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Rebuilding the American Dream

            In The Deflation of the American Dream, I contrast the bleak outlook for jobs with the sunny outlook for corporate profits. American workers feel disconnected, and this is fueling both populism and protectionism.
            Unfortunately, the outlook has not improved, and unemployment is likely to remain above 9% through 2011. Government stimulus is not creating jobs, because it's not creating organic demand in the economy. As CautiousInvestor noted, Why would any business expand employment?
            In case that's not depressing enough, low interest rates and bulging deficits are hurting the dollar, and setting the stage for protracted inflation by 2011-2012. For now,  three temporary factors are keeping inflation tame:
  • Fed purchases are propping up the Treasury market, and reducing implied inflation.
  • The cyclical downturn in oil prices is depressing year-on-year inflation measures.
  • The credit collapse is causing banks to cut lending, which is offsetting government stimulus, and reducing both growth and inflation.
            Nevertheless, my outlook is not all doom and gloom. Even though the U.S. has some rough years ahead of it, I believe the economy will eventually adapt, and rebuild a firmer foundation for long-term growth. In the meantime, I expect tech, healthcare, and commodities to prosper as the global economy reflates. I also think that high-dividend stocks are a good hedge against inflation, as are select emerging markets.
            Below is an outline of how I see things playing out, and how I would position portfolios. The steps towards "Rebuilding the American Dream" are not meant to be exhaustive or sequential. I am just laying out some of the challenges ahead, and some of the opportunities.
Rebuilding the American Dream Requires Four Steps Down…
Despite a deep recession, the U.S. economy still faces painful adaptations that will take a few more years to play out.
1.     Government: We are swinging to the left politically, towards a larger government and regulation. This will shift Federal budget priorities to healthcare, and away from defense. There are signs of resistance to a larger government, however, and the pendulum shows signs that the swing to the left is complete.
2.     Consumption: American consumption must fall as consumers rebuild their balance sheets. In addition, the U.S. needs to reduce the trade deficits and the capital inflows that fund our humongous budget deficits. I believe the ongoing drop in American consumption is bearish for consumer stocks of nearly every stripe. (This includes consumer staples, since firms like Procter & Gamble (NYSE:PG) profit mainly from brand extensions and enhancements, and not cheap solutions.)
3.     U.S. Dollar: Erosion of the U.S. dollar is now de facto government policy, and will be used to shirk our national debt obligations. The decline in the dollar has been orderly thus far, but I assume that it could tip over at any time into a full-blown currency panic.
4.     Education: Higher education is in a "bubble" that has been insulated from the recession. The system assumes an unrealistic level of income from parents, and high levels of debt from students. It also assumes bright employment opportunities for college graduates. The drop in American living standards, however, will put pressure on enrollments, tuition levels, and staffing. 
…and Four Steps Up
Until the forces described above play out, American investors face stagflation. After the changes below take root, a sustained economic recovery can begin. To generalize, the recovery is based on debt retrenchment, and on technological solutions that consume less resources.
1.     Government: High taxes, huge deficits and the lack of jobs will cause the political pendulum to eventually swing back towards pro-business policies. This is essential to long-term economic health, and may require painfully high interest rates.
2.     Consumption: America must adopt energy-efficient and tech-savvy lifestyles to maintain living standards. This includes changes such as re-urbanization, telecommuting, smaller homes, smaller cars, etc. (In other words, it looks a lot like Switzerland.) My long-term outlook is bullish for tech, which benefits from the gradual, but revolutionary impacts of the Internet and nanotech. The focus should be on content creation in healthcare, entertainment, and software, and on global producers of technology and hard commodities.
3.     U.S. Dollar: Until the dollar stabilizes, inflationary forces will dominate. It isn't clear when the dollar will stabilize, or at what level. So until the outlook improves investors should focus on inflation and dollar hedges.
4.     Education: The U.S. must shift its students from universities to trade schools and to online education. These are more cost-effective solutions for the current economic outlook.
Investment Implications
Overweight: Dividend stocks, select emerging markets, energy/basic materials, healthcare, technology, capital goods, gold, TIPs, WIPs, and commodities.
Underweight: Treasurys, long-term bonds, the U.S. dollar, consumer discretionary, consumer staples, financials, defense.
Disclosure: Long TIP, GLD, USO, IVV