Q1 2011 Market Review: It’s Time to Raise Interest Rates

Since the financial panic of 2008, I have generally been an interest rate and inflation dove. In my view most of the inflation damage was done from 2001 to 2007, not in the time after the financial crisis. The combination of the TARP and Fed policy halted a potentially deflationary downward spiral in prices and asset values. Now, however, the economic need for monetary support is over and business investment, which is and always has been the driver of self-sustaining economic growth, is rising again. Waiting for residential real estate investment and construction employment to recover before declaring economic growth self-sustaining would be as foolish as the mistake of the early 2000s when Alan Greenspan waited for technology investment to recover from the dot com bust even as real estate investment was roaring ahead. Today we effectively have the same situation in reverse. The market is sending its classic signals that global monetary policy is too easy. While I place more blame on the central bankers of emerging market economies like China, there are several market signals that are telling us that US monetary policy is too loose as well.

I have gradually come to the conclusion that our forty year experiment in using monetary policy to manage the economy has failed. Monetary policy has been used to drive up asset prices and support the use of financial leverage while eroding our purchasing power by encouraging inflation. Higher asset prices and supportive credit markets are great for the elites, who can use their knowledge of the financial markets and already ample capital bases to accumulate more assets. This state of affairs is harmful to the middle class, however. As inflation eats up middle class purchasing power, they have turned to borrowing to support their lifestyles. The middle class’ borrowing backfired royally with the housing bust of 2007-2011, yet the Fed’s economic remedy remains the same…encourage borrowing, support the financial sector and prop up asset values with ever-lower interest rates.

It is now time to normalize interest rates. The financial instability of wildly swinging interest rates, asset values and debt levels accrues to the benefit of the financial sector at the expense of the real business sector. If the Fed focused on policy stability, there would be far less need for hedge funds, commodities traders, bond traders, private equity funds and the seeking of profits via financial engineering. There would instead be more focus on trying to earn returns from actual investment in productivity-enhancing business investment. America has one of the most innovative and productive financial sectors in the world, but even I, a member of that financial sector, must admit that it has grown too large relative to the non-financial economy.

Interest rates

Source: Bloomberg, Vanguard Funds, tylernewton.com

The yield curve is telling us that inflation is expected to be well higher than the Fed’s target range of just under 2% for the 10 and 30-year time horizons. 5-year Treasury Inflation Protected Securities (“TIPS”) yields are negative, and treasury yields of less than 10 years are well below their equilibrium levels, signaling that the market expects the Fed to leave rates low for too long and then lose control of inflation.

The long end of the yield curve continues to offer the most value, particularly among treasuries and munis, even with the current market view of inflation. If inflation expectations come down, we could see another rally in long bonds.

The dollar

Source: economy.com

The broad real dollar index has for the first time punched well below 85. It is also trading at the bottom of the range relative to the major currency index as well. It should be noted, however, that dollar bear markets have tended to last about 10 years (1968 to 1978, 1985 to 1995), meaning that cycle timing-wise, the dollar bear that began in 2002 may be due to end and that the dollar may be ready to enter one of its periodic 7-year bull markets (1978-1985, 1995-2002). It may be time for the Fed to tighten if only to focus on strengthening the dollar a bit.


Source: economy.com, tylernewton.com

The ratio of commodity prices (CRB futures index) to the Consumer Price Index (CPI) is at the highest level since the early 1970s. Commodity prices are a leading indicator of broader inflation.

Most are aware as well that the price of gold, widely viewed as a neutral currency, has been skyrocketing for some time now.

Source: economy.com


The housing bear market continues, but may be nearing the bottom. Expect a rounded bottom in the housing market over the next several years, regardless of Fed policy.

Source: Standard and Poor’s, economy.com, tylernewton.com


My market valuation model (which uses inflation-adjusted trend earnings) shows stocks to be fairly valued currently.

The 6.8% return implied by today’s S&P 500 is driven by a long term inflation assumption of 2.8%. If inflation expectations drop, so will the stock market.


If interest rates get normalized on a schedule faster than the market currently expects, short and intermediate term interest rates will rise and stocks will likely fall somewhat. I don’t think the housing market would be affected, as the market is not moving higher even with the current ultra-low interest rates. So yes, tighter monetary policy would be a moderate negative for the financial markets. To this I am finally saying, “So what”? It’s time to wean ourselves off our need to surf from financial bubble to financial bubble and get back to the hard work of building the real economy.

Why the Fed Likes Inflation (And What it Means For You)

Why would the Federal Reserve Bank, who is holding interest rates at zero, be purposely trying to whittle away the purchasing power of savers in this country? Below are a few simple rules to understand how the Federal Reserve operates, why interest rates will likely remain low for a while, and why that’s good for stocks and commodities.

The remainder of this article can be found at the website Man Of The House.

You Need Skills to Pay the Bills

The economy has gone haywire and politicians and economists are in total disagreement as to what to do about it. Regardless, the key to getting ahead is to look at the world how it is, and not how it ought to be. The world is tilted toward those that are well-educated or highly skilled and jobs will continue to shift from classic middle-class occupations like manufacturing and back-office work toward technology, education, health care and leisure services. There are two choices: complain about the trend or join it.

The remainder of this article can be found at the website Man Of The House.


Catalyst Investors Blog: Real Time Bidding and the Rise of Mid-Tail Content

For those of you interested in online advertising technology, my colleague Susan Bihler and I have written a two-part series on the Real Time Bidding ecosystem and its effects on online and offline media. The second part is a discussion about how RTB will help the Mid-Tail publisher, how RTB will hurt traditional TV and cable advertising and how Google is well-positioned to dominate the market. (click link to see the article)

Market Review: Beware an Emerging Markets Inflation Crisis

Right now the only assets that aren't overvalued (according to my model) are long term treasury bonds and long term municipal bonds. You can be confident that this is likely true because it feels the most wrong. Global monetary policy is supporting stocks and commodities right now, even though they are artificially overvalued, and they should be expected to keep rising until the policy trend comes to an end. We should expect the trigger event for the next market takedown to be an emerging markets inflation crisis, which would cause the existing global policy trends to go in reverse.

Fixed Income predicts continued malaise

The bond market has changed very little from the end of 2009, although there was a wild ride in between.

(Data from Bloomberg.com, Vanguard Funds, Economy.com)

The fixed income market is telling us that the Federal Reserve will likely keep the Fed Funds rate very low for at least two years and maybe more. Policy should be normalized sometime between year 2 (2013) and year 5 (2016). After year 5, however, the market expects an extended period of higher-than-equilibrium interest rates all the way through year thirty (2041).

While the Fed's bond-buying program may be affecting the short-to-intermediate end of the nominal treasury curve, the Fed is not manipulating the inflation-protected market ("TIPS") which are pointing to low real interest rates and a return to normalized inflation after only several years of aggressive monetary policy.

The basic message that the market is sending is that the economy and the financial system will underperform for at least the next two years. This is consistent with my view that housing will remain weak through at least 2012. Housing weakness affects the collateral values that underpin most consumer and small business lending. Thus the deflationary undertow of real estate on the financial system will weaken both the supply and demand for these certain types of credit.

Housing remains overvalued

The Case-Shiller house price index points to real house values being 5-10% overvalued relative to their long term trend (which is about 100).

The Fed Gets It

The Fed understands all this, however. The Bernanke Fed is performing quite well under the extreme circumstances. All the hoopla blaming the Fed for inflation (which so far is showing up only in commodity prices), is misplaced. The real culprits in grand market manipulation and inflation-creation are the central banks in emerging market economies. They are refusing to rein in monetary policy by the proper amount because they don't want to let their currencies appreciate and potentially weaken their export-led growth models. It is rapid demand growth in emerging markets that is driving up commodity prices, not overheated monetary policy in developed markets.

The "Virtuous" Market Circle

So now we have a policy framework that is about as beneficial for equity and commodity markets as possible. Weakness in the real estate and banking markets in the developed world result in low interest rates. Corporate America, which is relatively unaffected by the real estate markets, is racking up profits as emerging markets expand and productivity surges. Emerging market policy makers are over-expansive for fear of hurting their export machines. Emerging market central banks thus purchase developed world assets, keeping interest rates low and asset prices high.

Stocks are still overvalued – but may remain so for a while

The S&P 500 is priced to deliver only a 6.6% long term return today.

Earnings are well above trend, as the playing field is tilted in favor of multinational companies at the expense of labor and small business. If domestic or foreign government policy toward multinationals was to change, today's record margins would shrink and earnings would return to their long term trend level.

This policy mix keeps interest rates artificially low, stock and commodity prices artificially high, and is artificially holding up housing prices. Stock prices are probably only one recession away from becoming cheap, however.

Historically, earnings yields (inflation-adjusted trend earnings divided by the S&P 500 level) in excess of 6% imply a safe time to buy stocks with a long-term buy-and-hold strategy. We're not quite there, but should expect the end of the secular bear market that began in 2000 to come with the next recession.

Beware an Emerging Markets Inflation Crisis

What would bring the policy circle to an end would be an inflation crisis in emerging markets, which would force them to let their currencies appreciate to slow their overheated growth. While this change would put an end to the great economic imbalances that bedevil the global economy today, a sudden policy reversal could be very disruptive. Interest rates and the dollar would rise and stocks and commodities would fall as liquidity dried up. My recommendation to world leaders would be to start making the necessary adjustments now. This is essentially the argument that the US and EU have been making to the likes of China for years and it has been falling on deaf ears. For now, the Fed will continue to stick it to the emerging market central bankers and stocks and commodity prices will continue to rise.

Investing in Bonds – Keep it Simple

Investing in bonds doesn’t have the same macho appeal as investing in stocks. Bonds aren’t always about betting on price appreciation; they are usually purchased for the simple purpose of generating interest income. It is possible to make money with price appreciation in the bond market, however, it means taking on a little bit of risk.

The remainder of this article can be found at the website Man Of The House.

Simple Rules for Investing in Stocks

Forget the hype. Investing in stocks is not a game. Unless you are a professional trader or a trained financial analyst on Wall Street, you should be wary about investing in and trading individual stocks. There is an army of well-paid professionals on Wall Street that are paid to trade and analyze stocks for a living, and they don’t beat the market as a whole.

Two rules for investing in stocks: keep it simple and diversify.

The remainder of this article can be found at the website Man Of The House.

Where to Put Your Money: The Basics

“Asset allocation” may sound like the kind of term used by rich money managers and Ivy League university endowments. In fact,  anyone with a savings account,  a 401(k),  a pension plan or real estate should be thinking about asset allocation. “Asset allocation” is just a fancy way of saying “don’t put all your eggs in one basket." By putting your money in several different baskets, you can reduce risk and potentially increase returns by diversifying your investments.

The remainder of this article can be found at the website Man Of The House.

Are You Your Biggest Investment?

When it comes to your investments, you might consider your 401k or your house as the most valuable. Little do you know that your biggest investment is your career. Your career is an investment like any other and once you determine the financial value of your career, understanding how to invest the rest if your portfolio becomes much easier.

The remainder of this article can be found at the website Man Of The House.