Part 3: Investment Ideas

Welcome to the final installment of my investment outlook. I began by giving a brief presentation on where I believe the U.S. economy currently stands and followed up with a comparison between Japan in the 90's and the U.S. today (courtesy of The Economist). Now that I have made an educated hypothesis as to where I believe the economy is headed, I can now proceed to do what I enjoy most...allocate my funds accordingly! I have found that after building a robust forecast, common sense is all that is needed to select big, Everest-like trends. Here's how it will work: I will give you general investment ideas that I am currently looking at (remember, these are just my opinions, so feel free to discuss via comments) and will attempt to keep them as simple as possible, playing off of macro themes that I feel will be present in the future. I won't give specific allocations due to the millions of different risk and return profiles, but rather provide you with an idea of where I'm putting money to work. It is also important to note that these are investments, not trades. Trades will come and go on a daily/weekly basis, but most of the investment ideas listed below will simply be adjusted as time goes on. My list of investment ideas is just about as volatile as the markets, so I will constantly be updating the list to account for adjustments.

U.S. Equities:
Given the fragile state of the U.S. consumer, I am still steering clear of domestic equities. Until consumers are back on their feet (which might not be for awhile), try to avoid any consumer dependent industries. The stocks I am looking at possess these qualities:

• Strong balance sheets - lots of cash, little/no debt, reliable credit line if needed
  
• Healthcare, Consumer Staples and Utilities all posted positive Q4 numbers relative to 2007 - these sectors might be a good place to start (see chart below)
  
• Dividends - Dividend income accounted for almost 70% of U.S. Equity returns since 1900, according to a recent Credit Suisse study (see list below for companies that have actually raised their dividend this year - this is exactly what I like to see)
• Certain infrastructure plays - infrastructure will likely be the means for job creation, so the government will focus future capital in this direction

Remember, just because stocks have fallen so much doesn't mean they're cheap. Back in 1975 and 1980 we bottomed out with P/E's around 7, we are currently sitting around 13x earnings (assuming $60/share on the S&P this year). However, interest rates and inflation are also at nil, so we could see a bottom closer to 10 or 11 times earnings this time around. As companies continue to slash dividends, the valuation picture grows uglier (take the present value of future dividend payments).

Source: Bespoke Investment Group

Source: Bloomberg

Investment Grade Corporate Debt:
This is a relatively safe way to play an interesting dislocation in the credit markets. The average investment grade security is yielding 7.15% compared to a yield of 3.5% on the 30-year treasury (I find it hard to believe that there are still people out there willing to loan the U.S. government money for 30 years). The average spread between investment grade corporates and the 30-year t-bond over the past 40 years has been around 100 basis points (1%). With a current spread of 350 basis points (3.5%), any reversion to the mean would provide a handsome capital gain. Given my grim outlook on the economy, default rates will continue to climb, so that is why I'm sticking with quality. High yield debt yielding close to 18% is attractive, but not nearly as safe. Many companies will go bankrupt over the next year or two, so I'd prefer to stick with well-established, investment grade companies. I will look to play this discrepancy through the iShares Investment Grade Corporate Bond ETF, LQD. It is yielding almost 2x the S&P with half the volatility (Standard Deviations: 9.88% on LQD vs. 21.75% on SPY). Higher income with lower volatility...Gotta love it.

China:
When it comes to emerging markets, China looks to be the first country that will eventually recover from this global slowdown. As Jim Rogers states, "Just as Britain was the country of the 19th century, the U.S. the country of the 20th century, China will emerge the country of the 21st century." I couldn't agree more. The Chinese have tasted capitalism and they're hungry for more. This minor blip in growth serves as a great long term buying opportunity for patient investors. One way to gain diversified exposure to China is through the FTSE/Xinhua 25 Index ETF, FXI. Even though a few companies in this index are partially state-owned, the growth of China will still be reflected in the returns generated by the index. I'm hoping that eventually capitalism will overtake socialism, and these companies will be given the opportunity to prosper in the free market. For a more developed play on China take a look at the MSCI Hong Kong Index ETF, EWH. For the fundamental reasons why I'm bullish on China please view China: Down, but Not Out.

Gold:
I, along with many other investors, always like to have a little gold in my portfolio to help hedge against a "worst case scenario" outcome. Many professional investors are happiest when their gold positions are declining in value because that usually means the rest of their portfolio is doing well. Gold serves as a great tool for diversification. Recently, gold has been on a tear gaining 10% over the past month, but over the past few days it has made a considerable pull-back. This might be nearing a good buying opportunity. For more thoughts on gold, and the Gold ETF, GLD, please see my earlier post Golden Opportunity?

Agriculture:
Demand for almost every commodity has fallen through the floor, but I have made some room in my portfolio for a small chunk of agriculture. Here's why:

• The world population will continue to eat (This is a clock that compares productive land growth to world population growth...scary)
  
• With credit tighter than ever, farmers are unable to get loans to purchase equipment and fertilize/expand their crops
• Just as homeowners are overextended on home loans, farmers have become overextended on land loans
• Looking into the future, as climate change intensifies, crop cycles will be much less predictable

I have chosen the PowerShares Agriculture Index ETF, DBA, to capitalize on these broad long-term trends.

Cash:
I continue to keep a significant amount of my powder dry given my forecast of continued economic weakness due primarily to deleveraging. Prices on many of the assets I have mentioned above may, and probably will, fall further. Because of the fragile state of the global economy, I will wade back in slowly. I will begin by taking small positions where I see value/opportunity and build on these positions over the coming months as long as the fundamental picture remains intact.

Stay tuned for adjustments because "flexibility" will likely be the name of the game for investing in 2009.