August 24, 2010
What Our Economy Really Needs
The Investment View from Prescott, Arizona
As strange as this may sound, what’s really wrong with our economy, and I mean the entire world’s economy, is that we need more abandoned factories.
The hard truth is that we won’t be in economic recovery until we see more of them.
I say this because we are in a deflationary environment. The consumer price index that is the official register of inflation shows zero inflation over the past 3 months, and a negative .9% inflation over the past two years.
Negative inflation is deflation, and deflation is driven by excess production capacity.
Economics 101 tells us that inflation is caused by too many dollars chasing too few goods, causing the price of goods (real estate, stocks, everything) to get bid up as buyers rush to spend dollars whose value is going down as new money is printed.
Deflation is just the opposite. Too many goods chasing too few dollars, causing the price of goods to drift downward until outrageous values attract some of those increasingly precious dollars that are out there.
I know that it seems logical that we should have inflation since the government is creating money in eye-popping amounts. But much of this money is not finding its way into the economy.
The power of deflation keeps sucking all of that money into the black hole of debt that needs to be paid off, and no one really knows how long it will be before the hole is filled and the extra money can slosh into the economy creating inflation.
Right now, the reality is that we have deflation, not inflation. It really doesn’t matter how much money there is. If people are not willing to spend, choosing instead to save and retire debt, we will not have inflation.
And until the excess capacity that is flooding the economies of the world with goods that must get chea
per and cheaper to compete for dollars is taken off line – perhaps forever – we will not get out of our deflationary spiral.
Just like the boom times of the 1920’s when electrification, radio and autos were changing the face of the world and there was an overbuild of factories and production capacity, investment capital has rushed in as a result of the tech and housing boom of recent years creating another round of overcapacity.
Too much investment was attracted, and too many factories were built in both eras.
This dynamic is what creates the 40 year cycle in the stock markets. It takes so long to come back from this type of cycle that plants often become obsolete before they can be reused and they end up looking like the photo above. It is a sad but normal part of the up and down cycles of our free market economy.
Incidentally, the 40 year cycle peaked and began to roll over in 2007.
A big concern of mine right now is that China’s main economic stimulus has been to increase production capacity; to build factories. This is like throwing gasoline on a fire. More goods being produced is not going to help fight deflation, it will increase it!
I’m convinced, like so many others, that we will have a return of inflation once this debt overhang is taken care of. I just don’t know how long that will be. If I had to guess, I’d say we are some years away from it.
As the Japanese, who have been fighting deflation for 20 years, have found out, deflation is a stubborn, stubborn problem, so it could be many years.
The way markets tend to work, inflation won’t take off for good until most of the believers have given up on it ever happening. What everyone expects to happen rarely does. If you and everyone around you think inflation is going to happen, that could be a clue that it probably won’t happen for a while.
Some investors are probably thinking, “I know I’m right about inflation, it is certain to happen. The market is just not recognizing my analysis yet. I’ll just buy gold and I know that eventually I’ll be right.”
The problem with this line of thinking is, as British Economist John Maynard Keynes once said, “The market can remain irrational longer than you can remain solvent.”
Or as an early editor of the Wall Street Journal said, “The graveyards of Wall Street are littered with the bodies of investors who were right too soon.”
I would encourage anyone who wants to hold lots of gold as a means of protecting themselves from inflation, to not go overboard. The old adage is “all things in moderation”, including gold right now.
Core Strength
It takes guts to be responsible every day for over $30 million of my client’s savings in crazy and changing markets like we have seen for the past 10 years. Having the inner strength to make tough decisions and still sleep well at night is one of my gifts.
But as I get older, core strength takes on a different meaning. It is what helps us keep our balance and a light step. Our core muscles are what hold many of our other parts together.
Four years ago, I had to quit playing softball, which I loved, due to an injury, and these days even routine visits to the gym can leave me hobbling around with sciatica. I spent a lot of the past four years looking for something that would keep me in shape but without the lingering pain.
Then I discovered Pilates, a system of flexibility and core strengthening exercises. I feel good, and best of all I have no pesky side effects like sciatica.
Suzanne Fisher teaches Pilates at the Y in Prescott and also at her private studio. Suzanne and I worked together 22 years ago, and she has become a wonderful teacher with a gentle style.
All of our exercises at the Y are done laying or sitting on the floor without a lot of fancy equipment. There are variations that make them easier or more challenging so beginners and recovering athletes like me can both feel right at home in the same class.
And I have to admit that any kind of exercise done lying down seems a lot more attractive to me than pumping iron.
If you are interested in getting in shape call the Y at 445-7221 (you don’t have to be a member) and ask for Suzanne’s class (there are others) or call Suzanne directly at 925-5163.
It Does Not Pay to Be Unlucky
Exchange Traded Funds (ETFs) have become mainstream investments in recent years, allowing investors to buy an entire stock index, like the S&P 500**, or make a focused investment in a specific area like gold mines, Brazil, or alternative energy. 
Like the market as a whole, these “sector” ETFs go up and down, and the relative lack of diversification can make these focused investments perform very different from the market as a whole.
Many of the disappointing performances recently from stock ETFs are understandable since the market as a whole has been down lately. But the decline in some ETFs is more puzzling.
To many, investments in alternative energy seemed like a sure thing a year ago. Politicians everywhere were talking about ending dependence on foreign oil, so the idea to invest in industries that could potentially solve the energy problem made sense.
Yet ETFs focusing on the clean energy market are among the worst performing ETFs of 2010. Many are down 20-30% since the start of the year.
Strangely enough, the driver behind these disappointing results is something not very obvious – bad luck.
As debt-burdened governments across Europe wrestle with budget problems like ours, countries that once offered lucrative subsidies have scaled back financial support for clean energy projects. This has changed the financial outlook for alternative energy stocks considerably, despite the fact that consumer interest in the sector remains high.
You might not have expected that one of the biggest losers from the world’s lingering fiscal crisis would be alternative energy, but it is.
A rough 2010 should serve as a good reminder of the risk that can come from where you would least expect it with any investment.
Riddle:
Q: I jump when I walk and sit when I stand.
What am I?
A: A kangaroo
What’s Going On In Your Portfolio?
We closed out the inverse funds in our Careful Growth* accounts last week. I think the odds favor a continuation of the downtrend that started two weeks ago, but with the risky nature of those investments I decided to close them out at the first pause in the decline.
The math of gains and losses can work against you in these, so they are never buy-and-hold investments. However, the decline has resumed, so I did buy them back this morning (Tuesday, August 24th).
Both our income strategies* and growth strategies* hold preferred stock funds, high yield bonds and gold.
As of Friday, August 20th, Flexible Income* accounts are fully invested and growth* accounts hold about 45% cash while I wait for the market to show me the direction it wants to go.
Municipal Income* accounts also remain fully invested.
Our Spotlight Strategy
The Municipal Income Strategy seeks a high level of tax-favored income consistent with capital preservation.
Just Let Me Know
As a client of mine you may know me as an investment manager, but I have years of related experiences to draw upon. Just let me know if there is anything else I can help you with. Membership has its privileges, you know. The only thing I ask in return is that if you have any friends that could use my services that you think of me. I’ll treat them just the way I have treated you. That is the way I do business.
* 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.
Balanced Strategy Description and Performance Information
Careful Growth Strategy Description and Performance Information
Flexible Income Strategy Description and Performance Information
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.
