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2nd Quarter 2009

2009 Second Quarter Review

Is inflation a threat? Is gold a good investment?
Dear Friends,
Greetings – we hope you are having a wonderful summer! 
In our First Quarter Review we discussed the Four Indisputable Reasons the Economy will Rebound and answered the question, “Is this rally for real?” We believed it was, but expected a 5-10% pullback at some point. We got the 10% pullback and have since continued the rally to new recovery highs. So far, our thesis is right on. But will inflation derail the economic recovery?
2nd Quarter Review
The second quarter picked up where the first quarter left off, continuing the rally (started March 10) through most of June and leaving us with large gains for the quarter as economic data continued to show evidence of recovery. But many still question if the recovery is real. And, if so, will it be able to survive the massive inflation we are “sure to have” as a result of the government “printing” money? Let’s update some of our thoughts from last quarter then address the inflation question.
  • Investor Sentiment – Despite a massive rally, investor sentiment numbers are still relatively week, indicating many are not convinced the recovery is real. I also suspect these numbers may even be positively skewed as many “investors” have been scared out of the markets completely. *Based on American Association of Individual Investors AAII. 
  • Consumer Sentiment – While still not optimistic, consumers are feeling better than they were in February. In fact, retail stocks have been one of the best performing sectors in the market this year and a recent study by ShopperTrak RCT Corp. showed customer traffic at large malls is back to “prerecession” levels. *Based on Michigan Consumer Sentiment Index MCSI
  • Economy – Despite the persistent doom and gloom, positive economic news continues to grow. Consumer spending, trade deficit, housing prices, home sales, and jobless claims have all been improving. The evidence supporting an economic stabilization strengthened significantly this quarter as GDP for the second quarter was announced to be –1%, better than most were expecting, but right in line with our expectations. We believe the recession is probably over at this point. *Based on government indicators -
  • Healing in the Financial System – Healing has continued as many banks have come out with positive earnings and some have even repaid the TARP funds. Much of the healing has come from the surge in savings as the savings rate soared to 6.9% in May. While many have criticized the banks for “not lending”, in reality, banks are doing what they should have done all along – following prudent lending standards. The healing process will still take several years and it is imperative that banks maintain these standards. *Savings rate released by Bureau of Economic Analysis.
  • Inflation – See below. 
  • Unemployment – As expected, the unemployment rate has continued to climb, but job losses continue to fall, baffling many naysayers. We still expect at least 10% unemployment later this year or early next, but the worst job losses are probably over. *Based on data from US Bureau of Labor & Statistics
Inflation -
Since our last update, questions regarding potential hyper-inflation and how to prepare for it have easily outpaced any others. As the mainstream press and many popular talk show hosts seem to be in agreement (there is a first time for everything), inflation is a major threat. Or is it?
The most common arguments for inflation are based on massive increases in money supply from government “printing” of money. The most common “investments” to survive inflation are gold, other commodities, and TIPS (Treasury Inflation-Protected Securities). 
Of course, very few are presenting the other side of the coin, the truth, in our opinion. Note - It is also important to point out there are really two issues commonly lumped into the inflation issue, monetary inflation and devaluation of the dollar. Note II – the mathematical formula for monetary inflation is: Inflation = Money Supply * Velocity. Note III – to aid in understanding, we have purposefully avoided the most technical aspects of these arguments.
  1. Money Supply – Because velocity fell off a cliff last fall, the Federal Reserve, led by Ben Bernanke, wisely increased money supply to keep us from experiencing another “Great Depression.” As money supply by itself does not create monetary inflation, the risk comes when velocity returns. In recent testimony to congress, Bernanke said, “It is important to assure the public and the markets that the extraordinary measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation. We are confident that we have the necessary tools to implement that strategy when appropriate.” 
  2. Printing Money – the technical term for this is “monetizing.” While most people are disgusted by the government “printing of money” to pay for the stimulus, in reality, the vast majority of the stimulus has been funded with government borrowing, not with money printing. Naturally, the massive debts created as a result will be another issue we will have to face at some time. Many fear the solution will largely be monetizing the debt and significantly devaluing the dollar. This may come to pass, but it will likely be many years from now.
  3. Deflation Pressures – At this point, we are still facing deflationary pressures due to excess capacity in the system (manufacturing, employment, housing, commodities). When was the last time we saw such widespread wage decreases? Do you ever remember unions agreeing to wage cuts? Think of how much more you can get for your money today versus 12-18 months ago – housing, cars, fuel, milk. In order for inflation to become an issue, we will have to use up much of the excess capacity, which is not likely to happen for 2-3 years, if not more. 
  4. Death of the Dollar – It seems like every day we read another article about the death of the US Dollar and the fear the Dollar will lose its reserve currency status. We do not believe this is likely any time soon as Europe and Japan are in worse shape than the US and the Euro still looks overvalued relative to the Dollar. At this point, foreign central banks have continued to increase their dollar-based holdings, which indicates continued confidence in the safety of the dollar. However, we do expect the Dollar to depreciate somewhat versus many of the emerging currencies over the next 10 years. As long as this happens at a reasonable pace, this will be a good thing, not the disaster many believe it to be, as it will make our exports more competitive in the world market.
  5. Gold – As a result of the rampant inflation fears, many people have been rushing to “invest” in gold or other precious metals and commodities. While the perception of gold may lead to its short-term appreciation in an inflationary environment, in reality, gold has been the worst performing asset class over time, even failing to keep up with inflation. In our opinion, gold has very little, if any, intrinsic value. It has minimal industrial usage and produces no earnings or cash flow. So the value is solely determined by perception (supply & demand), much like baseball cards, Beanie Babies, or classic cars. When this perception changes, prices can drop very swiftly, leaving most “investors” with significant losses. We believe there are better ways to “hedge” the threat of inflation that offer better potential returns over time plus earnings & cash flow that helps protect against significant permanent losses.
If you read this far and your head is not spinning, congratulations! We understand this is one of many complicated issues or concerns we are all facing. Rest assured, we stay well informed on all of them, researching them from many different perspectives. We take the honor of serving you very seriously and work hard to help you reach your goals and dreams.
Kind Regards,
Darren T. Munn, CFA
Camelot Portfolios, LLC is a Registered Investment Advisor offering portfolio management services to clients. Branch Office is located at 1700 Woodlands Dr. Suite 100 Maumee, OH 43537. All disclosure documents and ADV II / Schedule F are located at . Please review the disclosure documents and ADV II / Schedule F before investing. Hard copies may be obtained by calling (877) 315-5558.
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