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, July 19, 2009

8500

The big question this week is whether the market has turned a corner. As I write this, the Dow Jones Industrial Index is trading back above the crucial 8500 level. We have considered this 8500 a critical pivot point.

If the Dow can stay above the 8500 point, it may be ready to advance further, following its recent correction. In any event, there are plenty of investors (myself included) that are breathing much easier with the market back up off its most recent bottom.

Some of this advancement is due to the Producer Price Index (PPI) numbers that were released on July 13. PPI is a reflection of prices at the wholesale level, essentially inflation before it trickles down to the individual consumer. When PPI was released, it was higher than the market had suspected, and stocks initially reacted positively to the news.

The next day, July 14, Consumer Price Index (CPI) numbers were released, and were also higher than expected. In response, stocks again showed strength. Furthermore, the dollar has resumed its downward trend in the currencies markets, weakening against several major global currencies, as well as commodities.

The big picture, as evidenced by PPI, CPI, and currency markets, is that inflation is picking up and the dollar is weakening. And lately the stock market has been reacting positively to any news hinting at approaching inflation.

This is because, despite being a four-letter word in many conversations, inflation isn’t inherently a bad thing, ITALespecially in this market. With all the new money created last fall, any signs of inflation indicate that this new money is beginning to circulate through the economy. This resumption of the flow of credit is exactly what is needed for an economic recovery.

However, that isn’t necessarily a bad thing. The Economics majors out there will recall that a weakening dollar does have its advantages on a global scale. First, it makes imports more expensive. Second, it makes American exports relatively more attractive in other countries.

Both of these things lead to increases in demand for American goods and services, which lead to increased production, lower unemployment; and a more healthy economy overall.

Unfortunately, inflation can also wreak havoc on an economy domestically. Just ask anyone who lived in the Weimar Republic. There are plenty of stories of wheelbarrows full of Weimar dollars being traded for a single loaf of bread.

Here’s a more relevant example: A typical American factory worker in 1970 was making $10,000 per year. Let’s say he retired with a $100,000 retirement plan, which was considered adequate at the time, and invested that $100k in a high grade corporate bond, which at the time were paying 6% interest.

This gave the retiree $6,000 per year, or 60% of his working income, which was considered plenty. To give you some perspective, in 1970 a new American car cost approximately $3,500.

Fast-forward to 1980, after a decade of high inflation and rising interest rates (a predicament which we are poised to see again very soon). The retiree is still getting his $6,000/year. However, a comparable new car costs about $12,000. Furthermore, if the retiree decided to sell his corporate bonds, the market price of the bonds he originally bought has fallen to about $57,000 because of the rise in interest rates.

Remember this: Bernanke is a student of the Great Depression. Since he was appointed Chairman of the Federal Reserve, he has maintained that he would inflate his way out of a financial crisis like the one we faced last year. And inflation isn’t bad — if you’re prepared for it. But if you aren’t prepared, look out.

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