Think or Swim

There are times in the economy when crawling back into the womb is a very alluring thought. But life continues and we have a choice, repeat history or learn from it. During the dotcom bubble there was a phrase I grew to loathe, "the paradigm has changed." It hadn't. Only perception, fear and greed had changed in relative quanitities.

Having said that, this time it's different. Yes, that is the other cliche' I hated. It's never different. But since we have to go back beyond meaningful memory of anyone in this country, this time I think it is in fact different. The fundamental drivers of investment behavior have shifted and our hardwired attitudes will not be appropriate over the next decade.

The US banking system is insolvent. The US debt burden is reaching levels that are not business as usual. Discussion of nationalizing the country's largest banks is a daily occurance. The policy responses and real economic activity that will be forthcoming are going to be new and heretofore unacceptable. Other nations are in similar or worse conditions. Iceland, one of the go-go economies of the past few years is cooked. It turned itself from a small fishing nation into a rather large hedge fund. Now it is a defunct hedge fund.

By the estimates of some at the annual economic forum in Davos Switerland this week, 40% of global wealth has evaporated in the past five quarters and it is getting worse. What are the fuels to drive any investment positions higher?

In 1981 the Fed Funds rates was 16.39% as Chairman Volker took inflation by the throat and squeezed. That marked the moment of a secular change and interest rates began to fall over the next twenty-seven years ushering in the greatest bull market for bonds in memory as lower rates drove bond prices higher. Today the Fed Funds rate is 0.19%. Unless we slip into a truly deflationary environment, bonds lack a significant upside now. Baby boomers nearing retirement age are trained to believe bonds offer a steady and acceptable return. In the years ahead, bonds will offer negative real return and steadily declining value.

The major question still facing investors and policy makers is whether we are indeed facing longer term deflationary pressure or inflation ahead. We would do well to step back and discuss the nature of inflation. It is not a rise in prices. By definition, inflation is the increase in the supply of money. A rise in prices is the result of inflation, not the cause.

The creation of money in the public sector may be offset by the destruction of credit in the private sector, approximately four $trillion and counting. However any way you slice it the two trillion dollar deficit needing to be funded by someone, somewhere, is unlikely to attract willing contributors for essentially zero return. The "sound as a dollar" dollar looks suspect with fundamental strengths more resembling emerging market economies like argentina. we will be structuring client portfolios to reflect this future.

What will provide real investment gains over a reasonable time period is going to be with strategies and tactics unfamiliar to most people. The CNBC, Cramer style rant of the past decade has ill equipped many for the challenges and opportunities to come in the coming decade.

John Barnyak
President