May 2008 Edition

financial analysis

The bin is getting empty

Creative investing outside the box likely will succeed

By John Hummel

It is sometimes difficult to fully appreciate when one is living in extraordinary times. The younger generation might have had little prior experience with which to compare current events. In certain ways, we are at a tipping point separating two eras. America has been eating its seed corn and the bin is getting empty.

Three powerful issues are confronting our society, and they will have serious repercussions for investors in the next several years.

What we are facing

First, the federal government has been operating a ponzi scheme of social welfare benefits (Social Security, Medicare and Medicaid), conceived in the 1930s and massively expanded since the 1960s. Rather than create a special investment fund with realistic actuarial assumptions, the Feds chose to use a pay-as-you-go approach.

The outcome is likely to be a combination of higher taxes, lower benefits, and more inflationary pressures in the system.

Second, the U.S. dollar is the world’s reserve currency, a result of financial circumstances that prevailed at the end of World War II and no longer exist today.

What had been a virtuous cycle of dollar strength for many years could turn into a vicious cycle of persistent dollar weakness for years if not decades. As the dollar has weakened, many countries which had pegged their currency to the dollar are experiencing rising inflation and are giving consideration to undoing their peg to the dollar.

Third, as the world’s largest energy importer and largest per capita consumer of energy, the United States will face the most serious retrenchment challenge, if the world cannot continue to increase oil production at a rate sufficient to sustain global economic growth.

There are no quick or seamless fixes to an energy-short world.

Recent history

During our lifetime, the Federal Reserve and the federal budget have been creatively used to fix every recession. The public and private balance sheets, as well as foreign balance sheets, have been leveraged up in order to stimulate production, employment, and asset values.

Such tactics can work well. However, if we have entered an era of scarce resources, especially oil, the owners of these scarce resources will be reluctant to accept dollars generated off printing presses or electronic entries on bankers’ books.

The Federal Reserve has taken major steps to intervene in financial markets. In addition, a quick bipartisan congressional effort approved a major stimulus bill to issue checks to the majority of Americans to stimulate spending. There also is a move to have the government take over many delinquent mortgage loans.

These are powerful efforts that should contain a negative domino effect that might otherwise occur. The problem with all of this is that it has unintended consequences. It will weaken the dollar, increase inflation, and encourage unjustified speculation in the future.

Although these strategies worked in earlier cycles, two factors are different. First, a higher level of leverage already exists, and, second, we have entered a resource-scarce environment. These factors could destroy the long-term bond market, driving interest rates to double-digit levels even as short-term rates are kept low by the Fed.

Critical point

It is critical to watch market prices to either confirm or refute these statements. However, it also important to recognize the limitations of markets to anticipate major change. One widely cited example is the failure of European bond markets just prior to World War I to price in any unusual risk premium for what was about to tear the continent apart. If a major disconnect is about to occur, markets may not properly anticipate it.

The current government efforts are likely to stabilize conditions. If further financial or economic problems develop, both the Federal Reserve and the federal government will again step in.

How does one invest given these potential risks? Investors who seek capital preservation of their capital through a traditional approach of emphasizing fixed income will be the big losers.

First, avoid long-term bonds and avoid municipals with unfunded liabilities. The investor will not be rewarded for the increasing inflation and higher default rates will occur.

Gold and commodities will benefit along with companies producing or selling these basics. Access to energy supplies may become a primary government policy issue.

In summary, creative investing that requires thinking outside the traditional box likely will succeed while staid traditional investment strategies will struggle.

John R. Hummel is president and a founder of AIS Futures Management LLC and AIS Capital Management LLC, a registered investment advisor. Hummel has 40 years of investment experience managing equity, fixed income, and futures portfolios. The AIS group of companies manages four investment strategies combining macro economic fundamental research with proprietary quantitative strategies. Hummel’s papers and published articles can be found at the website: www.aisgroup.com . His e-mail is jhummel@ais.com.

What do you think?
Will the information in this article increase efficiency or save time, money, or effort? Let us know by e-mail from our website at www.ToolingandProduction.com or e-mail the editor at dseeds@nelsonpub.com.