May 2004
It appears that the above quote could be Alan Greenspan’s recent determination. His policy of promoting global growth using the lowest interest rates in 45 years is coming to a close. With risks of deflation reduced, and growth resumed, we now expect the Federal Reserve to seek “just the right amount” of inflation. We believe there is such a thing as “good inflation”, but only if investors simultaneously side-step speculative excesses caused by low interest rates and take advantage of other positive investment opportunities in the global market place.
In developing our current approach, we reviewed the basic inflation/deflation issues. We define inflation as “too many dollars chasing too few goods.” It follows, then, that deflation is “an amount of dollars chasing too many goods.” In the history of capitalism, it has almost always been inflation that one both hopes for, yet fears if too high.
In the 1970s, and early 1980s, Presidents Nixon, Ford and Carter fretted over inflation which was running as high as 10%. They used price controls and notions like WIN buttons (Whip Inflation Now) in order to tame the price spiral. The oil embargo made matters worse. Then Federal Reserve Chairman Paul Volcker implemented a crushingly high interest rate policy in response. In retrospect, it may not have been high interest rates that tamed inflation as much as it was improvement in American productivity due to technological innovation and a corporate focus on creating shareholder value. In any case, and fortunately, interest rates and inflation have been dropping for three decades now. The nagging inflation issue remains, however, and it is our job to determine whether this time we face good inflation, or bad inflation.
As we have written before, inflation has a way of hiding in different asset classes. The worst case, as in the United States during the 1970s is when prices of all goods rose rapidly, (too many dollars chasing too few goods). More recently, inflation has roved among sectors, sometimes hiding in the price of silver, oil, and dot.com stocks. Right now, one can look at the real estate market to see signs of inflation. The same goes for speculative technology stocks (Google might be the next example). However, many asset classes are not inflated. Selected Blue Chip stocks like Kimberly Clark, United Technologies and ITT Industries are far from overvalued. Likewise, prices of consumer goods, appliances and technological products are very reasonable.
While the prices of many basic commodities have risen smartly over the last two years (aluminum, steel and plywood prices are up 30%-40%), much of that rise is due to gigantic, and currently waning, demand from China. We expect China to grow in “fits and starts,” but the long-term impact is for Chinese manufacturing prowess to cause global prices to remain in check. The question is, then, are current inflation fears the result of “too many dollars chasing too few goods” or is it a rational, market-driven allocation of resources, followed by “just the right amount of dollars chasing too many goods from China!” We think the latter, and therefore, expect a temporary jump in inflation, modestly higher interest rates, and strong global growth and vibrant corporate earnings.
Before concluding, though, allow us to draw attention to potential risks associated with selected speculative excesses in real estate, the bond market and some equity holdings. First, in many locales home prices seem to have exceeded those justified by arms-length rents. This makes property appreciation essential for owners to have a return and may indicate a possible speculative bubble. Accordingly, we do not own any mortgage companies or home builders, and we have twice realized some of our outsized profits in home improvement retailer Lowe’s. The bond market may also be poised for a fall. We look to bond investments as a way to securely preserve client capital. In our view, it is “speculation” (not investment), when one buys a 20-year bond with plans to own it for months, days or minutes. Our average bond maturities are relatively short and we expect to lengthen them as rates rise.
Finally, the latest technology stock bubble remains a risk. Although a big problem for small technology companies, valuation remains spurious for many large ones as well. As an example, Cisco Systems trades at 70% less than at its peak, but is still valued at 24x its earnings before taxes and a whopping 34x trailing earnings. This compares to Johnson & Johnson who recently increased its dividend by 19%, and trades at one-half the relative value of Cisco.
In summary, we have positioned client portfolios to benefit as the world continues to grow on a modestly inflated basis. It is not only what we buy for our clients but, also, what we make sure they avoid. Therefore, we do not own long bonds, overvalued technology stocks or mortgage-related real estate investments. We do own short-term bonds and equity positions in 35 global Blue Chip stocks that, with light winds of inflation at their backs, can now pass along selected price increases for their products. We remain optimistic as history shows that stocks generally perform poorly while interest rates rise, but often do very well once rates stabilize. While Alan Greenspan “Trumps” the market by “firing deflation,” we expect to continue to preserve client capital and provide for long term growth.