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Buy and Hold?

In an economic world that appears more precarious than at any time in the last 65 years, there's no shortage of risk. And so, for the sake of --should we say-- fun, we decided to move a jaundiced eye towards where we fear the greatest risks may be hiding, while knowing full well that the gods, like the audience at the local Cineplex, always seem to prefer a surprise ending, or a disaster flick, over what's reasonable and predictable.

We also know from hard experience that risk should be avoided when possible even in the best of times and, when accepted, should pay high premiums.

So, with safe returns --from both long and short-term interest rates-- hovering at historical lows and every indication that the Fed will hold them that way until at least until they can have no effect on the November elections and a dollar that has lost nearly 25% of its value in the last 12 months, there is somehow increasing pressure to take on the risk of either highly valued stock, REITs, commodities, bonds or even the currency markets.

There are plenty of analysts (hypesters and pumpers) out there who are ready to tell you that we have reached a virtuous moment in which booming asset prices; stocks, gold, housing, you name it, a depreciating dollar, rising corporate profits and easy credit for the indefatigable American consumer against a backdrop of very low inflation rates have somehow laid the groundwork for a real recovery.

For these guys, it's not too late (for you) to get into the market, which in some cases is up 50% from the bottom it hit back in 2002.  Jobs, they argue, are sure to follow and an improving job market will trigger further spending, savings, taxes and profits.  According to this analysis, we have rounded the corner and, having dodged the bullet through a heavy dose of government goosing are now heading for the next real boom. For these experts, the siphoning of jobs and manufacturing know-how to China and India, is the counterbalance that keeps prices in the stores low and thus dampens the usual inflationary pressures caused by distorted government and trade deficits and a depreciating currency.

The skeptics, of course, see a quite different picture: stagnant or sinking wages, reduced benefits, sinking dollar, government debt growing without any real prospect of moderation, widening trade deficits only marginally mitigated by the dollar devaluation, consumer debt now reaching 90% of GDP, job creation happening abroad in Eastern Europe, and mainly Asia. They also see a very deceptive inflation rate that undervalues things like the quickly rising costs of education, housing, healthcare and state and local taxes. By our reckoning --we of course count ourselves among these worrywarts-- it is only a matter of time before either some chain of events sets off the process or the ball of yarn starts to fall apart on its own no-shortage of internal tensions.

So --while always genuflecting to the aforementioned cinemaphiles, mind you-- let's conjure up the kinds of events that might cause the center to spin apart? Then, in an act of further hubris, we'll try to gauge what the possibilities might be.

We think that most people would agree that another terrorist attack of the magnitude of 911 would, depending on its strategic targeting, set off a wave of devastating economic setbacks as fear and physical destruction take their toll. Think, say, a dirty bomb attack on one or several city centers --we know al Khaida likes to stack its hits-- or, say, a bioweapon that hits humans or even the food supply. 

And the risk?  Again, we don't claim to know, but according to our neighbor Tom Ridge, something like this may be nearly inevitable.  We do know that the Soviets and others have had sophisticated germ and chemical programs and that both the know-how and the materials are out there and possibly, along with nuclear waste, for sale. Can we depend upon our intelligence organizations or border police to keep them out?  Again, knowing what we do about the number of people that infiltrate the borders every day and the lack of control in ports and even certain airports, we have to guess that someone with money, an undercover network and knowledge --sound familiar?-- could smuggle in the wherewithal to pull off a major attack.

Could that same gang have sleeper cells in this country ready to act?  Again, knowing what we do, it would seem to be a given; having had a 10 year head start, that there are likely guys already deeply embedded into this society who are only waiting to get the substances and the plans to go.

Another possibility is the outbreak of a worldwide epidemic like SARS.  How likely is that? Well, we know that SARS came close to getting out of the bottle just last year and we can  see today, with the Bird Flu, another example of a disease that just might totally overwhelm the system.  A worldwide epidemic could easily bring the economic system to a grinding halt.

To us, that alone would argue against any scenario in which an investor sinks a large percentage of  her capital into stocks or even bonds. In other words, there seems to be little room left on the upside and a whole bunch in the other direction.  Bonds, of course, have no where to go but down. Unless you believe interest rates will go negative.

So, let's say that everybody with a choice ought to be thinking about limiting exposure to risk even more today than usual.  If you believe that buying and holding stocks was the way to go last century --the American Century-- (it still wasn't) then you have probably long ago stopped reading this.

There's a strong contrarian argument out there that commodities are the way to go forward, at least, long term. According to this line of thinking, goods like oil, copper, titanium, gold are in limited supply and that as China and India grow their economies and 3/4 of the world's population gradually become consumers of electronic goods, scooters and automobiles, commodity prices as a class will rise even as demand in the industrialized countries stays flat.

Gold, of course, is that special commodity that will remain in relatively short supply while holding its historic role of ultimate storage of value.

But there are downsides on commodities.  A stagnant world economy on the brink of a deflationary spiral as more and more factories in Asia go on line, could drag commodity prices down and ultimately slow growth in Asia once again.  Economies, as we know, tend to move in fits and starts, booms and busts....and China, with all its upside, will be no exception.

Bear in mind also that petroleum and gold prices can be manipulated by political wills in ways that other markets won't be. In the case of gold, there is always the chance that behind the scenes the central bankers find it necessary to dump gold as a feint to slow the slide of the dollar.  As for the price of oil and the dependency that all players in the global economy have on it, countries will see oil prices as too strategic to be held to the whims of Mr. market.

On the other side, the major upside that is, should there be a serious crisis both gold and oil will inevitably shoot upward no matter what stop gaps are put in place.

So, all things considered, there is a little downside in a basket of commodities.  The central banks will try to hold the dollar from going to much further down and some will try --as if there weren't enough market pressures-- to "influence" China to move the RMB up to take some pressure off the dollar.

That brings us to currencies.  The real question out there is not whether the dollar will strengthen but whether it will stay pretty much where it is and only move slowly further down. The Fed made it more than clear today that they were going to hold down rates here --with a little juke move where they dropped the not really significant words "considerable period" from their outlook-- as long as it takes.  Once again, this week, Fed Gov. Bernanke raised the specter of a deflation crisis: <http://www.forbes.com/markets/newswire/2004/01/27/rtr1229477.html>.  So we have the possible losing battle scenario of the Japanese and perhaps next the Europeans busily throwing away their money buying up dollars as fast as we can print them.

But what the Europeans, the British and the Aussies won't do is lower their interest rates for fear of losing control of their economies.  And so the dollar has no where to go but further down despite the jawboning and head-fakes of the last couple of weeks.  The big question is whether there will be some kind of currency war if the US pushes too hard and further whether the Chinese will continue to throw good money at US Treasury and Agency bills as vendor financing to keep the status quo.  Should they decide they no longer have to worry about loss leaders and to keep more of their money for investment at home or stow it more safely in euros, then the seams could come apart.

Bottom line:  very little downside risk in deposits in strong currencies paying higher interest rates. In other words, there is an opportunity to store money in high interest paying denominations.

We also think that despite the high valuations, the general flimsiness of the asset bubble in general and the heavy state of consumer debt, that with much less upside potential the stock markets are unlikely to fall precipitously on their own weight this year.  That is, without some tsunami-like chain of events.  We say that because low savings account interest rates (and, shall we say, greed) are driving salivating unwashed investors back into markets that they may have had more appendages than their fingers burned in just a few years ago. Also, the money supply --M3-- which had started to slow on its own accord in November and December, will be boosted further by the Fed that will continue to keep the pedal to the metal at nearly all costs leading up to September.

As Warren Buffett is reported to have said: "throw a trillion dollars at any problem and you're sure to get some results."  The government will continue to spend on homeland security, on Iraq and further military and country-building efforts, while fazing in further tax cuts.  All of that borrowed money will filter into the economy where further borrowing fueled by low interest rates, will multiply the impact.  A cheaper dollar should also have short-term stimulating benefits: foreign goods (did anyone say Airbus?) will get more expensive while US made goods will cost less on the world market. Fewer Americans will take their vacation money to Europe and more Europeans will see bargains in visiting this country, etc.

So, we could easily be wrong about the above scenario, but let's look at what might cause the wing beat in the forest that leads to the tsunami.  For us, of all the great tightrope walking situations out there, from the above terrorist scenario to the possibility of serious setbacks in Iraq to cheap-dollar-instigated general slowdowns in Europe and Japan, to a jobless muddle-through recovery at home, the great currency imbalance seems to offer the greatest risk. 

The Fed thinks they have this under control since cooperating Group of Seven governments and the IMF have their hands on most of the levers.  But there is that little sticking point of the upcoming election: judging by the interest of voters in Iowa and New Hampshire, the continuing bad news out of Iraq, Bush just may seem beatable on the twin issues of jobs/economy and rebuilding Iraq.

The President, with the helping hand of the Fed, will pull out all the stops.  But where to go?, surely interest rates can't go any lower and it's questionable whether anyone would notice if they did.  The Congress can't vote an emergency tax giveaway that would take place a couple of weeks before the election. So??????  That leaves further currency manipulation.... and that might just set off a crash course that ends in driving the Chinese out of the US bond markets.    

 

rmb

dymaxionweb@verizon.net

Copyright 2003 Richard Mendel-Black All Rights Reserved

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