May 27,2011

Now that everyone is talking about inflation it is a good time to talk about our real problem—deflation. We live in a world where almost every individual, institution, and government is de-leveraging. The whole world is paying off debt, liquidating assets, and cutting spending.


QE2 was initially seen as a way to replace the money lost in this frenzy which has brought with it a potential deflation. The inflation rate at QE2’s inception fell to .08% and was threatening to go negative. Hence, the Fed intention to increase it to 2%, to break the back of deflation. Now at the end of the reflation policy, the economy will gradually return to its natural state. We will see the effects of de-leveraging; debt defaults, a search for safety, very conservative spending by individuals and governments everywhere, and less leveraged investments.


As this occurs we should see lower interest rates, slowing growth, a rising dollar, and falling stocks. Commodities should fall back to lower levels and stabilize. Just as everyone begins to focus on the last couple of months of higher inflation rates, which are lagging indicators, the disinflationary/recessionary bias has already set in. I seriously doubt most people are ready for this. It isn't a terrible scenario, but it is a confusing one.


That is why it is so important that the fed keeps the money supply stable from this point on. M2 has been running about 4% for a year now. What the Fed decides to do with its balance sheet isn’t nearly as important as what it does with the money supply. It needs to keep it growing at the present rate at a steady pace. At some point the market will adjust to it, and then rely on it to remain stable, before being able finally to relax about it and return to a more normal state.


We have seen the bump from QE2. The stock market went up, commodities soared with increased speculation (leverage), interest rates rose by more than a point to over 4%, the dollar fell, and inflation went up just as the Fed intended. Now we will see the effects of unwinding that policy. The Fed policy will eventually be perceived, except for a small bump in inflation, as neutral. Eventually it will be seen as an anti-deflation policy, rather than an inflationary one.


The question is, will we have a soft landing -- and if so, where will we land? My guess is that we will end up at the same place I envisioned at the start of the year, not in a double dip recession, but in a low L-shaped recovery for a long period. While it appears we staved off deflation and another recession, I must admit the housing market worries me. We still haven’t found a bottom. Estimates are that foreclosures held by banks are still at over 800,000 with another million to come in the next year. (Shadow inventories of potential bank foreclosures are estimated at over 4 million!) Estimates of at least another 5% drop in housing prices are plentiful on the street.


This at a time when we are on a glide path to lower economic activity, structurally high unemployment, and austerity that will include displacing government workers on all levels. This will obviously place a drag on the economy for the foreseeable future.


What also worries me, and the last thing that most people are worried about, is China. If for any reason China falls into recession, or anything even close to it, it could bring the rest of the world down with it. Exports will be hurt most if this happens, and the dependency of all nations on exports could lead to worldwide recession and deflation. Imagine what that would mean to the fragile economies of Europe with their debt problems, or to a Middle East who is more dependent on selling oil for revenues than ever before. And America will not be immune. I am watching China closely, and I don’t like what I see.


With this last run up in commodities we have been able to get our house in order. We have made excellent profits, paid down debt, and raised cash. Now is the time to pause and look for low risk, high probability, trades and investments. And while doing so, we need to keep our eyes open for the next shock—because it’s coming.


Market Update:

The markets were flat this week. The one exception was the bond market. There was a huge demand at the Treasury’s auction for notes this week. The bid to cover was in the mid 3’s to 1, the highest in over a decade. Almost half of the demand came from abroad. And interest rates fell to recent yearly lows. Rick Santelli, bond market expert on CNBC, gave the 7 year note auction an A+ and called it the best auction he’s seen in years. The bond market rally took most investors by surprise. Bill Gross and Pimco got out of treasuries at their low’s and totally missed this rally. 

Having taken profits last week I have decided to park the money in RIET’s which pay dividends of 11-18%. REIT’s are holding companies that buy government guaranteed mortgage backed securities. They must, by law, pay out 90% of their profits. Their profits are made on the spread between interest rates. The risk is that interest rates will move against them, which will force their stock price down. To offset this risk they hedge their position, and that is a cost of doing business which is already built into the stock price. REIT’s today are selling at about 7 to 10 times earnings, and right at book value.

My opinion is that we are going into a slower economy with inflation rates going from higher to lower levels. REIT’s are a place to hide and make stellar returns while preserving past profits. I divided my purchases between three different REIT’s: CXS, MFA, and TWO. I also opted into their dividend re-investment plan. So the compounded returns will exceed the actual dividend rate. Returns should exceed 11%. If demand for these stocks increase, you can add capital gains increases to that figure.

I expect the trend of all equity and commodity markets to continue to be stable to lower. Patience is what is required for the coming weeks and months unless and until we have a new factor enter the mix.


Cash, gold & silver