This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Sunday, June 14, 2009

Signs of inflation

So far this year, the prices of 10-year Treasury bonds are down more than 27 percent. Of the various forms of Treasury debt, the 10-year bond is the most closely tied to mortgage rates. In fact, the Federal Reserve has been known to trade in 10-year Treasuries in order to raise or lower mortgage rates when it sees fit. The Fed is obviously losing control of the current situation, as Federal Reserve Chairman Ben Bernanke has stated repeatedly, their intent to keep 10-year Treasury yields low in order to keep mortgage rates down.

The result of this development is that, while prices for the 10-year Treasury have been falling, yields have been rising. Due to their close relationship, the rise in yield has led to an increase in mortgage rates, an increase that is not likely to be temporary. The message is clear: for those in the market for major financed purchases (homes, cars, boats, etc.), borrowing money is getting more expensive. The window Americans have had to buy with cheap money at depressed prices is closing surprisingly quickly.

This is, of course, a sign that the economy is improving. If you need more convincing, look no further than oil prices. Having fallen briefly below $35/barrel at their bottom several months ago, oil has since more than doubled, trading over $71/barrel this morning (June 10). Oil prices are an even better indicator of economic strength due to crudes role in manufacturing and transportation.

However, rising oil prices are also a sign of inflation, defined as an expansion in money supply without anything backing that new money. While the following illustration actually occurs as a consequence of inflation, it is a prime example of how inflation is recognized in the market, as well as the effects on the public:

• Once an economy bottoms, interest rates start to trend back up,

• When financing is getting more expensive, people don’t wait on big purchases, so

• Prices begin to rise as people do their buying before borrowing gets any more expensive.

For the past six months, since the Fed and the White House opened the bailout spigot, we have been watching inflation occur. Money has been created out of thin air to “rescue” banks, automakers, insurers, and even newspapers. The predictions that we make now, such as oil and gold prices rising, are based on the fact that new money has already been created. Based on what we know has happened, there are certain investments that will perform better than others.

The results of actions taken by the government have already been determined, but not yet realized in the market. Now, we play the waiting game. Once this economic recovery advances further, banks will resume more normal lending and much of the new money will begin to circulate through the system (this is called velocity). Once it does, the inflation that has already occurred will begin to be recognized in the market.

Now, the Fed and the new White House administration are caught in a perfect storm with both high unemployment and a coming of wave inflation. If this sounds familiar, think Jimmy Carter; the only question is whether the same fate will befall Obama. While the storm that’s brewing will have serious consequences for the America and its people, those who are invested properly have the opportunity to prosper.

In order to take advantage, we’ve compiled the following list of simple guidelines:

• Look at investments with a horizon of six months or more;

• Find investments tied to hard assets (commodities like gold, oil, real estate), which tend to maintain their value during periods of high inflation;

• We prefer foreign investments, since dollar is set to weaken relative to other currencies.

Investors’ appetite for risk is returning to the market (i.e.: stocks are up, riskier currencies are outperforming dollar and Treasuries are down). However, returns will be selective within market sectors and even specific securities. For that reason, we do not recommend dabbling in stocks; there’s simply too much risk in individual companies, evidenced by the past nine months. We prefer mutual funds for this, among other reasons. Talk to a financial adviser to discover some of the other advantages to using mutual funds.

While we don’t consider ourselves stock-pickers, we feel that we can gauge rather well what sectors should perform better than others. For example, the index of precious metal mining stocks traded on the Philadelphia Stock Exchange (XAU) is up 22 percent year-to-date. The 30-year Treasury bond, on the other hand, is down more than 40 percent over the same period.

The most important advice that we can give at this point is this: Keep contributing to accounts. The market continues to trend higher, and the public needs to be invested in order to prepare for the coming wave of inflation. Those who aren’t may not lose money, but they will certainly lose purchasing power, and as a result will find it much more difficult down the road to maintain their current lifestyle.

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