Burning Up Money

© Can Stock Photo / ancientimages

No doubt you probably noticed the turmoil in the stock market over the past several weeks. You might have assumed, if you watched the stock indexes hit a low of more than 10% below their peak, that some particularly ugly piece of news had hit the market.

If so, you would probably be surprised to hear that the biggest news stories leading to the correction were that the economy was booming and unemployment was at record lows. So why were investors panicking at this seemingly positive news? The answer is inflation.

You see, as the economy grows, increasing wealth leads to increasing demand. This means higher prices–or, in economic terms, inflation. This creates a couple of problems for the stock market. In the long term, rising prices make it harder to maintain economic growth and may contribute to an eventual crash. In the short term, both economic growth and inflation increase the pressure on the Federal Reserve to raise interest rates, making bonds and other interest-driven investments more attractive relative to stocks.

We are deeply skeptical of this short-term rationale. While bond investors may salivate at the prospect of higher interest rates in the future, we think this is short-sighted. Tomorrow’s higher interest bonds may sound attractive, but you would be foolish to buy them if the interest rate is going to be even higher the day after. On February 5th, when the stock market was posting headline-grabbing declines fueled by interest rate paranoia, investors were actually buying up bonds–bonds that stood to lose purchasing power as soon as better, higher interest bonds started being issued!

The longer term concern, that inflation may spell the beginning of the end of the current economic boom, is a bigger threat. We have warned for a long time that the Federal Reserve was likely to wind up overshooting the mark on its 2% inflation rate target. We think this is even more likely now that the government has passed a very stimulus-minded tax package. Cutting taxes during the middle of a boom is likely just throwing gasoline on the fire: it is possible we may see some explosive growth, so in the short run we are excited about the market, but in the long run the economy may just burn out that much faster.

Clients, many of you have been in business with us long enough to remember the roller-coaster years we saw around 2007. The dip at the start of February may potentially be forgotten as the market forges on ahead, but it will not be the last one. The roller coaster is coming back, and although we look forward to the ride we will keep a mindful eye for the day we may need to think about getting off. Call us if you have any questions about the market and the broader economic outlook.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.