Where to invest to maximise absolute returns

Stock markets may have soared in the last days of the old year, but private investors should be wary. Paul Van Eeden explains why you should hold gold rather than follow the money managers into stocks.

Near the end of 2006, the US dollar rebounded on foreign exchange markets and as a consequence the US dollar gold price fell. The dollar appreciated 2% against the average of the euro, pound, yen and Swiss franc while gold fell 4.7%. This is nothing but the natural volatility that we should expect from public markets as investors try to be forward-looking and react to new data. While traders try to anticipate volatility and profit from it, I try to ignore it and keep my eye on the bigger picture.

Look out for a gold buying opportunity

I believe that the US dollar gold price will exceed $1,000 an ounce in the next few years, and so my only interest in the short term gold price is the possibility of a sharp decline in sympathy with base metals - a superb buying opportunity if it occurred, and fortunately easy to identify. In the meantime, declines in the gold price, like the past week's, are easy to ignore.

Gold's rise to $1,000 will be on the back of a falling US dollar and I expect the dollar to fall as the US economy falters. But that is, apparently, not what Wall Street or Federal Reserve Bank expect to happen.

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According to an article in the Wall Street Journal last week, the US central bank and much of Wall Street are now betting that declines in real estate and the auto industry will prove to be isolated events that will not impact the economy beyond those respective industries. Apparently they believe (hope?) that home builders and auto makers are curbing production to trim excess inventories as a temporary response to a decline in the unsustainable demand of the past few years. They do not believe that there are broader forces tipping the entire economy into recession. I do not share that optimism, and you can find my reasoning in previous commentaries on my website at https://www.paulvaneeden.com/pebble.asp?relid=34.

Why stocks soared at the end of the year

Perhaps Wall Street is just being optimistic, but there is another explanation for the soaring stock prices that we have seen lately, and it has to do with the fact that the majority of money being invested today is invested through mutual funds and professional fund managers.

The measure of a mutual fund manager's success is how well he fares relative to the competition (other money managers) and the market as a whole. He is therefore most concerned with relative performance. It does not matter if he loses 20% in one year as long as other money managers lost more and the market segment that he invests in declined on average by at least that much. It also does not matter if he only makes 3% gains, as long as he is outperforming his peers and does at least as well as the market on average.

The one thing he cannot afford to do, is to under-perform either the market or his peers, for then he could lose his lucrative job. Because performance is usually measured on a quarterly or annual basis, or both, the professional money manager has to concern himself with short-term performance. He cannot make longer term, contrarian investments that could pay off extremely well because he might get fired before his investments mature. Fund managers therefore often try to gauge the impact of current events on markets with a short-term (one month to one year) time horizon.

With the US economy slowing it is becoming more and more difficult to see how the Fed is going to justify raising interest rates in the near future. If economic activity slows sufficiently, the Fed may even cut rates, and lower interest rates are usually good for stocks. That is why professional money managers are pouring money into the stock market and why the stock market is in record high territory.

Absolute returns: why investors should lookat the bigger picture

Of course, if you look at the bigger picture, it would make sense to do exactly the opposite. If the US economy is slowing down then it will ultimately start impacting corporate profits and stock prices. And if my thesis about the dollar falling while US interest rates rise is correct, we could have a really negative environment for stocks. But mutual fund managers cannot easily make that bet, because it requires them to act contrary to their peers and therefore represents great personal risk to them.

On the other hand, when you invest your own money, like I do, then relative performance becomes entirely irrelevant and the only thing that matters is absolute returns. My own investment strategy is therefore often at odds with the majority of other investors and investment trends. It bothers me about as much as short term volatility in the gold price. I am only interested in positioning my investments where I perceive the best upside potential for the least amount of risk.

First published on Kitco.com (www.kitco.com)

By Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.