Friday, January 6, 2012

Deja Vu All Over Again

Hope springs eternal in the investment world.  A few curmudgeons may make their mark as curiosities.  But optimists rule the day on Wall Street.  And rightfully so, most of the time.  Over the long haul U.S. equity prices have appreciated 8% in value per year on average, including reinvested dividends.  That's outpaced bond portfolios by 3%-4% a year, depending how it's measured.  And even bonds have beaten inflation by a point or two, again depending on the time frame and the particular indexes used.  Looking at things one year at a time, the U.S. stock market has gone up three years for every one year it has gone down.  Wall Street makes its money by selling to securities, and it's easier to sell them when prices are rising.  Plus the odds actually are in favor of an advance, just looking at the long term data.  So it's not surprising the investment community is bullish today.  It's a natural instinct.  Whether there's any logic to it remains to be seen.

Prices are floating higher on the wings of Benjamin Bernanke's latest money printing scheme.  Let's call it "QE-squared" (Quantitative Easing - Europe).  The Federal Reserve shoveled half a trillion Dollars to Europe to support the banking system there.  It also persuaded the European Central Bank to "exchange" $600 billion of bad debt held by European banks for freshly made euros, propping up their balance sheets even further.  All that new cash is driving the euro down in value, which actually is making Germany and France quite happy because it's boosting their export competitiveness.  It's all looking good right now.  Same as it did when the Federal Reserve undertook its QE-2 routine last year.  Everyone thought they'd found an easy way out.  But there wasn't a genuine improvement in economic activity.  Inflation picked up.  Real incomes declined.  And that was that.

Here's our prediction.  The price of gasoline and other commodities will jump, just like they did the last time.  Last time the economy was cushioned by rising labor productivity.  That peaked in Q3 of 2011 and is still declining.  So the inflation impact might be harder this time.  Maybe some of the pressure will be alleviated by a warm winter, reducing heating bills.  But unless the supply of goods and services picks up the leap in the money supply is bound to show up.  That will nip consumer spending in the bud.  Maybe Europe will avoid problems.  Maybe China will keep it together while a new government is formed.  But whatever happens, the world is not going back to normal.  The zero interest rate policy and the massive deficit policy will continue.  That's going to scare people, and keep progress under wraps.

Our advice is to remain cautious.  Right now monetary policy is amazingly expansionary.  The Obama Administration is just creating money like crazy.  The monetary base, which usually grows 5% a year in normal times, is up 30% over the last 12 months.  Free reserves at the Federal Reserve, which usually total $3-$5 billion, are now over $2.2 trillion.  The federal budget deficit, which normally is 2%-3% of GDP and temporarily peaks at 6% for 1-2 years when the need arises to prime the pump, currently is 9%-10%.  And it's been there for three years.  And the Government wants it to go up in 2012.  Maybe it will all just blow over.  Our recommendation is to prepare for an adjustment process, though, one that might involve some material pressure on the financial markets. 

Walter Ramsley
Executive Editor

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