AHEAD OF THE CURVE
Time for a Change
Monday, June 19, 2006
Now that we're at the end of the rate-hike cycle, you should sell what's been working for you.
The following is an "Ahead of the Curve" column published June 16, 2006 on SmartMoney.com, where Luskin is a Contributing Editor.
What can I say but, "Whew!"
For a while it looked like stocks were going to fall — and fall hard — every day until they hit zero. Scary in any event, and especially for me as I have been writing in this column that this would be a buying opportunity. Well, I know that being right too early is like being wrong. But that's a lot better than being wrong too early.
So no crowing here, but I still stand by every bullish word I've written over this last month of stock-market decline. The particular timing and nature of this week's turnaround in stocks convinces me, more than ever, that my basic premise has been correct: The Federal Reserve is going to act decisively enough to quell inflation risks, and in time to do so with interest rates that are not so high as to kill the economy.
Just think about when the stock market recovery started this week. It was following Wednesday morning's announcement that the core Consumer Price Index had grown by 0.3% in May — the third month in a row to register that same very high inflation number. Bad news, right? Hasn't this whole decline of the last month been an inflation panic? Why should that rally stocks?
Simple. Because Wednesday's May CPI put the inflation problem right out in the open where nobody can dispute it. I've been warning about rising inflation risks in this column for more than two years, and I've been a voice in the wilderness. Now we can all be agreed on what's real — and what needs to be done.
And now that we are agreed, we can be sure that what needs to be done will be done. Until a month ago, plenty of reliable inflation indicators were going into the red zone, because there was no confidence that the problem would be recognized and addressed. Gold had soared to quarter-century highs. The U.S. dollar made new cycle lows. And the TIPS spread — the difference between Treasury bonds and their inflation-indexed counterparts — had moved wider.
Now all those indicators have violently reversed. Fed chair Ben Bernanke and other central bank officials have made it clear that inflation-fighting is job one. We're on our way to the inflation problem being over.
And, thankfully, the recognition comes in time so that the cure won't have to be worse than the disease. Considering how far markets like gold, the dollar, and the TIPS spread have retreated from inflation-panic levels, it looks like the Fed won't have to raise interest rates much beyond 5.5% to do the trick. That's two more quarter-point rate hikes at the next two FOMC meetings. And then — voila! — it's over.
Does anyone seriously think that interest rates at 5.5% are going to kill this economy? I suppose there are those who think the economy is going to roll over even at today's rates. But those are the same people who said the economy was heading into recession when rates were still at 1.5% and again when they were 2.5%, again when they were 3.5% and 4.5%. The perma-bears have been perma-wrong. That's not going to change now.
Here's a factoid for you: Since 1984, 5.5% happens to be the average short-term interest rate. Over the same period, real gross domestic product growth has averaged 3.4%. So what, exactly, is so bad about 5.5% interest rates?
It's not going to be all sweetness and light from here, though. We're at the end of a rate-hiking cycle, so we're entering a whole new world. The investment strategies that paid off the biggest over the last three years aren't likely to do so again. In fact, they're likely to do the worst. People are going to get hurt. Investors need to adapt — or die.
Think about what has done the best over the last two to three years of unusually low interest rates and rising inflation. It's the end of the road for the all the investments that depended on those things.
The one everybody already knows about is housing. I'm not forecasting a housing crash, but there's just no way that that housing market isn't going to at least cool off here. I don't think that's the big problem for the economy, but there will surely be a lot of empty condo towers in Miami and Las Vegas — and some former day traders who have recently become real estate agents who are going to be rather disappointed.
The speculation in commodities is over. Gold. Silver. Copper. They were all bets on inflation fears getting worse. Those fears have topped out and are heading lower, and so are the commodities that have fed on those fears.
The nations that produce commodities — mostly emerging markets — have topped out, too. They've benefited both from the rise in commodities prices, and the fall in the value of the dollar. In an important sense, that's saying the same thing two different ways (they're both symptoms of inflation). But for Americans holding emerging-markets investments, it's a double whammy. The commodities prices underpinning the emerging economies will collapse, and the exchange rate between the currencies of the emerging economy and the U.S. dollar will collapse at the same time.
Japan is the most vulnerable emerging economy of all. How can I call a mature country like Japan "emerging?" Simple. Japan has been struggling for years to "emerge" from a devastating decade-long monetary deflation. Its central bank, the Bank of Japan, has declared victory in the war on deflation, and it's now tightening. Big mistake.
That's because it's happening at the same time as the Fed is tightening even more, which is causing the dollar to appreciate vs. the yen. So the Japanese Ministry of Finance no longer has to intervene to weaken the yen to keep it competitive — and that intervention was key to the recovery from deflation. With no more easing and no more intervention, Japan is likely to slip right back into a deflationary recession. Is it too late to sell the Japanese stock market? Maybe. But I sure wouldn't be a buyer.
The end of the road for inflation plays applies to oil and the stocks of companies in the energy industry. Yes, part of the story there all along was global growth, and I expect that to continue. But when the inflation story is taken out of the equation, at least half the energy thesis is stripped away.
My institutional-investor clients are acting very resistant to accepting these new realities. It's always hard to give up on "what's working." But it's time to get real. "What's working" has stopped working. It's time to find the next play, not cling to the last play.
What's the next play going to be? Honestly, at this point I don't know and I don't care. For now the money is going to be made by what you don't invest in, not what you do invest in. Ask yourself: Are your investments dependent on rising inflation? Rising commodity prices? Falling dollar?
If so, then there's only one thing to do. Get out. The world has changed.
http://www.trendmacro.com/a/luskin/20060619luskinSMC.asp
