Today, March 5, 2013, the Dow Industrial Average reached a new high.  But is it really a “high”?  The price level reached today is indeed a new nominal high; however, adjusted for inflation the Dow is not higher than it was 13 years ago!  The graph above from The Wall Street Journal show the difference between nominal and real prices.  For investors this is very important to understand. 

The goal of investment is to grow your savings to outpace inflation (the general rise in prices).  The last real, or inflation-adjusted, record for the Dow was on January 14, 2000.  Although the Dow appears to have risen by 22% from the record high of January 2000, adjusting this increase for inflation over the same period of time still leaves the Dow 10% below that record! 

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Bill Gross from PIMCO wrote an excellent article recently titled “Credit Supernova!”.  It is a great, but at times a little technical, read.  Bill posits that the current global financial system is fragile due to its structure based on fractional reserve banking.  He explains how the system evolves toward crisis, and he shares some thoughts on what investors potentially could do. 

The global financial system is based on a fractionally reserved credit system.  A “fractional reserve system” refers to monetary policy requiring banks to hold only a fraction (typically 10%) of depositors’ funds as cash reserves.  The remaining 90% of deposits can be loaned out to create new deposits which in turns create new loans, and so forth.  This is known as the multiplier effect.  In other words, what Bill is saying is we are living in a world where money is “created” through credit creation – or a little more precise, the money supply is expanded when more and more credit is created.

Bill compares the global fractional reserve financial system to the force of entropy in the universe.  The universe is expanding so rapidly that everything will end with a “big freeze” (luckily for us a few trillion years from now.)  According to Gross: 

          “…the advancing entropy in the physical universe may in fact portend a similar decline of “energy” and “heat” within the credit markets.”

 Bill references the political economist Hyman Minsky’s financial instability hypothesis (which serves as the theoretical framework of my Master’s thesis examining the 2008 global financial crisis.)  Minsky’s main argument was that our current capitalist system was inherently unstable.  “Good” economic times eventually produce financial crises.

 Bill describes some implications for investors with regard to this fragile financial system.  I cannot agree more that credit is currently funneled increasingly into market speculation as opposed to productive innovation.  Asset price appreciation is now critical to maintain the system’s momentum and longevity.  Again let me quote:

          “…our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time.”

 Bill has the following suggestions for how savings should be positioned:

1. Position for eventual inflation.
2. Move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems.
3. Consider global equities with stable cash flow.
4. Start transitioning from financial asset to real assets.

Click here to read the entire article: http://www.pimco.com/EN/Insights/Pages/Credit-Supernova.aspx.

 Here is a link to LPL Financial’s Outlook 2013.  I don’t know how their research department came up with the percentage probabilities, but I would say there is a bigger chance of the bear path than what they predict.  Maybe 35-40 percent.  I agree that the most probable outcome is the compromise path.

http://www.sanddollarinvest.com/pdfs/Outlook2013.pdf.  Here is a link to the Youtube summary video of the report: http://www.youtube.com/watch?feature=player_embedded&v=7BEXH3MzquI.

Here is a link to a thought provoking discussion about the need for coordination between monetary policy and fiscal policy by Tim Duy on his blog, Fedwatch: http://economistsview.typepad.com/timduy/2013/01/safe-assets-and-the-coordination-of-fiscal-and-monetary-policy.html.

He quotes Kansas City Fed president Esther George, and Goerge’s quote really needs pondering.  I’ll repeat it here:

“But, while I agree with keeping rates low to support the economic recovery, I also know that keeping interest rates near zero has its own set of consequences. Specifically, a prolonged period of zero interest rates may substantially increase the risks of future financial imbalances and hamper attainment of the FOMC’s 2 percent inflation goal in the future.

A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system…The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

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