November 16, 2010

Musical Chairs on QE II

Investment Insights from Prescott, Arizona

A primary mechanism that the Federal Reserve Bank uses to increase the amount of cash in the economy is to buy Treasury Bonds on the open market, taking the bonds out of circulation, replacing them with cash.

The underlying idea is that the cash will then be spent, boosting the economy.

The big news the past few weeks was the Fed’s announcement that it was going to buy up to $100 billion per month in longer term Treasury bonds and mortgage-backed bonds in what has been called QE II, short for quantitative easing, round 2.   The Fed has already bought $1,500 billion (1.5 trillion) bonds this way during QE I.

Getting this money to circulate in the economy is not all that easy, however.  Most of the bonds replaced by cash are not in the hands of consumers, but in investment accounts, pension funds, mutual funds, etc., that are normally reinvested rather than spent on things that more directly boost the economy, like cars, houses, etc.

These investments then gradually shift from bonds to other things, often stocks.  Corporations then take the money and build factories and stores, hire workers, etc. and money slowly gets into the hands of individuals who then buy the houses, cars, etc.

The key word is slowly, as it can take many months, even years, for this process to boost the economy.

A more immediate benefit is reducing interest costs.  The Fed is obligated to pay interest on bonds, but not on $100 bills.  In 2010 the interest on the national debt is estimated to be $413 billion.

If the Fed were to keep buying bonds, in a few years they could theoretically retire the entire federal debt, currently $13 trillion and change, saving taxpayers $413 billion per year in interest payments.

Neat trick, huh?

But who is the loser in this deal?

Foreign holders of our debt?  No.  The Fed’s buying keeps bond prices high. (Remember the teeter totter?  Low interest rates = high prices.)  So, foreign bond holders are getting top dollar for their government bonds.  They won’t mind that.  And as long as the Fed keeps buying, prices will stay high.

Ditto for the pensions and mutual funds holding government bonds.  They, too, will get top dollar for their investments.

The losers will be in two main categories:  the people holding the $100 bills will find they buy less and less as more are printed.  When the land rush to spend those dollars before purchasing power is eroded happens, that will trigger full blown inflation.  However, no one knows when or what spark will set that off.

And the holders of remaining debt will see the principal values of those bonds diminished by inflation from the new cash as soon as inflation flares up.

Bond prices will be held up by one action and pushed down by the other.  Trying to time when the pendulum will swing from one side to the other is very difficult for the average bond holder, so the risk of being caught holding bonds at the wrong time is rising steadily.

Sadly, items that few people consider as debt, such as social security payments, pensions, fixed annuities and CDs – all moneys you are owed – will also get hammered if we have inflation.  Oh, those folks will get their money, for sure.  The problem will come when they try to spend it and find it buys less than what it used to buy.

The real value of money is what it buys, not how high the stack of bills is.

The process the Fed is undertaking is called monetizing the debt – turning interest-paying bonds into non-interest-paying money.  As you can see, it has its good points (reducing government debt) and its bad points (inflation at some point).

One difficult part is determining exactly when inflation might really kick in.  So far inflation has not appeared in a great way, but the text books all say it will at some point.  The process of waiting for the outcome feels a little like musical chairs. At some point, our options will run out and we may be done.

Inflation is a silent tax, and when government’s backs are against the wall economically, they have always chosen inflation as the best choice available . . . for them.

That we will all be taxed to pay for the excess government spending of past years is a given.  With the new political atmosphere in Washington, direct taxation is a lot less likely.  But the piper still needs to get paid, so get ready for the silent tax.

Retirement Plans

The other day a client asked me about my retirement plans, and I was reminded that I owe it to all of you to let you know what I am thinking in this regard.

First of all, I can’t imagine going out any other way than with my boots on, as we say here in Arizona.  In short, I don’t have any plans to retire, so you all can relax.

Some years ago I realized that even if I were to retire I would do the same thing every morning that I do now: get my cup of coffee, shuffle into the office at home, turn on the computers and start analyzing investments, often before I am out of my PJ’s.

My work is the most intellectually stimulating thing I have ever found to do, and I can’t imagine ever giving it up.

Also, I inherited great longevity from both my mother and father – a great-great aunt actually lived to be 107, back in the 1960’s, when 107 still meant something – so don’t think you’ll be rid of me anytime soon.

Technology lets me work from wherever I am, so I don’t need to retire to do some traveling.  I was on the road 70 days last year and I’ve already logged that much time away in 2010, managing your accounts from places like Scotland, Yosemite, Disney World and a cruise ship.  

Part of my travel is business related as I help run the National Association of Active Investment Managers and train other investment advisers, but I also spend a lot of time in the motor home, too.  

Since I already act a little like I am retired I feel no pressure to actually hang up my mouse, so to speak.  I feel that life is good just the way it is, and I have no desire to change a thing.

Hepburn Capital also has detailed plans to deal with the “What if Will gets run over by a beer truck?” question.  I will address them for you in an upcoming newsletter.

The Market Says “Don’t Worry, Be Happy”?

Despite an economy that continues to struggle, the stock market is telling us that things don’t look too bad, despite a losing week last week.  

We hear so much talk in the media about the economy that it is easy to forget that we do not invest in the economy, we invest in the financial markets and they are really two separate things.  

When the stock market and the economic reports contradict each other, the stock market is almost always the one that is correct because it tends to lead the economy.

As a result, over the years, I have learned to keep what I hear about the economy separate from what the facts tell me about what is happening in the markets. Right now the facts are good.

The stock market, going up the way it has been, is telling me that we will not be having a double dip recession (barring an outside shock to the system such as a terrorist attack or further financial instability), but a slow and steady economic recovery.

During the past week the market did decline enough to get my attention, but not enough to signal that a true downtrend is underway.  Mid-November often brings market softness, so I don’t want to overreact, but I am watching closely in the event a true downtrend develops.

Roth Conversion Deadline Looms

If you are in the $100,000 plus per year income bracket and are considering converting your traditional IRA to a Roth IRA during the 2010 window available to you, please contact the office now.  928 778-4000.  

Although the IRS deadline is not until December 31st, due to the year-end crush of business at various processing centers, we cannot guarantee that your conversion will be processed in time unless you begin the process immediately.

What’s Going On In Your Portfolio?

Careful Growth strategies* have done well recently with gains from our growth stocks, emerging market country funds, and gold.  At this writing, Sunday, November 14th, Careful Growth* accounts are fully invested.

Someone asked about what seemed to them to be high concentrations in stocks like Netflix, Chipotle Mexican Grill and a couple of others we hold.  This person was used to seeing hundreds of individual stocks in mutual fund portfolios and accounts managed by national firms.  

Marty Whitman, co-manager of the Third Avenue Value Fund, was quoted recently in Barron’s saying, “Diversification is a damn poor surrogate for knowledge”.

When I buy any investment for you, I do it in a way that is designed to limit your risk of loss to a maximum of 1% on any single investment.  As you accumulate gains in a particular stock, I can add to that holding and still not go beyond my 1%-risk guideline as I build a larger position in a winning stock.

The secret to successful investing is to quickly cut losers and let winners run.  This is one way I accomplish this.

Flexible Income* accounts are also fully invested, but our nice gains are being eroded as the income markets shift gears, so I anticipate some changes in the Flex Income* model by my next newsletter.

Our Spotlight Strategy

The Municipal Income Strategy strategy moves from high yield to high quality municipal bond mutual funds and ETFs to produce greater income than buy and hold, with lower risk as measured by fluctuation in principal values.   HCM’s Adaptive Market Strategies® direct investments into parts of the municipal markets showing the greatest strength.  If the price weakens, they are replaced with new investments that are going up or hedged until the market stabilizes.  Repeat as needed.