Recently, a very good friend suggested that I discuss bonds in light of our current economy. I think he had a great idea. That will be a topic of a few blog entries. I wish to do this for a few reasons other than it is a really, really great idea, however.

You and Me 

I consider our relationship one of the most important professional relationships in our lives. You strive every day for your hard earned dollars in a world that is becoming more competitive by the moment. If you are retired you want to know that your money is going to be there. I take your efforts and desires very seriously. So much so that I do not feel that the industry standard of barely understanding the tools available for investing your money just enough to “tell the story and sell it” is acceptable. Being "sold" when it comes to financial strategy and investing is the last thing anybody should want to be. I know that I do not want to be sold. I also do not feel that the 30 second information bits found in mass marketed channels like Morningstar, MSNBC, Motley Fool, or the local weekend radio show to be of high value by themselves. They can contain accurate information. In the same way descriptions of over-the-counter medicines are accurate, even valuable; but are not the bases of a sound health program. There is a substantial amount of free information available with the goal of leading us all to the sale.

 
The Point 

This leads to the point. In each and every recommendation I make, often the only visible part is what we discuss for 10 or 15 minutes OK, I know I talk a lot, so I’ll change that to 15 or 20 minutes. The vast majority of the information is behind the scenes. In your busy, daily activities I feel it does not provide value bogging you down with two hour conversations on market and portfolio theory. I try to get to the point. Please know that even though I don't go into the exhaustive details, they are being considered before I recommend anything. This series on bonds will show a few of the details. Today's story will be the first in a series over several days or weeks that starts with basics. Throughout the entries information will become more like the behind the scenes stuff that I review daily. If getting down to the nitty-gritty sounds a bit boring, I know it can be. Talking finance isn't as exciting as going to see a Stones concert. I get that. I'll take the edge off by having a synopsis at the beginning or at the end of each entry. So, with that in mind let's explore why bonds can make sense even while our government prints money and artificially depresses interest rates and there seems to be no financial direction at all.

 
Bonds = Debt, but What Is It, Really? 

Corporate, agency, and sovereign debt are generally the types of debt available to you and me in the retail investment marketplace. Sovereign refers to government debt by United States or foreign government originators. Agency refers to agencies that are legislated like Fannie Mae and are technically not backed by the US treasury, but have an implied "good faith" government backing. Corporate bonds are similar IOUs issued by corporations worldwide. When bonds are issued the proceeds are used to provide federal state and local governments as well as private businesses the funds they need to make their systems work. All their systems come together to make our system.

Make no mistake about it; bonds are not only a centerpiece of our economic system, but perhaps thecenterpiece.  All of this debt trades in several ways. There are centralized exchanges like the New York bond exchange and negotiated or over-the-counter markets that are organized through the web. According to the Securities Industry and Financial Markets Association, the average daily trading volume in 2009 in the US bond markets was about $814 billion per day. During the same period the average daily stock market trading volume was about $105 billion per day. This isn't some little pansy market. So, why do we hear about the Dow Jones stock index many times a day and not a bond market index? I am not sure but I have a good guess. The stock market has entertainment value and the chance for BIG gains. Also, I truly believe that this is a case where if we are told enough that something is important; it becomes important society-wide.

How Do They Work? 

You give the issuing organization your money, you get a certificate that is essentially an IOU, they pay you interest along the way, and you get your money back in the end…almost.

For example: as of today, you can get 3% from a US backed 30 year Treasury bond. Do you really want to hold onto a bond for 30 years and receive only 3%? Further if inflation happens to be 3% for the 30 years you lose purchasing power after-tax.

 

What's More Important How Much Money You Have, or What You Can Buy?

At the end of the day you are probably far more interested in your power… That is purchasing power. Think of it like the Great Depression example I used on an earlier post where a dollar in 1933 bought six cents worth of goods in 2009. So if you earn 3% and inflation is 3% you might think you are breaking even. You are not. Remember that the Government thinks that part of what you earned belongs to them. They tax you on your gain. If your federal tax rate (forget state and local taxes right now for simplicity) is 20% then your real net is only 2.4% per year in a 3% inflation environment. You have actually LOST purchasing power. You may not lose MONEY on a US government-backed bond, but you CAN lose purchasing power. How much you lose is largely out of your control.

As is almost always the case in life, short-term thinking will rarely get you where you really want to go. Long-term thinking is far more involved but more likely to get you where you want to go.

So, what if you would like the higher interest of a thirty year Treasury, but need your money before thirty years is up? The next blog entry will be about what determines bond value during your ride along the way.

 Please feel free to contact me at 952-230-1340 if you have any questions or would just like to talk. I welcome your call.

 Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing
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Bonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Securities offered through LPL Financial. Member FINRA/SIPC.

This Week's Markets

Are we in another economic crisis?

Over the last 75 years voters have learned that government might can be brought to bear on almost any economic problem and it gets be solved. Think of the recessions of the 1980s and 1990s. Think of the Great Depression. (Even though it has been proven that government intervention actually prolonged the Great Depression; people think that the government actually reduced it.)

As a result, voters have grown to expect that government can create a relatively riskless society. When things get bad people get scared, government steps in and everything becomes okay. There is a catch however. There is a price to a riskless society. Society is not inherently riskless. Having a special daddy that steps in when times are bad and takes away risk can be a costly affair.

The devil in the details is that in every emergency the government grows in size and stays larger than it was before. It typically stepped in and borrowed other people's money, applied the fix, and worried about the bill and its increased size of the economic total later. Eventually however the cost of doing this accumulates to the point where the bill cannot be paid. That time is visible on the horizon.

We are finding out the limits to the cycle. Eventually, government grows to the point where it will have difficulty making its interest payments. How do we know we are fast approaching it? On one hand there's common sense. On the other hand there are credit rating agencies like Standard & Poor's who offer opinions to investors when common sense has been exceeded. They run the numbers and tell us whether we are safe or out at the plate. We are rounding third base now. First base was it getting its share from taxes. Second base was it borrowing what it thought it should have. Third base is when it borrows to meet its interest payments. S&P and the markets are telling us that it is well down the road to reaching its limit.

Has our government finally run out of other people's money?

This is not something that just appeared last Friday. Financial analysts saw this coming months ago if not years ago. S&P had warned that it was likely coming if the debt ceiling bill lacked meaningful spending cuts. The market reaction is likely program trading not based upon fundamentals, but on trading tactics. I do not think we are in another financial crisis. We are just extending the previous one. Stay conservative.

Regards,

Chris Gerber, CFA

As always, if you have any questions or would like to talk please feel free to call our office at 952-230-1340. I look forward to hearing from you.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Just Sign Here, Sir, to Co-Sign this Loan

Can you remember the last time, if ever, that you co-signed a loan? Did you have misgivings? If so, it may have been for good reason. There is everything to lose and nothing to gain. The other party gets the cash and you accept the risk. What is good about that? Sometimes it can help a child get started in life. Co-signing is certainly the exception to the rule - often for love - but not the norm.

Actually, you and the rest of us have co-signed trillions in loans for the US Government and you are likely doing more co-signing as you read this. In the next few days you are about to co-sign another big one as the debt ceiling is raised. Offering some perspective on our current co-signing scoreboard...The Bureau of Economic Analysis says that government spending has risen to 37% of our GDP (all economic transactions summed up) up from 27% in 1960. If the trend they see continues, we will be at 50% in less than thirty years. Our increase in national debt amounts to 100% of our GDP today up from 42% in 1980. It's obvious we're co-signing like there is no tomorrow. So, what happens from here?

We have two choices:

1. We continue business as usual which will increase our debt dramatically. Some feel this will lead to a tipping point soon where so few people pay for the debt.  According to the Tax Foundation, 51% of Americans pay no federal income taxes and the top 5% pay approximately 60% of all federal income taxes. This does not include other taxes like state, local, property, and sales taxes.
2. We implement some sort of austerity program that is actually meaningful and the world regains confidence in your and my ability to make interest payments on the loans we have cosigned. Many will scream when their "benefits" are reduced, though. Politicians do not like conflict from voters.

As you can imagine, this is a difficult topic to broach. It actually reaches into politically incorrect territory bordering on public policy and fundamental ideologies. I'm going to let you wrestle with those topics while I focus on the economic effects of our options.

We do not have far to look to see what happens when we don't increase the debt ceiling. We also do not have far to look to see what happens if we do not begin addressing our long term borrowing.

Without raising the debt ceiling it's a cinch that there will be literally millions of government employees and private suppliers laid off. We will likely have depression level unemployment within a couple of months. For this politically repugnant reason alone, I think the odds are that we will see a debt ceiling increase by the deadline. This relieves the short-term pressure, but it does nothing for the actual issues, like unemployment. Unemployment in this country would be at depression levels now were it not for the artificial stimulus packages. Think back to 1932 and 1933 when unemployment was at approximately 25%. Now think to today. The Bureau of Labor Statistics calculates the national unemployment rate six ways: U1 through U6. You normally see U3. This does not account for those underemployed and if you have worked at all during the week that they accumulate the numbers you are considered employed. That number at the end of June was 9.2%. U6 on the other hand adjusts for those who are part-time and underemployed. That number at the end of June was 16.2%. This is a much more accurate representation of our unemployment rate. Also know that people who stay home to raise a family or help around the house are considered employed for the purposes of these calculations. Let’s compare the 1930s to now.

In the early 1930s the unemployment rate was approximately 25%. There was not a government safety net and families stood in soup lines. Today, there is a safety net. Families no longer have to stand in soup lines, they just receive cash. The lion’s share of the cash is borrowed. Excess federal government borrowing (not state and local) over the last couple of years has amounted to about 9% of our economy. Imagine if that 9% was not borrowed. It is not a stretch to imagine that perhaps 9% of those now employed would become unemployed. If this estimate were to pan out, taking away the safety net could easily cause unemployment to jump to around 25%. This adjustment to make the two eras comparable is likely not too far off.

Without a debt ceiling increase, within a few weeks normal interest payments may not be made on federal debt. As you can imagine, this will send a message to borrowers that the United States government is no longer a risk free borrower. Lenders he will need increased interest to compensate them for increased risk. Existing bonds issued by the government will drop in value as new government bonds are issued with higher interest. The three major credit rating agencies will probably carry out on their threat to lower their AAA rating on US debt. Standard & Poor's has warned of a rating downgrade even if the debt ceiling is raised. Without a credible plan to reduce the federal government's budget deficit they feel risk is higher. The fallout does not stop there.

Many large banks are reviewing contingency plans according to the Wall Street Journal. For them, decreased portfolio values have far-reaching effects. Increased interest costs, decreased loan initiating ability, increased investment portfolio risk all impact them. Insurance companies might be in a similar situation. Mapping long-term assets (guaranteed cash flows from US government debt) to guaranteed liabilities (money that absolutely, positively has to be paid, like death benefits) becomes not so easy. Economy-wide impacts will affect most of the prices you pay from your car payment to your house payment to the food in your refrigerator.

This is obviously a very important issue that I am following. It has had an effect on how we invest and will continue to have one for the foreseeable future.

As always, if you have any questions or would like to talk please feel free to call our office at 952-230-1340. I look forward to hearing from you.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

It's Only a Label, It's Only a Label, It's Only a Label, It's Only a Label...

IT may seem like it is only a movie, but it is real. It is time for a change in asset allocation.

As you might know, one of the primary items I monitor to determine investment policy is the activity of the largest consumer in our economic system: Government. It is now biting out a larger piece of the economic pie. In 2000 total government expenditures were proximally 17 ½% of total GDP. As of the end of 2010, they were approximately 20% of GDP. It does not take a giant leap of faith to assume that over the next several years the government's portion of GDP will increase drastically with the new healthcare program and collections needed to pay debt. To give you a feel of how large the debt is becoming, deficit spending in the month of February of 2011 was $222.58 billion. The budget deficit for the entire fiscal year 2007 was $162 billion.

The Congressional Budget Office (CBO) projects that starting in 2013 the deficit will begin dropping very, very dramatically. From 2011 through 2013 they see it dropping by over 52 %. To accomplish this they are expecting GDP to increase by

·    2011-3.7%,

·    2012-4.4%,

·    2013-5.1%

This can happen, but it would be considered aggressive growth. Of course, it would require that Congress and the Administration actually spend according to assumptions. Stranger things have happened. I actually do not know what these stranger things might be. But I'm sure they have happened.

The whole point here surprisingly is not the size of the deficit. The result of this deficit is what is more important. When I evaluate the results of Executive Order 6102 (see the picture above), I see that it leads directly to where we have come. In 1933, we had a depression. Prices were dropping, factory output was following suit, and GDP was taking a huge hit. This all led to unemployment and soup lines. Since that is pretty far off of the political correctness charts Franklin Roosevelt issued this order. It required that except in some circumstances (jewelry, manufacturing, artwork, etc.) everyone turn in their gold and receive below market prices for their efforts. The goal was removing gold from the system and making it an illegal tender. He figured that if we could remove gold from the system and replace it with fake money (a.k.a. fiat money: the dollar we know now) he could regenerate the system by causing inflation to replace deflation. This would cause wages to increase and demand to increase and factories to begin working again creating the products to satisfy the newly found demand. Subsequently he began doing what our federal government has done ever since: printing even more money. Within two months the amount of inflation in the system was measurable. He got his wish on this and several other labor related issues likely resulting in an extension of the economic pain much longer than it had to go (Ohanian and Cole, 2004: UCLA).

Fast forward to today. During the approximately 80 years since, have you ever heard of the government reducing the amount of money in our system in order to increase the value of our dollar? I have not. In fact, all they have ever done since this period is create more money. A dollar now buys about what six cents bought in 1933. So, don't think of at dollar as worth anything specifically. The word "dollar" really only represents a floating currency whose purchasing power is constantly being lowered. This is my concern now. I should probably remove "dollar" from my lexicon. It really is only a label. I should probably replace it with "PP" standing for purchasing power. That's what money really is all about. With this tsunami of debt and subsequent issuing of new currency by the Treasury I think we need to re-think how we allocate our assets going forward.

There should be significant emphasis upon maintaining purchasing power in an inflationary environment. There are caveats, however: inflation has typically occurred when factory utilization is 90% or above. We are at about 75% now. Additionally, it has occurred as wages have ratcheted up. Wages are barely keeping pace with population growth right now. Without these, there could be a legitimate question as to whether we will have inflation. I'm going to take the stance that we will have inflation, but perhaps not runaway inflation like in the 1980s. However, I do think we are susceptible to enough inflation to dramatically reduce the purchasing power of our money.

I'm only sharing with you right now the tip of the iceberg on the research that I've completed over the last four weeks. There is much more to cover but a blog such as this is really not the right place to do it.

I will summarize by saying that we are probably at a tipping point where portfolios should be reallocated with a goal to counteract inflation. Therefore, over the next 2 to 3 months everyone should be in for portfolio reviews. Please call the office (952-230-1340) at your earliest convenience to set this up.

Chris Gerber
952-230-1340

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

QE2, R2D2, π r squared…What Does it all Mean?

Quantitative Easing

Is it important?  Yes. Why? Jump to the reasons...


Quantitative Easing 2 is the Federal Reserve Board policy instituted in late 2010 to “re-liquefy” the banking system. Normally, the Board is responsible for maintaining member bank (all of the big commercial banks are members) liquidity. This translates to maintaining enough money on hand to meet the public’s need for funds. You are probably familiar with the concept of bank reserves. If you go to your bank to withdraw $1,000,000,000,000,000,000,000,000 (think Dr. Evil for Austin Powers fans) the bank would not have that on hand. Disregarding that that much money does not exist, the reason is reserves. They are only required to keep a small amount of actual cash on hand in the vault which is added to cash deposits held with the local Federal Reserve Bank to make up their reserves. The Federal Reserve Bank says it this way: “Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.”

So, how much to they have to keep in reserve? Here is the answer as of 12/30/2010

Net transaction Accounts1 from $0 to $10.7M – reserve requirement 0%
Net transaction Accounts from $10.70 to $58.8M – reserve requirement 3%
Net transaction Accounts over $58.8M – reserve requirement %10

FOOTNOTE
I know footnotes in a blog are pretty lame cutting edge, but, innovation is a way of life around here. A Net Transaction Account is a specific listing of deposits a bank must include in the total, minus what the bank is owed by other depository institutions plus certain in process collections. And you thought this footnote would be really boring.
END FOOTNOTE

Now that we have that out of the way, the Fed normally used Federal Open Market Operations to influence the interest rate and cash reserves in the economy. Cash reserves greatly affect bank ability to lend, thus influencing economic activity and ultimately wealth and inflation. 

Now the Good Stuff

Quantitative easing is generally seen as central bank expansion in order to stimulate the economy. They have done this almost daily for decades with short term securities. They buy securities from commercial banks (banks normally keep money in government bonds due to their low risk) for cash and the bank then has more money in reserve. They sell bonds to banks for cash and the bank has less in reserve to lend from. If the banks do not want to buy, the Fed raises the interest rates they will pay.

A key point in the current activity begun in November, 2010 is the Fed’s willingness to purchase longer term securities from the Treasury. It is like a super injection of cash. When they purchase securities, their prices go up (demand) and interest rates decrease. (This phenomenon will be the topic of another blog.) Since short term bond interest rates were at or close to 0%, there was no room to influence rates. Hence the purchase of longer term securities. The resulting increase in Fed reserves provides banks with an ability to lend more. It is not too much of a surprise that this increases inflation expectations. But, what are the alternatives?

Pretty near nothing from the Fed. They are in a tough spot. Unemployment, albeit a smidgen better, is still not that far off of 10%. Housing prices, the source of wealth spending in the past are not anywhere near stimulative. Factory utilization is moderate, around 76%. Gas prices are way up resulting in conservative capital investment and weak auto buying. Overall, thee way Ben (Bernanke) says it: “Excess capacity” is not shrinking at a meaningful rate.

Now for the Bellyaching

International governments are claiming that inflation is the fault of the US policy. They say that since inflation expectations for the US are up all over the world, we are wrecking their economies. They claim that because certain important commodities are generally traded in dollars - think food and oil as examples - worldwide prices have soared due to the Fed’s flooding our economy with dollars. They have to buy more dollars to buy food, oil, etc.

There are many reasons the dollar’s price changes. I do not know if Fed policies are the tipping point or not. I DO know that the inflation of basic prices in the world is having SOME effect on moods, particularly in poor economies. Since many of those governments are highly corrupt, and their economies are relatively underdeveloped, it is impossible to tell what exact affect US policy is having. The IMF is pointing all fingers here. That’s little surprise, though. They get paid to fabricate scapegoats. Ben essentially said this recently when he explained that every country has tools to control their own inflation. Go Ben.

Ben also says that the Fed can scuttle the program (begin to selll the bonds) and influence interest rates up to slow inflation in time to slow the economy down. Others on the Board of Governors have the same opinion. We’ll see.

Interest Rate Commentary

So what’s wrong with higher interest rates? That’s like asking what’s wrong with less money.  It depends. How much less?  The same with goes for interest rates. How much higher?

Next Post: Higher interest rates and your bond portfolio.

Take care!
Chris
952-230-1340

Securities offered through LPL Financial, member FINRA/SIPC. The LPL Financial registered representative associated with this site may only discuss and/or transact securities business with residents of the following states: MN, WI, VA, TX, AZ, FL.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Deflation

Recently we have heard a lot about the potential for economic deflation. This blog post will be about defining what deflation really is and taking a look at the big picture to evaluate whether it is a true threat or not. More after the jump...

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Securities offered through LPL Financial, member FINRA/SIPC. The LPL Financial registered representative associated with this site may only discuss and/or transact securities business with residents of the following states: MN, WI, VA, TX, AZ, FL.

 

Deflation: What It Is

It is actually pretty simple. It is when prices generally decline in the overall economy. It hasn't happened too often. During the period from about 1922-1938, during the Great Depression, deflation is what helped make it "Great". When prices decline as a result of a lack of demand, workers are laid off in order to lower costs. This spirals out of control to the point where economic activity slows dramatically. When this happens, since it is a cycle, wages typically fall and the Federal Reserve Board really runs out of ammo to stimulate the economy. They can lower interest rates as much as they want but they can't go below zero. Additionally, everyone circles the wagons and resists raising capital because it probably wouldn't help their bottom line anyway.

How Close Are We to This?

Over the last 12 months our consumer price index, a proxy for overall inflation, has risen by 1.1%. Take out food and energy and it only rose 0.7%. That's pretty low. As you know, that Fed is trying to stimulate our economy through lower interest rates and supplying banks with as much money as they need to lend. Banks, for good reason, are hesitant to lend loosely from fear of getting hammered by the regulators reducing their capital ratios with non-performing loans.

There are several factors that could have significance in propelling us into a deflationary spiral if they were to simultaneously go the wrong way: oil prices, food prices, the dollar, and the unemployment rate. I'm going to discuss in some detail those I think are likely the most important: the dollar and the unemployment rate.

We have run a current account trade deficit as long as I can remember. In 2010 the US current account trade deficit rose to about 3.5% of gross domestic product from about 2.5% a year before +40%. Clearly, we are not competitive with the rest of the world in several key areas. We are importing the majority of our oil which we use to drive our not-so-competitive economy. Combinations like this do not work in our favor. Occasionally, the flight to quality increases the value of our dollar, but long-term our dollar value trend is down since about 2002. We are more stable now, but we are not gaining much ground.  A lower dollar makes our goods less expensive for overseas buyers, but it still reflects the fact that we are buying more than we are selling. Please know that there are many more factors affecting the dollar’s value. The price reflects their combination effect, though.

It is estimated that gross domestic product growth of somewhere between 4% and 5% might decrease our unemployment rate by about 1% per year. Currently we are sputtering along at less than 4% (unusually low for this phase of a recovery). Our growth rate could improve dramatically because economic recoveries typically gain steam at an increasing rate for while. However, there still appears to be a bit of a headwind in the face of corporate America.

Real Estate

Real estate value underlies many of these issues. In many areas of the US may have declined by as much as 25%. Does Japan ring a bell? Are we going to replay their economic disaster? From 1990 through 2005 land values dropped as much is 70% in some places. Additionally, the Nikkei index (Japan's most well-known stock index) had jumped 237% between 1984 and 1989. Subsequently it dropped 78% by the end of 2002. It is currently only about 10,600 -- over 20 years later. (Source: Global Financial Data) We are likely in better shape than they because our asset prices didn't have as far to fall. We also have a much more diversified economy and we have a higher population growth rate which is a natural demand stimulator over time. However, unless our government gets its fiscal act in order we could be in line for a very long slow growth period.

The federal reserve board statement of January 26, 2011 weighed in on our current situation with this quote: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."

Going Forward

The Fed’s actions tell me that we are not out of the woods. If we were, they would be targeting rates at a more normal level. Economic recoveries can produce surprisingly fast stock market recoveries. They can also produce surprisingly big declines. If investors are inclined to gamble before many of the pieces are in place, this is probably the time. Regarding their serious money, however, until sound reasons for a robust economic recovery appear they should not be lulled to sleep.

In a blog in the near future I expect to discuss stock market gains against the backdrop of our very slow economy.

Take Care,

Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Securities offered through LPL Financial, member FINRA/SIPC. The LPL Financial registered representative associated with this site may only discuss and/or transact securities business with residents of the following states: MN, WI, VA, TX, AZ, FL.

Financial Muscle Special Report: Egypt: Upside Down Pyramids

The rioting and general taking to the streets and the resulting increasing oil price has surprisingly not unraveled our markets to any great extent at the time of this writing. This is surprising given the elasticity of our markets to bad news in the recent past. I monitor the VIX, which is a reading of stock market volatility. It shows a reading of around 17 which is pretty low. Why have market participants not reacted more? More after the jump...

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Securities offered through LPL Financial, member FINRA/SIPC. The LPL Financial registered representative associated with this site may only discuss and/or transact securities business with residents of the following states: MN, WI, VA, TX, AZ, FL.

This is something that has been brewing for some time. It appears that the unrest is fairly universal in Egypt. Hosni Mubarak represents the National Democratic Party. Since 1967 they have had “State of Emergency” powers. That tells me most of what I need to know. With power concentrated in the hands of a few in the ruling class, eventually a population has had enough. The most they can do is throw rocks, cause havoc, and be generally unruly as they do not have widespread access to firepower to overthrow their perceived oppressors. The root of their troubles appears to be economic. Their annual gross domestic product per person is around $6,200 according to JP Morgan. The similar US statistic is approximately $40,000.  Their unemployment rate is perpetually high. Elections appear to be rigged with the National Democratic Party gaining over 80% of the electoral seats. Eventually the masses become fed up and they are doing it now. What are our risks in the marketplace?

There is not so much a risk to oil shut-off from Egypt. They are not a major world producer. The bigger oil risk is when those who oppose non Muslim control of anything move in to take advantage of the power vacuum. This is a real risk. I will take the conservative stance and assume that it will happen to some large extent. Could this disrupt the oil flow? Perhaps. More likely is that it will create the perception of risk and oil prices will rise. They appear to have already risen in reaction to the unrest. Since we are forced by regulation to import the majority of our oil, we will be affected by prices and disruption. According to the International Energy Agency, a $10 increase in oil price has the potential to cut US GDP by 0.3%.  Oil prices affect our economy similarly to a tax. They increase the cost of consuming and doing business as they are passed on ultimately to the consumer. JP Morgan estimates that a GDP growth rate of 5% is necessary to cut the unemployment rate by 1%. You can then imagine that with oil’s price increasing, the outlook for our recovery slows by a not insignificant amount.
All of this is used in the portfolio recommendation process.

Please feel free to contact me at 952-230-1340 if you have any questions or concerns.

Take care,
Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Securities offered through LPL Financial, member FINRA/SIPC. The LPL Financial registered representative associated with this site may only discuss and/or transact securities business with residents of the following states: MN, WI, VA, TX, AZ, FL.

Your Financial Muscle February 3, 2011 Volume 2011-1

Welcome to the first post of Your Financial Muscle! This will mostly take the place of the quarterly newsletter known as News from the Front. The quarterly newsletter is a large undertaking and is prone to running out of room. So, in the interest of quick, timely information and a format that can be added to, the blog offers the best of a few worlds. I say a few because there are times when a blog will simply not provide the continuity necessary. For example, when the topic is too large and important to skimp on the size of the writing, or if there are too many charts for our own good, a blog just will not cut it. I will fall back on News From the Front special reports that will be attached to FinancialMuscle.com. Keeping you informed of what is real, material, and important is what this site is all about. So, keep it handy.

To keep it handy you have a few choices: make it a favorite, make my website a favorite because there will be a link to it from there very soon (www.privatewealthadvisorsllc.com), friend me on Facebook.com (Give me a few days to be there), follow me on Twitter.com (Give me a few days to be there). All of these locations will have links to here and will be updated when there is a post. In the future, I expect to provide you with podcasts of the same information for the drive home.

It has taken me a while to get “social” but when I get…I really get. Your information flow from me will increase many fold in the near future due to these changes. If you have any trouble getting on any of these sites, just call Angie and she will walk you through it.

I am really looking forward to sharing back room information with you. I want you to know that there is a mountain of consideration that goes into your portfolio and the financial analysis I do. I am hoping this format helps you know what I know.

So with that, lets GO!!!!

Hyperinflation, Currency, and Other Scary Things

"I just want to say one word to you - just one word.... 'Plastics.'” from The Graduate

We have fiat currency. Nothing backs it other than confidence. Where do we get confidence in it? Generally from the strength of our economy compared to all others. When our confidence is shaken like the last two and one half years, it is no wonder that currency substitutes have become a hot topic. Just turn on your radio for a half hour and you will likely hear multiple advertisements for currency substitutes. Let’s dig deeper, though. When does a currency likely collapse from lack of confidence?

Option1:  Government overthrow: I am not worried about this at this particular moment.
Option 2: Hyperinflation could cause a currency collapse, but it did not in the late 1970s and in the early 1980s. But, do we really have a similar situation now? 

Inflation in and of itself is an everyday occurence. Normally, inflation of 2-3% is condidered necessary to reach full employment - assumed to be 5-6% unemployment. Hyperinflation occurs when inflation is raging in an uncontrolled manner to the point where the Fed does not feel confident reeling it in. Surprisingly, I am not too concerned about hyperinflation right now. I am more concerned about deflation, as is the Fed. Let's break apart inflation into its main components:

Wages

Deficits

Dollar

Wages: the single most important component of national income is wages, they account for about 62% of all national income. If wages go up so does spending and so does money creation. Wages can have an enormous impact on inflation potential. The reality check is best thought about in terms of some key questions to bring this factor close to home: How many people do you know receiving big raises? Likely none or almost none. You probably know more people out of work or working two or three jobs to stay afloat. At just under 10% unemployment it is unlikely that wages will increase dramatically anytime soon. There is ample evidence that we will have high unemployment for years to come, but that’s another post. So, what about the deficit?

Deficits: There is no question that the deficit is high. You would think that wage expansion is not necessary because the printing of money is creating enough dollars in the system to stoke inflation. The real numbers say that the relationship between money supply and inflation does not exist like it used to. We remember a time in the 1970s when inflation ate our collective lunches. Then, economic output as measured by factory utilization was maxed out. The administration fed more dollars into a maxed out system and inflation had nowhere to go but up. Production of goods and services had nowhere to go. So, more dollars chased a relatively static number of goods and services. Now, things have changed. Industrial production in the US is only at 74.8% according to the Federal Reserve Statistical Release. Additionally, economists think that the amount of money in an economy is not as crucial as it used to be. They have found that contrary to decades ago, credit and debit cards make it easy to base spending habits on things other than physical dollars in your drawer. The ease of the transaction makes it possible to base purchase decisions on things like how much you want to work for it, how much you are spending, and how much you want to borrow at a given time. Transaction ease has changed the landscape of modern commerce and inflation potential.

Dollar: So, how does a falling dollar lead to inflation?  The conventional wisdom is that cheaper dollars lead to higher import prices. It takes more dollars to buy a, say, British pound, making the Rolls Royce more expensive. So let’s say that that actually happens. Surprisingly, imports are only 16% of our GDP. Let’s say that the dollar falls by 10%. So economy-wide the Rolls (the proxy for all imported goods in this example) increases dollars necessary by 1.6% overall. It is not really that much of a problem.

Show Me the Money!

Let’s look at how we spend our money (GDP):

According the Bureau of Economic Analysis, here is the make up of GDP:

2010 Annualized GDP (based on 3 quarters of 2010)       $14,750 (trillions)

Personal consumption                                                            $10,383

Investment                                                                              $1,895

Imports                                                                                   $2,399

Exports                                                                                   $1,897

Government: federal, state, and local                                     $3,023

The elephant in the room for inflation purposes is personal consumption. Unless something miraculous occurs, personal consumption is in for a long slow growth spell just based on unemployment alone.

The next post will be on deflation and why the Fed is far more concerned about it than inflation. Please call me if you have any questions or comments.

Take care!

Chris

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Securities offered through LPL Financial, member FINRA/SIPC. The LPL Financial registered representative associated with this site may only discuss and/or transact securities business with residents of the following states: MN, WI, VA, TX, AZ, FL.