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Posted on February 26, 2007 -
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By John Reizner |

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We live in an era of particular asset appreciation. In spite of the much ballyhooed report of the real estate bubble bursting, I just saw recently on a financial news show that an 80 million dollar home/estate for sale had attracted more than one bidder, and that the bidders were, of course, in the financial field. Stock prices are hitting records. The price of oil is still high, and even the agricultural commodities are moving now. So where is all this commodity inflation now, what will it do to our stock market, and how does this relate to our past economic experience?

I remember having a conversation in the late 70's, the heyday of commodity price booms, with a Bear Stearns broker. I said, "Do you know what moves markets these days?" He said "inflation." Back then it was the obvious answer. Today it might be the extremely high level of corporate profits that keeps the stock market afloat. But can you imagine unemployment above 10%, sharply escalating prices for just about everything, and interest rates going sky high? I recall 27 years ago walking into a branch of a major New York City bank and being offered 19% interest on one year commercial paper. Can you imagine getting 19% today on a one year CD? Can you imagine paying 15% on a home mortgage? The reason why I bring all this up is that now economically we have it great compared to the seventies. Many people do not realize how good it is now. It is almost scary how good it is. We can attribute this satisfaction to the triumph of and eventual adherence to the principles of free market capitalism (major interference in the economy can have large unintended effects), free trade, and an enlightened Federal Reserve. On the other hand, when things look most rosy and optimistic, should that condition becomes a mania, a bubble in society, then it is most prone to serious and lasting reversal. At the peak of the 1970's and early 1980's inflationary spiral, the gold price eclipsed $800 in a mania, and there was no shortage of doom and gloom regarding stocks. Twenty seven years later, gold is only now recovering. However stocks were cheap back during these inflationary times. Price earnings ratios, a common measure of value in equities, had contracted dramatically. Stocks were on the bargain table. And few analysts were aware of the long term potential of equities at that time. Of course, today we experience comparatively rich prices for equities, with price earnings ratios that are much greater than the distant past of the 1970's. The bull market in commodities in the 1970's occurred simultaneously as the difficulties in equities. Contrarian style thinking, thinking against the crowd, finding value, is always good bedrock to successful investing. I have written about the contrarian style of investing in another article, titled Stock Market Investing and the Power of Contrary Opinion.
There was also a mania for internet stocks during the late 1990's. The reason, in my opinion, why the economy and the stock market did not fall into more desperate economic straits than they did after the stock market technology bubble burst in 2000 - was Alan Greenspan's policy of lowering interest rates dramatically and pumping money into the system from his position as Federal Reserve Chairman. The Fed also became worried for a while that the economy might sink into deflation. Had we not had a Federal Reserve Chairman with the experience and knowledge as Alan Greenspan, the result after the bubble burst in 2000 could have been dire. As during other recessions and crises, providing liquidity and monetary stimulation, with a time lag, brought the economy and the stock market out of a possible deflationary condition. In other words, once again, as happens in recessions, Federal Reserve easy money saved the day.
But what about now? I think the fact that the market has done so well in the face of an inflationary like oil commodity boom (though oil has come down some lately),could be an indicator that this commodity based inflation scare could be over, that the stock market could sail on. Nothing would please me more! Of course in the meantime we have been treated to an oil and oil service company stock price boom, just as happened when the oil price was escalating during the late 1970's.
What about this inflation scare and the market now? Taking the other side of the market that we are going down the path to greater inflation, I say this: sometimes one needs to turn a chart on its head. Just as when the gold charts (a measure of reflation) at $300-$400 an ounce "looked bad" because they were showing an extended time of depressed prices for the yellow metal, it really meant that the gold price has been going through a long process of becoming undervalued for years: in other words, it became a relative intermediate term bargain. It did not really "look bad" (gold is now over $600. per ounce). The fact that until very recently, inflation has been very low, may indicate in some manner that the psychology of inflation is suppressed in our economy today and that as a result we are susceptible psychologically to inflationary surprises. Inflationary expectations are a psychological condition in consumers and companies, whereby an inflationary momentum builds in the economy because the participants see that prices are increasing, and they have the belief, the expectation, that prices will continue to increase. Thus, prices are marked up and a cycle of increasing prices begins that is very difficult for the Federal Reserve to stop.
The end of disinflation in a substantial sense down the road would put a lid on stock prices for a while. Remember that the stock market was in a trading range between 1966-1982 during the inflation that began and built during those years. At the beginning of an inflationary economy, people have extra money in their pockets due to asset inflation. Their balance sheets improve, due to the excess increase in the value of their homes, etc. They become good consumers at this time, shopping at the malls with this extra money and propping up the economy. Things may look good. Prices will not have started to escalate rapidly. We may be at that point now. Whether inflationary expectations take hold and build into a spiral remains to be seen. On the other side of the spectrum, I think the current Federal Reserve Chairman, a student of the Great Depression, is savvy enough to avoid a serious deflation of assets, where most assets decline in value, including both real estate, commodities, and equities.
Given that, what is the prospect for stocks during 2007? The third year of the President's term in office is usually positive for the stock market. You cannot ignore this. It also pays to be a student of the Federal Reserve movements. Rate increases, especially discount rate increases, are bad for the market, and discount rate decreases are generally good for stocks. But in line with the philosophy and method I describe in my eBook, A Way to Wealth - the Art of Investing in Common Stocks, a long term view is best, with the emphasis on individual stock selection and long term mutual fund ownership. My eBook is available here.




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