I have approached the challenge of advising you on how to invest your money with trepidation. Having invested other people’s money and my own for decades, I know that the world is a lot more complex and subtle than even the smartest guys in the room can comprehend. Nobody knows what is going to happen, when, and how. All anyone knows for sure is the price of an investment. So, how should you proceed in a world of irreducible uncertainty?

The first step is absolute clarity as to  what you are trying to accomplish. To assure that you have some financial security no matter what, the goal of your investment portfolio must be to preserve your capital in real terms at minimal risk of permanent capital loss.

While the future is a closed book, it is possible to learn what causes what, why, and what your theory of how the world works means for how things are likely to work out. There are no formulas, techniques, models, etc. that will assure investment success in all seasons. An investment professional must always think about the specifics of a situation. While I don’t believe that the path of stock prices can be predicted, I do think it possible to make a sensible judgment as to:

1. The broad direction and magnitude of the major forces driving the performance of a company, an industry, or even the economy, and
2. The implications for an asset’s value in the future.

The basic process is to organize information and analysis into a simple theory of the case for an investment and then try to disconfirm it.

To navigate successfully in a world we don’t understand, you have to rely on sound principles and disciplined adherence to good processes. I won’t get into processes because they are meant for practitioners of the art of investing. As a client, however, you should understand the core principle of intelligent investing: an investor  must always have a margin of safety between price and what he thinks the investment would be worth to an informed, rational buyer. Warren Buffett expressed it succinctly: “Price is what you pay; value is what you get”.

A successful  money manager must be adept both at estimating what something is worth and at judging how confident he can be that his assessment is roughly correct. Without a roughly right baseline, built on an understanding of the key drivers of results long term, it is impossible to judge whether something is mispriced.

It is difficult to determine whether an investment firm with a good track record has the right stuff. They may have been lucky, or taken a concentrated risk that paid off, or really do have a sound philosophy, and the discipline to stick to right principles, even at the cost of short-term performance. It occasionally happens that market participants collectively can go crazy and run prices up far beyond any remotely rational concept of good value. In that case, excessive risk takers will outperform only to crash and burn eventually. Conversely, markets can become irrationally fearful. Consequently, to quote Mr. Buffett again, you should, “be fearful when others are greedy and greedy when others are fearful.”

By asking the following questions , you can improve  your odds of finding someone who will preserve your capital and make it grow over the long term:

1. Why do you think the investments you want me to make are worth more than what I would be paying?
2. How confident are you that you are correct? Why?
3. What are the handful of developments that will have the greatest impact on the outcome?
4. What would make you wrong?
5. How much can I lose if you are wrong?

If you use a money manager other than me, besides asking the right questions, carefully examine whether there is an alignment of incentives between yourself and  your adviser. Ideally, the manager of your money should invest his money the same way he invests yours.

Since money management is difficult , it is essential to keep management fees as a percent of assets to a minimum. Very few managers beat the averages over the long term. If you find you just don’t have time to “look under the hood”, the best approach is to buy an S&P 500 equal weight ETF (exchange traded fund). An example is the Invesco S&P 500 Equal Weight ETF. The main advantage of an ETF is that unlike an equal weight index mutual fund, an investor is not exposed to taxable events, e.g., sales that trigger a capital gain) caused by the portfolio manager’s activity.

Here is the asset allocation I recommend:

Physical Gold 20-30%

(1 ounce gold bars)

Common stocks 40-50%

(with emphasis on energy and hard assets)

Cash (short treasuries) 40-20 %

No long bonds

Since we can’t know how prices will vary day to day, we should build positions gradually, but opportunistically.

These are meant to be guidelines, not hard and fast rules. The principles of sound investing don’t change, but how you abide by them is circumstance dependent. If, for example, prices and/or circumstances change radically, the investment strategy must change. I also must always be on the lookout for mistakes as well. No one strategy, e.g., the widely popular 60-40 stock bond mix, is fit for all seasons.

OK, let’s  apply the core process to what I am recommending.

Asset Allocation

Theory

Sooner or later investors globally and in the United States will lose confidence in fiat currencies (paper money) created by governments at will. To preserve wealth, they will turn to assets that cannot be created from nothing. Since 1981, the U.S. government’s debt has risen from $1 trillion to over $31 trillion. This debt has been financed not by real savings but by the Fed’s money creation.  The explosion of money has facilitated a long holiday from reality, but at the cost of an eventual epochal hangover. The children of ever-growing, debt-financed government spending relative to GDP and staggering mouse click money creation are waste, mal-investment, economic stagnation, and inflation. I know of no exceptions to this pattern.

The Fed faces a no-win choice. To subdue inflation, it would have to raise interest rates above the rate of inflation. This would crash the economy because debt – government, consumer, and business – is so high already relative to cash flow that even a small rise in rates – far below the level needed to whip inflation — would trigger mass defaults and bankruptcies.

The alternative is to flood the financial system with mouseclick money, government guarantees, and, if necessary, more government spending. This is worse for the public long run because it assures higher inflation and longer stagnation, but to a me-focused politician, it has the advantage of providing  a temporary delay in the arrival of the day of wrath. The seven bad years become somebody else’s problem.

Brave talk notwithstanding, when forced to choose between  imminent financial system collapse or creating as much money as it takes to prevent a society-wide wave of bankruptcies and bank failures, the Fed will choose money “printing” every time. A continuing and perhaps accelerating decline in the purchasing power of the dollar seems inevitable. Investors eventually will see what’s happening and flee to assets that are tangible and whose supply is not easily ramped up at least in the short run.

How the theory can be wrong

• Uncertain timing. I have high confidence that there is a limit to the amount of debt, financed by money creation, a society can absorb before the combination of unpayable debt service costs and stagnation from massive spending on uneconomic activities causes a depression. I think the U.S. and Europe in particular are getting close to this limit, but perhaps not. It could be years before the malign consequences of promiscuous money creation emerge in full flower.
• A technological advancement that jump starts a massive improvement in productivity. This is quite  unlikely to happen soon enough to prevent some sort of meltdown, if at all.
• Policymaker acceptance of the necessity for severe short-term pain. Paul Volcker had the support of Ronald Reagan. Today there is no political support whatever for doing what is necessary for prosperity long term, and even if there were, it would quickly evaporate. Since government debt is over thirty times greater now than in Volcker’s time, the level of economic pain required to address the inflation issue is way beyond what American society would accept voluntarily.
• Incorrect understanding of what drives inflation. I think inflation comes only from government spending and money creation. Others think it is caused by exogenous factors such as temporary supply constraints or war. If they are correct, inflation could go away of its own accord.

Gold

Theory

Gold is not an investment; it is a currency. Unlike all fiat currencies (government issued money backed by nothing), it cannot be debased. It has no counterparty risk. Holders need not worry that their wealth is dependent on other people making good on their debts. For thousands of years, humankind has used gold as a store of wealth and medium of exchange. It has proven itself time and again as a reliable hedge against monetary disorder. By contrast, fiat currencies have had a 100% failure rate. Gold’s purchasing power stays constant.

How the theory can be wrong

• Bitcoin replaces gold. Would you rather own a piece of computer code you don’t understand or a gold bar? Who do you go to if all of a sudden your bitcoin account somehow disappears? What redress do you have?
• Governments won’t let you buy gold or make you sell what you have at a price they fix. You must hold your physical gold in a jurisdiction that will support your property right.
• Gold is a non-productive asset that earns nothing. True. The same can be said for a hundred-dollar bill . You want to own gold only if you think the chances are good that in your investment timeframe, the investing public will lose confidence in fiat currencies.
• Supply surges. Not possible. New mine supply at best could grow at low single digits.
• The dollar remains the “cleanest dirty shirt” indefinitely. So long as investors believe that the Fed can contain crises without causing a spike in interest rates, gold will not be attractive. Gold is a bet on loss of confidence in paper money.
• Gold will never again be used to back a currency. Maybe, maybe not, but even when gold is not used to support a currency, people still use it as a haven from fiat currency decline.

Common stocks

• The best investment is the common stock of a great company in a great business run by good people and purchased at a bargain price. The problem is that these are few and far between today. A couple of broad measures are illustrative. One, the Q ratio, compares the market value of companies to their replacement value. It is a rough measure but useful for comparing today’s ratio  to the long-term average. The ratio currently is not at an all-time high but is well above its average over the last 123 years.

https://www.advisorperspectives.com/dshort/updates/2023/03/01/the-q-ratio-

and-market-valuation-february-update

Another gross measure is the Shiller p/e ratio.

https://www.multpl.com/shiller-pe

It too  is way above average but not at an all-time high. The ratio is understated because profit margins are unsustainably high. Markets are not grotesquely greedy, but there is not much fear either. In general, margins of safety are slim.

Given my view on how economic and financial conditions are likely to evolve, I am partial to companies whose value rests on tangible assets, especially oil and gas. The ESG / climate change nonsense has caused many investors to shy away from energy companies. Herein lies opportunity.

Theory

Demand for fossil fuel will outstrip supply indefinitely. Conventional oil production has peaked and shale oil is in the early stages of peaking. Markets don’t yet believe the latter. Demand for oil outside the US and Europe will grow. The cost and convenience advantages of fossil fuels over other forms of energy  are huge and unlikely to diminish much, if at all. The main driver of that advantage is that the ratio of the energy produced relative to the energy used to create it (energy return on energy investment or EROEI) is far greater for fossil fuels than alternatives, except for nuclear. Besides being inefficient, unreliable, and intermittent, green energy alternatives are toxic to the environment.  There are signs that public awareness of the environmental damage caused by wind and solar energy production is growing.

Many institutional investors have been dissuaded from investing in energy because of (unfounded) concerns about the impact of man-caused CO2 emissions on climate. As measured by price to book and price to earnings ratios, energy stocks are cheap relative to other industries. The earnings yield they offer is well above inflation.

It is not essential to the validity of the case for energy stocks, but, based on my study of climate issues, I think the odds are good that starting sometime in the midpart of the decade, surface temperatures may cool.

The natural gas story is similar to that for oil. Natural gas sells for a little over $2 per mcf in the US versus about $16 in Europe. That gap will close as more natural gas liquefaction facilities come online and more American gas is exported. LNG (liquified natural gas) shipments were constrained last year when damage from a fire shut down a liquefaction plant and terminal. They are expected to be  brought back in operation gradually over the next few months.

Since Europe enjoyed an unusually mild winter, the reduction in American export capability was accompanied by below average demand. The combination of these temporary factors – stranded supply and soft demand — caused prices to move sharply downward.

If you think, as I do, that the main factors driving down the price of natural gas are temporary, then natural gas looks dirt cheap, and certain stocks are a compelling bargain. Each year the SEC requires gas producers to estimate what their reserves are worth. The methodology  is to calculate the after-tax present value of a company’s proved reserves, net of debt, at a 10% discount rate, based on the prior year’s average price per mcf.  For stocks I bought for myself, Range Resources (RRC) and Antero Resources (AR), the PV-10 valuations  are at least twice the current quote, based on a forward strip pricing of ~$4.25 per mcf. Both companies have strong balance sheets, a necessity in a business where price is so volatile.

For brevity I had to give you a 50,000-foot view. I would be happy to provide as much additional detail as you want.

How the theory can be wrong

• I am wrong about the direction, magnitude, and timing of prices. Weather and economic conditions can have a huge effect on prices short term, but the really big,  structural forces driving price upward should dominate long term. I can’t tell, however, how long it will take for prices to start hovering around  an average price at least $2-3 per mcf higher than the current quote (low $2’s). The potential for permanent capital loss is low. The stock prices of natural gas producers  are not discounting a significant rise in price from the current level despite the fact that the factors depressing price are temporary.
• Prices will remain depressed as advances in drilling technology will unlock huge additional supply. Technology has contributed somewhat to productivity improvements, but the main factor affecting well productivity has been well location. Producers have been drilling their most productive wells, a practice called “highgrading”. Tier I locations, however, are rapidly being drilled up; the remaining Tier 2 locations are proving considerably less productive. This suggests that supply growth is being underestimated and will fall short of demand growth.
• Growing demand will trigger development of new supply in other basins. The location and quality of shale formations worldwide are well known. Seven of the ten best shales in the world are in the United States, and are being aggressively exploited. The remaining three are in Argentina, Colombia, and Russia. They do not and will not for a decade, if ever, be developed. The necessary technology and property right structure are not available in these countries.
• Demand collapses as prices rise. Gas is a very clean burning fuel and highly cost-effective relative to alternatives. Its value is multiples of its price; demand therefore is inelastic. What would destroy price is a supply glut, which we do not think is in the offing. The contrary appears more likely.

Oil stocks are not as cheap relative to value as natural gas producers. I think you should have several of them in your portfolio. I will specify which ones in a subsequent note.

Cash reserves

Theory

You never know when opportunities are going to arise; it is wise to have some dry powder so you can take advantage of them without having to sell something you want to keep.

How the theory can be wrong

The downside of having reserves is opportunity cost – what you give up by having “cash”, i.e., laddered 30-to-60-day US treasuries. It can be trying to stay patient, but if you wait long enough, really  attractive investments do come along. It is a certainty that investors will panic from time to time. My experience has been that in the long run, the return from having the cash to capitalize on an outstanding opportunity swamps what you give up by holding your chips.

Bonds

Theory

Bonds are aptly named “certificates of confiscation”.  We have been in a bull market for bonds for the last forty years or so. For all the reasons discussed above, that is over. Also, it is in the interest of the federal government to keep interest rates below the rate of inflation. The bureaucrats know that government debt is unpayable. What they know they must do is inflate it away. Bond investors will be dealing with a headwind for decades.

How the theory can be wrong

If my strategy is wrong, then I am wrong about bonds.