Long-Term Key: +50

 

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Inside this week's update...

 

***** The problem of connectedness.

***** Green can mean a lot of things.

***** Inflation and the coming downturn.

***** Don't get spooked out of gold.

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Stock prices rose last week for the 12^th time in the past 13 weeks, which makes this the biggest quarterly winning streak in the past 20 years or so. 

 

We have to attribute much of the advance to higher consumer confidence resulting from the perception (true or otherwise) that the economy is improving. Frankly, we're getting a little tired of hearing the phrase “green shoots.” Sure, some of the recent statistics have a somewhat healthier tone. But are these green shoots the first buds of spring, or just toxic mold on our loaf of bread?

 

Bear in mind, we cannot look at anything in isolation in today's interconnected world. The Butterfly Effect, whereby the beating of a butterfly's wings in one corner of the world can produce a hurricane somewhere else, is not just some New Age metaphor. It was developed by an MIT meteorologist, Edward Lorenz, who used chaos theory to show that small initial differences can have a big long-term effect on outcomes.

 

As with butterflies, so with matters like green shoots, global warming, and energy policy, small differences could make a big difference.

 

For example, this morning I came across an article that supports the argument in my book, Game Over, regarding the interconnectedness of resource demands. Two scientists from the University of California, Davis, conducted analysis comparing mass transit versus automobiles. They conclude that, even if mass transit uses relatively green technology, it may not produce lower long-term emissions than gas-driven SUVs. The problem is that energy use involves more than just tailpipe emissions. Construction and maintenance of a transit system and the production of the materials that go into it also use a lot of fossil fuels. A fully occupied SUV may in fact be more energy efficient than a half-empty train. (Of course, we realize that many SUVs on the road are less than full. But then so are trains, especially if they are built in areas without the population density to fill them every morning.) Clearly, like most issues, transportation has its complexities.

 

And so does the market...

 

COULD INFLATION CRUSH OUR GREEN SHOOTS?

 

Let's consider for a moment whether today's green shoots are really green, or whether they could in fact be poisonous.

 

As we've pointed out before, the rise in stock prices this spring coincided with a rise in bond yields. As with stocks, the rise in yields has been very sharp – sharper in fact than at any other time in the past 50 years. Industrial commodities (excluding oil) have also shot up in the past 10-13 weeks at a record high rate. Ditto for other commodities. Only copper has ever risen this quickly before, and that was in 2005.

 

So if today's green shoots so healthy and positive, they certainly have some less than desirable traveling companions, in the form of higher prices for goods and loans. Friends like these could easily short-circuit the benefits everyone longs to see.

 

Mortgage rates, for instance, have recently climbed 50-60 basis points. There's nothing green and healthy about that. While it's great that consumers are willing to spend more, it's not great that they'll have less money to spend.

 

As for the Federal Reserve, it doesn't have many options for keeping rates down. Yes, it can buy back agency paper and Treasury bonds. But the more the Fed resorts to these methods, the worse the government budget looks, the less faith investors will have in these instruments, and the more pressure there will be for yields to rise. 

 

In fact, it looks to us as though we are heading towards a standoff. In an ideal world, the market would to continue to rise while oil and other commodity prices leveled off. That would be a return to the Goldilocks economy of the 1990s. However, it seems unlikely, since the U.S. no longer drives the world economy.

 

The driver – or drivers - in today's world are the developing nations, especially Chindia. They account for virtually 100% of global growth, while the developed world remains in recession. These developing nations are solely responsible for the growing demand for resources, and the higher commodity prices we see in the U.S.

 

Our challenge today is that, if the markets keep rising, so will commodity prices and therefore inflation. The only way the Fed could keep inflation in check would be to tighten monetary policy – stop buying bonds and allow interest rates to rise.

 

However, any tightening of monetary policy today could turn our current recession into something far worse. Let's remember that while the government's plan to stabilize the banks has been successful so far, it contains no meaningful way of expunging all those toxic assets clogging up the financial system's balance sheets. Remember too that home prices are still falling – making it harder for the average consumer to spend more money than he actually earns.

 

So any attempt by the Fed to tighten could lead to an outright economic disaster. In 2008, the Fed had a tighter policy in the context of rising resource prices – and look what happened!

 

So here's the bottom line...

 

STAY LEVERAGED TO INFLATION

 

We feel stock prices are close to the top of their current trading range. That doesn't mean the market will turn downward today or tomorrow, but that very little upside remains. Our concern is how far down the next move will take us.

 

We suspect that in the next downturn commodities will continue to outperform the market. Of course, in a big sell-off, beating the market may not equate with positive gains. We also expect that in a downturn the Fed will feel forced to increase its purchases of T-bonds etc. Rather than tightening credit, it will do everything it can to loosen credit further.

 

Keep in mind that the most promising of all the green shoots has been the improvement in consumer confidence. The loss of 345,000 jobs, or 9.4% unemployment, certainly is not the source of that confidence. Most likely, consumer confidence is resulting from higher stock prices. If stocks turn down, confidence will fade. Again, the Fed will be forced to loosen rather than tighten credit.

 

In that case, we could see a weaker dollar, which will further boost the prices of gold and commodities.

 

We mentioned last week that gold could temporarily retreat, and it has. The yellow metal seems to be in one of those periods when it moves in a close mirror to the U.S. dollar. We thought the link between the two had been broken earlier this year, but it has returned in recent days. So as the dollar bounced higher last week, gold fell.

 

The more gold responds to the dollar, the harder it is to predict short-term gold prices. Long-term, however, gold appears destined to be the investment of choice. Whether we have dollar-driven inflation, resource-driven inflation, or both, gold will soar.

 

We want to stay leveraged to future inflation, so we will stick with our current portfolio choices. Maybe we'll have to endure a mild correction in gold – but we've done so before and came out smiling.

Keep your eye on the prize. We can't give you an exact date, but one fine morning you will wake up to find gold selling for $1,000-$1,200. 

 

Meanwhile, we are recommending plenty of great stocks, especially in the materials sector. We also continue to like companies that are expanding in the developing world – such as Coke (KO) and Johnson and Johnson (JNJ) – and can benefit from the continuing growth there.