The Effects of Government Intervention on your Portfolio And how our portfolios prepared for it.

In the United States we have capital markets that operate more or less freely. The two exceptions to complete free market operation are regulation and intervention, the former being necessary in some measure and the latter being superfluous. Regulation is necessary for the simple reason that human beings can’t be trusted to act in the common good with regard to money. We can debate this ad infinitum but facts are facts and some regulation is necessary to ensure equality in access to capital markets and to prevent certain market participants from taking unfair advantage due to their size or their political influence.

It is my belief, that once a proper regulatory system is in place and working, any further government intervention will not only be wasteful and expensive, but will in fact do more harm than good. Large-scale interventions such as we have seen recently with the financial sector bailout have resulted in massive increases in public debt without a corresponding benefit to the public responsible for paying it back. Quite to the contrary, government intervention in almost all cases has benefited specific players, in effect circumventing the very regulation intended to prevent this possibility. The bottom line is that intervention has worked for the benefit of those with money and influence at the expense of those without. This is clearly a situation that must not be allowed to continue.

All is not lost however for those who pay attention to the free market’s reactions to intervention and the ultimate consequences. No matter how much some want to believe that the government can save us from ourselves, ultimately the free market will regain control. While governments are intervening, markets tend to use the excess capital provided by taxpayers to (1) generate profits in excess of normal for those sectors targeted by the intervention (think financial sector), and (2) push excess capital into the formation of new bubbles. What the government is trying to do in effect is maintain the status quo in the standard of living by replacing private capital formation with government capital (funded by taxpayer debt).

The expectation is that ultimately business activity (private capital formation) will resume at some point and excess tax revenues will allow for the repayment of the taxpayer debt. It all sounds plausible in theory but we are faced with one large looming problem that is going to bite us in the derriere. The original standard of living, which the government intervention is intended to maintain, was artificially inflated because of past Government interventions. Much of the GDP growth from the period of 2000 to 2008 was inflated by leveraging the mortgage and housing market. This was coupled with a perversion of the financial sector where ‘profits’ were being created out of thin air without ever producing anything but paper backed by paper, backed by inflated asset values. So the intervention has focused on maintaining a phantom standard of living that was never actually supported by real economic fundamentals.

Now that we have seen the crux of the problem, let’s take a look at how free markets have reacted so far. With the massive government intervention thrown into the capital markets, we have seen (1) a string of record profits by the financial sector (with corresponding bonus checks for the great job they’ve done), and (2) inflation of certain asset values (with the effect of allowing specific players preferential capital market access). There is of course no free lunches, much of the benefits accorded the financial sector have come at the expense of others. When the Federal Reserve continues to keep interest rates near zero %, banks who can borrow at these preferential rates buy 10 year treasury notes, effectively loaning the money back to us at 3.5 % or higher. The “savers” who rely on returns from lifetime savings to maintain their existence, suffer with rates near zero. The longer rates stay low, the more suffering for those who are disciplined at saving. The banks also begin to devise schemes to profit from low rates instead of acting like banks and stimulating the economy (which is the reason they are provided preferential borrowing rates in the first place).

These schemes will no doubt hurt all of us in the longer term, either by causing more problems in the financial system when rates rise or alternatively continue to hurt the ‘disciplined savers” of society (and by proxy all of us) if rates stay low. Those least able to take risk are being put in an untenable position; A recipe for trouble in America all over again.  The message is clear: as long as you can afford to lobby Washington, you’ll be OK, if not, too bad.

The magnitude of the bubble we have just experienced both in terms of capital (money) and time tells me that some reversion to the longer-term mean is in order. While government intervention can indeed modify free market behavior in the short term, there has been no historical evidence that longer-term market dynamics can be suppressed. What that means is that the process of asset devaluation, which began in 2007, will at some point continue. The massive government intervention will most likely have hurt rather than helped the average citizen and the ramifications of that may lead to social discontent once the realization sets in about how using taxpayer funds did not bring better opportunity for most. The only way out of this terrible boom and bust cycle is to allow the free markets to work.

Asset devaluation is a natural part of market behavior and while no one wants to see their assets lose value, you either have free markets or not, there is no middle ground. We constantly rail against China for manipulating its currency and urge them to adopt free market reforms, perhaps we should start following our own advice. Here is what I would hope to see in order to help us get back to equilibrium.

1. Raise interest rates slowly and steadily. It should be apparent at this point to almost everyone that             letting the banks earn record profits does not do a thing for the average American citizen.

2. Stop trying to convince people that their homes will always appreciate and never lose money. The             sooner we get people used to the idea of lower asset values the better we can deal with the crisis to             come.

3. Consider that historically a nation’s currency has been used to‘re-balance’ their place     in global             finance. We must match our true economic output and potential with dollar valuation. If that        means adjusting our currency to reflect our current situation, we need to take our medicine like    everyone else has in the past. Why are we different than any other nation that bit off more   than they could chew?

4. We must acknowledge that our standard of living has been propped up without a firm foundation        and cannot be sustained with current economic prospects. Stop borrowing to try and maintain the       status quo. It will not work and will cost us more in the long run. This is critical to future recovery.

Once the intervention fails the stock market will attempt to adjust asset valuations to match economic realities. That means either a long period of malaise with little forward progress or a shorter but deep corrective action.  I believe we will see the former if the Fed starts to raise rates to a more normal level soon and the latter if rates stay low for too much longer. I’m not sure which dose of medicine is best at this point but we can prepare for both.  In either case when the banks start loaning again, and all the money created starts to circulate, we could also see a period of high inflation.

 

How you are protected from declining stock values.

For those of you that are retired or very close to retirement, you have five years worth of living expenses in cash and short term bonds. A decline in the stock market will have no effect on the next five years of your life. If we do not see a recovery within five years, you have another three to six years worth of income in intermediate term bonds.

An investment in equities (stocks) always carries the risk of a decline in value.  For this reason any money that you plan on spending within the next five years is not invested in the stock market.  This five year time line gives us the opportunity to buy stocks when others are selling and prices are low, it also gives the markets time to recover, so we don’t have to sell stocks to raise cash for living expenses.

Younger savers have protection of a different sort, your allocation to stocks.  No one working with me has 100% of their portfolio invested in the stock market, that would not be smart investing and we are smart investors.  Your allocation to stocks was determined by your willingness, and ability to take risk. When markets decline we take advantage of the fact that stocks are “on sale”, we sell cash reserves and short term bond positions and buy cheap stocks.  Over the long run, we buy low and selling high.  As you near retirement your allocation to stocks will decrease as you no longer have the need, willingness or ability to take as much risk.

Inflation

Before we look at investment strategies, let’s review the underlying causes of inflation today.

The monetization of debt refers to using inflation (which reduces the value of each dollar) to pay off the national debt. Paying off the debt with somewhat worthless dollars can be politically expedient. That said inflation leads to many problems for investors holding investments in cash or investments denominated in dollars.

Growth in the money supply is a function of the multiplier effect, which picks up as banks begin to lend money. Right now bankers will tell you that low interest rates do not allow enough profit to justify the risk of loans. But artificially low interest rates will end, as the federal government needs to sell ever more Treasury bonds to fund deficit spending. They’ll need to increase interest rates on those Treasury bonds to make them attractive enough to sell. Higher interest rates will accelerate the multiplier effect as banks again find the risk/return relationship satisfactory to allow them to initiate more loans. More bank loans increases what is called money velocity. With the large numbers of dollars already in circulation, increased velocity will cause the money supply to grow rapidly. It is politically impossible for the new money to be somehow withdrawn from the economy before it causes inflation. Doing so would put us back into another recession. As inflation takes hold, the dollar will be devalued relative to other currencies. The higher cost of imports will add to the inflation we are likely to see in earnest soon.

How your portfolio is protected from inflation

1. Inflation-protected bonds: These provide investors with income and some protection against inflation. Every six month an inflation adjustment is added to the principal. Our investment in this area is the SPDR Barclays Capital TIPS Ticker symbol TIP.

2. Non-dollar denominated bonds: Owning bonds denominated in currencies other than the dollar offers a hedge against declines in the value of the dollar. They can provide income and also add diversification. This can be a good hedge on the premise that U.S. inflation causes a devaluation of the dollar. Our investment here is SPDR Barclays International Treasury Bond Index ETF Ticker symbol BWX.

There are many other investments considered a hedge against inflation. No doubt you’ve heard pundits pushing gold or commodities. My problem with most conventional inflation protection investments is that they are too expensive and way too volatile.

We are well prepared for the uncertain future ahead.  The most important lesson history teaches is to stay the course, follow a plan, and re-balance when given the opportunity.  As always if you have questions or concerns please let me know.



Share This On:
facebooktwittergoogle_plusredditpinterestlinkedinmail