Inflation and Tax Outlook for 2010


Successful investors are patient investors.  There are many ways to lose money in this business, the most frustrating is by being right - too soon.  

Knowing this, I have been cautioning readers to not get ahead of themselves fretting about inflation.

The fact that virtually everyone in the world has been expecting inflation to take off as a result of the government printing money to fight the financial crisis, yet it has not happened tells us something.  It means that the forces of deflation have been stronger than the forces of inflation.  

Few of us have had experience with deflation (broadly falling prices), since the last bout of widespread deflation in the US was in the 1930s.  And what could be wrong with falling prices?  The vast majority of businesses make very little on each sale.  If the very little profit gets wiped out, businesses go under and jobs are lost and a vicious cycle can begin.   

Look around you at all the sales you see going on.  This is the face of deflation gnawing away at once-profitable businesses, eroding the foundation of our economy.

It is easy to look at a few everyday items and think that prices are going up.

However, the prices of big things like stocks, real estate, cars, electronics, clothing and a lot more are way, way down over the past few years.  Even the price of money (interest rates) is way down.  But things are starting to change.

One of the few markets in the entire world at new highs is gold.

It took the Indian government's purchase of 200 tons of gold in October to finally cause gold to break above the $1,000 per ounce mark and stay there.  Gold has approached this level and dropped back 4 times over the past 2 years.  Gold_Rises

Gold prices alone don't determine inflation, but gold prices tend to lead commodity prices (grains, lumber, oil, etc.) and commodity prices are a key component of inflation.   If gold stays high like it is finally doing, commodity prices generally follow and can kick off inflation when they do.

You have probably heard me say that the easiest way to make money investing is to have more money in investments that are going up, and less in investments that are going down.  It is my job to look for investments that are going up to use in your portfolios.  However, this inflation information is important for more than just my ability to invest for you.

Government methods of calculating inflation (Consumer Price Index, or CPI) show a year over year inflation rate of negative 1.3%.  Negative inflation is deflation - prices going down.  This 12 month CPI number is what most people accept as the inflation rate.  However, that is what inflation has averaged over the past 12 months, not what it really is at the moment.

The current year over year calculation is heavily influenced by a terrible 4th quarter last year.  The most recent numbers are pointing toward inflation having already returned to an uncomfortably high rate.

Add to the current inflation the mounting price-pressures from rising commodities prices and inflation will likely go even higher next year.  You heard it here first!

The only thing between us and economic disaster this past year has been the Federal Reserve Bank keeping interest rates near zero and flooding the economy with money.   However, the Fed will be finding themselves between a rock and a hard spot pretty soon.  If they keep interest rates low, we risk inflation, and from the amount of money created over the past couple of years, it could become high inflation, quickly.

If they raise interest rates to fight inflation, we risk sliding further into economic recession, continuing joblessness, foreclosures, etc., and all the problems that brings.

The cynic in me says to expect inflation.  

Governments, when their backs are against the economic wall, have always chosen inflation as the least painful way out - for them at least.   Governments cannot technically go bankrupt, you see.  They simply inflate the money supply so the currency becomes worth less and less.

Have you been watching for tax increases?  It's no secret that the government needs to raise money to pay for all the new programs it is enacting.  

While we all expect taxes to go up, most of us are thinking income taxes.  However, federal income tax increases have not been proposed (yet).  Instead we get fees, surcharges, add-ons, levies, carbon offsets that will be raising electric bills and a host of other government charges that are called everything but a tax, but still cost money.  

The feds even push expenses and mandated spending down to state and local governments, forcing them to cut back on services and ultimately raise local taxes that indirectly end up paying for federal programs.

But, the biggest tax of all is also the most silent tax, inflation.  With this tax, your dollars are not taken, just their purchasing power is.  The real value of your money gets watered down each time new money is created in Washington, D.C.

Buy T-bills or CDs with next-to-no interest, and your dollars will be preserved.  You put $100 in and you will get $100 back at maturity. The problem comes when the hundred dollars invested buys a month's worth of groceries, but when redeemed may buy only a half month's worth.

In this example, half of your groceries will have been eaten by inflation, offsetting another small portion of government spending, just as surely as if it were taken by an income tax.   No hearings are held.  No votes are taken.  Inflation just quietly does its work taxing us all.  

I don't know for sure when inflation will really take off, or to what degree.  I just know that it appears to be beginning in earnest and wise investors will protect themselves.  I will be greatly surprised, if in the next six months inflation does not become a really big deal.

Who will be hurt the most?  Savers.  Those prudent investors who choose to invest in fixed-principal CDs and annuities to avoid stock market turmoil, and have the assurance that their money will always be there. If inflation picks up they will find their principal worth less than before in terms of purchasing power.   Those on fixed incomes, will see the usefulness of those monthly checks become smaller and smaller, too.

Who will benefit the most?  Those who are flexible in their investments and can move their money out of harm's way and into more productive investments on short notice.  Recognizing what is actually happening and reacting to that reality is a much better way to protect your money than buying something and hoping it works out.

This need for flexibility is why we, at Hepburn Capital, invest only in investments that are liquid on a daily basis and not encumbered by commissions or exit fees.

No one knows what the future holds, but I am convinced that, inflation-wise, we are going to see things change in 2010.  The strategies I use to manage client accounts are designed to Adapt to Changing Markets®.  We are ready for change.   

If you or your friends are concerned about being prepared for inflation, I would be happy to talk about how our strategies protect from this very real threat.   Call (928) 778-4000 to schedule an appointment.

What We Said A Year Ago

"History is unfolding right in front of our eyes, in excruciating slow motion.  Economic and financial records are being broken every day, it seems.  Consumer prices plummeting.  An unprecedented housing market collapse.  Huge companies going out of business overnight.  Dizzying price movements in the stock markets.   The old saying "Who'da thunk it" does not even come close to summarizing what is going on these days."


"With the wild swings in the stock market - down 6% two days in a row, up 6% the next day - one would think that price volatility could not get much worse.  Don't count on it. . . During 1929-39, those days that experienced a movement of 3% or greater, up or down, occurred at a 4 times greater frequency than what we are now experiencing.  Fasten your seat belt.  The wild ride may get wilder."

Back to today:   What actually happened?  Over the following 8 months we experienced an additional 39 days when the stock market was up or down by more than 3%.  About two days out of each week we saw volatility greater than 2%!  It certainly did turn out to be a wild ride.

How's The Market Doing?

The runts are suffering.  A month ago I wrote about the valuable measure of money supply expansion and contraction I glean from the activity of small company stocks.  Lately, small company stocks have been performing poorly.  This tells me that money for stocks is tighter than it has been for a while.

I have mentioned in the past that the two things that matter the most for the markets is the amount of money that is available and people's willingness to spend it.  Money is the lifeblood of all markets.  If there is no money for buyers to spend, markets will fall. 

With consumers wanting to put more into savings these days, the willingness factor is steadily shrinking.   For the past month, small company stocks have been weaker than the large companies, signaling a contraction of the money supply and delivering a double whammy to the market.

I discussed being worried about this back in September, and it looks like I was right.  Right now I am guessing that the Fed is withdrawing liquidity to keep next year's inflation from getting out of control.

The good news is that the market is just stumbling around, and not falling like a rock as we saw a year ago.  Still, this tight-money indicator is telling us this is not a time to be taking a lot of risk in the stock market.

Cathleen Hepburn Soloing in Handel's Messiah

Serious singers recognize The Messiah as Handel's most famous creation.  Written in 1741, The Messiah and its Hallelujah Chorus are among the most popular works in Western choral literature.


On Sunday December 6th, at 3:00 p.m., over 200 singers will pack the stage at Yavapai College's performance hall to perform The Messiah.


This year's soloists will be none other than my wife, Cathleen and her good friend Pat McCarver.  My son, Matt, will also be on stage playing timpani.


If you want to hear some beautiful, moving music, get your tickets early at the performance hall ticket office.  The 1100 seats always sell out well ahead of the day of the show.


I'll be in the audience.  You will recognize me by my "I'm with the Diva" shirt.



Riddle of the Week

Question: What can run but never walks, has a mouth but never talks, has a head but

never weeps, has a bed but never sleeps?

Answer: A River


What's Going On In Your Portfolio?

The news this week has been that the Dow Jones Industrial Average**, one of the best known stock market indexes, has been posting new highs for the year. However, the rest of the indexes and the markets in general have not, and that is a caution signal.  

Focusing on stock indexes like the Dow Jones Industrials** or the Standard & Poor's 500** can be very misleading.  The Dow** is only 30 stocks, not a lot considering there are thousands of stocks trading.  The S&P** contains 500 stocks but due to the math they use, price movements of its largest companies can have hundreds of times the effect on the index value as its smaller companies.   

As a result, strong buying (or selling) in just a handful of stocks can greatly influence the value of the index you see in the headlines, even though the majority of stocks might be doing something very different.  That may be what we are seeing right now.   

For this reason, our Careful Growth* strategies are only about 40% invested in stock funds and hold about 30% cash and 30% high yield bond funds.  This mix has kept us close to stock market performance recently with less than half of the risk.

Our Flexible Income* model is still fully invested in the high yield bond funds which we have held since March.

In a sideways market, there is not much money being made, so we don't want to take much risk if we are not getting much reward.    When the market shows us its direction, we will follow that cue.  In the mean time, I will just be patient.

Our Spotlight Strategy

Our spotlight strategy for this newsletter is our Socially Responsible Investing (SRI)* portfolio.  
For some investors, how their money is earned is more important than how much is earned, and their priority is having their investments in line with their values.

My SRI* portfolios operate similarly to my Careful Growth*, Flexible Income* or Balanced strategies* used in my main body of work with one significant difference.  If socially screened funds are available in the category we want to invest in, that is the investment we will use in the SRI* accounts.

Social screens come in many styles.  Some may exclude companies involving things such as tobacco or gambling.  Others include investments with certain social criteria such as strong environmental or women's rights records.  Some SRI investments also apply religious values.

We don't maintain performance charts for SRI* accounts like we do for our Flexible Income* or Careful Growth* strategies, because we have just a handful of investors using SRI* and many of those portfolios are dissimilar in size or include other holdings, so a single number may not be representative of the group.

Here is a summary of how the SRI* accounts were positioned recently:




Thank You!

Referrals are a great compliment.  Thank you for the many referrals we get.

If you like what we are doing, please continue to tell your friends.


*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.