Investing in a Deflationary, Reflationary and Inflationary Economy

If you’re not confused by this stock market, you’re probably not paying attention. The Dow-Jones Index halved from an all time high of more than 14,000 in October 2007 to less than 6,600 in March 2009. From March until September 2009, the index increased 50% to 9,800. Many pundits now believe that a new bull market is emerging and just as many believe a correction is coming; some believe the pullback may retrace the March lows.

The optimists believe that the speculative bubble is now deflated, reflation is well under way and that a modest correction may be coming merely because the market rallied too far too fast. They see investor sentiment as too bullish and point to retail investors pouring money back in the market as an indicator of a temporarily overheated market. (In March, cash amounting to 46% of the total value of our equity markets was parked in money market accounts, but by September that ratio fell to 30%.)

Pessimists, however, believe that the current market recovery is temporary and point to significant economic problems yet to be addressed. They believe that the looming risk of deflation will cause the coming correction to be protracted and severe; they also believe continued problems in the financial sector could catalyze another major deflationary spiral.

The consensus among optimists and pessimists is that unprecedented global government spending and deficits will eventually lead to robust (if not hyper) inflation. The pessimists, however, also believe that all those “reflation efforts” will prove insufficient to keep the world economy from returning to the brink of collapse. They argue that all the spending and expansive monetary measures should continue until deflation is realistically off the table. The Great Depression was the last major deflation, so even today’s experts are unfamiliar with the phenomenon and, as a result, are much more frightened by it than the more common inflation. Ample anecdotal evidence suggests that the risk of deflation should be seriously considered:

The goal of delevering the global economy to a debt-to-global-GDP ratio half its peak of 400% will require, for example, a 30% global debt reduction and a 30% increase in global GDP. That process will be difficult and will take liquidity out of the global economy. Current global government spending in the trillions may still not be enough stabilize the deflationary vacuum caused by eliminating all that debt;

Consumer prices continue to fall as debt-overextended consumers curtail their discretionary purchases in an effort to firm up their personal balance sheets. Private consumption representing 70% of the US economy is unlikely to bail us out of our economic doldrums as it has in the past;

The US recession may be finished, but no one expects a robust recovery. Continued rising unemployment and slow growth will exacerbate tepid consumer demand and the delevering process;

Banks are still failing at an alarming rate and many believe a looming crisis in commercial real estate, consumer credit and all types of derivative products are the proverbial shoes waiting to drop that could stress an already fragile global financial system. Additionally, financial reform designed to prevent the problems that caused this crisis is still lacking and, in fact, irresponsible mortgage lending practices continue, ostensibly to bolster otherwise lackluster residential real estate sales;

Residential real estate prices continue to fall in many major metropolitan markets;

Bank lending continues to be minimal relative to the huge amount of liquidity created by an expansive monetary policy, and money velocity remains very slow; and

Many knowledgeable investors are leery of investing in the stock market, even with this summer’s robust rally. Corporate insiders are selling shares more than usual and cash on the sidelines, at 30% of total equity value, is still well above the typical 20% average cash ratio. What do they know that we don’t?

Governments around the world seem to be cooperating to fight deflation, but what if all that reflation is not enough to plug the multi-trillion dollar hole left by disappearing debt? Additional stimulus is always a possibility, but lowering interest rates already near zero won’t add much stimulus. Japan learned those lessons the hard way in the early 1990s and is still in the economic doldrums today!

Moreover, and assuming we successfully dodge a deflationary spiral, a long period of significant world-wide inflation is likely to result from all that monetary and fiscal stimulation being employed right now. That will be bad news for economic growth, but global governments will actually benefit as high inflation over a long period of time will reduce the real cost of all that government debt and make it cheaper to repay. Governments know this and often inflate out of their debt. That fact alone almost guarantees that inflation is in our future. Some believe gold’s recent steady price rise is already signaling the inevitability of future high inflation.

Obviously, no one really knows if any of this will play out in reality. But if you subscribe to the deflation theory, you should probably sell into the current stock market rally, patiently collect cash and wait for the opportunity to reinvest when the market tanks. Also, if deflation is indeed coming, now probably isn’t the best time to borrow money or buy a house. Deflation will make borrowing more expensive in real terms and will obviously impair the real value of your home. If deflation does occur it is likely to be triggered by some economic or geo-political panic event and likely to persist for several months if not years.

If you don’t subscribe to the deflation theory, but believe high inflation is coming, you should consider repositioning your portfolio and invest selectively, especially in proven inflation hedges such as gold, oil, commodities, real estate, and other tangible assets. Furthermore, if you believe the US dollar will weaken relative to other currencies because of inflation and other factors, investing abroad or in US companies that export or otherwise earn significant income abroad probably makes sense too.

Many knowledgeable investors expect some type of correction (minor or major) within the next several months, early-to-mid 2010. In addition, some expect the Fed to start tightening as early as late 2010, which suggests that deflation risk should be significantly reduced by then and replaced by inflation as the dominant price stability concern for policy makers. A significant increase in bank lending will be another sign that inflationary pressure is building.

Are you optimistic or pessimistic? Are you more comfortable missing a market rally by selling your investments in anticipation of deflation, or ignoring the signs of deflation, riding the current rally and risking your gains on a potential big correction? A realistic assessment should probably weight each possible outcome as equally likely. Consequently, now is probably not the right time to go all in or stay completely out of the market.

Foreign Critics of US Government Spending Should Rethink Their Opinions

Foreign critics envious of America’s robust consumption and spending are taking some pleasure in seeing America struggle through its current financial crisis. However, as they celebrate our misfortune they should realize that they too have benefited from our excesses and if the golden goose dies, they too will do without its seemingly endless generosity.

By all historical measures, America is straining its purse strings. Current budget deficit and government spending estimates as a percentage of GDP are 12% and 28% respectively, and are unacceptably high levels not seen since World War II. US debt as a percentage of GDP is currently 45% and is projected to nearly double in the next ten years.

America is particularly fortunate that its sovereign friends around the world are willing and able to lend us the money we need to sustain our nation. But those lenders are being more than fairly compensated for their support. China, Japan and other nations lend us money by buying our interest-paying bonds, the most risk-free investment available, all to give us the wherewithal to buy their exports and pay for, among other things, the one trillion dollars the US spends annually to maintain the peace and security of the planet we all share. That security provides the backdrop of certainty and confidence that all the world’s nations need to grow their economies, trade freely and ultimately improve their quality of life. As such it should be obvious that our lenders have as much at stake as we do. Don’t you wish you could lend money to our government virtually risk free, instead of paying income taxes, for the services you receive?

Additionally, the US spends by far more than any other nation on global humanitarian endeavors. Even our enemies that engage us in warfare are compensated in defeat. After World War II, America practically rebuilt Europe and Japan. Plans for how America will rebuild Iraq began almost simultaneously with the war itself several years ago. Currently there are serious discussions about building infrastructure in Afghanistan as part of a strategy to achieve a victory there. Don’t you wish your conquering enemies were as kind to you?

Everyone should be rooting for America to get its fiscal house in order for our sake, and for the sake of our friends and our enemies.

Reforming Obamacare

The president addressed a rare joint session of Congress Wednesday night and rather eloquently laid out his "wish list" for healthcare reform (“Obamacare”), this time with specific talking points about who and how Americans will benefit. As far as program details or how it will be financed, the president either isn't saying or doesn't yet know.

The president's lack of transparency and detail coupled with the government's long history of profligate entitlement spending makes it easy to understand why Americans are reluctant to buy into the president’s program, especially when the reform narrative keeps changing. The original priority was to insure the 47 million uninsured, but quickly turned to overhauling our entire healthcare system, one that according to polls satisfactorily serves 75 percent of the 250 million insured. Called out by protesters at the prospect that taxpayer money would subsidize healthcare for illegals, the president changed his tune and referred to 30+ million uninsured and assured us that illegal aliens will not be insured under his program.

Originally, healthcare reform was going to be substantially paid for with cuts in Medicare and new taxes on the wealthy. Seeing backlash from seniors probably led the president to rethink that approach and definitively say that there will be no Medicare cuts to pay for Obamacare. The president is now saying that half the costs of Obamacare can be paid for by eliminating the waste, fraud and inefficiency from the existing system. That's a difficult one to swallow especially knowing that one of the House proposals calls for 53 new government bureaucracies to be created under Obamacare!

President Obama is urging us to “trust him,” but has not earned that trust. Critics of Obamacare point to language in the various proposals that refute many of the assertions made by the president in his speech. The president hasn't backed up any of his statements with any details or actual documentation. In addition, he "sold" us Obamacare by hyping the positives, without acknowledging even the possibility that there will be unintended and potentially negative repercussions from such comprehensive and complicated changes to our system. Finally, his stimulus plan early this year showed us that he has neither the experience, expertise nor the inclination to add value to his own programs.

Notwithstanding all the evidence to the contrary, the president says that he is seeking incremental reform that fixes the problems with our system. If he truly means what he says, his “incremental” reform should consider the following common sense suggestions:

Enable interstate competition among insurance companies. Greater competition among insurance providers should lead to cheaper insurance for consumers. We buy our home, auto and life insurance in a national marketplace, why shouldn’t we buy our health insurance there too? Instead, Obamacare proposes to create some type of national exchange for insurance companies. Apparently, no one knows how it will work, including the president.

Eliminate mandates for minimum insurance coverage. One reason health insurance is so expensive is that we’re forced to buy insurance for every conceivable health condition and situation. Again, Americans select their home, auto and life insurance by making choices among coverage alternatives, why should health insurance be any different? Let consumers select from a menu according to their own needs, once their basic needs are met. Healthy young people, for example, who otherwise would not seek any insurance, should be encouraged to purchase “catastrophe insurance” to insure against major events that can potentially strike at any time.

Reform medical malpractice law (tort reform). The president mentioned tort reform last night, but his comments clearly indicate that he has no intention of taking decisive action in the time frame contemplated for his reform package. Many believe tort reform is critically needed in order to contain future healthcare costs. If the president is serious about reforming healthcare, he needs to put aside the long-standing allegiance of the democrats to the civil trial lawyers of America.

Tort reform refers to making changes to our civil justice system that would limit the incidence and monetary awards arising from litigation. Should victims of medical malpractice be compensated for their misfortune? Absolutely, but does the average settlement need to exceed a million dollars, and should that practice be allowed to paralyze and potentially bankrupt our healthcare system? Approximately one third of our healthcare costs are driven by “defensive” medicine and more than 80 percent of U.S. doctors admit they require unnecessary tests for their patients just to avoid potential patient lawsuits arising from alleged negligence on their part. Tort reform has the potential to save $100 billion annually in healthcare costs and any proposed reform of healthcare should address the cost, waste and inefficiency created by the current law.

Provide tax incentives to individuals who purchase health insurance. Employers and businesses pay for employee insurance premiums with after tax dollars, why shouldn’t all of us be able to do the same?

These ideas have the advantage of being straightforward and can be implemented incrementally. I hope the president will keep his promise and seriously consider them for his healthcare reform program.

Consumer Banking Tip: the Devil is in the Details

As the euphoria of averting the collapse of the world’s banking system wears off, it is clear that banking’s halcyon days have ended and its road to full recovery will likely be long and difficult.

The good news is that the Fed is managing to keep the yield curve steep. As a result, banks today are able to borrow money effectively for free (have you checked your bank’s interest rates lately?), lend at much higher rates and thereby generate significant profit margins. And, with tons of cash parked in banks and reluctant to move back into the stock market, total bank profits are likely to continue to be substantial. Those profits will be needed to ultimately offset the unprecedented asset losses and write downs continuing to occur on bank balance sheets.

The bad news is that all the pending bank failures, mergers/acquisitions, and cost reductions are negatively affecting the quality of the customer experience. Bank staffs are increasingly short-handed, untrained and inexperienced, and with banks revising their operating procedures according to those of new corporate acquirers and new federal banking regulations, it is no wonder customer service is suffering.

Even the banking giants likely to survive and thrive in the future are as deficient in their customer service as many of the smaller community banks that will likely disappear from the treacherous banking landscape during the next few years. Consequently, in order to insure a satisfactory level of customer service, customers will need to take a more active role in managing their banking. The following tips should assist you in that mission:

Know the FDIC insurance rules and limitations. Make sure you set up your accounts in compliance with those rules and that your accounts are fully FDIC insured. Bank personnel don’t always communicate accurately or completely when answering questions about those issues. However, many banks will offer you a free FDIC brochure that tells you everything you need to know on the topic, or you may download it yourself directly from the FDIC via the internet.

Banks believe that paper is so twentieth century. Many banks will do almost anything to avoid giving you a paper receipt that specifies the important details of your account, such as the interest rate, expiration date, balance, etc. Many look at you dumbfounded when you remind them that CD is the acronym for “Certificate” of Deposit. They sincerely believe that in this age of online account management hard copies that verify that you’ve turned over your life savings to them are completely unnecessary. Insist on receiving that paper receipt, as it is often useful in revealing clerical mistakes that you will then be able to correct immediately.

Verify account tax IDs. Always check the accuracy of account tax identification numbers, which are typically social security numbers for individual accounts. Do it every time you receive an account correspondence or statement. Wrong numbers on year-end tax forms, such as 1099s, may lead to problems when you file your income taxes. Don’t be surprised if you find yourself reporting disparities often, as some banks claim to have several files for accounts all of which do not automatically revise your change. Another typical excuse for such errors is that bank computer software may override and undo revisions according to some corporate compliance measure. Banks readily blame their computer software for many of their administrative screw ups.

Account titles can be problematic. Pay very close attention to how you title your accounts. Trust accounts can be particularly confusing, even when titles are specified by competent legal counsel. A typical trust account title might be “John Doe Revocable Trust UA (under agreement) dated 01/01/09.” The next line usually indicates the names of the designated trustees, in this example let’s say “John Doe and Jane Doe Trustees.” Such simple time-tested legal language should be foolproof. However, that language is often ambiguous to bank lawyers and their amateur acolytes who administer your account. Some interpret the “and” between trustee names to mean both trustees must sign off in order to execute transactions. They believe that if the intent is to have either trustee act unilaterally, then the title should read “John Doe or Jane Doe trustees.” Others believe that if the intent is to have either trustee act unilaterally, the title should refer to them as “co-trustees.” When the lawyers don’t agree, everyone in the bank gets to offer an opinion. By the way, your opinion doesn’t count.

Keep bank account-related documents handy. Periodically, and certainly every time a bank is acquired or merged with another, new account administration procedures are implemented, which often require account owners to verify the ownership structure of their accounts. Be ready to take all pertinent documents to the bank frequently to satisfy those new requirements. As unfair as it sounds, banks apparently take no responsibility for verifying once-and-for-all your authority over your accounts, so be prepared to clarify your accounts periodically.

Avoid automatically renewing CDs and other savings accounts. Do not lose sight of the fact that most banks exploit your laziness or lack of vigilance to seek the best financial terms for your accounts. In the old days, expiring CDs were automatically rolled over with the reasonable expectation that your renewal interest rate for a certain term would compare closely to the prevailing rate for that term shown on the market yield curve. Today, promotional rates are offered for bank-favored maturities and all other rates are set artificially low. Those bank-favored maturities change frequently, which almost guarantees that your account with its set maturity will not receive a favorable rate upon automatic rollover. Worse yet is the fact that promotional rates are often two or three times greater than the rates for other maturities. So, if you miss the promotional rate, you are likely to receive a mere fraction of the prevailing market rate for your account. You must actively manage your CD rollovers.

Frequently monitor money market account rates. A casual inspection of your monthly money market account statement will often reveal a slight but continual reduction in your interest rate every month, even though other current money market rates at your bank might be much better. You need to actively manage your money market accounts and inquire constantly about upgrading your account to prevailing money market rates.

Beware of bank investment services. It’s bad enough you need to struggle to get a banker’s attention to assist you with your legitimate account needs, but these days you must fend off the army of bank-sponsored financial consultants who may be trawling your accounts in an effort to entice you to invest your bank account money into non-bank (non-FDIC insured) and often much riskier types of investment accounts. Be able to differentiate between bank and non bank types of accounts.

Avoid banks that really don’t want your business. You may have already noticed that banks seem unwilling to offer preferred customer rates for savings accounts and loans unless you are willing to make some concession to them, such as opening a direct deposit savings account or checking account. In the current low interest rate market environment preferred customer rates are substantially more favorable on a percentage basis than other rates. Clearly, they don’t want your business unless you submit to their concessions and you don’t need their below market rates. So, do them and yourself a favor and consolidate your banking needs with a few banks. The recent decision by Congress to extend until year-end 2013 the FDIC insurance increase, from $100,000 to $250,000 per account, will make that consolidation easier for everyone.

What if Big Brother (Government) Turns Out to be a Bully?

Harsh recent criticism of our free market economic system has resulted from the long standing belief that the greed and self-interest that drives our private sector were the major culprits of our current financial and economic mess. Some of those critics now believe that government control and regulation offers the only solution to the problem and many elected officials are seizing the opportunity to insinuate government into many of our major industries, including automobiles, banking, energy, healthcare and many others.

Although the free market system is far from perfect, history has clearly demonstrated its superiority to all others, especially systems where government has primary responsibility for driving the economy. And, if “greed” and “self-interest” are the catchwords of private sector capitalism, “corruption, waste and inefficiency” have become common descriptors of the public sector and government.

Furthermore, somewhat ironically and despite the rap against the private sector, it is clear that government was complicit in the acts that led to our financial debacle. First, during the prosperous 1990s the Clinton Administration paved the way to financial ruin by implementing a public policy that encouraged home ownership among our most economically-challenged and pressured banks into providing financing that ultimately led to an explosion of sub-prime mortgage lending. That policy, coupled with others that encouraged banks to lever up their balance sheets as an easing monetary policy reduced interest rates to multi-generational low levels, created a financial maelstrom we have barely been able to escape. In addition, the Bush Administration, by its own admission, knew this disaster was coming and claims to have urged Congress to take preemptive action to prevent it. It should have tried harder.

America is now being asked to choose between the free market’s invisible hand and the dictatorial hand of government. A free market system allows us to choose the products we wish to consume; it relies on prices set by the interaction of supply and demand, which ensures that suppliers offer products consumers want to buy. A government run economy encourages us to vote for public servants who we must trust will represent our interests; it relegates production decisions and who and how much we consume to public sector bureaucrats. Do you want the government telling you what car to buy, how much energy to consume, and what healthcare you will receive?

If you still believe bigger government is the answer and have faith that our government will serve our best interests, consider the following: First, even though government does not take private sector pride in greed and profit motives, it trades money for power and plenty of both is involved in greasing the gears that drive government and its participants. Second, many of those wanton capitalists from the private sector ultimately seek government office, and not necessarily because they feel an overwhelming desire to serve the public. Third, Barack Obama did not become president by accident; he had the greatest financial backing of any presidential candidate in history, especially from the liberal rich and famous, and received a resounding if tacit endorsement of most of the mainstream (read liberal) media. Contributions to all election campaigns last fall totaled more than one billion dollars and media support for Obama’s candidacy could not have been more apparent. It should be no surprise to anyone that our president (who campaigned as a moderate) should be pushing an emphatically liberal agenda, instead of pursuing the center-right interests of the American public who voted for him.

The last 100 years of world history has proven that economies work better as free markets than under government control. But even capitalists know that there is a role for government to play in correcting the failures of free market capitalism. That’s what our government should be doing, not attempting to supplant our free market system altogether.

Obama and Bernanke-- U.S. Economy’s Yin and Yang

There is a tug of war of negative (yin) and positive (yang) energy in our economy evidenced by a stock market that cannot seem to break free from a very tight trading range. Over the past year the Federal Reserve, led by Ben Bernanke, pumped an unprecedented amount of capital into our economy to keep a fragile financial system from falling apart. At the risk of completely trashing the dollar and potentially igniting a high (even hyper) inflation rarely witnessed in the northern hemisphere, the Fed lowered and has kept interest rates near zero since late last year. It also exploded its balance sheet by trillions of dollars by buying a variety of government and mortgage-related bonds. The Fed's plan was to reinforce the financial system by flooding the market with liquidity in the hope that all that cash would encourage banks to lend and individuals and businesses to spend, invest and ultimately spur economic recovery.

Despite all that capital and the bailout of our financial system by TARP, bank lending has continued to languish. Banks have cited poor borrower demand as the cause, but the fact is that banks are terrified to lend. They have been to the brink of extinction and have been forced to submit to government control in order to avail themselves of the capital needed to survive. They fear that even the strictest of lending criteria may not keep them from falling further into the financial abyss as asset values (loan collateral) continue to fall; they also dread the prospect of ever having to seek additional capital from the government. In addition, the Obama administration’s willingness to change the rules of the game and to abrogate the rule of law in order to further its political agenda has compounded those fears and has contributed to an environment too uncertain and risky to justify new investments.

As experts extend their expected time frames for economic recovery, the banks know that conditions are unlikely to improve in the short-to-medium term, and could indeed be exacerbated by the president’s continued priority to implement the most liberal agenda in our nation's history. The stimulus plan executed last February has thus far proved to be a bust and a growing consensus believes his current “cap and trade” and “healthcare reform” initiatives could have catastrophic effects on the economy and our exploding government deficit. Furthermore, the president’s stated intention to raise taxes on investment capital and small businesses is providing a backdrop of negative energy that could hold both the economy and the stock market hostage for many years to come.

Aggravating an already bad situation is the possibility of replacing Mr. Bernanke when his term expires early next year. The real concern would be if the president replaces him with an individual more sympathetic to his own thinking. That would not only taint the historically arms-length relationship that has existed between the executive branch and the Fed chief, but it could also suck out all the positive energy currently being provided by the Fed. The prospect of replacing Mr. Bernanke is especially ironic because it would appear that replacing Obamanomics with more traditional policies might be just what our economy needs now. Have you noticed that the market seems to rally lately at the slightest hint that the president’s policy initiatives may not pass muster with Congress?

I am hopeful that Congress, especially blue dog democrats, will press the Obama administration to abandon its politics for the sake of our economy and that it will do so before our nation’s yin and yang becomes Cheech and Chong, and sends our economy and our future irretrievably up in smoke!

Ascent of Money: Must See TV Documentary

This interesting and relevant TV documentary is currently viewable in South Florida at 9pm Wednesday evenings on PBS. The documentary is presented in hourly installments that roughly track the chapters of Niall Ferguson’s 2008 book titled The Ascent of Money. Each segment, narrated by its author, examines milestone events from world history from the perspective of their financial and economic roots. In a few short episodes, it has already answered questions that had never even occurred to me, for example: Did you know that the French Revolution had its roots in a government-created speculative investment scheme that occurred in France decades earlier? Did you know that the U.S. Civil War’s turning point might be traced to the role of cotton in financing the war and the Confederacy’s loss of control of the City of New Orleans? Did you know that world bond markets were borne out of the need for capital by Europe’s sovereign powers to finance wars?

Particularly noteworthy for its relevance today is episode six, titled “the return of risk,” which directly relates to our nation’s current debate about the role of government in our financial crisis and for bringing about an economic recovery. That episode discusses the historical tendencies of societies to “nationalize risk” by making governments responsible for the risks its citizens face; it introduces the welfare state and identifies the apparent successes and failures of a few examples from history, including the United Kingdom, Japan, and Chile.

The episode also makes the point that while some welfare states are considered successful in their ability to satisfy basic societal needs, none has been particularly prosperous economically. For example, the author suggests that Japan’s welfare state may be at the root of this otherwise industrious nation’s inability to recover from its economic collapse more than a decade ago. And, in stark contrast to Japan, Chile’s ability to climb out of its economic doldrums might be attributed to its overhaul of government in the mid 1970s and its institution of a new capitalism.

Those are important comparisons and relevant situations to consider as we witness the rapid expansion of our own government according to the apparent liberal agenda of the Obama administration. You may find, as I did, that episode six provides an insightful perspective from around the world about the historical successes and failures of these ideas, and some useful context as the debate over government intervention in our economy and our lives rages on. Episode six is must see TV, especially for the most civic minded among us.

After viewing half of the episodes, I am confident that business and non-business types alike will find viewing this entire series worthwhile for its sheer novelty, entertainment value as well as its eye-opening perspective on much of the history you “thought” you learned years ago in school.