Constructing a Rock Solid Portfolio

Words such as ‘rock’ and ‘solid’ are becoming less meaningful by the day as past assumptions about the security of banks and money market funds have been swept aside. What were previously firm foundations feel like pack-ice melting and cracking underfoot.

Investors have been quick to respond to endemic threats by snapping up short-term US Treasuries: they may yield next to nothing but are the safest place to park temporarily. At the other end of the risk spectrum some are wondering whether to buy equities at current levels. The extreme high witnessed in the VIX index is a good pre-cursor of a bounce. But like the NASDAQ and the Nikkei before them, markets may take decades to re-test their old highs. We have been through an earnings bubble such that the E in P/E was an ersatz number artificially inflated by credit creation. In the Great Depression, gold and mining stocks provided one of the few areas of positive performance. However, the mining sector has lost substantially more than financials in the last five months, in spite of far superior earnings prospects.

Meanwhile the dollar appears to have regained its ‘flight to quality’ status, courtesy of the dash for cash and repatriation. Investors have been shunted out of risk assets and have desperately clung to the dollar. Their losses may later be compounded as devaluation resumes. The Paulson Plan is just the latest and largest in a long line of artificial stimuli which serve to accelerate the eventual loss of America’s Reserve Currency status. For now it seems that the dollar is the best of a bad bunch, particularly when European governments go it alone with bank guarantees. Such beggar-thy-neighbour policies are reminiscent of the selfish devaluations of the 1930s serving only to deepen the Depression.

Precious metals have been purchased on the simplistic assumption that the next few years can be spent fly-fishing with finances forgotten. The halving of Platinum over four months re-enforces the ‘snooze-you-lose’ principal. Gold is undergoing its usual accumulation for the Indian wedding season while American domestic demand also surges. The US Mint has even run out of gold and silver coins as the public scrambles for tangible assets free from liabilities. Although unlikely to be repeated, the private possession of precious metals was outlawed back in 1933, just prior to the dollar’s formal devaluation. Unless ensconced in Fort Knox, its ownership requires the services of a bank somewhere along the line. However, the metal is still at risk if not allocated or in a safe deposit. Exchange-traded certificates offer access to metals with affordable transaction and custody costs – a case of purchasing power to the people. As ever, there is the caveat of counterparty risk.

While Swiss banks’ safe-haven status has been severely tested, one should bear in mind that many are not corporate behemoths but conservative institutions, with a fine tradition for stewardship. Such concepts were regarded as cranky relics of a bygone era when they should have been lauded as timeless business models. Perhaps the family or partnership model in finance will emerge once more. Well-intentioned share option schemes mutated banks and corporations into geared monstrosities; share price targets took priority over their products and the people they were meant to serve. This fast-track to wealth served to side-step the responsibility fostered by true equity ownership.

Ironically, Islamic financing methods could provide a blue-print for Anglo-Saxon institutions. The concept of a highly capitalised bank matching borrowers and lenders is indeed alien to westerners, as is the idea that an institution shares risks and rewards with its customers. While interest payments are forbidden and capital is not guaranteed, depositors can still receive a return by pooling their money, giving the bank restricted or unrestricted mandates for investment in useful projects. The bank is often a co-investor, ensuring an enhanced level of ethics and accountability.

While recent events have pole-axed our perception of what constitutes a rock-solid investment, they may paradoxically lay the foundation for a more sustainable and inflation-free financial system for years to come.

Toby Birch

October 2008