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Will the sub prime lending debacle cause the entire lending and housing bubble to burst and extend to the overall stock market?

It took a while, but people are finally waking up to realize that borrowing beyond one’s ability to repay can lead to unwelcome results and when an entire nation does this and lives and consumes beyond its means – results can in fact be quite disturbing, indeed. So, now that everyone is crying “wolf” and talking about the potential aftermath and bloodbath that is likely to follow the lending / housing bubble burst, let us remember that this is only one side of the coin and the other side of this coin is inflation, yes inflation – really! The well managed devaluation of the almighty $ over the past couple of years (and with more to come, I am sure) means that “foreign” sourced goods now have a higher cost basis in $. So far, these costs have been mostly absorbed and have not reached the end customers, but that has recently started to change and we now see definite signs of “cost push inflation.”

Undoubtedly, expanding M3 money supply and easy credit that came along with it supported by foreign purchases of real estate along the US coasts and other “prime locations,” has led to inflation in real estate prices that is obvious to anyone from a shoeshine boy on Main Street to Donald Trump on Wall Street. Just as obvious these days is the energy inflation, but inflation on other goods has been slower to catch up, but that is about to change – there simply is no other way!

Need some proof? To combat rising fuel cost and reluctant to raise their basic rates significantly, freight forwarders and shipping companies like UPS, DHL and FedEx have all instituted indexed fuel surcharges in the past four years. On the other hand, there are no alternatives for shipping a 1 Oz first class letter – US Postal Service has a regulated monopoly on the service and this cost has been used as a good gage of “real” inflation. However, because of significant costs involved in implementing rate changes, the post office attempts to change these rates as infrequently as possible. In fact, in modern times (in the last almost 50 years), they have changed the cost of a 1 Oz first class stamp only 17 times (inclusive of the recently announced change on May 14th of this year). That’s once about every 2 ¾ years, on average. Changes that were implemented more often than the average, have only come during either the hyperinflationary period of 1974 – 1981 and in the past 8 years. (Raw data source.)

Now, let’s recall that baring any monumental changes, things generally tend to their long term historic mean. Thus, historic long term relationships between costs of various goods and services are very likely to be restored. If everything is managed “properly,” i.e. we don’t piss off China any more than we already have, Fed doesn’t raise the Prime Rate by 3% overnight, we don’t go to war with Chavez and etc., the real estate market as a whole will continue it’s recently started slide, while costs of the other goods will continue to rise.

Facing rising material input costs, smaller companies in some industries will no longer be able to stay in business, which will increase unemployment and therefore limit wage inflation. On the other hand, this will be great news for many larger US based companies, as they experience reduced competition and are able to hire better qualified workers for less and charge more for their products. (It will also make them more competitive in the global market!)

Will there be a wholesale drop in the market as people get nervous before this whole scenario plays out and/or due to a credit crunch? I don’t know – probably, but I don’t know when this drop will happen, what will be the starting point of the drop, how deep it will take us or how long it will last. What I do know, is that if I keep everything in the bank at 5%, I will certainly loose out to inflation, especially after Uncle Sam takes his “fair share” and Colorado bytes off another 4.6%. I also know that US Government needs inflation if for no other reason than to keep Social Security solvent.

What does all this mean for my investment strategy? Well, for one, I stay away from companies that are in the most at risk industries: lenders, construction, building material manufacturers and resellers, upscale manufacturers and retailers, restaurant and hotel chains, moving and shipping companies and etc. And, I would not touch a smaller company in just about any industry. Also, I do not buy stock in companies with large debt leverage that will need refinancing in the next 3 - 5 years or those whose book values depend heavily on their US real estate holdings.

The US companies I consider relatively safe at this point are large value plays in recession-proof industries – companies that have performed well through different economic cycles, have a strong management team, global exposure and sourcing ability, not flush with cash they do not know what to do with, yet with a clean balance sheet and sufficient positive cash flow to make opportunistic acquisitions and investments without negative impact on the financials. As the markets are rushing to ever higher highs these days, such companies are rather tough to find, but opportunities do come up on occasion, when market players overreact on a piece of breaking news, misinterpret results, or dump after analysts’ negative remarks or downgrades.

With the above criteria in mind, here are some bargains that I snapped up in the first quarter of 2007

US government deficit is not the reason the $ is down. If US government is borrowing money, it increases the demand for the money and increases the US interest rate. The increase in the US interest rate makes US assets more attractive and as the result increases the demand for US dollar. The higher demand for US dollar makes the dollar more attractive to foreign investors, therefore our currency appreciates.

Ok, let's assume for a second that everything really works the way it should and forget that the $US is a “Fiat Currency” which for decades now has not been backed up by any hard assets and that the Government, now that they do not even report M3 money supply, can print up as much currency as their hearts desire and no one is the wiser. But how can you also forget that Bernanke himself less than five years ago said that “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation?”

Now, how is this related to a huge budget deficit? The deficit forces the Government to borrow more and more money in order to avoid bankruptcy. How can they entice our biggest public debt purchasers to acquire more of the IOUs without interest rates going through the roof at an auction? Well, for one, you can sell that debt to foreign holders with whom you have a large trade deficit. They already have all those extra $ anyway, so why not put them to work and earn a marginally higher interest rate in the US than they would at home after converting the profits back to their local currencies? And the next time your trade deficit partners are ready to take the money out they realize that they would get fewer wons, rupees or whatever for their hard earned $, because $ lost ground, so they defer converting again until better times and buy more US Government bonds. After a while they realize that we owe them so much money that if they were to dump all these IOUs, the price they could fetch for them would be miserable little compared to what they paid. So they can’t do that, nor can they even stop buying our silly IOUs, because if they did, we would have no money to pay for their goods, so the best they can do is gradually reduce the value of bounds they purchase from us. Eventually even such bond purchase reductions (along with other factors) will cause bond interest rates to rise, thereby reducing value of previously purchased bonds and effectively decreasing our public debt in real terms. Bernanke’s job is to make sure this scenario unfolds as smoothly as possible!

And that, boys and girls, is the story in a nutshell. Of course, by the time all this unfolds, we better reduce the deficit sufficiently so that we can afford to pay larger interest payments on new debt, otherwise Bernanke will have no choice but to turn that printing press on full speed and that would spell disaster the same way it did in post World War I Germany, Greece under German occupation during WWII, post WWII Hungary, and war ravaged Yugoslavia on the early 1990s. Need I say more?

So why does your nice theory of large budget deficits leading to currency appreciation not work in practice? Many reasons, but mainly it is because investors (understandably) loose faith in governments that operate with ever increasing uncontrollable budget deficits and also to a large extent, because paper currency is not a scarce good, as long as the Fed can print more bills at will.

Dude, the economic side of your essay is totaly out of touch with modern Macro theory.

Dear Dr. can you elaborate what you found incorrect? I think he was write on a dime there?

If I would give someone an investment advice right now it would be:
1 If you have any equities that are double digit up in last couple of years, sell them.
2 if you want to buy, put your money in CD and wait the UNCERTANTY out.

I don't think he was giving investment advise per se. I think he was just trying to keep the topic going which I personally think is worth having.

Second he said he actually bought them right? That means if you want you now
keep track of his performance, also worth having for future reference.

Third, although I disagree with his investment timing I think the stocks he mentioned would do well if the market does well, so again I don't see anything wrong there.

But everyone is entitled to his own opinion. :)

There are two main causes of the fall of dollar
b) SLOW down in the real GDP of US economy
The inflation is not a problem during slow down in the business cycle unless the price shock (aka OIL price during 70s) occurs; so they fall of our currency will benefit local manufactures and instead of made in the rest of the world we will see made in the USA more often. In addition US imports as of share of GDP is not high enough to cause inflation in the short run.

You are 100% correct that the US Trade deficit is a big reason that the $ is down. Another reason is our ever growing budget deficit, which causes concerns among foreign buyers of US debt over our ability to repay it, so they slow down purchases and demand for $US decreases. There are, of course, other very visible reasons for the demise of the almighty $, such as ability (and projected future ability) to purchase commodities in currencies other than the $US, availability of higher return on invested capital in other currencies and etc.

As far as your claim that the decline in the $ will cause us to see more "Made in USA" labels, I would like to believe it, but frankly, I do not see it happening… Obviously, the $ slump should benefit domestic production with relatively lower costs, but by how much? It took companies decades to build up trust and infrastructure to move production offshore. They did that for many reasons, but the major driver was cost that was literally orders of magnitude lower in countries like India and China and now that they have made the multibillion dollar fixed cost investments and gained experienced with oversees production, moving manufacturing back to the US would be unthinkable. For this scenario to make economic sense the $ would have to fall not by 20% over a period of several years, like it has, but more to the tune of a factor of 3, at least and very quickly. Alternatively, labor costs in newly industrialized countries would have to rise by something like a factor of 10, or transportation costs, driven by the price of fuel would have to rise dramatically. Now, I am not saying that these scenarios are impossible, but if we are faced with any of these, we will have much bigger problems than dealing with a return of the US from a service based economy to a manufacturing one.

I am not a certified financial adviser, so I have no business giving stock market or any other type of financial advice. What I can do is share my thoughts and if they help put current events in perspective for some of my blog readers, I’ll only be happy. Also, as tempting as market timing is, I have never met anyone professional or amateur who has been able to do well timing the entire market. On the other hand, I have met plenty of people who made fortunes investing for the long term. The point of my entire essay, was to remind my readers to keep this long term perspective, yet to point them towards stock investments that may be safer at this time of extreme uncertainty. I was in no way implying that anyone should rush out and buy all the stocks they can, as soon as they can. However, it is never the wrong time to look for certain opportunities and be ready and not afraid to jump in, whenever you see them.

It remains to be seen but we know of a number of institutions effected by the mortgage debacle. It would be interesting to find out when the big ones to report the earning. Like the Wells Fargo, Washington Mutual and B of A. I think if the big ones begin to crumble we could have a full blown bear market on our hands if you add inflation on top of it this could last a while. Jake keep on posting I love to read your articles.

As far as stocks are concerned, ever since 3 years ago I only buy preferred stocks
that pay high dividend and also have options. I only do buy writes where I hold the stock and collect the dividend. My favorites to date are those that I have hold for a period of time are:

BPT and KMP however lately I am considering buy PFE because it's getting a lot of negative publicity and I usually consider it bullish for stock. I think I would buy it anywhere close to $25 or in that range. In addition WM (washington mutual) is also looking very good, considering a hefty dividend at 5/14 dividend. I think when it will test a $39 range it's a great buy with sell set at $45.

Wells Fargo has sold off many of their subprime loans, but continuess to service them. This is a very positive thing, as they reduced their risk significantly without sacrificing the revenueWells Fargo has sold off many of their sub prime loans, but continues to service them. This is a very positive thing, as they reduced their risk significantly without sacrificing the revenue. MDC Holdings is a home builder with low inventory of land and this limited risk. Nevertheless, I would not touch either with a 10 foot pole at the moment, because they are likely to take a big tumble alongside their brethren.

I think wfc is a bargain or rather will be a bargain after a 10% correction due
in May - June time frame. Considering it pays 3% dividend and you can sell
a cover call for protection. Personally I think it will double in the next year in a half if we don't have a bear market :)))))

Excellent perspective and writing, Jake.

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