The stock market is all about expectations

The stock market has rallied strongly since March. Why has the market rebounded in the face of weak economic data? The reason: because the market is all about expectations.

The stock market is a reflection of investor expectations about future economic profits. When investors expect economic conditions to improve and companies to make growing profits, the stock market tends to go up.

Recent economic reports do not show a growing economy, but they do show that the economy is declining less quickly. Why is that a good thing? Think about an airplane in a nosedive. Before it starts to climb again, it’s rate of descent needs to slow. Then it levels off before it climbs. The rate of descent must get less bad before leveling or climbing can occur. Same with the economy.

The market has rallied since March not because economic data or profits have grown, but because things are getting bad less quickly. If it turns out that profits level off at a low level, keep declining slowly, or climb at a slower rate than people expect, the market will decline. In other words, the market will decline if economic growth and company profits don’t meet or exceed investors’ current expectations.

How likely is it that economic growth and company profits will miss, meet or exceed expectations? I have no idea, but in the short run that’s the $64,000 question. If you invest long term, pick good investments, and pay the right price, you don’t need to guess this outcome.

But, it’s an interesting question to ask. Do you expect strong economic growth over the next year? Do you think consumers are ready to start spending again despite 10%+ unemployment? Do you think recent government efforts to spur economic growth will work? Do you think company profitability will rebound by around 50% like the market is expecting?

After listening to conference calls over the last 3 weeks, I have to admit to having an opinion (for what that’s worth). Almost every company I’ve listened to has beat profit expectations by cutting costs and missed expectations in terms of sales. In other words, they are missing expectations for selling products, but meeting profit expectations by firing people and not spending for future growth. That doesn’t sound sustainable to me.

The market seems to be basking in the glow of potential, not actual growth. If that growth turns out to be ephemeral, look out below!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

China’s precarious position

One of the major reasons for the market’s continued rally is China.

China has been buying up commodities, especially copper, and that has caused a resurgence in the price of copper. Because copper is such a fundamental unit in overall economic demand, many are taking the surge in copper prices as a sign that underlying economic demand is rebounding and set to run for quite some time.

But, is the demand from China fundamental, or is it due solely to economic stimulus from China’s government? Even if it is due to government stimulus, does that mean such demand will or will not continue? These questions are not easy to answer.

China’s banking system is not very sound because so many loans are given out as political favors. On the other hand, the Chinese save a huge percentage of their income, some say 20-40%, which is three to seven times higher than here in the U.S. (and that’s the highest U.S. saving rate of around 6% since the 1990’s). Savings become investment over time, and investment can make up for a lot of bad loans.

China is also experiencing political unrest. China’s highly centralized government is fighting to balance the interests of 600 million people living on the east coast (who benefit from free trade) with the interests of 700 million people living in China’s interior (who are mostly dirt-poor farmers). This is a delicate balancing act, and, without high economic growth, likely to get much more difficult.

China’s economy is very dependent on exporting products. Because worldwide demand is down so much, China has little to export. They are trying to shift their economy more from exporting to internal demand, but this will take a lot of time and effort, and success is by no means assured.

If China succeeds in their efforts to keep growth going, then expect higher commodity prices and increasing growth for the world economy. If China can’t keep the growth engine going, then expect commodity prices to tank and for the world economy to muddle along.

China is likely to be the main driver of short to intermediate economic growth for some time.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

How to invest with deflation/inflation

Last week, I talked about why I thought we’d be experiencing deflation over the short term and inflation over the long run. This week, I’ll discuss how to invest in both scenarios.

A deflationary environment is the harder of the two.

The thing that does best is U.S. government bills, notes and bonds. This was clear late last year as U.S. Treasuries were the best performing asset class. Cash and gold did okay as well, but U.S. Treasuries were the all-star.

Not much else does well in deflation. Some people think other bonds like corporates or municipals or mortgage backed do well, but I beg to differ. The problem is that deflation usually leads corporations to collect less revenue, thus increasing default and bankruptcy risk. Municipalities suffer from less tax revenue and, unlike the Federal government, can’t print money or run huge budget deficits. Mortgage backed bonds do poorly for the same reason as corporations–people default on their loans under deflation.

Gold tends to hold its value, but it doesn’t produce any cash flow and it is very expensive to store, insure, etc. Cash is a great thing to have, especially if you can deploy that cash as deflation is bottoming and before inflation has taken off.

Stocks tend to get clobbered during deflation. Some companies do better than other, though. High quality companies do better than low quality companies. Companies with pricing power–that can raise and lower their prices easily–tend to do well. Companies with low or no debt do well.

Another problem with investing during deflation is timing. If deflation increases or decreases, it can dramatically impact returns. If you are sitting in U.S. Treasuries when deflation bottoms, you can get clobbered (and many have since January). Nobody can time the market, so trying to go to Treasuries and jump back into stocks or other risky assets is very tough. I don’t know anyone who can consistently do it.

Inflation is an easier environment to invest in.

Most people instantly think of gold, but I don’t believe gold is the best investment in inflation. Once again, gold is expensive to invest in and it doesn’t throw off cash. It will maintain its value over the long run, and that’s important, but other investments do better.

Commodities do well under inflation. Resource and mining companies tend to do even better. Land and real estate–as long as it’s not bought with debt–can hold up well in an inflationary environment. The things that do well in inflation tend to be tangible.

Stocks tend to do poorly in the initial stages of inflation, but then do outstandingly when inflation is brought under control. Once again, companies with pricing power do better. Companies with debt can do well as long as their debt isn’t floating (variable rate).

The problem, like with deflation, is getting the timing right. It’s not easy or even possible to do.

For that reason, I have a different approach than most to investing in a deflationary and then inflationary environment, especially because I know I can’t get the timing right on when deflation will turn into inflation.

First, I am buying high qualities companies with pricing power. They should fall less during deflation and should recover more quickly when inflation kicks in.

Second, I am buying companies with resource exposure as the market goes down. I can lock in better and better prices on the way down, and then really do well as inflation kicks in.

Third, I’m investing in foreign companies. When the dollar goes down for U.S. macro-economic reasons, that doesn’t mean other country’s currency will go down, too. High quality companies with pricing power in countries with more solid economics than the U.S. fit the bill here.

Finally, I’m caring more cash than usual going into this deflationary scenario. I will have cash as the market goes down and will be able to buy great companies, resource companies and foreign companies on the way down. It’s hard to buy low if you don’t have cash because you have to pick something that will probably have gone down a lot to buy something else cheap.

Deflationary and inflationary environments are tough to invest in, but there are smart options. Timing things perfectly can’t be done, so don’t try it. Investing to benefit from such an environment, however, can allow you to build tremendous wealth over the long run, and having a disciplined plan in place helps. Happy investing!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Inflation or deflation?

One of the big arguments raging in markets is whether we face inflation or deflation going forward. This is an extremely complex subject, and I don’t believe anyone really knows, with certainty, which will happen. I certainly don’t. My educated guess is that we’ll experience deflation in the short run and then inflation in the long run.

I believe this issue is clouded because the terms “inflation” and “deflation” are used to refer to two entirely different, but related, things in reality.

One is what I’ll refer to as monetary inflation and deflation. Monetary inflation and deflation is caused when the supply of money grows faster or slower than the economy. When money is created faster than the economy grows, all things equal, then inflation results. When money is created slower than the economy grows, all things equal, then deflation results.

The second kind is what I’ll refer to as credit based inflation and deflation. Credit based inflation or deflation is caused by the creation or retraction of credit. This is very similar to monetary inflation in that banks can create money equivalents when they advance credit to borrowers using the money they gather from demand depositors (that’s your checking account–it’s lent out to borrowers). When credit money is created faster than the economy grows, you get credit based inflation, and when credit money is destroyed through bad loans or banking regulation, you get credit based deflation.

Credit inflation and deflation require more explanation, so stick with me for a little bit. Credit inflation creates an artificial demand that flows into whatever sector is popular–housing in the mid 2000’s. Credit deflation occurs when the credit expansion collapses because asset prices collapse without an ever-increasing supply of more credit–welcome to the 2007 and 2008 residential real estate bust. Credit deflation is very ugly because using borrowed money to buy a product and then finding out you can’t pay back what you borrowed creates a real decline in growth. Borrowing $100 and paying back $90, when done in the aggregate, leads to negative economic growth. No fun.

If you’re lost at this point, you’re not alone. Like I said before, this subject is complex and it doesn’t seem like anyone has a firm grasp on this overly abstract subject.

I don’t think you’ll find any conventional economists or investors using the terms I’ve used above. It’s my nomenclature and it’s based on my extensive reading and experience on the subject.

Things get very difficult to grasp because when the Fed creates money in the monetary inflation sense, it also causes banks to create credit based inflation as well. This was easy to see in the Dot Com bubble of the late 1990’s and the housing bubble of the early and mid 2000’s. In both cases, inflation didn’t show up in the conventional measures (like the consumer price index), but it was easy to see in assets prices–technology stocks in the first case and residential real estate in the second.

With that framework in mind, let me explain where I think we are now and where I think things will go. I think the monetary inflation that was unleashed to fight the Dot Com collapse created a credit inflation that went, predominantly, into residential real estate in the early and mid 2000’s. Because these loans went bad, meaning people in aggregate borrowed $100 only to find out they invested in something that was worth less than $100, we are experiencing credit based deflation.

The Federal Reserve is trying to fight that credit based deflation by using monetary inflation. This keeps prices from spiraling down, in theory, but it doesn’t make the original credit based borrowing justified. What you see, in the short term, is a credit based deflation in relative equilibrium with monetary inflation, keeping prices, as a whole, from falling.

The problem is that printing money–monetary inflation–doesn’t really solve the problem. When someone invests money and doesn’t get all their money back, then you have insolvency instead of a lack of liquidity (a lack of money to lend or spend). What needs to happen is people need to spend less than they make to replenish the capital that was lost in bad investments made with credit based money. That takes time.

When that capital is replenished and growth continues, the Fed will have to use monetary deflation–taking money out of the system–to prevent inflation. I’m not sure if you can see where this is going, but the Fed has an almost impossible task. It has to print just the right amount of money to make up for credit based deflation–and no one knows exactly what that number is–and then they have to take the exact right amount of money back out of the system when the credit based deflation ends and becomes inflation again. I think that’s a super-human task that no mere mortal can perform (not even Ben “Helicopter” Bernanke).

Perhaps a simpler way of putting it is this: the banks made a bunch of bad loans at the behest of politicians trying to bring prosperity through collusion, and then those loans went bad. Now the Fed is printing money to make up for the bad loans, but the banks aren’t lending that money out, yet, because they need to rebuild their money to make up for loan losses. When those losses are made up for and the banks start lending again, the Fed has to bring all that printed money back out of the system.

In the short run, I think the Fed isn’t printing enough money to make up for loan losses because it’s under-estimating how many bad loans were made. That’s why I think we will be experiencing deflation over the short term.

Eventually, though, due to higher saving rates (consumers have gone from saving less than 0% of their income 2 years ago to saving almost 6% of their income now), capital will be rebuilt and banks will start lending. This will not be entirely clear at the time, and the Fed (facing a lot of political pressure from the President and Congress) will not want to pull money from the system until they are sure the economy is going again. The Fed will almost certainly wait too long and not pull the money out fast enough, which will lead to inflation.

In my opinion, this will be the highest inflation we will have seen since the 1970’s. The Fed will get on the ball, eventually (like it did in the early 1980’s), and that will probably cause another nasty recession (like it did in the early 1980’s).

The result, in my humble opinion, will be deflation over the next few years and then high inflation.

Next week, I’ll address how to invest under these scenarios and why this could be an unbelievably good time to make money when everyone else is losing theirs.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What could go wrong?

The economy seems to be getting back on its feet. New unemployment claims seem to be turning the corner. Manufacturing seems to be turning up. The housing market even seems to be stabilizing.

There are very good reasons to believe the U.S. economy may be growing again before year end.

That’s the good news.

But, what could go wrong? When things look rosy, I begin to wonder what would happen if most people are wrong. There are good reasons to worry.

This is not a normal post World War II recession. This is a credit induced recession, and credit induced recessions take longer to work out. It’s possible we are out of the woods, but I don’t think it’s likely.

For starters, the thing that got us into this recession, a credit induced binge to buy real estate, doesn’t seem to have worked its way out, yet. Housing may be stabilizing, but option ARM, jumbo, Alt A and prime loans will be reseting to higher rates over the next couple of years. That could put us right back into a 2007-2008 scenario.

On the other hand, the governments of the world have done everything they can, both monetary and fiscal stimulus, to get the world economy going again. There’s no such thing as a free lunch, so such stimulus will have consequences. Those consequences could include much higher inflation and perhaps even a dollar crisis.

More credit defaults would be deflationary. If the economy improves, then government stimulus will be highly inflationary. We are stuck between a rock and a hard place. If everything happens perfectly, then we’ll be okay and we won’t experience inflation or deflation. But, that doesn’t seem to be the odds-on bet.

More likely than not, investors will want to be prepared for both contingencies. If deflation happens, then you’ll want to be in solid companies with strong balance sheets and earnings power. If inflation happens, you’ll want to be invested in companies that benefit disproportionally from inflation, like resource companies or companies with strong pricing power.

It’s possible for us to reach a Goldilocks economy again with low inflation and good growth, but it doesn’t seem likely considering the dynamics currently at play.

Be prepared for either inflation or deflation. Keep some dry powder in case great opportunities come up. Don’t invest in marginal or junky companies–this is not the time to gamble.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.