Inflation vs. Deflation

In a continuous effort to try and understand what the world will look like in the next several months (and therefore our investments as well), the dynamic between inflation and deflation should be understood on at least a basic level.
 
First, let’s understand what both of these really are.

Inflation – too much money chasing too few goods/services.  So if there’s lots of money in the economy and the individuals who have it are buying stuff (there’s that technical term again), there will be higher competition for the stuff, which results in higher prices.

Deflation – too much debt and difficulty making the interest payments.  Need to sell stuff to reduce debt exposure.

With the issues in Europe and even here in the US regarding the need to reduce debt, it appears to me deflation is in control, which would mean lower prices for stuff (stocks).

I would offer the more interesting question is how will we know when the economy switches from a deflationary stance to an inflationary stance as this will have a significant impact on the prices of food, gas, and other consumable items.  During a high inflationary period, you will see the prices you pay for goods and services go up and potentially faster than you see the value of your paycheck increase each year.

Inflation is made up of two parts.  The first is an increasing money supply.  This is how many dollars are in the economy.  The second is how fast each of theses dollars are turned over (or said a bit different, once someone spends a dollar, how quickly does the person receiving the dollar turn around and spend that same dollar).

Let’s look at a chart showing how many dollars are in the economy and see if it has been increasing:

Looks to me like we definitely have an increasing money supply.  It even looks as though it’s been increasing at a higher rate since 2000 (have to print money to fund these bailouts).

Next, let’s look at the velocity these dollars to see quickly they’re changing hands:

Looks to me as though anytime someone gets their hands on some money, they’re not doing anything with it.  Since we need both for inflation, as long as the velocity points down, deflation will be in control.

 

So, once velocity turns up (people start spending all of this money, which they will at some point), we will begin to see inflationary pressures.  The outcome of this will be the Federal Reserve raising interest rates (think in terms of the interest you can get for a mortgage, if you have a variable rate you will start to see your monthly payment rise as your rate adjusts) to slow down the pace of inflation by selling securities to collect some of the dollars you see in the first chart.  The simple way this works is the Federal Reserve sells securities and when someone buys these, it takes this money out of the system.  Also by “flooding” the market with securities, it will drive the prices down, which has an increasing affect on interest rates (ex. you own a bond, which you paid $1000 for and it pays $50/year, if someone paid you only $500 for this bond because there are a lot more of them in the market, they would still collect the $50 and so their interest rate received would be higher than what you were receiving; or $50/$1000 equals 5% whereas $50/$500 equals 10%).  If you recall from a previous post, interest rates are at historical lows with nowhere to ultimately go, but up.

Over the next several months, look for deflation to persist as countries and banks look to unload assets to clean up their finances.  Then watch the velocity of money for a signal when times may be changing.

I still get an eerie feeling the stock market is teetering on the edge of a cliff.  The euro has be accelerating its move lower, which I can’t help but think this means we will soon be hearing some negative news come from our friends across the pond.

Cheers,

Joel Fink
joel.fink@yahoo.com

Interesting Interest Rates

After some relaxing time visiting family and friends over the holidays, it’s time to get back to sorting through this mess of economics and investments.  I’ve mentioned previously about sharing what I believe will be one of the best investments of the next several years, but before I dive in I want to quickly review my general position on investing.

Great investments for me are areas such as markets that are so severely shunned by others that they are selling at crazy levels or stocks for example that are sold relentlessly, but really still have a sound financial structure and a relevant business model.  These are the types of situations, which get me excited about opening up my wallet and purchasing an investment.

So with this fresh in our minds, let’s move on to discuss interest rates.  There are very few guarantees in life, but one guarantee is that people will not lend money (at least for very long) to others for less than 0%.  Why would anyone give someone else money to use and not get paid something in return for giving them the money.  So from my point of view, this puts a worst case scenario for interest rates at 0% (the downside risk).  I happen to think the actual worst case is something higher than 0%, but let’s stick with the zero.

The following is a historical chart of interest rates the US government has paid to borrow money for ten years going back to the late 1800’s.

In the past 100+ years, the interest rate for a 10 year bond has been at its lowest around 2%.  The current rate for a 10-year bond is 1.87%.  So, if we place odds on whether rates will be lower or higher over the next several years, my money is easily on higher.

Just to be clear, I couldn’t tell you exactly when interest rates will be higher because markets tend to stay at extreme levels for longer than anyone typically estimates (anyone who says they know is guessing and don’t let them convince you otherwise). But I am willing to bet (put my money into an investment) they will be higher in 5-10 years from now as opposed to lower. 

The big question now is how to take advantage of this as part of an overall portfolio.  TBF and TBT (leveraged – uses debt to juice the returns) are exchange traded funds (ETF), which purchase securities designed to allow an investor to position themselves for higher interest rates.  Since I still believe the economic environment is weak for at least a good part of 2012, I do not believe we see a whole lot of upside pressure on interest rates in the near term.  However, I will be looking to begin making purchases of these ETF’s throughout 2012.  From my point of view the odds are stacked in our favor here, low risk with high potential opportunity.

Should you find this interesting and intriguing, contact your financial advisor and ask them their recommendation for how to best take advantage of a long term, higher interest rate environment.  Let them earn their money in 2012.

I plan on keeping a close eye on the market over the next few months with everything that’s been going on.  Some pretty bearish positions have been executed in some different areas (actual investments made as opposed to someone simply talking about different investments on the news, but not really putting their own money behind it), so I’m not the only one who thinks 2012 could be a rather bumpy ride and willing to put their money behind it by buying some protection.

Happy New Year!

Joel Fink
Joel.fink@yahoo.com

Some more crumbling sounds...

As a famous dog once said, "Ruh Roh!"

The attached article is about Oracle's earnings report this afternoon.
http://finance.yahoo.com/news/Oracle-misfires-fiscal-2Q-apf-2124910865.html?x=0

As we've discussed recently, these rosy earnings projections just may be too rosy.

Crumbling Foundation?

Will the S&P 500 2012 earnings projections start to show some cracks in the foundation?

In a recent post, you probably picked up on my position regarding the fact that things must be so good in today’s economy that S&P is projecting record earnings for 2012. I read recently that Barclays Capital has two thoughts as to how earnings have been so good, yet the economic environment feels so terrible. “In our view, there are two primary explanations: 1) an increased reliance on overseas sales (particularly emerging markets) relative to prior business cycles; and 2) reasonable leverage in the nonfinancial corporate sector prior to the crisis, which allowed for a symmetrical recovery…”

I’m not going to elaborate on the second point (its technical balance sheet type stuff and frankly not as much fun to write about), but I do want to make some comments on point number one. First of all, I agree fully with them. Secondly, I can’t help but to believe this is the same reason, which will keep the S&P 500 companies from meeting these ambitious 2012 targets. A quick review of revenues from some of the bigger companies in the S&P500 show percentages ranging from 15% to 55% of revenues generated from international sources. In my world, the dots are easy to connect. Europe will be in a recession, emerging markets sell to Europe, and so emerging markets will be affected in some manner negatively. In summary, US company earnings have been strong on the back of overseas sales (i.e. emerging markets) and emerging markets have a good probability of being impacted negatively by the European crisis. Once again, all of this adds up to earnings disappointments in 2012.

Now let’s take a look at some of these bigger companies influencing the S&P500. First, ExxonMobil and Chevron. Both are related to oil and with projections (my own) that we will see lower oil prices at least in 1H 2012; this will have a negative impact on their stock prices. Next, let’s look at Apple and IBM. Apple earnings have grown at a ~65% annual clip the past 5 years. IBM has also grown at a ~17% clip over this same time period. Imagine if your salary grew at these same rates year after year. Life would be good, but you couldn’t expect that kind of a pace to continue. Please don’t misunderstand me here, I am by no means saying these are bad companies with bad products and services, I just don’t think it’s possible for any company to continue on this kind of a pace and without some kind of correction. It just might be the global issues that serve as the catalyst.

As I’ve said before and you will hear me say many more times, I like to stack the odds in my favor and right now I just can’t see a high probability that the S&P500 as a whole can meet these optimistic forecasts. Since I don’t like to take unnecessary chances with my money, I would be underweight stocks in any portfolio.

I had some more data and statistics, but an unfortunate loss of the information has caused me some heartburn this week. I’m hoping to start sharing some more opinions in upcoming articles about specific investments and still plan to share what I believe is going to be one of the best bets for the next several years.

Happy Holidays!

Joel Fink
Joel.fink@yahoo.com

The European Union Saga

I'm going to give my best efforts here to outline in simple terms this ongoing situation in Europe. 

To start, you may have heard the European Central Bank lowered interest rates on Thursday to make lending easier.  First, this is like using a bandaide on a gunshot wound.  Second, the issue in Europe is too much debt and not enough revenue to support it, so they lowered interest rates to continue enabling money to be lent out to the folks who can't pay it back.  Huh?  This is what's called "buying some time".

There really are no good solutions.  It's a choice between a bad outcome and a horrible outcome.  Greece is a fairly easy example.  They struggle to pay their debts, so they are receiving money to help out.  In return for receiving the money, there are certain requirements. Greece is expected to improve the receipt of taxes owed them (in some instances people and business don't pay their taxes and aren't held fully accountable), many of their citizens won't be able to retire in their mid 50's, and the government will have to sell off some of the assets they own (Greece gov't owns a railroad company with about $250mm in revenues and roughly $1.25 billion in various expenses... Ouch!).  What crazy demands!

I know I'm really simplifying this, but normally a country would just print more money.  This has some other consequences, but it's the luxury of having your own currency.  Oops, that's right, Greece uses the Euro, so they don't have any control over that option.  I'm sure moving to the Euro sounded like such a good idea in the beginning.

At the end of the day this all boils down to decreased spending, whether by consumers, governments, or both.  And when you have decreased spending, there is decreased, if not negative, growth. It is the same outcome for Greece, Italy, Portugal, Spain...  The list goes on and on.  I just can't see how this doesn't have a bigger effect on the earnings projections of companies, yet the forecast in 2012 is for record corporate earnings.  The question to try and answer is how does this affect the US stock markets (and our retirement accounts) if these forecasts prove to be too ambitious. 

I may have to unleash my research department to see where these earnings are projected to come from.  I'll get myself right on it!

In my upcoming posts I want to share with you some more thoughts on the S&P500 (including these record earnings projections) and what I think will be one of the best investment moves of the next several years.

Cheers!
Joel Fink
joel.fink@yahoo.com

Note: There have been some new developments recently (nothing that improves the situation. Just some more promises with no action).  I will comment on these in future posts.

Friday's Employment Report

The employment report came out last Friday and as I’m sure you may have heard, unemployment dropped to its lowest level in almost three years.  Wow, that feels good to hear doesn’t it?  Warms the heart.  Well actually, only for most of us.

What I’m wondering is how those people feel that we stopped including in the calculation.  The unemployment rate is a simple calculation; it’s the # of employed people divided by the civilian labor force.    Simple, elementary math, eh?  Here’s one of the rubs, the civilian labor force calculation does not include those folks, which have been looking for work longer than 12 months (I believe this is the correct timeframe; regardless, the point is that it excludes certain potentially available persons looking for work in the calculation).  That’s right, if you couldn’t find a job in 12 months, you’re not included anymore.  In November, 315,000 less people were considered part of the labor force as compared to October.

Ok, so let’s look at it a bit differently.  What if we just simply looked at the current number of employed civilians compared to the population of the nation.  It should be a much more consistent number since it doesn’t exclude anyone.  Well, in November 58.5% of the population was employed.  This statistic has been in the 58% zone since September of 2009 and before that, the last time we saw this number in the 58% zone was January of 1984 (which at the time was an improvement over the 57% in 82’). 

I don’t even want to tell you what I was doing back in 1984, but I sure wasn’t worried about the fact that interest rates were above 11% and the unemployment rate was north of 7% (over 10% in 82’).

The bright side, the early 80’s was the start of one of the greatest bull markets ever.  That’s not to say now is the time to jump in with both feet, but when things are at their worst, there is nowhere to go, but up.

Cautious Investors!

Someone help me understand what this article from Reuters is really saying: http://finance.yahoo.com/news/stock-futures-gain-hopes-euro-124607096.html

Here is a section from the article, “U.S. stocks were little changed in choppy trading on Tuesday, with cautious investors hoping S&P's downgrade warning for euro zone nations would lead to tighter budget rules at a summit this week.”

I’m not sure who these “investors” are, but I sure hope they have no impact on my well being.  By the way, one of my favorite sayings, “hope is not a strategy”.

I’m a simple guy, so with that being said, here’s where I need help.  If European governments tighten their budgets, doesn’t that mean they will be spending less on buying stuff (this is a technical term) and potentially spending less on programs for their citizens?  If so, that means the citizens will be buying less stuff because they have to save more due to the reduction in any benefits (a person’s pie is only so big, you have to cut from one place to spend in another, unless you have access to borrow even more money…), and so that means businesses are selling less stuff because the citizens and government are buying less stuff.

If I recall from one of my Finance classes, this means earnings for these businesses will most likely drop and not be as rosy as currently projected (S&P is projecting record earnings for S&P500 companies for 2012, times are that good!), and I believe this is what is called a recession (or even worse the dreaded “D” word) if they are not as rosy as previous reports.

Now if I put two and two together, this means “investors” are hoping the S&P warning puts the euro zone into a recession because that will be a good thing?  Maybe it is only the “cautious” investors hoping for this, the rest don’t care.  I may need to go back to school because I must have missed something the first time around… 

I have more opinions on this stuff yearning to come out, but enough for now.

Joel Fink
joel.fink@yahoo.com