Asset Price Inflation – October 2005

October 24, 2005

Dow Jones Average: 10,215
S & P 500 Index: 1,180


Asset Price Inflation

The three objectives of the Federal Reserve Board are controlling inflation, maintaining a healthy banking system, and encouraging economic growth. At first glance it appears that Alan Greenspan met the prime directives of the Fed in his seventeen years as chairman of the nation’s central bank. The United States enjoyed long periods of economic growth, loans were generally repaid, and inflation, as measured by the consumer price index (CPI), was contained at about two percent. Alan Greenspan was seen by many as a maestro, perfectly conducting the nation’s economic affairs. Some economists have postulated that cheap imports, outsourcing of jobs, and the inflow of foreign savings allowed the Fed to maintain a low interest rate policy, without fear of sparking the kind of general inflation of wages and goods that often accompany cheap money.

The type of inflation that resulted from historically low interest rates was asset price inflation. The major asset classes, i.e., stocks, bonds, and real estate, all appreciated tremendously in value throughout the past seventeen years. The Fed occasionally voiced concern about asset inflation, but largely stood by and watched it happen. Alan Greenspan became a hero to many, because their assets appreciated so much during his reign. The Fed only stepped in and tried to cool asset inflation when it appeared to reach bubble proportions, and became a threat to people of lesser means.

In our opinion, the Federal Reserve Board reacts more quickly to adverse economic trends that threaten people with limited financial resources. It is assumed that wealthier people can adjust to changing economic conditions. Lower income people do not own many assets, so they are not immediately affected by asset price appreciation or a decline in asset values. They spend a larger portion of their income on staples such as food, energy, housing, and heath care, and are negatively impacted by price increases on those basic necessities. The steep rise in real estate prices is starting to affect rentals, and the surge in energy prices is a great burden for people of modest means. The inflation that was reflected in asset prices is leaking into more general pricing of goods and services.

In reality the country has experienced a good deal of inflation over the past seventeen years, just not the kind that affected the whole population. The rising price of stocks, bonds, and real estate has made it possible for many investors and home owners to cover higher tuitions, medical costs, and energy bills. People who do not own many assets, and did not experience appreciation, are having a particularly hard time coping with the general inflation now occurring in rent, goods and services. The Federal Reserve Board can no longer provide the cheap credit that fuels inflation. The central bankers are being forced to raise interest rates, reducing the value of bonds, stocks, and real estate, in an effort to contain price inflation of goods and services.

Current Strategy

Finding worthwhile investments in an era of high asset prices is a continuing challenge. Investors have to be careful about overpaying for stocks, bonds, or real estate when the Federal Reserve Board is working to control further price appreciation through higher interest rates. Even though credit has been cheap and plentiful during much of the Greenspan era, there have been four periods (1990, 1994, 2000, and now) when the Fed felt it needed to tighten credit. In a rising interest rate environment investors assume that corporate profit growth will slow, while short term cash holdings provide a more competitive yield. Stocks do not attract as many buyers in such an environment. The recent, sharp decline in stocks indicates that buyers are reluctant to commit funds to the market.

We are buying selected stocks as prices decline, realizing that it may be some time before other investors bid prices higher. In the past six months we acquired new positions in AIG, Abbott Labs, and 3M at significantly reduced prices. We have chosen companies that should do well even in a slower growth economy. As investors move funds from some of the previously strong sectors, such as energy, we hope that they choose the kind of stocks we have been buying recently.

Our strategy with regard to fixed income investments has been consistent throughout the year. We are sticking to short term paper which has been going up in yield every time the Fed raises rates. We see potential danger in longer term bonds that can lose capital value as rates rise. The course of inflation will determine how high the Fed feels it needs to go with rate increases. Investors are hanging on every piece of data that may give a clue about the direction of inflation. When the Fed becomes more relaxed about inflation, investors will begin to commit more aggressively to both stocks and longer term bonds.

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