When BusinessWeek agrees with you

For years, I have read those off-white, yellowish Business Outlook pages in BusinessWeak (sic.) with some disdain. The message is always loud, clear, and the same: The economy's great! Greenspan is a genius. And you really don't have anything to worry about. So increase your leverage. Invest in stocks. And go out and buy something you don't need (and increase your subscription while you're at it).

Now, just before sitting down to write this post - having crafted the bulk of it in my mind - imagine my shock as I sat down, looked at those yellowish pages, and read much of what I was going to write!

HEADLINE:
"Bernanke May Have His Work Cut Out for Him: If the economy doesn't cool down, rates could go higher than investors expect."

I will quote much of the article, as I am chagrined to admit, because it sums up my viewpoint better than I could have written myself:
"The latest UBS Index of Investor Optimism jumped sharply to its highest reading since June 2004...A bit less than two-thirds of those surveyed said it was a 'good time to invest in the financial markets.' In particular, investors don't seem overly concerned about inflation or interest rates...The results suggest that investors believe inflation will stay tame and that the Fed is all but finished raising rates. This expectation of perfect policy from the Fed is one of the biggest risks in the outlooks for both the financial markets and the economy...But what if the economy doesn't cooperate?...Also, despite the Fed's rate hikes and the runup in oil prices, the credit markets see even less risk in the economy now than they did when the Fed began tightening policy...

"Energy is once again adding to those inflation worries...The real danger to the economy and inflation is oil at $100 per barrel, the result of a classic supply shock, should actions in Iran and Nigeria result in a substantial drop in oil flowing to world markets...

"Watch the economic data closely over the next couple of months. If the numbers fail to imply that the economy is cooling down a notch, then the new Fed chairman could have a lot more work to do in 2006, a situation that would surely put a damper on investors' confidence."

And with that, the outlook ends!!!

To me, as a investor looking for that which the market and concensus opinion have not already caught, this article is worrying - not because of its content - but because lots of people are starting to write about the same stuff: higher oil, possibilities of inflation, a further rise in interest rates (short & long), and on top of all that, the chance all this growth will lead to slower growth - as interest rates rise.

This final point - the seeming paradox that growth that is too fast can actually cause a recession - is, like most things in life, not what it first appears.

My latest thinking to explain this phenomon - as well as describe the broader trend in the economy - is actually quite simple, namely:

Changes in inflation and disinflation SIGNIFICANTLY LAG changes in money supply growth. For example, when the Fed set the stage for massive money supply growth right after 2000, inflation did not appear at once. Similarly, when money supply growth began to slow in the late 1980's, a prolonged period of disinflation was not understood to be taking place until many, many years later.

If this theory (and it is just a crackpot theory - more reverse-engineered to explain observations - rather than based upon a detailed economic paper to back it up) is correct, the implications are profound. The profound implication is that the Fed sets policy too quickly, and that the damage has already been done by the time they set out to fix it. Money supply growth many quarters ago set inflation rolling, and the Fed can only now (too late in the game) raise rates and force the economy into recession. Even so, inflation may continue to occur, and we may find ourselves in a situation similar to the 1970's and early 1980's, when the Fed had to raise rates despite a massive recession to "break the back" of inflation.

Of course, the ensuing slowdown in money supply growth beginning in the 1980's set the stage for a period of steadily lower inflation, and eventually a perception that inflation had been cured. All the while interest rates were brought lower and lower, credit growth expanded, and by the mid 1990's, money supply growth began to accelerate again, speeding up significantly around 2000.

So as I doubt my own analysis and wonder why the burgeoning concensus opinion and I are no longer at odds, I go to bed thinking: hey, we might actually all be right! And when everyone starts to believe in inflation, that's when it really begins!

Sweet dreams of Oil futures and Gold bars...
And wow are those XOM LEAP calls looking nice! Up 50% since we recommended them at the beginning of this month.

What to look for in 2006

While we are sceptical of those making macroeconomic predictions, we are also warry of those unwilling to make bold enough predictions to help others actually make money.

So after much deliberation, we are going to lay out our expectations of how 2006 may unfold.

We think the big story of 2006 will be the price of Oil. We think Oil is going back through $70 a share and beyond. We think this price increase is being driven mostly on the demand side, as non-OECD countries grow their economies and increase their Oil consumption. Investments that have been made to increase supply will not prove sufficient to keep up with this demand. Already, we have seen a rising U.S. dollar towards the end of 2005, a possibily slowing U.S. economy, moderate winter weather, and yet the price of Oil has bounced off $55 strongly and now resides around $63 a barrel. We are not able to predict how high Oil will go, but we think whatever the final price, it will be a surprise for most people.

The other big story of 2006 will be interest rates. We think the Fed will be facing an unenviable dilemma: namely Oil and other inflation in conjunction with slowing economic growth. We expect the Fed to stop raising rates at 4.5% - 5.0%, with the likely final number being an awkward 4.75%. We think this rise in rates will severely hurt the housing market, which will flow through to the rest of the economy. We look for bad economic numbers (employment, GDP growth) beginning around March. To date, we have been impressed by how well the economy has performed, so we do think there is an outside possibility that the economic could continue to surprise. But given the fact that all the economic drivers of the past several years (housing, government spending, lower interest rates) are topping out, we believe an economic slowdown to be more likely. Despite the economic slowdown in the U.S., other economies may continue to advance. Japan's stock market performance, and China's, India's and Russia's booms may all continue, thereby driving the inflation of internationally-priced commodities. How the Fed reacts will be fascinating to watch. Our belief is they will be more inclined to lower rates, even as Oil advances, in order to keep the U.S. economy growing. If the scenario we forecast does emerge, we look for lots of confusion and volatility in the marketplace, as market participants attempt to disgest the meaning of this new paradigm.

So where should investors place their money in 2006?

• Have some Oil stocks. We like XOM Leap Options (string 70 2008s are our favorite at $4.2) as a good hedge against our forecasted Oil inflation. We also like PTF, a Oil trust that yields over 10% and pays dividends monthly.
• Short-term, high-yielding preferred stocks and corporate bonds. We think there are still a few gems out there that provide greater yield and less risk than most other debt instruments. Among these are GAJ and Amerco Series A. Both provide yields well above 8% will what we perceive to be little default risk.
• Some hedge against the U.S. dollar. While the U.S. dollar has performed very well in 2005 - a result mainly of interest rate differentials - we think the long-term fundamentals signal U.S. dollar weakness. We continue to believe that a conservative and well-managed portfolio should have some protection against the U.S. dollar. We think that FAX and FCO are good ways for the average investor to achieve such protection.

What to avoid?

• Financial services stocks. We think financial services stocks will perform badly throughout 2006. A flat yield curve, over-extended consumers, a slowing economy and housing market will slow growth across a variety of financial services sectors, including credit cards, mortgages, bond trading, and much more. We expect net margins to stay tight and defaults to rise. Not a pretty picture.

In the end, we don't think 2006 will be a terrible year, but one where it pays for investors to be cautious. Foreign stocks will likely continue to do well, although likely not quite as well as 2005. U.S. stocks are hardest to predict, and depend greatly on how much the U.S. economy slows. If forced to wager, we'd guess U.S. stocks will return around 5%, and that better returns can be had in the areas highlighted above.