Author: Jack Brown, Laureola Asset Management
Covestor model: Dividend Payers
Bernanke policy through 2013: Nowhere to hide!
Raise your hand if you’ve had enough of 0% money market rates. Count me in. What Mr. Bernanke said (in so many words) in August was that he intends to keep Fed Fund rates near 0% through mid-2013. This means money market rates near 0% until then, most likely. It also means savers lose.
His accommodative position is traditional medicine to spur economic growth, but let’s consider the burden. When an average investor wants to set some funds aside for later, the default choice is cash (i.e. money markets). In a 0% rate environment, inflation erodes the value of cash. Consider that $100 bag of groceries that will cost $103 in a year from now, while $100 in money markets will grow to approximately $100.50 over the same period. Savers lose.
Normally, money market yields approximate inflation, so cash (money markets) isn’t a bad alternative for those who need an investment break. By pursuing a policy of “nowhere to hide,” Mr. Bernanke established a negative incentive to put money aside.
Since we are already in a low rate environment for Treasury bonds, inflation expectations exceed the yields available throughout much of the yield curve. For example, inflation is expected to be greater than Treasury yields for the next years, and equal for the next ten. So even if you buy a 10-year AA+ rated Treasury bond, you’re expected to break even with inflation at maturity (this even assumes you re-invest your coupon payments).
Despite low rates and Mr. Bernanke’s attempt to stimulate risk-taking, many investors are still holding cash or low-risk bonds and CDs – and losing the battle to inflation.
Others are buying gold
Gold has a long history as money, and is a finite resource. Therefore, the story is that it will keep the value of your money safe. Consider the following hypothetical statement: In the next year, suppose the value of the Dollar falls significantly (either by inflation or currency depreciation, which is basically the same). This means that the value gold must increase. Is this a fact or theory? Because the price you receive for anything you sell will always depend on the next buyer, this is a theory.
What does the next buyer care about? It depends, but a sizable percentage reacts to incentives – like anything else. The missing incentive is income. For example, the next time you are discussing investments with friends, ask someone who owns gold if they would sell (and move to cash) assuming money market rates were 3-to-4%. In recent conversations I’ve had, the answer is often ‘yes.’ At 5-or-6% the answer is ’oh yes.’
The fact that gold lost the majority of its value in the 1980s and 1990s while we had high inflation, means that that the proverbial printing press can in fact run while gold declines in value. Consequently, without a clear sign of a bubble in gold, perhaps the best ‘red- flag’ warning will be a reversal in Fed Policy.
Inflation or Deflation?
Today, we fear a decline in the value of the Dollar. With easy Fed policy, excess government debt, and fiscal imbalances, the printing of money seems likely. An increased money supply is usually inflationary – assuming too much money isn’t just parked somewhere (say in the banking system). Because more and more money is being parked in the banking system, the ‘velocity of money’ has been slowing down.
When the velocity of money picks up, money changes hands more rapidly. Combine rising velocity with an increase in money supply, and inflation is likely to follow. This hasn’t happened in any significant way yet, so inflation has been tame (unless you spend most of your money on gas).
Chances are that when money velocity finds its footing or turns up, we’ll see both inflation and decent GDP growth (mathematically, this is a fairly safe bet, as per the Equation of Exchange in economics). In the meantime, as much as we worry about uncontrollable inflation, the Fed seems more worried about deflation.
Inflation is an unpredictable part of life. Fed policy is promising us that cash will lose value with any inflation for the next two years. Gold’s current price is promising us we’ll get a boat load of inflation, but it could be wrong.
From an investment standpoint, we believe diversification, asset allocation, and rebalancing provide the best way to beat inflation or deflation.
Hibernating Bulls
Turning our attention to the stock market, over the past 13 years investors have seen two periods of boom and bust that left the S&P 500 close to where it began. In my view, however, stocks provide more opportunity today than any time within the last 20 years.
However, it is hard to be a bull. How could you be, with
- Europe on the brink
- Civil unrest in the UK and Middle East
- Fresh and credible recession fears in the US and China
- Debt and deficits as far as the eye can see
- A credit downgrade for US Treasury Debt
- Recent volatility and declines in the stock market
- A long de-leveraging process whereby spending is reduced in order to pay down debt
- Investor frustration from 13 years of near break-even stock prices
- Higher than normal structural (read long-term) unemployment
These are some of the ugly facts and fears right now. Perhaps the most important question for investors is: how should we interpret these things? I read much of the same commentary that other informed investors read. I am impressed by the logic and dominance of dour and dismal dialogue. So despite Bernanke’s “nowhere to hide” policy, it is no wonder that investors are turning away from risk (i.e. selling stocks, buying treasury bonds and gold).
But for every seller, there’s a buyer. We know what is motivating sellers, but who is buying (and why)? Today, if you are buying stocks, you’re probably motivated in part by low prices. Based on many historical valuation measures, stocks are on sale.
Conclusion
A generally low interest rate environment and Fed policy have made it unappealing to hold cash or many high-quality bonds. As a result, some investors are losing out to inflation. Some are taking more risk than they’d prefer, while others are buying alternative assets like gold and farmland, driving prices up in these asset classes. With so many concerning issues, it can be challenging for investors to discern an appropriate course of action.
At the end of the day, we believe a comfortable asset allocation will always be an investor’s best friend. The worst performing markets and asset classes can resolve themselves into the most attractive. When an investor is not overly committed in one asset class or another, it’s easier to commit funds to what could become the most attractive future outperformers.
Today the evidence seems to be telling us that equities are becoming quite attractive. The dust probably hasn’t settled yet, but we believe the bargain bins are filling up.
