The Great Tug of War

Since interest rates began to rise in February, everyone, at least everyone who follows the markets, thinks that inflation is the next big thing. It may be. But, hey, I’m a contrarian. When I notice “everyone” doing the same thing it makes me think that something else is likely to happen.

Last month I wrote about both deflation and inflation, and since the national discussion is heating up I thought I’d revisit the topic and offer a few more ideas. There is a great tug of war between these two forces, and exactly how things will shake out is unclear. I feel we will see both conditions and should prepare for both. The question is in what order will we see these conditions and how have your investments positioned effectively. William Hamilton, the fourth editor of the Wall Street Journal, said “The graveyards of Wall Street are filled with the bodies of men who were right too soon”. Since there is no room at the inn, so to speak, let’s not go there.

First, our country is awash in debt. Fifty years ago no one heard of credit cards or Home Equity Lines of Credit or 100% mortgages. “Real” federal government debt now totals $530,000 per family (of 3.5 persons).* Clearly this cannot be paid off by traditional, responsible means. And federal debt does not include all of the personal debt I mentioned, nor does it include corporate debt, which is also staggering.

The lesson learned from 4,000 years of history is that governments and politicians, when faced with a crisis, be it military, economic, internal or external, will always opt for inflation as the least objectionable “solution”. I assume our present government’s attitude is no different. Expect massive inflation in your future.

However, I believe that the huge edifice of debt that overhangs our economy will not bring inflation the way it did in the 1970s, but it may be waiting for us once the forces of deflation have been whipped. There is precedent for this idea. Reviewing 200 years of stock market history, we see 7 distinct cycles averaging 28 years each. The economic environment in each cycle’s decline has alternated between high inflation and deflation. Those who expect inflation to show up be like it did in the 1970s are like the generals who make the mistake of fighting the last war. We had an inflationary market decline from 1966 to 1982. The next big decline will be deflationary in nature, and excessive debt will rigger the deflation.

Last month I mentioned that deflation could be defined as too many goods chasing too few dollars, pushing prices down. If the fed is trying hard to expand the supply of dollars to fight this trend, what is the problem?

The problem is debt. It takes dollars to service debt. As interest rates go up, it will cost more and more dollars to pay down debt. These dollars won’t be available to buy goods and become inflationary. Instead they will be directed to pay off debt. The price of goods will come down as they fight to attract dollars.

As people scramble to pay down debt, they will need to find more and more dollars to do so, and will normally resort to selling things to raise cash to feed their “alligator”. They will sell stocks, bonds, mutual funds, real estate and collectibles in increasing quantities. The more interest rates rise, the more this problem will accelerate. The result could be lower prices across the board. In a word, deflation.

Now, I don’t expect the Federal Reserve Board to sit by idly while all this plays out. In fact, they are already increasing the money supply to offset this phenomenon. What we don’t know is how effective they will be. I know of no situation where a central bank like the Fed has successfully fended off deflation, and I know of no situation where the total amount of debt that will drive deflation has been so massive.

My experience tells me that government policy won‘t change the outcome, only delay it. One vote for deflation. Seconding that motion are the internet, Wal-Mart, and job exports. All are deflationary factors. I also know that the Fed can print money until the cows come home, and that history tells us that they will do so. A vote for inflation. Also, when debt increases this puts money into the economy, driving prices up and being inflationary. War, too, is inflationary. The recent rise in interest rates may be enough to begin the deflation spiral, but it is too soon to see it’s effects in the markets.

So, what is an investor to do? Lighten up on any debt oriented investments. These include bonds, mortgage backed investments and fixed rate annuities. Higher interest rates will hurt resale values, and there is a huge supply of debt. Some of it won’t be repaid.

Most importantly, stay flexible. Don’t fall for the old buy-and-hold-is-the-only-way-to-invest line. The ability to quickly move to cash as the tug of war goes on will be paramount to your success as an investor. Fortunately, this is our forte at HCM.

* Steve Shellans, Moni Research

{mospagebreak title=On the Lighter Side}

On the Lighter Side

A New Retirement Plan:

(Prices are as of 2001)

If you had purchased $1000 of Nortel stock in 2000, one year later it would have been worth $49.

With Enron, you would have $16 left of the original $1,000. With WorldCom, you would have less than $5.00 left.

But if you had purchased $1,000 worth of beer one year ago, drank all the beer, then turned in the cans for the aluminum recycling price, you would have $214.00.

Current investment advice: drink heavily and recycle.

It’s called the 401-Keg Plan.

Will Hepburn is a private investment manager who specializes in active investment strategies. He owns the Prescott Center for Adaptive Market Strategies, and is President of Hepburn Capital Management, LLC, a Registered Investment Advisor. He may be reached at 2069 Willow Creek Road in Prescott, AZ or by calling (928) 778-4000 or emailing Will@HepburnCapital.com.

Copyright 2004. 

The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes a solicitation for purchase or sale or any security.