Tuesday, October 28, 2008


Stocks do 350% better during times of declining inflation; such an important concept for investors to appreciate. Many investors think bonds are the investment to own during times of low inflation but the irony is that bonds should be bought when inflation is high but about to go down. Stocks and bonds are first cousins. Unlike gold, stocks and bonds earn a stream of cash; most bonds give off a fixed, limited and guaranteed stream and stocks give off a variable stream. The stock variable stream grows best during times of low to moderate inflation. Real estate is an even more distant bond cousin. Utilized real estate also usually throws off a growing stream of cash. Real estate is more closely related to stocks than to bonds. The rough times are when the net returns produced by stocks or real estate are negative.

The US dollar has recently skyrocketing against many currencies. One of the sharpest runs has been against the Aussie Dollar. By the same token, the Japanese Yen has risen even faster than the dollar. Marvin Appel writes about foreign investing in "Investing with Exchange Traded Funds". He notes how volatile emerging growth stocks can be and how one one can lose money for very long periods of time in foreign stocks. If you are not enjoying this market, say a word of thanks that you are not heavily invested in Russia.

Back in 1967, democrats were in control of our three "houses" of government (the make up of the supreme court is always important but never truly "in control of a party"). Under one party rule, a lot of mistakes in the same direction were made. The presidents of the 70's were all forced to fight hyper inflation. Nixon, Ford and Jimmy Carter still get blamed for tough times that were the result of the inflationary policies of the Johnson years. By the Carter years, wage inflation was so bad that the only way to keep the economy together was to allow the hyper inflation of other stuff. The FOMC went along with the hyper inflation "cure". Interest rates adjusted for inflation were negative from 1973 to 1981. Indeed, by late in the Carter years, real interest rates reached minus 6%! while the price of gold soared and the US dollar collapsed.

We just got a small taste of what it was like during the 70's; real interest rates were negative by a percent or two from late 2002 until early 2005. Negative real interest rates hyped the value of houses just as the congress pushed banks to lend 100% to non qualified buyers. We are all paying the price for "forced charity". We are paying a great price yet due to our lack of understanding we are about to continue in the direction of forced charity.

The good news, so far, is that there is no wage-price spiral, like the one of the 70's. Real interest rates were positive during 2006 and 2007 and only went negative, again, at the end of the oil-commodity price spike. Real rates went negative by about 2% last summer and the stock market has been pounded almost as bad as it was in the late 70's. The difference this time is that inflation expectations have already collapsed, as noted in the price of every thing from copper to oil. Some talking heads continue to worry that large increases in money supply will cause hyper inflation but the truth is that the tendency of most businesses and consumers will be to pay down debts over the next several years.

Back in the 70's and early 80's, wages went up rapidly regardless of the price of raw materials. Starting by 1966, union members got big wages, the minimum wage was raised rapidly and even the very tough recession of 1973-74 did not take away the inflation caused by mandated wage increases. Without the intervention in the markets by government and unions, the invisible hand of Adam Smith would have solved the problem quickly. As it was, the invisible hand eventually won but it had to battle the fact that the starting wage of a bag boy at the local grocery went from $1.00 per hour in late 1965 to $1.80 per hour by 1968; an 80% increase in about 2 years! Bag boys earned $2.50 by 1970, an increase of 250% in slightly over 4 years. And, they all made about the same, the hard working ones and the goof offs. The real price was much higher as everyone paid extra to cover the waste perpetrated by the goof offs.

This time around, amazingly, we continue to experience deflation in durable goods prices. We were on the edge of seeing significant price increases in manufactured goods about the time oil hit $147 per barrel but the turn has been made. The number of people working in manufacturing jobs continues to fall. Around the world, manufacturing jobs are being reduced as are the prices of everything from computer phones to car batteries.

There are two things going on here: 1) "Ricardo style" processes where one manufacturing set up after another is reviewed to find more efficient ways to produce goods while using fewer materials, and 2) The more important process going on is the Schumterian "gales of creative destruction". In other words, inventions are totally changing the way things are done. For example, scientist have invented carbon fibers that weigh less than steel but are many times stronger than steel. More importantly, they are learning how to "print" these fibers into any shape they want. The day is near when a manufacturer or maintenance company will need no parts inventory; it will "print" the part it needs just as the part is needed. Can you imagine the savings of capital and transportation? Can you imagine a world where steel is no more valuable than flint arrowheads?


The sad thing is that politicians who do not appreciate what drives Schumterian creativity are about to win control of government. As part of the backlash against the ridiculous executive bonuses that have been paid and as a result of a news media that has been willing to fight the war on terror with a war of words, these politicians propose that we throw the baby out with the bath water. They want to increase already high taxes on innovation. The economic rule is simple, tax innovation more and the less of it you get.

The additional taxes to be applied to capital gains is a terrible economic idea and sending "refund" checks to those who do not pay taxes could be the start of yet another gigantic and harmful government program.

Thomas Jefferson would be appalled. In the 1780's Jefferson was very concerned because there were too many parasites living off the industry of others. Can you imagine Jefferson's heartache if he saw his and our constitution being shredded?

Obama says it is a matter of fairness, to confiscate from some and give to others. Of course, tax policy will never be exactly fair and there will always be those who pay too much and those who pay too little, but forced "charity" is a disservice to the provider and the recipient. It takes away the incentive to work from both parties. It is the stuff of the Lyndon Johnson years. At the time of Johnson, one could argue about the need for government largess as the way to solve the major civil rights problems of the day. As usual the government did things the hard way and made matters worse before they could get better. Millions of children have been raised by single Moms as a result of the mistakes made by Johnson (perhaps even Obama himself).

Obama's missing ingredient is that the hardest working people are the ones who make life better for the rest of us. The fellow who just invented the process for "weaving" cloth at 10,000 times the old speed will become rich but he will save the people of the world trillions of dollars. Obama says this man should be taxed heavily; I say that this man is likely to spend millions to save us more trillions, if we give him a fair shake. How about the thousands of inventors who only occasionally hit a single or a double, compared with this mans home run. Inventors normally strike out many times more often than they even make it to first base. The inventor who makes $200,000 in one year and is taxed heavily may not want to risk his balance on another high risk, high potential project.

Again, the economic truth is simple, when the government taxes rich people and subsidizes poor people, the result will be fewer rich people and more poor people. The law of supply and demand is more powerful than all laws made by man. The laws of man can be changed but only God can repeal the law of supply and demand.

In the mean time, real interest rates are set to rise in the USA and in Japan. The market is waiting with baited breath for the FOMC and the Japanese central bank to decide about lowering the nominal short rate. The prices of many things are falling, including the price of money. The strength of the US dollar and the Japanese Yen shows the relative projected strength of our economies. Countries like Canada, Australia and Russia are seeing a collapse in their currencies (and thus higher inflation rates) as a result of the lower demand for the raw materials produced in these resource rich countries.

Ironically, the best news would be for the FOMC to not need to lower short rates. The yield curve is very steep. Both monetary policy and fiscal policies are pushing the US economic locomotive forward. To further bring down the price of gold and other commodities, real interest rates need to go up. The strongest move would be for short rates to hold or rebound while the price of abundant supplies of coal, copper, oil, Tupperware and other durable goods falls. As low cost nuclear energy comes on line in China, the cost of durable goods will fall another notch.

(By the way, Intel expects to make 7 trillion digital radios over the next several years; more than 1,000 radios for each man woman and child on the planet. Your computer telephone is going to know the amount of milk that is left in the jug inside your refrigerator.)