Friday, July 11, 2008

Cash is King

The United States of America has a long history of booms financed largely by credit followed by periods of recession and limited credit. You don't have to be an economist to see these trends. You do have to be a calculating, unemotional investor to take advantage of them. Take the Kennedy family. They were doing pretty well during the 1920's, but Joseph Kennedy knew his history and economics. He cashed out well before the crash. Then, in the depth of the Depression, he went on a buying spree with the cash he had. Thus a family of little economic note went from the lower middle class to being one of the richest in America in a single generation. Only then did the political experience of the family, previously of account only in Boston, bloom into a dynasty of national importance.

There is nothing wrong with taking credit under appropriate circumstances. Between 1936 and 2003 buying a house on credit was a sound investment in most of the United States. Taking some credit to ease a business startup can be rewarding too. But even when these general rules applied, there were specific counterexamples. Buying a house in a city whose factories moved to Mexico or China, or even to Alabama, did not work out for a lot of people. Most small businesses fail or limp along.

You would think with the Internet stock bubble of the late 1990's in the rear view mirror that people would have been more cautious about buying McMansions on credit between 2002 and 2006. In the vast majority of cases, while the price of the house was an issue, the two main factors in the personal disasters were buying a house that was too big, and spending too much on luxuries (often fueled by additional loans).

For about a year and a half now we have been seeing the other side of the equation, a contraction of credit. The Federal Reserve was created to minimize the credit cycle, but it did a poor job at that starting when Alan Greenspan took over. Voodoo economics, the theory that markets always reach an equilibrium that has good results for humans, can only partly be blamed. Credit was created off the Federal Reserve's books, so to speak, and like Enron stockholders, the Fed acted like that was none of its business.

In 1928 Al Smith was the Democratic Party candidate for President. Herbert Hoover won by a landslide; he was already a national hero. The Dixie wing of the Democratic Party could not get the voters behind Smith, a Catholic whose only real political difference with Herbert Hoover was that he was for ending Prohibition (of the sale of alcohol). If Al Smith had won the election there would still have been a Great Depression. The Republican Party would have come to power in 1932, and as the credit cycle turned it would have established itself again as the party of Prosperity. History would be very different.

While we are in a credit crunch, cash is king. Unless you want to use your dollars to buy foreign assets, you can buy almost any investment cheap. Stocks, bonds, real estate, you name it.

True, if the U.S. or world economy collapses, you will look like a fool for not holding onto your cash. But if that happens, all bets are off; even cash may not save you. A collapse is not very likely. Parts of our economy, notably agriculture and manufacturing not related to construction, are doing quite well. Unless the Fed or Congress does something really stupid, there will be a bottom and then a liftoff period. No one will really be able to see the bottom until it is a quarter or two behind us.

Best bet in this environment? Stocks and bonds of well-established, profitable companies with global distribution networks. Buy what looks cheapest on a value basis; don't read too much into other people's selling, which is based on their liquidity needs and their fears. Figure this credit squeeze will last a while, which means spreading your conversion of cash into assets over time. Keep in mind that the important bottom is the credit bottom, not the stock market bottom.

And keep diversified.

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