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What the Markets Know Isn't Worth Knowing: Part II


A debt-ridden, asset-based economy needs inflation or the dreaded "right side of the balance sheet" could eventually take over the left side...

Click here to read What the Markets Know Isn't Worth Knowing: Part I

The Tightrope of Deflation and Inflation and the FOMC's Dilemma

I have long thought that I was walking an economic tightrope between inflation and deflation.

I believe this because a debt-ridden, asset-based economy needs inflation or the dreaded "right side of the balance sheet" (debt and its inherent debt service), could eventually take over the left side (assets) of the balance sheet. So, while the Fed talks hawkish on inflation, they know they need ever rising asset prices to keep the debt game rolling. If you don't believe me, refer to the Greenspan quotes at the beginning, where he was obviously suggesting lenders and borrowers alike take more risk. As the Fed has been talking about inflationary fears in most of its comments, note the growth in M3 in the chart below, reconstituted courtesy of, (remember that when Bernanke took over the reins from Greenspan he rendered M3 - the overall money stock - to be "irrelevant").

While the rate of money growth has slowed lately, it is rather obvious what the Fed has been doing for years-pumping money like crazy. Why? Because, in my opinion, they must keep asset growth alive.

But here is the conundrum…one of the Fed's stated goals is to control the level of inflation to the degree that it doesn't get out of control and eat away at the purchasing power of consumers and take a bite out of the real (inflation adjusted) return of financial assets. This is where it gets dicey. Job growth has remained constant as money supply growth continues unabated and has now taken us towards the level of "full employment" as it is reported by the BLS (Bureau of Labor Statistics). The problem here is that the Fed must become more vigilant at this point as a shortage of labor is deemed to be stagflationary-in other words, when the economy slows down and profit margins erode with higher wages (wages are reportedly 2/3 of all business costs).

So I dreamed up the chart below on Friday after the April employment report was released and showed a five year low in the unemployment rate of 4.4%. I have plotted the unemployment rate against that of the S&P 500. The inverse relationship is rather obvious. Peaks in unemployment have been accompanied by bottoms in the stock market while troughs in unemployment have been accompanied by a peak in stock prices. This is what I mean about the tightrope between inflation and deflation. We need inflation, but not too much that it kills the golden goose of asset prices.

One could conclude that the Fed is now "between a rock and a hard place." On one hand they need asset inflation, but if unemployment rates remain subdued near multi-decade lows, then they must remain restrictive from the perspective of money supply growth. This could lead to falling profit margins, slower earnings growth and lower stock prices. In any event, I consider this to be an eventuality, not a possibility. It is why my firm has established a position in gold shares during the recent correction as a hedge against a "credit event" and possibly a weaker dollar. It is why my firm vacillates from an asset allocation perspective in equities between "neutral" on declines and "under-weight" on rallies as we did recently (we bought into the late February decline and have since taken profits - not as tax efficient as we would like but money is money as we hold longer-term core positions). My firm will only be overweight stocks across the board on a substantial decline, not the mere 6% decline that the press got so excited about in late February.

Click here for What the Markets Know Isn't Worth Knowing: Part III.
Position in gold shares

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