Issue #25

What’s this? The lowest levels of consumer confidence in 70 years and the stock market is going higher? How can that be? Aren’t things now clear? Isn’t it obvious? The economy is getting worse. The real estate market mess looms ahead as a complete train wreck. The Dollar is dropping like a Peso. What is wrong with investors, don’t they see? The facade is finally broken. The finance economy is kaput. The end is nigh!

Last Monday (March 17th), JP Morgan purchasing Bear Stearns, an 85 year-old investment bank on brink of insolvency to stave off disaster. If Bear Stearns had ceased operating, the status of trillion’s of dollars of derivative contracts and clearing operations would have been unknown. Apocalyptic reverberations would have pushed the global financial system to the brink. Had Bear Stearns not been rescued, we could have had the market sell off 1000 points, maybe 2000.

Democracy would have suffered, as systemic risk would have run wild, and job losses would have been much higher, on Wall Street and on Main Street. Democracy (the public good) required that Capitalism act to save the system from implosion.

Capitalism versus Democracy = Creditors versus Debtors

You see, in monetary policy we see the political balance of the social compact. It is the balance between Capitalism and Democracy. Democracy is ruled by the law of 1 Person, 1 Vote; whereas under Capitalism, the law is: $1, 1 Vote. The arbitration of the peaceful coexistence of Capitalism and Democracy is the job of the Federal Reserve. The Federal Reserve orchestrated the JP Morgan takeover of Bear Stearns. And the Stock Market DID NOT TANK. Systemic collapse was avoided. What does that mean to us as investors?

Stock Market Talks – Is Anyone Listening
The stock market is prescient. It sees today’s bad news, and it foresees solutions that are going to make today’s bad news less bad tomorrow (or at least 6 months from now). In January, the market sank to new lows, (11,922 on the Dow Industrials). These lows did not represent phenomenal values in price. Stocks at their January 2008 lows were still pricey compared to the Armageddon witnessed in the stock markets of 1932, 1949, and 1974 and 1980 when great stocks paid 6% dividends. But the January lows were impressive and similar perhaps to other market lows in 1957, 1962, 1970, and 2002. It just may be that the market is seeing solutions that will make today’s bad news seem less bad tomorrow.

Technicians get fooled by massive inflection points less than the fundamentalists, because they are focused on the biggest picture, the price action of the aggregate knowledge of all investors. That price action is smarter than any one, or group of people. We think that there is a good chance that we will not crash through to lower levels in equities this year. Here’s why.

Since January 22nd, the market has experienced 9 trading days in which more than 90% of the trading was down (these are known by Lowry’s Research as “90%” down days). They represent panic selling. But last week we had our first 90% up day of the year. More impressive, despite 9 different panic selling days since January, the market averages are 4% to 10% higher than their January lows. The prescience of this price action indicates that the market may have already discounted most of the bad news of 2008. We may have already seen the lows.

Helicopter Ben
Let’s think for a minute why, and how, that may be. Last week, Federal Reserve Chairman Ben Bernanke rescued a bankrupt 85 year-old bank by utilizing little known emergency powers of the Fed which were put into place in 1932.

Bernanke is an expert in the Great Depression. He wrote dissertations and books on the subject. In 2002 when deflation was rearing its ugly head, he referred to Milton Friedman’s statement of using a “helicopter drop” to inject money into the economy to prevent deflation. The “Bernanke Put” has since come to be the implicit guarantee from the Fed that it would drop money from helicopters before it would allow a depression to take place here (in the U.S.) again. Helicopter Ben just isn’t going to let the deflationary forces of wage pressure and the mortgage massacre drag down the U.S. Economy.

Bernanke will sell the Dollar down the river, dump money into the system like a drunken sailor, securitize the bad debt of our commercial banks… but deflationary forces and bankruptcy are just not going to be granted seats at the table under his reign.

And that is what this stock market is seeing. It is seeing that an inflationary process calling the tune. And in an inflationary process, world-class companies (i.e. stocks) have pricing power and real value. This is why stocks might not go any lower than they did in January.

Who Pays for Inflation?
But Barnes, isn’t this a frontal attack on America’s fixed-income investors? Are you not saying that monetary inflation is high while interest rates are low? Who is going to pay for the reported $460 billion in credit losses in the commercial banks?

Folks, I hate to break it to you, but yes, the fixed income class, otherwise known as risk-adverse investments, is being sold down the river. As an asset class, fixed income has averaged. What does that mean? It means every bank account holder, every bond holder, every foreign investor buying our treasury debt, every buyer of Bank CD, loses.

But wait, don’t be surprised. It’s not uncommon at all. In fact, economically, and politically, we’ve seen this time and again.

What does Payment look like?
Payment can take many forms. However, in order for payment to be exacted, it must be disguised for public consumption. The time-proven disguise is inflation. Inflation defines our progressive democratic institutions, because inflation by definition is a tax on the asset owners (Capital).

Inflation is democratic. Inflation levels the field. Inflation is the political force that Democracy demands, to ensure a system that provides jobs, schools and public institutions to every person (Jedermann). Inflation is the payment is disguised as a tax. No one ever votes for a tax increase. But the social contract demands goods, services, and the public good. When the government can no longer tax people enough to pay for government services, they are forced to create money (i.e. inflate).

So who does Inflation hurt Barnes?
Inflation hits creditors hardest. Stocks and bonds both suffer in periods of higher inflation. However, we believe that the primary price of the inflation tax is going to be paid by the owners of the least risky investments, fixed-income securities.

Savers get Screwed
Fixed-income investors will be most harmed by today’s solutions being enacted by your inflationist Fed. So who are these fixed income investors you ask? It’s you!!! Your checking account, your savings account! It’s your Dad’s money at the local credit union, it’s your Grandma’s treasury bonds, your brother’s fixed annuity. It’s any investment guaranteeing a 5% return.

More than half of all wealth is held in the fixed income market, about $20 Trillion. High Net Worth families, those with millions of dollars of municipal bonds, and the Risk Adverse, those with low interest bearing bank accounts and insurance contracts, will be hurt the most by today’s solutions because the inflation that is being created will exceed the interest generated by low-risk investments. Currently, 10-year government bonds yield 3.5%, while 2-year notes yield 1.67%. If real inflation is 4%, then the real return of your bonds is -0.5% or -2.33% respectively. When you lose 2% every year, you fall more and more behind every year. Does this sound familiar?

The following Chart shows how the stock market (DIA) is beginning to outperform the bond market (AGG). You can see this by seeing how the DIA has broken above the 1.20 level. This shows the market discounting at work. The market is saying that stocks are cheap, relative to bonds. A floor seems to have been set in January. Whether that floor will hold, is another question, for the moment, it seems like it will.

Inflationist solutions should come as little surprise. By hitting creditors (the affluent and rich) hardest, inflation is by definition populist and democratic. The costs of maintaining the public good, of saving the system from collapse, are borne by those most able to absorb the hit. Today’s spending is paid for by incipient inflation tomorrow. Get ready. Oh, gas is already $4/gallon. I guess you don’t need to get ready, it’s already here.

The Social Compact
This transformation of communist economies into market economies imposed a similar dilemma to our situation today. In order for the new and developing social contract between capital and democracy to be honored, governments in the early 1990s in Czech Republic, Poland, Hungary, Russia, Ukraine and Romania, were forced to choose between supporting the retirees of the ex-communist state system, and investing in the infrastructure for a modern economy. The choice that they faced was analogous to the solution that caring parents make with their children: the welfare of the old, were sacrificed for the opportunities of the next generation.

Economic growth and transformation was achieved at the standard price: INFLATION. This is always the pattern. Creditors lose on the value of assets, or order for social compact between capital and democracy is upheld.

While retirees lived on fixed pensions in economies experiencing 10%, 20% oven 100% inflation, the ground was set for their grandchildren to be able to earn a living that could afford them better shelter, motored transportation, and discretionary income. The State governments in Poland, Hungary and Russia could simply not afford to pay a living wage to its pensioners while it was transitioning to a market economy in what was essentially a bankrupt state. They did indeed honor, for the most part their pension obligations, but due to rampant monetary inflation, the pensioners were lucky to be able to pay for a week’s groceries on their monthly pension checks. And to a lesser extent, so it will be today.

Inflation: The Fudge Factor that balances all Budgets for the Public Good.
Let me show you how the monetary policy of emerging democracies, and the monetary policy of Federal Reserve, is similar.

The Fed is creating inflation via low interest rates, higher inflation and a declining dollar. Today’s creditors (you, your Dad, Grandma and Brother): you are all underwriting and subsidizing today’s financial bailouts by accepting higher inflation in the years to come, and consequent lower returns on your low-risk investments.

This is not a bad trade-off. Those most able to pay, the creditors, who are the affluent, the retired, subsidize today’s spending, by accepting low and even negative real returns on their fixed income investments. It’s a small price to pay for actions which protect Main Street, jobs and the public good (salus publica).

In summary, the struggle between Democracy and Capital is always with us. So long as capital is willing to pay the price of lower returns in times of crisis, the system serves us well, the public good is preserved and the competing interests between debtors and creditors remain in balance, mostly.

If you would like to read more on the subject of the struggle and compact between Democracy and Capitalism, look at Paul McCulley’s archived letters including “In Democracy We Trust” August 2004, at www.pimco.com/LeftNav/ContentArchive/Default.htm

Barnes – What’s the Bottom Line?
The actions of the Fed this month, will go a long way to solving the systemic problems of 2008. The markets’ refusal to break to new lows indicates that the market sees a better future for equity securities. The price that will need to be borne to pay for the Fed’s solutions is unknowable. Perhaps a good guess is that real inflation will be 1% higher than it would have been. On a market of $20 Trillion in fixed-income assets, that amounts to a tax of perhaps 5%-10% over the next decade after accounting for discounting that cost over a 10 year time frame (1/2% x 10 years x 20 Trillion equals a total tax of $1 Trillion. Can see that through the obfuscation of monetary inflation, the government just taxed the more affluent constituents and every person with a bank account balance, an additional $1 Trillion to pay for today’s financial pickles? You know what they say, a $Trillion here and a $Trillion there and pretty soon you are talking about real money!

The bottom line is that monetary policy will lead to lower, possibly negative real-returns on low-risk investments over the next decade. It remains to be seen if higher risk investments will be equally damaged. But for now, it seems like the answer is a resounding ”No!” The stock market is confirming this conclusion through its reaction to current bad news. It’s speaking to us. It is saying that it sees the future, and the future is not worse that the present.

In Conclusion
We believe that capital preservation and growth strategies will fare significantly better than low-risk assets such as Certificates of Deposits & Government Bonds. The action of the markets bares this out. Today’s dividend yields on the world’s best run-corporations, while not at historic highs, are on very sound ground, many with dividend yields higher than the interest rates paid on 10-year or even 30 year government bonds. For example, General Electric pays a 3.4% dividend. That dividend is growing at 10%-12% a year. Meanwhile, many of today’s wealthiest, and the pension funds of the middle class, are invested in “safe” securities like the 10 year Treasury bond. These yield 3.5% interest. With real inflation in excess of 4%, you tell me who is going to lose over the long term, the equity investors or the debt holders?

We’ve made no new adjustments this year. We continue to manage our clients’ money in the less economic sensitive sectors and we are still taking advantage of the once-in-a-lifetime opportunity in precious metals, while using solid dividend paying blue chip companies as our core equity holdings.

As always, we appreciate any referrals by our network of colleagues, friends, and clients. Our approach is to protect and grow our client’s wealth with less portfolio risk than standard stocks and bonds. We are still accepting clients with portfolios under $250,000.

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503.

This entry was posted on Thursday, March 27th, 2008 at 3:08 pm and is filed under Insight Newsletter. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.