'QE2': How to Invest in Manipulated Markets

NEW YORK (TheStreet) -- On paper, the recent rally in U.S. equities may seem impressive -- but priced in gold (a representation of the U.S. dollar's diminished purchasing power), U.S. stocks have ridden a downward trajectory for months.

Blame the Federal Reserve.

The Federal Open Market Committee, through its purchases of dollar-denominated assets, has been steadily injecting liquidity into the U.S. economy. The process (known as quantitative easing) increases the U.S. money supply, allowing financial institutions to boost reserves and the U.S. government to borrow (and repay external debts) in a debased currency. In essence, the U.S. economy is "lending" itself money by creating more.

Earlier this year, famed value-investor Seth Klarman made a disturbing statement: "There is nothing natural in the markets. Everything is being manipulated by the government."

Today, the situation has worsened, as most asset classes have lost historical correlations and speculators prepare for continued intervention by the U.S. central bank.

IMF Advises Continued Welfare -- for the Rich

The International Monetary Fund's October 2010 Global Financial Stability Report warns that additional trillions in taxpayer support may be necessary to shore up the balance sheet of our financial system. This is a tough pill to swallow considering that Wall Street paid out record bonuses in 2009 -- with many of the largest bonuses issued within firms that received taxpayer support.

The U.S. financial system has become sickeningly anti-capitalistic -- rewarding the most productive members of institutions that produce negative economic utility. In other words, we continually reward the most destructive members of our society.

Monetary Policy a "Race to the Bottom"

During the height of the U.S. property/equity bubble, honest bankers may have knowingly issued bad loans as a last-ditch effort to stay competitive in an irresponsible business environment.

Today, consider America the world's most irresponsible bank.

The U.S. policy of quantitative easing is being adopted by foreign countries, desperate to lower the relative value of their currency, with the hope of increasing exports. The Bank of Japan has recently upped the ante with a $60 billion asset-purchase program, leaving open the possibility of purchasing ETFs and REITs (a new tactic in currency warfare).

Of course, as more countries engage in this "competitive devaluation," the less (intended) impact it will have (with greater potential for unforeseen consequences and societal costs).

Investment Policy in a Manipulated Market

Determining an intelligent investment policy in a manipulated market is a challenging, if not impossible task. Nevertheless, let us attempt to construct a policy with consideration of the following points:

• On a relative basis, U.S. stocks are far more attractive than U.S. bonds. The earnings yield of the S&P 500 (using 10-year trailing data), stands at 4.73%. Comparing this to the 2.40% yield on a 10-year U.S. Treasury note and the 3.71% yield on a 30-year U.S. Treasury bond -- equities possess a comfortable margin of safety in the medium and long term. While stocks may outperform on a nominal basis, this outperformance may not exceed the rate of devaluation in the U.S. dollar (resulting in paper gains, with an actual loss of purchasing power).
• Fear of an increased money supply has driven gold to record prices (priced in U.S. dollars). Other precious metals, and their respective ETFs, have followed a similar trajectory.
• The Federal Reserve has not published M3 data since 2006, obfuscating the true picture of U.S. money supply. Similarly, there is little transparency as to the gold supply held by central banks and governments.
• An increase in M3 (the broadest measure of money supply) will not immediately increase consumer price inflation.
• Global equity markets remain susceptible to manipulation and volatility, as a result of algorithmic trading.

Considering the near-2:1 yield differential between U.S. equities and medium-term debt, investors may wish to allocate their portfolios in a similar proportion. Perhaps 50% stocks and 25% bonds. Holding cash during a period of currency debasement may seem counterintuitive, but an allocation of 15% cash may offer opportunities to capitalize on market volatility and mispricings. Lastly, investors may wish to hold 10% of their portfolio in a hard asset, such as gold, as a form of "insurance" policy against a prolonged debasement of paper currencies. Now, let us expand our conclusions:

1. Stocks should be purchased only on the basis of attractive absolute valuations. The investor may wish to focus on large corporations with diverse global sales (in essence, diversifying the investor against specific currency risk). Exxon Mobil(XOM), Coca-Cola(KO), and Johnson & Johnson(JNJ) fit these criteria.
2. Bonds should be purchased directly -- whenever possible -- to avoid the risks associated with bond ETFs and mutual funds. If the investor must purchase bonds through an associated fund, he or she must be certain that the underlying holdings are guaranteed by the U.S. government.

   
   
   Corporate bonds should be avoided, unless they can be purchased at a distressed valuation and have a sufficient revenue-to-debt coverage ratio. The current yield differential between corporate debt and U.S. does not compensate for the fact that governments can print money; corporations cannot.

3. Gold -- if purchased for protection (as opposed to speculation) -- should be held in physical form. That's because precious metal ETFs such as SPDR Gold Shares(GLD) and iShares Silver Trust ETF(SLV) offer investors no legal claim against the underlying asset, they should be viewed as speculative instruments.

Final Thoughts

The individual American taxpayer proportionally owes $1.2 million in U.S. debt and unfunded liabilities -- a situation that is likely to worsen, if not become an unsolvable problem.

Americans may be best served by investing time in understanding the economic realities of our country and supporting leaders that campaign on tough, unpopular choices -- while actively working to restoring fairness to our markets and the capitalist system.

As a final thought, perhaps we should reconsider why a Congress member is elected every two years, our president is elected every four, a senator is elected every six years -- but a Federal Reserve governor is appointed every 14 years.

-- Written by John DeFeo in New York CityFollow @johndefeo

READERS ALSO LIKE:

10 Myths That Politicians Want You to Believe >>

>To order reprints of this article, click here: Reprints