July 29, 2009 Edition, Volume III
Inside Signature Update
- Stagflation… if inflation concerns aren’t bad enough
- Beware of the Herd
- On the Earnings Front - continued
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Stagflation… if inflation concerns aren’t bad enough
Among the many dangers wrought by a ballooning federal budget during a weak economy with high unemployment rates is stagflation. Though we may well not experience this two-headed monster, we need to better understand what its causes and remedies are and then strive to protect ourselves from its potential byproducts.
Most of us have come to understand inflation over the course of our lifetimes. We know that when the money supply increases, almost regardless of what causes the increase, the dollar tends to weaken; as a byproduct, the cost of raw goods or commodities (inputs) increases and ultimately that increase will be passed onto the consumer. If the economy is healthy enough for incomes to increase at the same time, and it most often is, then consumers may actually demand yet more of the higher priced good than they did before and a cycle of inflation ensues. If incomes don’t increase, or if employment levels decrease, then the input cost increases tend to be short lived as decreasing demand causes prices to return to previous levels.
But what happens when commodity prices increase due to an increase in the money supply and a weaker dollar while incomes and employment are relatively stable (regardless of their levels) due to a lackluster, though not deteriorating economy? When prices are rising, in the face of weak economic growth and demand, stagflation occurs, and while preferable to cyclical or systemic deflation; it is a combination of price inflation and economic stagnation and benefits virtually no one.
Many of us remember the high interest rate environment of the late 1970‘s and early 1980’s and recall that as a period during which the stagflation term was used as one of the many descriptors of our economy at the time. Though higher interest rates are not an automatic byproduct of stagflation, they are one of the more powerful tools the Federal Reserve has to stem inflation and strengthen the dollar, which in turn are expected to stimulate the economy. As the Fed is then able to decrease interest rates once inflation has been beaten back, a period of economic growth is likely to develop – both ‘stag’ and ‘flation’ having been thwarted.
The Fed has many tools at its disposal to adjust the course of the economy, just as we’ve recently seen. The most powerful and most likely to bring about rapid change is altering interest rate levels through the adjustment of the Fed Funds rate, which causes virtually immediate changes in most other interest rates. When the rate change is a decrease, the markets, businesses, and consumers breathe a collective sigh of relief. When the rate increases, however necessary and impactful, it’s not unlike the use of chemotherapy for the treatment of cancer: the application of the remedy is almost as damaging as the disease, but not quite. As soon as the disease (inflation in this case) is halted, the treatment shifts to one more supportive of overall health and the patient improves dramatically.
Even though little long term benefit is attained through a period of inflation, there are market strategies investors can employ to ‘ride the tide’ without being overtly damaged in the process.
Owning equities (stocks) in various commodity sensitive firms, such as mining and natural resources, and those industries supporting them, or any other industry that can glean a meaningful margin in the face of increasing raw material costs, may allow investors to enjoy portfolio values increases that keep pace with the rise in the CPI (consumer price index), one of the more common tools used to measure the impact of inflation. Stocks, commodities and real estate tend to do well in inflationary times; most other investments do not.
In deflationary cycles, holders of treasury, municipal and corporate bonds may benefit greatly as their interest incomes and eventual principal repayment may ultimately yield more purchasing power than expected when the instruments were acquired. But nearly all others are adversely affected by long-term decreasing prices; inevitably accompanied by lower wage rates and equities, commodities and real estate valuations. Real estate becomes one of the more sensitive issues as mortgages continue to need repayment at higher than market values with few dollars available from declining incomes. No wonder that deflationary cycles are referred to as spirals and are among the most damaging of economic trends.
Even though the
Among the most concerning trends developing, one that would almost certainly stall economic recovery, is the current house and senate’s interest in increasing income tax rates and other revenues from other sources.
Unlike most families and businesses, which when faced with the need to fund additional expenses in certain areas, curtail spending in others, the current federal legislature and administration does not appear to be prepared to decrease spending in the slightest. Though many of the proposed spending increases may appear noble they are ill-timed at best, and run the risk of damaging the economy in such a way as to undermine the very benefits they are intended to create. For example, the quest for fuel efficient transportation is only meaningful if households are able to afford to purchase new cars; the desire to offer cost effective health insurance is without merit if a prolonged period of high unemployment places the more affordable coverage out of reach; the potential benefits of a ‘cap and trade’ energy policy are meaningless if businesses aren’t able to manufacture and sell the goods and services these instruments are designed to cover.
I’ve been a business owner for most of the last 20 years and before that I was privileged to work for one of the finest firms on Wall Street. Throughout the years, I’ve advised many hundreds of clients regarding investments, tax and estate matters, and helped untold others through the rigors of the various aspects of owning and operating their own businesses. While there have been many trends we’ve recognized as they were forming, there have been at least as many that couldn’t be readily identified until the momentum had formed and the die was cast. That’s the nature of business and the markets; and for those few who are yet better able to see into the future, there are private islands in the
When navigating personal and business finance, there are many variables and a few constants - one of those has to do with the mentality of the herd. By that I mean, the actions of large groups of people, whether coordinated or not, towards any given end – they are rarely productive and oft times disastrous.
For example, in late 1999 and early 2000 when the US stock markets were soaring and virtually everyone was making money, new stock issues would come to market and be snatched up by everyone who could get a commitment from their broker, regardless of whether or not the stock was suitable for their portfolio; certain to be winners of the .com wave. You couldn’t open a newspaper, enter into a conversation with co-workers, or turn on the evening news without hearing about the millionaires being made in the high tech markets. Everyone wanted in and most got their wish - sadly.
Within weeks, the markets began to tumble and losses began to mount. Investors were certain the tide would turn and rode stock and mutual fund positions down 60, 70, and 80% and more. It was like watching lemmings topple over the cliffs of
The momentum gathered among novice investors was so extraordinary that everyone wanted their taste of fortune. But an eerily consistent trend was forming, one that has been seen over and over again: when everyone around is able to see the opportunity and ready to take action, it’s certain that the opportunity has past.
The same thing began to play out in 2007 as the real estate markets climbed month after month. Individuals put their nest eggs at stake and leveraged everything conceivable to buy another property – it was going to make them rich. Otherwise prudent investors began to ‘loan’ their creditworthiness to builders and others to help finance development projects and all of this was fueled by a political machine clamoring to make home ownership affordable. Less than two years later, the greatest evaporation of wealth in
A business associate and I saw this trend forming with clarity and began to advise against it. It wasn’t that we were so smart and others weren’t; it was just that we saw and heard the herd forming and recognized the signs of danger. One month in late 2006, several clients approached our firm and withdrew virtually all of their funds to invest in what we considered dodgy real estate programs. We saw that these people represented hundreds of thousands of others and commented to each other that the opportunity in real estate was about over, noting that it was time to sell rather than buy. As luck would have it, we were right and that month marked the top of the local real estate market. A few clients listened, a few chose to disregard our concerns, and a few even supposed that we were looking out for our own interests rather than theirs.
The herd can be just as reliable in identifying a bottoming affect as it can be at marking the end of opportunity. Just as our nation was in the earliest days of President Obama’s newly elected administration, the markets were falling apart at an uncontrollable rate, and it was exactly the wrong time. Trillions of dollars that had been invested in various parts of the real estate and securities markets were being set on the sidelines in cash and cash equivalents (money market funds, CD’s, etc.). Investors who had ridden the market downwards for many months could no longer face their family and friends and finally pulled out under the greatest of peer pressures. Tragically for many, fortunately for a wise and patient few, the declines were largely behind us and in less than two months the markets reversed a 50%+ decline and awarded investors with a 30% gain. The herd had already gone over the cliff and they had not only seen their savings diminish before their eyes, but now they saw the markets rebounding without them.
The moral of the story… be willing to turn away from conventional wisdom when it is neither conventional nor wise and always stop to consider if the momentum in the market has its foundation in something other than the market itself.
On the Earnings Front - continued
The recent rally in the
With the DOW up over 9000, the markets have staged a mid-summer rally many were certain wouldn’t materialize; the strength of which was tested by poor CCI (consumer confidence index) numbers on Tuesday, but almost simultaneously bolstered by improved housing reports.
The Conference Board Consumer Confidence Index™, which had retreated in June, declined further in July. The Index now stands at 46.6 (1985=100), down from 49.3 in June. The Present Situation Index decreased to 23.4 from 25.0 last month. The Expectations Index declined to 62.0 from 65.5 in June.
The S&P Case/Shiller Home Price Index showed improvement for the first time since 2007, and offered a clear inflection point for the 16 month tend in declining housing prices. This followed several months of increases in the volume of units sold and is the first clear sign that a bottom in the housing market has likely been reached.
Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC
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