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.

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