write and say their assets are totally in precious metals or some other class. Having all of your assets in a heavily mortgaged home would be quite risky in my view. I am a firm believer in spreading my bets and prefer a balanced approach. I suggest that every reader buy and read the two new books previously recommended: Conquer the Crash and Ultimate Safe Money Guide. They have some valuable and slightly different approaches to protecting your assets.

FLEXIBILITY IS DESIRABLE

It is very important that every individual and every family keep constantly in mind that the 1982-1999 period in our lives is gone for a long time to come. It will be impossible to plan for a long-term goal without making a number of mid-course corrections. The number of favored asset classes is very limited and the portfolio must be carefully managed as often as needed to meet any new circumstances.

No one can make money now by throwing darts at the stock page. Our recent suggestion of 3 major asset classes, each with 2 to 5 or more sub-asset classes can accommodate portfolio dollar assets ranging from 4 to 7 figures. Because of the excellent past and projected performance of these selected assets, they provide very attractive opportunities for flexible portfolio management.

So we recommend that our readers seize these opportunities. Here are some suggestions to consider. Select 6 foreign government bond funds of short to intermediate maturities, follow their performance closely and stay invested in the best fund(s). Do the same thing with the precious metal and short fund classes.

Periodically, review the percentage allocation to the 3 major asset classes. Do this separately from any rebalancing consideration. The future is always unpredictable but I am confident that I could handle just about any shift in the market climate by adjusting the major allocations. I can imagine specific favorable circumstances in which, starting with the 70-15-15 bond, gold, short asset mix, I might, for instance, cut the bond percentage to 40% and raise the other two classes to 30%. I can imagine other times when I would alter the ratio of the allocation to precious metals and short funds from its current equality to another that favors one class over the other. The number of possible combinations is almost endless. It takes a flexible capability to provide the best safety. This is the right vessel to get your assets safely through the uncharted waters ahead.

SUMMING IT ALL UP

Nothing in the entire world is ever completely safe. Collect all the expert advice you can and apply it to your individual situation in the very best way possible.

For nearly every reader in possession of a healthy mind and body, the financial assets of that person will be safest if under the full control and supervision of the investor. This will require time and effort, but who can do it better than you?

Consider these other options for a minute. Giving your money to a fund manager, who does not have a very specific sector in which to invest, could lead to very unpleasant surprises. That will not happen if the fund is restricted to holding specific bonds, precious metals and short sales. Even then, you must check the results to make sure that everything is going per plan.

Giving you money to a private money manager could be very scary if your assets were not large enough to permit frequent progress reports by phone from your manager. Under the best of circumstances, I could not do that with major assets and sleep well at night.

So my advice to all is: Do it yourself so that you can make any needed changes. Stay diversified in the best asset classes. Follow the portfolio performance through all the market ups and downs. Rebalance the assets when needed. Modify the asset allocation ratios to suit changes in the market climate and direction. Don't follow your portfolio daily and do not worry about the market indices. Remember that you do not own the indices. Your portfolio is unique and designed to bring you safely through stormy seas. Properly managed, it will get you to your goal safe and sound. Give it your very best effort, then relax and enjoy your life.

SPECIAL NOTE TO READERS

Please withhold your e-mails on foreign government bond funds. Good reliable current information is very hard to find. I am going to try very hard to fill this void and publish the available data as soon as possible.

Robert B. Gordon Sc.D.

Sun City West AZ 85375

rgordon145@aol.com

August 28, 2002