Two Powerful Forces in 2006

Two powerful forces will determine the fate of your investments in 2006.

The first, already in full view, is rising inflation. You can see it in the price of oil, gas, and coal … copper, aluminum, and steel … silver and gold. It’s abundantly evident in retail prices and wholesale prices. And it’s driving our favorite investments to higher and higher peaks.

The second, just now coming into sight, is a housing bust. New home sales in the U.S. have just suffered their sharpest decline in fourteen years. Existing home sales are also falling. And they could continue to spiral downward.

Can these two forces coexist? Can we actually have rising inflation and a housing bust at the same time?

My answer: Yes!

First, because the United States and other industrial countries of the world are no longer alone. High-speed growth in Asia and developing nations is driving up inflation regardless of what happens here.

Second, because the United States is so deep in debt to foreign countries. We owe trillions of dollars. This year alone, we’re adding another three quarters of a trillion. That’s a huge backlog of commitments that we have to meet regardless of whether our economy is strong or weak. And, ironically,

It’s precisely when the U.S. housing market busts and our economy weakens that foreign investors will run for cover.

That’s when they will start dumping their dollars. That’s when the dollar’s value will plunge in earnest. And conversely, that’s also when the price of virtually everything that’s measured in dollars — oil, copper, gold and other world commodities — will go through the roof.

In other words …

Until our huge pile-up of debt to foreigners is greatly reduced, a U.S. housing bust could actually make our inflation even worse.

At some point, will one of these two powerful forces prevail? Yes. But it’s too soon to say which … and far too soon to say when.

What should you do?

To make the most prudent investment decisions in 2006, you must assume both inflation and a housing bust. You have to seriously consider the inevitability of each in its own right:

The Inevitability
of Rising Inflation

Inflation is not just a passing phenomenon that comes and goes. It takes many years to build up … and once raging, many more years to bring back down.

That’s certainly the case with the inflation we’re seeing right now. It’s the natural consequence of at least three reckless policies that have been — and remain — firmly in place since the early 2000s:

Reckless Policy #1
Free Money for
Nearly All Comers

The Federal Reserve has consistently held interest rates below the inflation rate. So, in effect, the Fed has effectively been dishing out free money to nearly all comers.

They removed the natural risk of borrowing from the decision-making process of millions of consumers, investors, businesses, and governments.

They opened the floodgates to debt bingeing by households.

They encouraged the creation of a massive bubble of automobile credit.

And they fostered the greatest speculative bubble in homes and home mortgage markets of all time.

So today we face the consequences: Too much money chasing too few goods all over the world. Surging commodity prices. And inflation careening out of control despite 13 interest-rate hikes.

Reckless Policy #2
Unabashed and Unrestrained
Government Spending Binge

Under the previous Bush administration, Congress established pay-as-you-go rules (“Pay-Go”) which exercised at least some constraint on government spending.

The basic concept: If you add a new expense to the federal budget, you’ve got to find a comparable cut — or revenue boost — somewhere else in the budget. In other words, you must at least have a plan for where the money’s going to come from. Ditto for any measures that cut revenues.

But under the current Bush administration, those rules were dropped and replaced by a new philosophy: “Spend now and find the money later.”

It doesn’t work, and as a nation, we’re going to have to pay the price sooner or later.

Reckless Policy #3
Upside-Down
Foreign Trade

Back in the early 2000s, our government’s greatest fear was deflation — falling prices.

But lower prices, despite the near-term pain it can bring, were precisely what the doctor ordered for America to compete more effectively overseas.

Instead, our government decided to fight deflation and bring back inflation.

Now, here are five years later with the biggest oil-import bill in the world and some of the highest wages on the planet. Here we are buying goods from overseas by the torrent while letting our sales to overseas dwindle to a trickle.

End result: We now have a trade deficit that is far bigger than the greatest federal budget deficit in our history.

Throughout history, this has been a classic cause of unbridled inflation in virtually every country in the world that followed a similarly reckless trade policy.

There is no reason the United States will be very different: Inflation is bound to continue rising, whether the U.S. economy is weak or strong.

The Inevitability of
A U.S. Housing Bust

For quite some time, we were among the only ones writing about these dangers. But all that changed in 2005 when the Economist issued a very clear warning. Their headline:

“The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.”

Most Americans didn’t believe it. They made a series of arguments to rationalize their complacency. But the Economist refuted each and every one …

Argument #1
“Home Prices May Stop Rising.
But They’re Not Going to Fall.”

The Economist:

“A drop in nominal prices is today more likely than after previous booms for three reasons: Homes are more overvalued; inflation is much lower; and many more people have been buying houses as an investment. If house prices stop rising or start to fall, owner-occupiers will largely stay put, but over-exposed investors are more likely to sell, especially if rents do not cover their interest payments.”

Argument #2
“Home Prices Must Keep Rising Because
There’s a Limited Supply of Land and a
Growing Number of Households.”

The Economist:

“They made the same argument in Britain as recently as a year ago. But as the expectation of rising prices has faded, demand has slumped. America has faster population growth than Britain, but its supply of housing has also been rising rapidly.”

Argument #3
“The National Average for Housing
Prices Has Never Fallen for a Full
Year Since Modern Statistics Began.”

The Economist:

“Outside America, many countries have at some time experienced a drop in average house prices, such as Britain and Sweden in the early 1990s and Japan over the past decade. So why should America be immune? … America has in the past seen sharp regional price declines, for example in Boston, Manhattan and San Francisco in the early 1990s. This time, with prices looking overvalued in more states than ever in the past, average American prices may well fall for the first time since the Great Depression.”

Argument #4
“Even If Prices Do Dip, They Will
Quickly Resume Their Rising Trend,
Because Real House Prices Always
Rise Strongly in the Long Term.”

The Economist:

“After British house prices fell in the early 1990s, it took at least a decade before they returned to their previous peak, after adjusting for inflation.”

Argument #5
“The Only Victims Will Be
The Housing Speculators.”

The Economist:

“Even a mere leveling-off of house prices can trigger a sharp slowdown in consumer spending.”

Their reasoning: Americans have been “withdrawing” a steady flow of cash from their homes and using that extra cash like a source of income.

Now, even a minor weakening of house prices in the United States will hurt consumer spending simply because homeowners have been cashing out their capital gains at such a record pace.

Argument #6
“The U.S Economy Is Strong
Enough to Withstand Any
Weakness in Housing.”

The Economist:

“The housing market has played such a big role in propping up America’s economy that a sharp slowdown in house prices is likely to have severe consequences. Over the past four years, consumer spending and residential construction have together accounted for 90% of the total growth in GDP. And over two-fifths of all private-sector jobs created since 2001 have been in housing-related sectors, such as construction, real estate and mortgage broking.”

Indeed, the International Monetary Fund analyzed house prices in 14 countries during 1970-2001. And it identified 20 examples of “busts,” when inflation-adjusted prices fell by almost 30% on average. Only one of these housing busts did not lead to a recession. Nineteen did.

Our Three Primary
Recommendations
For the Year 2006

Do not count on one bad situation — the inevitability of rising inflation — to be ameliorated by another bad situation — the inevitability of a housing bust.

That’s like hoping a fatal virus will help you fight off a lethal bacteria.

Instead, make sure your financial and investment planning for 2006 is insulated from both, following our three major recommendations:

Recommendation #1. Stick firmly with investments that can help you profit handsomely from inflation — gold, mining shares, and diverse portfolio of natural resource companies. And for funds you can invest more aggressively, go for the biggest profits with the smallest capital exposure.

Recommendation #2. If you own investment property, sell now. Most people want to keep their own residence. But if you’ve been considering moving to a rental anyway, this is the time to do so.

Recommendation #3. Maintain a solid nest egg that’s safe and liquid at all times, such as a Treasury-only money fund. There are quite a few good ones to choose from.

You promptly receive higher yields as rates go up. You can write instant checks against your funds or get a wire transfer within 24 hours. Your money is invested strictly in the highest-rated investments in the world. And you get a full exemption from local or state income taxes.

The one disadvantage: If the dollar falls, so does the purchasing power of your money. But that risk should be fully covered by our recommendation #1.

One Final Thought

In a short while, Elisabeth, Anthony and I will boarding a flight from São Paulo, scheduled to arrive in Miami later this afternoon.

But unfortunately, our last day on the coast of Brazil was rainy and hazy.

The same, I’m afraid, may be true regarding the coming year. The two powerful forces I’ve told you about today are unstoppable. But the actual outcome is still uncertain.

Despite the bad weather, we still managed to trek up the wooded cliff behind our semi-deserted beach.

And, as we looked down to the next beach below, a ray of sunlight forced its way through the clouds and the trees.

I hope your next year brings a similar result.

Good luck and God bless!

Martin

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About MONEY AND MARKETS

MONEY AND MARKETS (MAM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Larry Edelson, Tony Sagami and other contributors. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MAM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MAM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Contributors include Marie Albin, John Burke, Beth Cain, Christine Johnston, Amber Dakar, Michael Larson, Monica Lewman-Garcia, Julie Trudeau and others.

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