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An investor’s tale: why the bear can’t get out of the woods

As things go from bad to worse, one of the most bearish advisories considers a change in tactics — but sticks with a very basic strategy.

He predicted trouble, and it came. He predicted things would get even worse, and they did. He doesn’t think the economy is anywhere close to getting out of the woods yet.

No one we’ve reported on in these pages has been a more consistent bear than Mr. Irwin T. Yamamoto. Throughout the past year, his portfolio has not changed: 90 per cent cash in money market accounts and 10 per cent in the Rydex Ursa Fund which shorts the S&P 500.

But recently, he tells his readers in The Yamamoto Report, he considered a slight change in tactics in order to combat the irresponsibility of those in high places. In a moment we’ll take a look at what he was considering and why he rejected it.

But first, he has something to recommend… or rather, someone.

Hands down, his favourite couple

Mr. Yamamoto feels very strongly about the Dolans. Ken and Daria Dolan had a show on CNN, then CNBC. They have written books on personal finance and they have a syndicated radio show and web site. “Hands down, the Dolans are my favorite couple of finance,” says the editor. “Now more than ever, it’s important to pay attention to them.”

We’re not in the business of endorsing on-air financial advisers, but it is striking that Mr. Yamamoto is so insistent on the value of their advice. The reason isn’t too difficult to discern. That advice is based on the most conservative principles: save money and stay out of debt.

Hard to imagine that such simple, straightforward advice could have been ignored by so many millions. But it has.

Now let’s see what kind of tweak the editor thought of giving to his portfolio.

When rates could be climbing

Bank money market accounts have been just fine, according to Mr. Yamamoto. “In spite of the numerous interest rate cuts, one can still find bank money market accounts paying 4.5 to 5 per cent, plus even more.”

Still, the editor did some research on certificates of deposit (CDs). “The idea was to lock in the higher rates to combat the irresponsible actions by Federal Reserve Chairman Ben Bernanke as the man continues to slice interest rates.”

But, money market rates proved to be superior to those of the CDs. His study of certificates of deposit, he explains, was focused on short-term instruments of three months to a year. And the reason for keeping it short was simple: interest rates “could be climbing again late this year or in 2009. Bernanke may not want to raise rates, but the bond market could do it for him when inflationary pressures appear.”

In other words, he could have responsibility thrust upon him.

But whatever interest rates do, equities fall short.

Investors are spoiled

Bank money market accounts should still outperform equities no matter where interest rates go, says Mr. Yamamoto. It is unlikely that stocks will register gains for a sixth consecutive year. And the editor has some tough love for investors.

“Remember, [stocks] don’t go up every year. Investors are spoiled. Bear cycles have been part of investing cycles in the past. And rest assured, they will be an element in the future.”

In short, you cannot expect a falling stock market to correct itself swiftly as a matter of course. The market can stay down for a long time.

In the meantime, the editor’s Rydex Ursa Fund has done well in the market sell-off. He intends to add more shares if a bear market rally offers him a lower entry point.

And he is keeping an eye on oil and gold, but they will have to come down a fair ways in price before they find their way into the Yamamoto portfolio.

Another shoe dropping

We have read a good many commentaries on the subprime mortgage crisis that talk about another shoe dropping. Mr. Yamamoto employs the same phrase, but somehow we feel that his shoe is heavier, and will drop farther, than most of the other figurative footwear invoked.

Many experts, he says, have been calling for a bottom in the U.S. housing market that could come as early as mid-2008. There might even be a bit of a rebound. “The figures don’t support their theory,” says the editor.

Sales of new homes plunged by 26.4 per cent last year, the largest slide on record. Existing home sales dropped by 12.8 per cent, the worst annual decrease in 25 years. (Think about it: that’s a lot of homes ready to be moved into that are standing empty.) To round out the misery, home construction fell 24.8 per cent, the worst in three decades.

The central argument of the optimists, Mr. Yamamoto points out, are based on another flawed premise. Namely, that employment will prop up the housing market.

The bulls lose their ally

“Well, don’t look now,” says the editor, “but the bulls just lost their ally.” In January, the U.S. lost 17,000 jobs. That’s right, he adds for emphasis, the job rate didn’t just rise at a slower pace. It fell — for the first time in four years. And there’s more bad news where that came from.

According to the Institute of Supply Management, the service sector — the one that supports so many jobs these days — fell behind. That hasn’t happened for five years. The figures say it is officially in contraction.

Layoffs have become commonplace. The names of those doing the laying-off are pretty scary: Citigroup (4,200 job cuts), Macy’s (2,300), Yahoo (1,000) and General Motors (which offered buyouts to no less than 74,000 employees in order to make way for lower-paid workers).

In December, the unemployment rate reached its highest levels since the 9/11 attacks. The editor quotes Bear Stearns economist Mr. John Ryding: “Since 1949, the unemployment rate has never risen by this magnitude without the economy being in a recession.”

A snail’s pace, or worse

But the unemployment rate did fall to 4.9 in January. Mr. Yamamoto is not impressed by this figure, you will not be surprised to learn.

Well over 1 million Americans won’t be able to find a job in the next six months, according to the National Employment Law Project, and will not even qualify for assistance. At the present pace, the editor reckons, unemployment could jump as high as 7 per cent. That would mean another 3 million Americans out of work.

The unemployment rate is a trailing indicator, Mr. Yamamoto reminds his readers. That is, it follows behind trends in the economy. The worst is yet to come, he insists. “Corporations have begun to lay off workers. Visualize the jobless headlines when economic growth begins to crawl at a snail’s pace, zero to one per cent.” Or even into negative territory.

In the months ahead, the connection between unemployment and housing will become crystal clear, says Mr. Yamamoto. The real estate market is off 10 per cent. Expect it to drop another 15 to 20 per cent, higher in some regions.

“Remember, we are only in the early stages,” he adds. “After a bubble, which we just had, the slide is pronounced and lasts for years.”

They won’t get it right

Working through the unhappy figures, we get to one of the central themes of Mr. Yamamoto’s argument. The people in positions of responsibility just can’t — or won’t — get it right.

“Actually, the unemployment rate has already surpassed the estimates which the Fed had for the next three years,” says the editor. “Yet the Fed shouldn’t be surprised at all.” Last year, another key measurement, the household survey, showed weakness. But it was largely ignored.

The household survey should attract more notice, in the editor’s opinion. It tosses up some very revealing statistics — like the fact that most of the job growth last year came in government, not the private sector and that many of the private sector gains were in two areas notorious for low pay — bars and restaurants, and health care.

Mr. Yamamoto makes the same point over and over again. The powers-that-be, on Wall Street or in Washington, are more interested in telling people what they want to hear than what they ought to hear. So are all those bulls that want the market to go up forever.

Thus statistics get misinterpreted and sugar coated to prop up a market that should probably be allowed to work its way through its troubles. And while all this false optimism is filling the air, the Fed rushes in with interest rate cuts to apply some equally false stimulus to the market.

That, at any rate, is one bearish editor’s take on the situation. Unfortunately, he is not without evidence to support it.

As far as Mr. Yamamoto is concerned, there’s a very good reason why there’s a bear in the woods. Deal with it. Or ignore him at your peril.