For those new to trading, new to me, or my methodology, I think the following ground rules will help...
Weiss: A Talk with Donoghue
02/11/2005 12:00 am EST
Bill Donoghue and Martin Weiss are both participants at the Money Shows, and here we have the unique opportunity to hear Martin interview Bill. Ironically, it was Bill, who 25 years ago, suggested the name, Safe Money Report, for Martin’s newsletter.
Martin Weiss: Bill, what will be the single most important factor driving the financial markets in the years to come?
The key factor to watch will be interest rates, especially as
they move higher and higher. They will dominate everything. They will
transform the financial markets and completely change the way you look at
your entire portfolio. Virtually everything Wall Street has been telling you to do in
recent years has been driven by falling or low interest rates. Now, the tide
is turning. Yet the advice you're getting from Wall Street is still ‘trust me,
stay the course.’ In my view, trusting traditional advisors is the biggest
and most dangerous blunder of our time. It can deny to baby boomers—plus their parents and children—a
retirement with dignity. And it can continue to destroy wealth unnecessarily.
Weiss: I agree rates are going higher. But I'd be interested in hearing your reasons.
Donoghue: The first reason is the
sheer fact that they're near historic lows right now and have nowhere else to
go. The second is that they're so low despite powerful real-world drivers for
higher rates, such as world economic growth, rising inflation, the falling
dollar, bulging deficits. The third reason is the Fed. The only way the Fed can
retain a modicum of credibility, control growth, and avoid inflation is to
continue raising interest rates. But it still won't be enough. Most of Wall
Street wasn't around back in 1966. But you and I were, and we remember what
happened. That's the last time the Fed triggered a period of long-term rising
interest rates, at a time when inflation seemed as if it was still under
control, just as it does today. And by 1982, money market funds were paying an
average of 22%.
Weiss: Do you think it will go that far this time?
Donoghue: It's too soon to say. But it's not too soon to recognize the near certainty of the rising trend for interest rates. In fact, they are already moving higher. We have a trend in place, and there's nothing on the horizon that can stop that trend from accelerating. There will be a high degree of market volatility, which is common during periods of rising interest rates. Many investors will get over-confident during rallies and get slammed during corrections. The difference today is that there are easy-to-trade, liquid, and convenient mutual funds that can help you make money in both directions. Sadly, few will use them. Too many investors and advisors are lulled into a ‘bull-markets-forever’ mindset.
Weiss: What do you see as the primary consequences of rising rates?
Donoghue: Rising interest rates can undermine the value of virtually any security on the face of the earth. In nearly all valuation models, the market value of a security is based on the net present value of a stream of future income discounted at some riskless rate and adjusted for any uncertainties. In other words, if you want to know what a security is worth, a good place to start would be to look at how much cash flow you expect it to earn for you in future years and then subtract what you could earn on your cash without taking any risk whatsoever. If you adjust that for the near certainty of rising rates, the stock and bond markets are currently far over-valued as long-term investments. What's ironic is that the closest connection between rising interest rates and falling stock values is among those stocks that produce the steadiest yields.
Weiss: Such as?
Donoghue: Utilities stocks. When interest rates are falling, these are among the best stocks to invest in. But when rates are rising, they can be among the most disappointing.
Weiss: What about long-term bonds?
Donoghue: Right now, in bond market mutual funds, there's about $1.3 trillion in investor assets that are going to sink in value when interest rates go up. The investors in those funds think they're safe. But they're exposed to severe losses.
Weiss: When do you see investors losing money in bond funds?
Donoghue: Sooner than they would like. Short-term rates are already moving up, and it seems inevitable that long-term rates will follow. Naturally, there are going to be ups and downs in long-term rates, but over time, I feel strongly that the up moves will dominate.
Weiss: What about the stock market? Which
are the riskiest investments?
Donoghue: The same stocks that went up the most when interest rates were falling in the 1990s—utility stocks, large-cap stocks, S&P 500 index funds, financial stocks, heavily indebted companies—will likely be the most volatile as interest rates rise. Did you know that General Motors shares plunged 25% in 2004? A lot of that plunge was due to expectations of higher interest costs.
Weiss: This raises a real dilemma
regarding 401(k)s, 403(b)s and other retirement accounts: You can't earn enough
to make up for lost time and rebuild your retirement savings in low-yield money
funds. But you also can't afford the principal risk of long-term bonds or
traditional stock mutual funds. So what do you do?
Donoghue: The real problem is that the government doesn't seem to trust you to manage your own retirement savings. So they delegated the choice of investments to your human resources department, your benefits manager, or even worse, to ‘consultants’ from the very mutual funds they will be investing in. They pick funds that appear legally safe for them but risk being financially useless for you. That's ridiculous. You're a lot smarter than that. The end result is you have employee benefits that don't always benefit employees. In the three-year bear market, millions of 401(k) investors lost more money in their retirement savings than they earned in their jobs. We are still near 45-year lows in interest rates; and these rates are bound to rise, negatively impacting bond and stock fund values. So a prudent man could make the point that 401(k)'s are not properly diversified unless they allow investors to take advantage of rising interest rates. Yet I am not aware of any 401(k) plans that offer investors the opportunity to invest in the dozen or so funds that are designed to profit from rising rates or falling stock markets. Would you buy a car that had no reverse? Would you want to park your car with no way to back out? No, right? So why would you be satisfied with mutual funds that can only make money if interest rates fall and stock or bond values rise? And they call this "professional" management?
Weiss: Their argument is that the stock
market will always rise over the long term.
Donoghue: The 2000s have proved them wrong. But even if they were right, how long is long term? And suppose it doesn't happen in time for your retirement. Then what? Looking ahead, the most likely scenario for the next decade is rising interest rates and a see-saw stock market. Meanwhile, nearly all mutual funds in the world are planning strictly for a one-way street: UP. They won't even try to protect your money from the known risk of a falling market. And the few that will are excluded from every 401(k) plan I've ever seen. That's financial suicide. You have to make up for lost time before you retire and you don't have the tools.
Weiss: Where do you think most of the 401(k) money is invested right now?
Donoghue: It's in hundreds of different stock and bond mutual funds. But if you could add the stock funds all together into one single mega-account, it would probably be pretty close to an S&P 500 index fund. And guess what! The S&P is overvalued right now. No matter how you turn and twist the numbers—price to book or price to earnings—the S&P is overvalued. So most Americans with their retirement money tied up in an overvalued stock and bond market will be lucky to break even by the time they retire. Many simply won't be able to retire at all.
Weiss: Can you give us a few simple rules of thumb for tax-deferred investing?
Donoghue: If you intend to lose money, invest in tax-deferred accounts. You will only pay taxes on what is left, effectively sheltering your losses. But who wants to lose a dollar to deduct 30 cents in taxes? If you intend to make money, 100% income tax-free Roth IRAs are a better choice. You get to keep all your profits and since these are, by definition, self-directed accounts, you can freely invest in funds designed to make money with rising interest rates or falling stock prices. Investment freedom is worth more than tax-deferral.
Weiss: What relatively conservative investments would you
Donoghue: The first thing I'd do is gain a better understanding of how inverse bond funds work and how you can use them to invest in the one bull market that's relatively certain—rising interest rates. If you're in Rydex Juno (RYAQX), that's fine. Next, watch the 10-year note as your bellwether. When its rate starts rising, start investing in the Potomac ContraBond Fund (PCBDX ). It has an effective duration of about minus 18. In other words, for every one percentage point rise in the 10-year note rate, Potomac is designed to go up about 18%.
Weiss: Don't you think that's a bit too risky for the conservative investor?
Donoghue: Actually, I think it's even riskier to keep all your money in a long-term government bond fund that will almost certainly lose money as interest rates rise. If you keep your allocation modest and combine it with other investments, you can reduce the risk. But remember: You've got to be flexible. Buy and hold won't work.
Weiss: No exceptions?
Donoghue: If you pressed me to pick an investment to buy and hold for the long-term, one would be Fidelity Strategic Income Fund (FSICX) precisely because its managers do not buy and hold. They actively manage their portfolio, shifting maturities, shifting sectors, bond grades, even countries. And they do a good job. They won't sell their portfolios short in a rising-rate market or go to cash, but they will shorten their maturities or shift to other fixed-income markets. Their three-year total return averaged 11.54% and their five-year average is 9.40%, with relatively low volatility (a low 5.65 standard deviation). That return beat the pants off of money funds and most other bond funds.
Weiss: We've looked at the fund in depth, and although it also invests in high-yield bonds, which do involve risk, we agree it makes for an excellent addition to our conservative portfolio to help boost its overall yield. Bill, thank you for your time."
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