My Market Friend…

For love…. and money..

Investing success,  just like marital success, is a determinant in the quality of one’s life. As such, we should approach the endeavor with prudence and conservatism. We should always keep an eye on the results that we are achieving and be willing to make adjustments, just as we are attentive to our spouse’s happiness and well-being making adjustments accordingly. While we may not achieve perfection, we nonetheless continually strive for excellence.

The goal of most marriages is to increase the love and happiness of those involved. The goal of investing is likewise quite simple: Increase one’s purchasing power over time.

Paul Kluskowski’s big strength is in having the discipline and training required to keep market losses within acceptable parameters. Rather than just buying, holding and hoping- Paul has a track record and a strategic plan for each of his clients to manage accounts playing BOTH offense and defense as appropriate.

Looking for a better way? Need a second opinion?

Beyond just management, but someone who is in your court, on your side, managing your assets.  Give Paul a call today!

Paul Kluskowski
Investment Manager
202-244-8210 office
202-421-4466 mobile

As a Physics grad, I am more than a bit familiar with the work of Einstein. While I did struggle a bit with General Relativity and its associated Vector Calculus, I do readily understand Albert’s assertion that compound interest is the most powerful force in the Universe. Like his theories of Relativity, it is a simple concept with profound implications. Save some money, collect your interest, re-invest it and earn interest on your interest. Over time, the results can be staggering. For decades, this was the essence of building a comfortable retirement. Save your money and let compounding work its magic. Ah, for the good ole’ days. In today’s world, the Fed and governments around the world have managed to neutralize the Universe’s most potent force. Through their combined efforts to gain and sustain economic traction, interest rates, short and long, are at record lows. With five-year Treasury rates at essentially 1% per year, notice the effect it has on the compounding of a person’s money. In a world of even modest interest rates, a person should be able to double his money at least every 15 years through compounding. Yet in a “stimulated” world, the rewards are far more meager. So if savers aren’t being stimulated by all of this stimulus, then who is? And more importantly, what’s a good saver to do?

The idea behind monetary and fiscal stimulus is that the economy needs to expand which is facilitated by lending money. This lending is presupposed to spur industry expansion and job creation along with asset creation as in new housing starts. This, then, leads to increased consumer spending which creates a virtuous cycle of sustained growth. If economic growth slows, then simply lower short-term interest rates to entice more lending. And, the cycle will be moderated much like the speed of a car is moderated by the accelerator pedal. In previous recessions, this method has been generally effective at keeping the American economy on the upswing. Following the economic one-two punches of the Internet and housing busts, however, something changed. Lowered interest rates that once would create demand for additional loans were being ignored, even shunned, by the masses. Now, rather than banks borrowing short-term money to facilitate long-term loans to businesses and consumers, they are simply buying long-dated Treasuries. Money that once would have found its way into the American economy and paychecks is now being recirculated amongst the banks. The net effect of this recirculation has driven 10-year Treasury rates below 2% at times. Money intended for economic growth and expansion has instead simply lowered long-term rates with still no stimulus effect for the economy at large. It appears that a glut of existing debt and bloated balance sheets has cured the appetite for further borrowing.

A similar situation is playing out in Europe. Where many Americans financed income and expense gaps with ever-growing mortgage debt, European nations did likewise with governmental debt. Unable to meet the obligations of generous government pensions and benefits, less-productive European nations issued AAA-rated debt thanks to their membership in Club Euro. European banks eager for yield absorbed this dubious debt with no reserve requirements in most instances. This has the European Central Bank facing a potential financial wildfire as the Euro weakling Greece teeters on the brink of bankruptcy much as Lehman Brothers did in 2008. With Greek debt on the books of so many banks, anything that resembles default could topple enough institutions to re-commence the global recession. This, then, provides the basis for the race to lower interest rates through printed money.

Certainly, the effect of lowering rates of all durations has provided some benefit to those in a position to borrow, or refinance their home. It has also provided an opportunity for some corporations to issue new debt at lower rates to retire higher interest bonds. Ironically, however, it appears that the rate effect has been of benefit to those banks that caused the housing bubble and bust in the first place. In our particular situation, US banks held a great many mortgage bonds which we now know were of questionable quality. Nearly all of these bonds were backed by mortgage giants Fannie Mae and Freddie Mac. When it became apparent that the AAA stamp from Fannie and Freddie was in fact flawed, the US government was forced to honor the mythical implicit guarantee of Fannie and Freddie’s backing. Bonds that, in any other world, would have defaulted were instead back-filled by US taxpayer dollars allowing them to soar in value as interest rates plunged. For the holders of all that mortgage debt, this has no doubt been a stimulating experience. For the US taxpayer, however,… And, this is the debate now taking place amongst the European governments as I write.

Irony aside, in a world absent yield and the resultant compounding, where is one to look for respectable returns absent undue risk? This is the dilemma presented to the conservative investor. Without the safe haven of risk-free, interest bearing instruments, risk becomes the only option should one seek yield. For us, this has been largely dividend-paying stocks. The associated risk is that the stock market has been generally rocky these past few months as everyone comes to grips with the European debt crisis. A 10% decline in stock price can quickly erase months of dividend payments leaving one in the red. Another strategy is the purchase of discounted corporate bonds. These are bonds that are selling at a “discount” to their face value. Generally speaking, a bond will sell near its face value of $1,000. A variety of factors can influence this price. What usually causes a bond to sell for less than face value, or at a discount, is that its creditworthiness is questionable. Most bonds selling at a discount today are below investment-grade. This implies more than a passing chance of default (read risk!).

With the Universe’s most powerful force at least temporarily suspended, the coming years will continue to prove both interesting and challenging. The global debates regarding safety-net provisions will undoubtedly rage on as costs continue to overrun ways and means. The institutions “too big to fail” may yet lead to discussions regarding governments deemed too big to fail. It is as economist Gary Schilling titled it “The Age of Deleveraging.” Every right-minded person and institution alike is striving to reduce its indebtedness to ensure survival forcing governments to do the opposite to stimulate growth. It’s a financial tug-of-war that’s more akin to a shoving contest. In the end, I will still put my money on the Universe.

A good portion of my investment management career has been spent grappling with bear markets. I was hardly 6 months in the business when I encountered my first. Still relatively inexperienced, I somehow managed to get most of my clients through it without any permanent harm simply by selling those stocks that were declining. Yet, there was one client who would not be spared. Holding a very large block of WorldComm stock, nothing I would do could prevent this client from making choices that ultimately turned a one-time $2 million account into $3,000 when it was all over. Not only did this early experience give me great reverence for the power of a bear market, it also showed me the role of personal psychology in the management of investments. This particular client could not bear the thought of selling the stock at anything less than its peak value of nearly $60 per share. If only it got back to $60, then the client would be willing to sell. At numerous points along the way, this client could have sold out and preserved some portion of the account’s peak value. Instead, in spite of my numerous lectures, pleadings, strategies, etc, the stock was held all the way to corporate bankruptcy. Broken not by the bear alone was this client, but also by an unwillingness to stand aside and let the bear pass.

            When the big bear of 2008 set in, it was a very different experience. Sensing something was amiss in late 2007, we were largely in cash as you may recall. As 2008 and 2009 progressed, the wisdom in this approach became apparent. I was inundated with reports from the clients of other advisors telling of substantial drawdowns in their accounts. When I asked how much selling had been done, the answer was always the same: none. Again, the unwillingness to sell and avoid dangerous markets showed its damaging effects. As I write this article during my much needed annual getaway, I once again find myself surrounded by bears of all sorts: bear carvings, bear skins, bear photos, and yes even real live bears (or so I am told).  Sitting here in northern Wisconsin’s bear country I cannot help but think it’s best to let sleeping bears lie. As for those on the prowl, standing clear seems the only sensible act.

 It appears that our markets and economy are similarly surrounded with signs of bears. Much of the “recovery” in the past two years has been driven by the government’s policy of quantitative easing. This practice of printing money to buy government debt has held interest rates at unnaturally low levels in an effort to stimulate borrowing and subsequently growth. Certainly it has created an ideal environment for purchasing a home for those who can meet the stricter requirements. It has also driven commodity prices as investors swap ever-increasing dollars for hard assets in an attempt to protect their purchasing power. All of us have felt this at the gas pumps and grocery stores. Unfortunately, far fewer have felt the intended effects in their paychecks. Hovering near 10%, persistent unemployment remains one of the biggest bears circling the markets today. Without stable employment, and clean balance sheets, few are willing or able to borrow, even at record-low rates.

            Governmental budgets and debt levels are recent additions to the bear clan. Across the Atlantic, the woes of Greece are on public display as the European Central Bank’s austerity directives sink into the collective consciousness of the Greeks. Not far behind is Italy whose retirees are in serious trouble due to dwindling government pensions and supplements. Much closer to home, the Minnesota government has been largely furloughed as state legislators work through a $6 billion budget gap. Without raising taxes, there is only one way out. On a much larger scale, our own federal government is struggling with its debt problems.  Faced with the prospect of insufficient funds to make its interest payments in August, along with threatened ratings downgrades, the leaders of our nation are discovering that deficits do matter. 70% of recent Treasury bond purchases have been made by the Federal Reserve, not foreign governments as was once the long-standing situation. Lack of foreign appetite for our government’s debt is a bear that could live a long life.

            Once the backbone of the American economy and workforce, the manufacturing sector has been in its own  bear market for years. Many of the nation’s rust belt cities bear testimony to this: Buffalo, Pittsburgh, Cleveland, Toledo, Detroit.  Visiting any one of these municipalities brings to one’s senses the effects of long-term economic hardship. From 2001, an estimated 42,300 American manufacturing facilities closed their doors. Three quarters of those employed 500 or more people. Each job lost represents one family affected. Many jobs lost represents entire communities being affected, some of which never recovered.

            If there is a singular explanation to these many and varied conditions that we face, then it most likely involves our diminishing role as the world’s economic powerhouse. Beginning at the end of WWII, the US had a unique advantage over the rest of the world: we did not fight that war on our land. This left us with the manufacturing muscle to provide a rebuilding world with everything it needed and wanted. This production capacity coupled with an abundant education system allowed the US to lead in both production and innovation. American agriculture still reveals this truth today. Thanks to ever-improving seed and horticultural breakthroughs, American farmers remain the most productive in the world. Years ago, land that produced 100 bushels of corn was considered an accomplishment. Today, even non-irrigated ground can be coaxed into producing more than 200 bushels per acre. This is an American industry for which we have a trade surplus with the rest of the world. So, there seems to be some validity to the notion that production and innovation are effective bear repellants.

            The next few weeks will bring more clarity to the impending debt crisis. Most likely, the debt ceiling will get raised and the USD will continue its descent relative to other currencies. Less likely, but still possible, is that the US would default on some of its interest payments while cutting costs and raising taxes. Unfortunately, neither is a best-case scenario. In the meantime, we will continue to proceed with due caution and sit when sitting is the sensible approach. Just as it pays to give reverence to the bears of the northwoods, the same holds true for the metaphorical bears of finance and economics.

 Financial reality is a constraint by which we are all seemingly bound. We have money to spend on goods and services to the extent that we have steady income or surplus reserves in the form of savings and investments. During those times when we must spend beyond our means, our savings are depleted. Perhaps we begin to accrue debt. That debt remains on our balance sheet until we erase it by living below our means and direct the excess to debt reduction. This very simple financial principle holds true for all of us: individuals, corporations, municipalities, states. This principle binds us all save for the US government. Using the Federal Reserve and the Treasury Department, the US government has a power that many people would love to possess, the right to print money. Should anyone else attempt such a deed, it is considered the crime of counterfeiting. When the US government prints, it is called Quantitative Easing.

The concept is certainly well-intended. A tremendous amount of wealth in the form of bonds vaporized in the great liquidity crisis of 2008. The financial world was neck-deep in mortgages, many hardly worth a fraction of their face value. As that reality came to the collective consciousness, billions of dollars were wiped from the ledgers of the major money houses. Wealth and money that once existed was gone in a New York minute. To prevent a complete collapse of the banking system, the printing presses went into overtime. Fearing a deflationary depression brought on by a rapid and severe contraction of the money supply, the Fed chose to devalue our currency with the printing presses. To get this money into the system, the Fed began a steady purchase of treasury bonds. And, these have not been small purchases.  According to a recent report by bond king Bill Gross, the Fed currently accounts for 70% of Treasury bond purchases. Through the process of printing and buying, the Fed has been able to hold the 10-year interest rate down to 4%, give or take. The desired outcome has been that borrowing would begin again and economic growth be stimulated. Certainly growth is exactly what we need right now. This most recent recession has seen industrial output decline by over 17%. No recession since the Great Depression has left such a mark. To drive this point even further, a recent Business Week article depicts the 60-year decline in American male employment. Peaking at 85% of working-age men in the civilian work force back in the 1950′s, that number has been reduced to less than 65% today. Stated in converse, 35% of working age American men are not employed in the civilian job market. So, if we are not growing our economy and putting people back to work, what are the effects of all this printing?

When money is cheap as it is now, it often flows to real assets as people trade paper for tangibles. In the early 2000′s, that meant housing. Now that we have all been reminded that what goes up can come down, we have an overabundance of homes with scant few who can buy them. No amount of stimulus can create buyers for homes that exceed the legitimate need. There are more houses than people and it’s just that simple. As an alternative tangible asset, raw materials and commodities have been drawing a great deal of money. One look at the commodity index below shows a clear trend. Comprised of energy, grains, livestock, metals and “softs” (cotton, sugar, coffee, etc) this index has been steadily climbing since April 2009. Coincidentally, this date aligns with the beginning of QE 2. While this benefits grain farmers and other raw goods producers, everyone downstream is paying the price in the form of higher consumer prices. Interestingly enough, soy bean prices have gone so high that Brazil, a major soy bean exporter, is restricting the inflow of foreign investment money over concerns for overheating their economy. The inflows from soy bean sales are apparently more than they can absorb.

Gold and silver form part of the commodity index, too. Gold has steadily marched higher while silver has displayed its usual manic behavior. After lagging gold’s rise for some time, it has made a meteoric move in the past few months. At $25 per ounce in late-January, it recently cleared $40. Market conspiracy theorists claim that some of the larger banks were selling silver short in an attempt to dampen its ascent and that those same banks are now caught in a “short squeeze.” No matter the exact mechanism, it is clear that easy money is flowing into gold and silver.

The euphemism that is Quantitative Easing is purported to end June 30th. Should real demand be sustainable, we will see prices hold and jobs return as demand gains traction. Just as likely, interest rates will rise dramatically as the top purchaser of Treasuries exits the market. Of the other main purchasers, China and Japan, it is doubtful that Japan will pick up any slack. They have plenty to spend their surplus money on now.  While those investors with cash to deploy would be well-served by rising interest rates, the remainder of the debt-bound economy will be choked off from any future growth. This then is the dilemma facing the Fed in the near-term. Longer term, we still need to work off the indebtedness that has occurred. And as many people are beginning to realize, we cannot borrow our way out of debt. The financial reality facing the US government is that belt-tightening and jobs growth is the only path back to prosperity. This outcome is inevitable; only the time it takes is optional.

Paul Kluskowski

Once upon a time, in a land not so far away, money was something very different from what it is now. Rather than being sheets of paper with intricate pictures printed on it, money had value in its own right. Made from gold, silver, platinum or copper, the holder was assured that his currency had value. He could weigh it, assay it, feel it. Money was real, tangible and without mystery. It had intrinsic value. This real money facilitated commerce and allowed for the accumulation and transfer of wealth. Since it couldn’t be counterfeited, or manipulated by other means, real money kept everyone relatively honest. And such was the nature of money for centuries.

            As civilization progressed, it became apparent that transacting business with physical metal was problematic. Imagine the logistics of a large purchase using gold or silver as the means of settlement. And paper was money born. Backed by actual stores of gold and silver, it seemed a logical progression. Paper money was issued at a fixed exchange rate on the promise that it could be readily swapped for the physical metal. For decades, $35 per ounce of gold was the price at which the US government would trade paper money for gold and vice versa. Under this system, the government and Federal Reserve were limited in the money that could be issued. Why? At a fixed exchange rate, the issuer must have sufficient physical gold on hand to cover all paper money in circulation. Any paper money issued beyond the amount of gold backing it would otherwise be worthless.

            While not fully backed by gold, US currency was largely guaranteed by the precious metal until the 1960′s. The war on poverty combined with the war in Viet Nam led to a loosening of that connection as government spending expanded beyond its means. Due to then-busy printing presses, inflation was getting out of hand and foreign governments were losing confidence in the buck. Both the Swiss and French governments swapped large US dollar positions for physical gold. Then, in August of 1971, Richard Nixon shocked the world by closing the gold window. No longer would the US government back its currency with a physical asset. Rather, it would be backed by the full faith and credit of the US government. This is, of course, secured by the ability of the US government to tax its citizens. From 1971 forward, the US money supply would be regulated by the Federal Reserve and backed by the power of taxation.

            Most of us pressing 50 or older remember that the 70′s were a bit of a grind financially and economically. Once the legendary Fed Chairman Paul Voelker beat back that era’s rampant inflation, it laid the groundwork for a 20-year economic expansion. The greatest bull market in stocks started in 1982 and ran full steam into 2000. Concurrently, and unnoticed by many, a similar bull market in bonds was born. It ran until its choppy end in 2009/10. Without a tie to a finite commodity, the monetary expansion drove financial instruments upward for decades. After peaking in 1980 then deflating for years, gold languished as everyone lost interest. Paper money was unquestioned and the US dollar was King. It wasn’t until early 2001 that gold began to quietly but steadily climb upward again in response to printing presses on overtime. As 2010 closed, gold marked 10 straight years of positive annual gains. Clearly, there is a rotational nature to markets in favor.

            One market that I know will always be in favor is the farm market. By this, I do not refer to large-scale grain or livestock operations. The farm market I speak of is populated by small-time fellas with produce patches and a few animals running about feeding naturally. Often gathering in public parking lots on Saturday mornings, these people bring genuinely fresh and healthy products as well as serve as little economic engines for the local community. Through their labor, they bring to market a product that has value. Much of it is exchanged for cash while some is swapped for another’s product. Bottom line: value is created and commerce results.

            I genuinely respect these producers. Where commercial scale farming has lost most of its wholesomeness, these locals take us back to a time when money was still valuable and food was still nourishing. These people live in a world where they stand face-to-face with their customers as business is transacted. It is a transaction that nourishes our bodies as well as enriching our communities. It’s not commercial; it is personal. As for me, I visit our farm market every week throughout the season. I make it a point to know these people because we are connected by the business we conduct. When our handyman mentioned he was soon to put his laying hens in the freezer, my wife and I offered to buy all the eggs they laid through the winter as an alternative. We are quite happy with this arrangement as is our handyman. We now have 6 chickens on our “payroll” and dozens of the most amazing eggs a person could ever eat. Again, a product with value is created and commerce results.

            The headline stories for 2011 will likely continue to tell tales of governments and municipalities in financial troubles. To be sure, there remains much mopping up to be done as the excesses of the 80′s and 90′s are wrung out. As individuals, there is little we can do regarding the potential bankruptcies of Greece, Ireland or even Illinois. But that doesn’t mean that we are powerless. We can look right under our own noses and find ways to create value in the world around us. By finding and taking those actions that create value we foster abundance and that supports sustainability. We are collectively experiencing a time that has not been previously navigated by most of us. So naturally, we will need to take actions that are new to us. While perhaps initially uncomfortable, personal growth will result. And that, too, has intrinsic value.

I have long been a fan of Yogi Berra. He is a colorful character with a quirky way of turning a sentence. One of my favorites, “It ain’t over till it’s over” came to mind with the recent proclamation that the Great Recession was over as of last year. Based on indications of renewed economic expansion, the National Bureau of Economic Research concluded that the recession officially ended in the second quarter of 2009. When compared with other post-WWII recessions, this one was a blockbuster. The depth and duration of the job losses are shocking. One glance at the chart will show you that we are years away from full employment. If in fact the Great Recession is over, then it seems that a return to prosperity would be close at hand. Yet, I know of few people who would make this claim. Lacking clear signs of prosperity, I am not certain that this is really over.

            Prosperity comes in a variety of manners, although for most, it involves a job. One of the features that sets the Great Recession apart from others is the sheer magnitude of the job losses. Not since the Great Depression have we seen numbers like this. I am sure we all know someone who has been touched by this event. Equally as frightening is the duration of joblessness once it does occur. As many of the unemployed will attest, once out in the cold, it’s tough getting back in. With official unemployment hovering at 10% and unofficial numbers at 22%, this represents significant levels of non-productivity by people who would likely choose otherwise. With the resultant loss of income in the present and loss of confidence in the future, there’s no catalyst to get our consumer-based economy rolling in earnest again.

            As Bill Gross has observed, stimulating a debt-laden economy is akin to building a campfire with water-soaked logs. This is exactly the Fed’s challenge. To help ignite a fire, the Fed continues to add lighter fluid in the form of low interest rates. For the short-term markets, the rate is essentially zero. By borrowing money at 0%, qualifying institutions (read commercial banks) can then buy longer-dated Treasuries paying 2-4% interest and pocket the interest rate differential as cash profits. This buying pressure on longer-dated debt pushes the prices up and the resultant yield down. To further this effect, the Fed has also hinted at another bout of Quantitative Easing (QE) whereby money is printed and used to purchase government debt. While this process is quite favorable from the banks’ perspective, savers are penalized in their ability to generate risk-free income. At the current 2.6% yield for 10-year Treasuries, it is hard to imagine anyone getting excited. Or, how much would one need to invest at 2.6% to feel prosperous?

            With risk-free returns so meager, yield hungry investors have little choice but to take more risk. Posting the best September since the Great
Depression, the stock market managed a 6% gain for the month. While it has hit some head winds in October, it appears that the uptrend is still in effect. At the same time, in spite of 65%+ gains since March of 2009, the major indices are still on par with 1998 values. In essence, index fund buy-and-hold investors have lost over 10 years with little gain to show for it. For those people (including many professional financial planners) who believed in 10% per year average returns, this period must be a bit distressing. Long-held beliefs that the stock market was a path to prosperity seem to be waning as the current market shows clear signs of reduced participation by small investors. In its place, we have market that rallies and retreats driven mainly by market pros and the Fed’s printing press. While we are in an uptrend, at current valuations we should not expect too much over the next few years. Rather than buy, hold and hope, we will rely on dividends and “hiding from the bear” to keep us on track. As for the average investor, only time will tell when stock market prosperity will return.

            And, no prosperity discussion would be complete without some mention of housing. Long-believed impenetrable fortresses of wealth for the masses, housing has been the most recent bear trap for many. Fueled initially by the already-mentioned low interest rates, the bursting of the housing bubble has cost us all dearly. For those who didn’t lose on an actual house, we still pay via Fannie and Freddie bailouts. The only “winners” were those mortgage bond holders who should have seen their investment clobbered but were rather made whole by Wall Street’s assertions that it was too big to face the wrath of a moral hazard. Apparently, misery loves company, especially when it is accompanied by taxpayer dollars. So much like the stock market’s lack of progress, many home owners are years away from being even.

            Taken in total, we have quite the mess on our hands. It seems that the scope and persistence of our economic challenges is becoming more present in our collective awareness. It also seems that frustrations with the situation are to be laid at the feet of the current administration and the Democratic Party. Rightly or wrongly so, assigning blame will do little to right the problems we face. At the same time, devaluing our currency through rock-bottom interest rates and endless QE is not the path to prosperity either. This, thankfully, has finally been at least verbally acknowledged by the Treasury. Currency wars have no winners; there are only losers as good behaviors such as saving and investing get penalized by the resulting loss of purchasing power. In the meantime, cash flow (not just cash) will remain King. We are seeing the nascent signs of inflation that must inevitably follow our current policies. For bond holders, this will spell trouble. For dividend collectors, the future should be brighter. Collectively, we will remain in this barrel until true productivity rises markedly putting people and other slack resources back to meaningful work returning us all from prosperity lost.

Paul Kluskowski

 Many things in this life come and go. The four seasons are in a constant and predictable rotation, each one taking its turn then giving way to the next. The world of fashion has similar cycles as wide ties give way to narrow then back again. Friends certainly come and go as job changes, family situations, etc create a constant state of flux. The same holds true for our economy. Economic conditions such as inflation, trade deficits, deficit spending, tax breaks all certainly ebb and flow over time.

One regular economic visitor of late has been deflation.  This prosperity shredder has been making periodic appearances since 2000. And, this most recent year marks yet another cameo. An interesting aspect of this powerful economic force is that it is rather rare in making appearances. Largely dormant since the 1930’s, deflation has been all too present in this past decade. Like a rowdy house guest who has already overstayed his welcome, this Haley’s comet of economic forces will likely be around for a few more years.

As we explored last quarter, much of the deflationary downdraft that we currently feel is the result of years of massive outsourcing of everything from manufacturing to accounting to engineering. The net result of value-producing work seeking the lowest-cost provider is the constant outflow of capital from our economy into that of developing nations. Rather than circulating amongst our domestic neighbors providing them with jobs and stimulus, the flow of funds to our foreign neighbors provides them with the jobs and stimulus while leaving us holding the tab. It is not with bitterness or resentment that I state this. Instead, it is the mere acknowledgement of our current situation which is a crucial step in formulating our strategy for today and the future.

The financial markets show clear signs of our house guest. High-quality bonds, such as Treasuries, get pushed to prices beyond perfection as investors favor return of capital over return on capital. This effect drives interest rates from low to extremely low killing any risk-free yield. Commodity prices fall. In part, slack demand can be blamed. But like nearly everything else, prices are falling, resources included. And, volatility returns to the stock market. There is nothing like a whiff of deflation to send stocks into turmoil.

Financial markets are not the only entities feeling deflation’s effects. As cash becomes scarce (that’s what deflation does), tax rolls grow thinner. As of this writing, the state of Illinois is facing a $12 billion deficit this year with $5 billion in unpaid bills sitting on the controller’s desk. Worse yet, the state’s pension is 50% underfunded threatening benefits for state workers and retirees. On a larger scale, the very same situation is making Greece the ugly step child of the Euro zone. Faced with the requisite cost-cutting and austerity programs, Grecians have taken to the streets in protest. And, they are not alone. Hungary floated the possibility of a national bankruptcy. Too, other lesser-stable Euro zone countries face the same cost-cutting reality. The financial trauma that forced many companies into insolvency through 2008 and 2009 is now bearing down on governments. Those with a penchant for making predictions are calling for the inevitable default of a sovereign nation(s) in the not-so-distant future. Only time will tell for sure.

Closer to home (literally), the lapse of the Fed’s housing tax credit has been somewhat of a gut-punch for housing sales. Despite record-low interest rates, housing sales slipped for the month of May with the average price increasing marginally. What remains to be seen is the full effect of bank-owned homes hitting the market. Many foreclosures remain on the banks’ books but not yet for sale. Some markets, such as Phoenix, reportedly have hastened as investors scoop up vacant homes for renovation and quick turnaround. How this plays out in an environment of more houses than people will surely be of interest.

Just like the 75-year phenomenon that is Haley’s Comet, this rare period of deflation will certainly pass. While not yet ready to leave, our transient house guest is creating future opportunities. In deflation’s midst, cash and cash flow are king. Cash is favored as it doesn’t decline in value as many other instruments do. Cash flow is vital as this allows for debt service. Like it or not, guaranteed yields are very low and stocks continue to be choppy.  Yet, as the excesses of years past get wrung out, valuations eventually improve and become attractive. One sector near and dear to my heart is the utility industry. A number of telecoms have dividend yields in excess of 5%, a magic number in stock pricing. Likewise, some electric utilities are also crossing above the 5% threshold. As dividend yields exceed those of Treasury bonds, the stocks become interesting. While downside risks still exist, the dividend provides some cushion. Our rowdy house guest may be with us for the foreseeable future, so we might as well be paid for the inconvenience.