Best European Countries to Invest In and How to Do It

Between the European economic and financial crises, PIGS (Portugal, Ireland / Italy, Greece and Spain) and various eastern European countries’ high debt ratios (and possible bankruptcies), and the devaluation of the euro you may wonder, are any of the European Union (EU) countries a good investment? Which, if any, EU countries hold worthwhile investment opportunities, the value of which has decreased due to economic and financial troubles in the EU? My goal is to find a diamond in the coal mine.

By way of background, a list of 22 countries which use the euro as their currency is available at Euro currency countries. The major European countries that do not use the euro are Denmark, Sweden, and the United Kingdom. The value of the euro has declined by 13% as compared to the US dollar and Chinese yuan (China's government has kept the yuan pegged around 6.83 to the dollar since mid-2008, when the global recession was intensifying) and 18% as compared to the Japanese yen over the last 6 months (as of June 18, 2010). The major advantages associated with decreasing valuation of currency are: exports increase and imports decrease, which helps the trade balance and has an expansionary effect on the overall economy’s aggregate demand. With the devaluation of the euro, the products of countries whose currency is the euro become much cheaper for consumers whose currency is not the euro. For example, the cost of French wines and cheeses should be discounted by 13% over the last 6 months for US consumers. It has the reverse effect for US products that are imported by euro countries where costs have increased by 13% (it has a positive effect if you are planning to go to vacation in Europe). Countries that are selling products which countries outside the euro countries want have a major advantage over countries that are not.

One of the financial crises in Europe is the high debt ratios tied to government debt. PIGS and several eastern European countries have very high debt ratios (budget balance % of GDP) that are not sustainable in either the short or long term. This will increase their cost of debt servicing and their ability to pay off their debt. For example Greece’s 10 year government bond interest is 8.15% and Spain’s is 4.57% (Germany is 2.56%). Since these countries use the euro they cannot downgrade their own currency to pay off the debt in cheaper currency (inflate their way out of debt like the US). The only way they can decrease their debt ratio is by increasing revenue (taxes) and/or decreasing expenditures (for example increasing the retirement age, decreasing funding for programs, etc.). Debt ratios for the following countries (2010):

· Britain -12%

· Canada -4.3%

· China -3.1%

· France - 8.4%

· Germany -5.6%

· Greece - 10.2%

· Ireland - 8.0% (1/2009)

· Spain -9.9%

· United States -8.8%

Ireland is the only PIGS government that has made major cuts in spending and increased taxes. The Irish government in 2009 gave two substantial pay cuts to public sector employees totaling 22.5% and made budget cuts of 4 billion euro. They have increased their taxes by targeting the rich living overseas. This has helped Ireland reduce their 10 year government bond interest rate and contributed to the Ireland market index which has shown a gain over the last 6 months. Their current 10 year government bond is 5.11% (as of 6/21) as compared to Greece’s 8.15%.

Merchandise trade balances for the last 12 months ($ billion - April 2010) are the following:

· France -60.1

· Germany 211.9

· Greece -44.3

· Italy -9.6

· Netherlands -51.3

· Spain -68.8

· Britain -132.5

· US -546.4

· China 132.5

Germany has the highest merchandise trade balance in the world (over the last 12 months) and their balance will increase with the devaluation of the euro.

The following shows major EU stock indexes’ (January 18 to June 18, 2010) performance in euro/local currency: (For euro currency countries subtract another 13% to compare with USD. For example in US dollar valuation Spain’s decrease would have been -32%.)

· Ireland - ISEQ Overall index: .03%

· Germany - DAX index (30 companies): 6.62%

· France - CAC 40 index (40 companies): -7.87%

· UK - FTSE 100 index (100 companies): -4.63

· Spain- IBEX 25 (35 companies): -19%

· Italy- MIB30 (30 companies): -13.92%

· US - DOW index (30 companies): -2.62%

If I was going to invest in one European country’s Exchange Traded Fund (ETF) index it would be either Germany or Ireland. The Germany iShare ETF EWG tracks the MSCI Germany index. It has decreased 14.5% over the last 6 months. The expense ratio is .55% and bid / ask ratio is .95% (the fund has $1.2 billion in assets). It has a nice yield of 2.7%. The major problem with the index is that 19% of the fund assets are invested in the financial sectors and it has been reported by the German financial regulators that German banks’ troubled assets are at 800 billion euro (over 1 trillion in USD). Germany has a high saving rate that generated a lot of capital for German banks to invest. Since the banks had large capital surpluses they invested in a lot of high-risk areas like U.S. toxic assets, Spanish real estate and Irish hedge funds. The banks had debt to net worth of 52 to 1 at the start of the financial crisis as compared to the US of 12 to 1. Germany does however have the largest merchandise trade balance in the world and it should increase with the devaluation of the euro. The decrease in the valuation of the euro helped the companies in Germany to increase sales outside the euro countries.



There is one Ireland index ETF (Shares MSCI Ireland Capped Investable Market Index Fund – RIRL), introduced May 5, 2010 (it has already dropped 20% since its inception). It has only $3 million of assets which will have a high bid / ask ratio. The Irish government has done a very good job of decreasing expenditures and increasing revenues but this ETF does not have enough assets for me to make an investment (I will not invest until the fund has over $100 million in assets).

Vanguard has a very low cost (.16%) European index ETF: Vanguard European ETF (VGK). Since January 1, 2010 the performance is -15.72% (in the euro currency it would be around -3%). The fund has a very good yield of 4.67% and has over $11 billion invested which will reduce the bid / ask ratio.

If you think the euro will reverse its 13% devaluation over the next year in relation to the US dollar, VGK will get a 13% gain (because of the currency change). Personally I am invested in a number of ETFs that have invested outside the US. For example, International non-US market index – Vanguard FTSE All-World ex-U.S. ETF (VEU). VEU has 44% of their portfolio allocated to Europe. I will not at this time increase my exposure to Europe but will continue to monitor European countries. It can have a major affect on stock markets outside Europe (for example the Chinese and the US markets) with the devaluation of the euro, high debt ratios, banking problems, possible countries defaulting on their debt, social unrest caused by increasing the retirement age and decreasing social programs and other difficulties. When the financial minister of Hungary talked about his country’s possibility of future bankruptcy in a newspaper interview, it had a distinct affect on the stock markets around the world the same day; this shows clearly that financial systems around the world are very interrelated. The devaluation of the euro makes it more difficult for China, Japan, the US and other countries’ corporations to sell their product in Europe (because of the higher cost) which will reduce their revenues and profits (which should lower their stock price).

Please chime in with your comments on investing in Europe, how the euro will do in the next year, or anything else.

© 2010 Paul Cusick

401K Rollover

I was an employee of Sun Microsystems until June 2006 and retained my Sun 401K plan, which was managed by J.P. Morgan, until June 2, 2010. I decided to roll over my 401K to an IRA rollover account managed by Charles Schwab for the following reasons:

1) Sun’s 401K plan was transferring to the Oracle 401K managed by Fidelity. A “Blackout Period” would be in effect from June 15 to the week of July 5, 2010. In light of a very unstable market environment, financial crisis on-going in Europe and the unstable political environment in Korea, the Middle East, etc., I did not want to lose the ability to manage my account for at least three weeks.

2) I already have a large amount of assets in an IRA rollover account managed by Fidelity and I wanted to diversify my IRA investment companies.

3) I would have a lot more investment options with my IRA rollover account than the Oracle 401K account.

I closed out my Sun 401K account at the close of business June 2, 2010. I told the customer representative at J.P. Morgan to have the check written to Charles Schwab For the Benefit Of (FBO) myself. The check would be sent to me by way of Federal Express (I had to pay $25 to receive the check 5 days sooner than US mail). The DOW and S&P was 10,250 and 1,098 at the close of business June 2, 2010. I received the check sent via FedEx on Saturday, June 5 and I deposited the check at Charles Schwab Monday, June 7. Since the check was written to Charles Schwab I would have immediate access to the funds.

I have decided to invest my new IRA rollover in the following allocation strategy for the next 3 to 6 months except for the cash (with this allocation I will have participation in worldwide stock markets):

1) Cash (future investments) – 18%
2) US stock market index – 58%
3) International non US market index– 12%
4) Emerging market index – 12%

I will use the following Exchange Traded Funds (ETFs) (see blog - BRIC ETFs and ETFs vs Mutual Funds):

· US stock market index - Vanguard Total Stock Market ETF (VTI)

· International non US market index – Vanguard FTSE All-World ex-U.S. ETF (VEU)

· Emerging market index - Vanguard’s MSCI Emerging Markets ETF (VWO)



Vanguard is a very low cost provider of ETF and mutual funds (expense ratio) because of their cost-conscious investment techniques. This helps the bottom line performance of your investment. These ETFs are large by net assets value which will lower the bid / ask spreads (important when you sell the fund). They also have large trade volumes, which serves to keep the price of the ETF very close to the Net Asset Value (NAV) and give the ETF more liquidity. The following are the yields of the ETFs (as of June 12):

· Vanguard Total Stock Market ETF (VTI) - 2.03%

· Vanguard FTSE All-World ex-U.S. ETF (VEU) - 2.21%

· Vanguard’s MSCI Emerging Markets ETF (VWO) - 1.42%

As of today (June 13, 2010) this is a plan - I have not yet bought these ETFs. Please chime in with comments on when you think I should buy these ETFs or if I should consider a different allocation strategy.


© 2010 Paul Cusick

Paul

My Dad’s Financial Common Sense

I did not have a rich or poor dad. My dad was not rich in material goods. He didn’t have many assets (money), a formal education (he did get a high school GED when he was in his 40s) or a white collar job. My dad was, however, very well read, talked with anybody that he met, had very good common sense and street smarts. Dad told me a number of financial ‘rules’ when I was young that I did not understand until I got older. I wish I had understood these rules at a much younger age.

Financial rules of my Dad:

• You need money to make money. When I understood how the rule of 72 worked (http://www.moneychimp.com/features/rule72.htm) I understood why this was a very important financial lesson. This is how the rule of 72 works; if you have 7.2% rate of return on your investment you will double your money in 10 years (72 / rate of return = time it takes to double your investment). If your returns are 3.6% it will take 20 years to double your money. For example, if you have $1 million of investment capital and your rate of return is 7.2% you will have $2 million in ten years. It is very hard (or impossible) to save $100,000 per year for 10 years. This is why, when you start working, you want to start a program to save money so you will have investment capital in the future. To understand this rule is to understand the time value of money.

• In the depression some people still got rich. There are always ways to make money in any economic environment. A number of investors made large sums of money using credit default swaps when the housing bubble collapsed. There will always be ways to make money whatever the economic environment or financial crises. For example, if you think there will be high inflation and interest rates in the US, short medium and long duration US bond funds or US government treasure bonds. You don’t always need a growing stock market to make money. What you do need to do is to stay positive, and you may have to think outside the box to make money in a difficult economic environment or during financial crises.

• The only things money buys is freedom and the time and means to help others. When you have accumulated sufficient assets that you don’t need to work anymore you are free to do what you like to do and help others. You can continue to work at jobs that motivate and interest you or, if the job is no longer fun or interesting, you can quit at any time or find a new job. You can help others financially or use your time to help them. 

• You always need a nut (money).  You should always have an emergency fund in near cash assets (for example, money market funds, layer CDs, etc.) of at least 6 to 12 months of your monthly living expenses. For example, if your fixed and variable living expenses are $5,000 per month you should have at least $30,000 invested in near cash assets. I prefer to have 12 months of living expenses. This is very important if you lose your job and there is an economic downturn at the same time. You don’t want to sell assets that may have decreased in value or use your retirement savings to pay for your living expenses (which can be very costly in the long term). If you do not have emergency savings or liquid investments you could lose your house, automobile or other assets due to lack of ready cash.
 
• Money talks, bullsh*t walks.  It’s put up or shut up. You can talk all you want about wanting to buy a house, stock, automobile, etc., but at some point you need to have the cash to buy it. It’s great to talk to somebody about buying a house, but the person selling the house will deal with the person that has the most money with which to buy it. If you want something you need the cash to be able to purchase the asset.
 
• It’s only worth something if someone is willing to pay for it. Your house may have been worth $1,200,000 on zillow.com in 2007. If you are trying to sell your house today and somebody will only pay $900,000 for it, it’s worth $900,000 not $1,200.000. You could wait a very long time to sell your house at $1,200,000. If a stock price was $100 on January 15, 2010 and it is now selling for $35 it is worth $35, not $100. The asset’s value is only what somebody will pay for it, not what an ‘expert’ says it’s worth.
 
• Never fall in love before you purchase something. If you fall in love with something before you buy it you cannot make an unemotional decision. You lose all power to negotiate and you can’t walk away without buying it. If you’re able to walk away from a negotiation at any time, you have the upper hand. For example, ask yourself if you could get the asset cheaper if you waited two weeks, can you negotiate a decrease in the price (the world is a flea market), would a competitor charge less, etc. You need to view an asset from the standpoint of its actual, true value. An automobile’s value is that it is used for transportation, not picking up women.
 
• Never be forced to buy or sell something.  If you are forced to buy or sell an asset, you will lose your ability to negotiate - you'll have no ability to walk away from the deal.  Avoiding this situation requires planning and/or an emergency cash fund. Money (nut, emergency fund, etc.) buys you time. If you know that you are going to need $30,000 to pay for your kid’s college tuition in 9 months you should start planning on how you are going to pay for it today. You do not want it in risky investments that could lose a lot of value just before you need to convert it to cash; you may want to put it into a CD or money market today.
 
• If you want to buy something over $100.00 go home and sleep on it and see if you still want it the next day.  This was in the early 1970s - with inflation you may want to increase the amount to $300. This is a great way to save money and not buy goods on impulse. For example, you go bike shopping and you find a great bike that costs $1000. You take it out for a ride and you love the bike. Do you buy it now? No. You tell the salesperson you will be back tomorrow to buy the bike (he will give you a lot of reasons why you cannot walk out of the store). You start asking yourself questions, for example, do I really need a bike, can I get a used bike for less cost from craigslist or eBay, can I get it on-line for less and not pay sales tax, does it cost less at another store, can I negotiate the price, can I fit it into my budget, etc. This has saved me money over the last thirty years and I have not ended up with a lot of stuff that I did not really need.
 
These lessons that I learned from my dad should be taught to every high school/ secondary school student around the world. Some of them took me a long time to fully understand and incorporate into my financial planning. I have to admit, when I was in my teens and twenties, I didn’t always think my dad was such a smart guy. To young people now, I would offer this thought: sometimes your parents know more than you think - you may want to listen to their advice. It could come in handy down the road.

Please chime in with comments on any financial lessons that you learned in your lifetime.

© 2010 Paul Cusick
Paul

Best Investments for Stagflation

Best Investments for Stagflation

My macroeconomic forecast for the next 3 to 5 years which I unveiled in my blog of April 12, 2010 predicts stagflation. This week's blog outlines which investments are the best for stagflation, focusing on commodities, precious metals and gold. Other suitable investments will be discussed next week.

As always, be sure you understand the tax consequences of your investments, how the investment works and what your exit strategy will be.

Best investments for stagflation: Commodities, precious metals or gold (see blogs Gold - January 2, 2010 and Natural Gas - February 8, 2010).

The following are methods for investing in commodities, precious metals or gold:

1. Commodity producing companies. Examples of commodity producing companies are coal and Natural Gas (NG) producer Consol Energy Inc. (CNX) and gold, silver and copper producer Goldcorp Inc. (GG). Consol Energy is the largest coal exporter to China for steel production. Canada Goldcorp is one of the largest gold producers in the world. I own the following commodity producing companies:

+ Lundin Mining Compnay - LUNMF.PK

+ Advantage Oil and Gas Ltd. - AAV

+ Pegrowth Engery - PGH

+ Penn West Engery - PWE

2. Future Based Commodity ETFs. Before you buy future based commodity ETFs you may want to read the following article “Commodities are a Rock in a Hard Place”:
http://www.morningstaradvisor.com/articles/article.asp?docId=17924. Before buying a future based commodity or commodity index you need to understand the contango and backwardation effects (you should also understand the tax consequences of a taxable account). Two famous future based commodity ETFs are States Oil (USO) and United States Natural Gas (UNG). These funds have been influenced by the contango effect in the future energy market. UNG lost over 50% of its stock value in the last year. A worthwhile article on the contango effect on UNG is “What’s Wrong With UNG?” http://etfdb.com/2009/whats-wrong-with-ung.

3 . Exchange Traded Funds (ETFs) or Mutual Funds (MF) index of commodity producing companies. For a very good article on ETFs of commodity producing companies indexes see http://seekingalpha.com/article/195688-the-benefits-of-equity-commodity-etfs. You can buy selector based ETFs, for example metals and mining (XME), global coal (PKOL), steel (SLX), etc.

4 . ETFs index of commodities. Before you buy a commodities index ETF in your taxable account you should read the following article about tax consequences of ETFs: http://www.investopedia.com/articles/exchangetradedfunds/08/etf-taxes-introduction.asp.

+ Powershare DB Commodity Index Tracking Fund - DBC

+ Dow Jones AIG Commondity Index Fund - DJP

These ETFs have about 20 commodities in the index. They include, for example, oil, NG, heating oil, gold, corn, wheat, etc. These ETFs have large total assets of over 2 billion dollars and at the same time large bid / ask spreads (also very high fees for ETFs). These funds all use future contracts and made also be affected by the contango effect.

5 . ETFs or MFs index of commodity producing countries. These also have currencies implications. I own the following ETFs and MFs indices of commodity producing countries (each of these funds has about 50% commodity stocks within its index):

+ S & P BRIC 40 SPDRS - BIK

+ Claymore/BNY BRIC - EEB

+ DWS Latin America - SLA

6. Real commodity assets (owning a forest or mine). If you have a lot of money like the Yale Endowment Fund (http://www.yale.edu/investments/Yale_Endowment_09.pdf) you may want to buy real assets such as a forest, large commercial building, or oil or natural gas fields. The Yale portfolio manager, David Swensen, one of the top investors in the world for the last 25 years, has been increasing his holdings in real assets over the last 3 years. It is an investment category through which you can take advantage of pricing efficiencies. One of the best ways forthe average investor to buy real assets is by buying Real Estate Investment Trust (REIT) companies. For example, Timberland has been one of the best investments for the last 20 years. Its return during the past two decades has been 12.8%. There are a number of Timberland REIT companies that own extensive timberland acres. For example, Plum Creek (PCL) owns over 7 million acres and has a yield of 4.3%.

In next week’s blog I will put forward best investments for EU countries. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.

© 2010 Paul Cusick

Paul

Worst Investments for Stagflation

My macroeconomic forecast for the next 3 to 5 years which I unveiled in my last blog is for stagflation. This week's blog will be about which investments are the worst for stagflation. As for myself, I don’t tie my whole portfolio to my macroeconomic forecast. I could be wrong, so I tilt some of my portfolio to stagflation investments (10 to 20%) and the rest elsewhere. It helps to hedge so that, if my forecast is wrong, I am not forced to sell assets that have lost value. Today a lot of people are finding themselves in the unfortunate position of needing to sell their houses to raise cash to pay debt and living expenses. You never want to be forced to sell an asset that has lost value. A well-diversified portfolio is key - you never put all your eggs in one basket.

I will review all of my investments against my economic forecast to determine whether any are no-nos for the forecasted economic environment. For example, for stagflation medium and long duration bonds funds are not good investments. If I have investments that are medium or long term bond funds I will decrease or eliminate my investment in that fund.

Also, always understand the tax consequences of your investments, how the investment works and what your exit strategy will be.

Worst investments for stagflation:

Long or medium duration bonds (see blog Bonds - February 27, 2010). For example, if you are invested in Vanguard Long-Term Investment Grade Bond fund (VWESX) with the average duration of 12.1 years and interest rate increases by 2%, your investment will decrease by 24.2%. If you invested $100,000 in the fund, after the 2% increase in interest rate, your investment value would $75,800. The time to invest in long term duration bond funds is when inflation and interest rates are at their highest and will be decreasing in the future. That’s why long term bonds have been very good investments over the last 3 years with declining interest rates. Over the last 3 years Barclays Capital US Aggregate Bond Index has returned 6.14% and the S&P 500 Index has returned -4.17%. This is why you do not want to follow performance. With the economic environment changing to higher interest rates and inflation you would not want to be invested in long or medium duration bond funds.

Long term fixed rate annuities, Guaranteed Investment Contracts (GIC) or anything that pays a fixed income. GICs are like Certificates of Deposit (CDs) but they are not guaranteed by the Feds and FDIC; they are only guaranteed by the company that issues them to pay the fixed interest rate. Today you can buy a GIC that will pay you 3.0% annually for 5 years. That 3% income is locked in for 5 years. If the inflation rate is 7% you lose 4% on you investment every year. GICs work like every other type of fixed income investment that will not protect you against rising inflation. The time to buy long term fixed income investments is when inflation rates are declining.

Investments in cash, for example, CDs, savings accounts, etc. Cash, or cash equivalents, generally provide the worst protection against inflation since it will not keep up with inflation. If inflation is 9% and you are getting paid a 2% interest rate annually for your saving account in 10 years (rule of 72) you would lose almost 50% of the value of your investment to inflation. During periods of inflation you just want only enough cash for emergencies. This might be 6 months of your living expenses. You may want to do CD laddering to get the best return for your emergency cash fund.

Stocks. In the short to medium term stocks have an inverse relationship to the Consumer Price Index (CPI). You will need to be very selective on the stocks that you invest in. Pricing power is very important when you have stagflation. Companies that cannot raise prices faster than their input costs will not do well in this environment. If you are a paint manufacturer and cannot raise your prices for paint faster than your major input oil you are going to experience a decrease in profitability or lose money. This will drive down the stock price. Companies that produce durable goods do not do well in a stagflation environment. (Durable goods are products that are not purchased frequently, for example appliances, home and office furnishings, and jewelry.) Examples of companies which are unlikely to prosper in a stagflation environment:

Whirlpool (WHR)

Boeing (BA)

Tiffany (TIF)

In next week’s blog I will be talking about the best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.

© 2010 Paul Cusick

Paul

Stagflation and Analysis

This week’s blog is my forecast for the economy for the next 3 to 5 years and my supporting analysis. My forecast is for stagflation which is high unemployment rate with inflation. Remember the Carter administration (1976 to 1980) which is known for stagflation and the misery index (employment rate + inflation rate)? We could be headed for the same economic environment that existed in the Carter years.

Interesting URLs:

Misery index: http://www.miseryindex.us

Money supply definition (M1, M2 and M3): http://en.wikipedia.org/wiki/Money_supply

US Debt Clock: http://www.usdebtclock.org

Analysis of the major causes of inflation:

1. One of the major causes of inflation occurs when the money supply grows faster than the potential output of the economy or real GDP. Over the last two years the M1 money supply has increased by 25.5% and M2 has increased by 11.5%. For the same time period the real GDP has decreased by .5%. This will promote higher inflation rates over the next 3 to 5 years. At the same time, the Feds may decide to keep interest rates low for political reasons. Examples of political reasons why the Feds would keep interest rates low are: to keep mortgage rates down (to help get us out of the housing crisis), to promote higher employment, keep the federal government debt payment level lower, etc. This will bring about more inflation as it leads to unsustainable levels of growth and inflation because cheap money is available. With lower interest rates on treasury bonds the Feds will be the lender of last resort and will need to buy the bonds. The only way they can buy more bonds is by printing more money (just like the last two years) and increasing inflation. The Feds or Congress may also determine the only way to pay off the national debt (over $12.7 Trillion and counting) is to make money cheaper through inflation. This will be the main cause of inflation over the next 3 to 5 years.

2. Rise in production cost of goods, for example, increases in raw materials and / or labor cost. There will be very little or no increase in labor cost over the next 3 to 5 years. Instead there will be downward pressure on labor cost during this period with jobs moving overseas and high unemployment. Cost of goods increases will stem from increases in the cost of raw materials, for example, corn, wheat, oil, natural gas, etc. There will continue to be increased demand for commodities in the emerging countries (for example, China and India) which will increase the cost of raw materials. Since commodities are one of the best investments when there is inflation, hedge fund managers and other investors will increase their investments in commodities, which will further drive up the price of raw materials.

3. Change in availability of supplies. The Arab Oil embargo of the mid 1970’s is a classic example of change in availability of supplies. The embargo caused an increase in the price of gas, paint, and other oil-based products. Inflation can also arise from speculation and increased demand from emerging countries. Of all the causes of inflation, this will be the wild card over the next 3 to 5 years. Oil is currently going up because of speculation. A major political event in the Middle East, Russia, etc. could drive up the price of oil to $150 a barrel or higher. For example, Iran is bombed by the US or another country seeking to destroy their nuclear power plants.

4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up the rate of inflation. I don’t see this being a factor driving inflation over the next 3 to 5 years.

5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, because a change in supply increases cost of goods) which causes an increase in production costs which increases prices and leads to further demands for higher wages. This will not occur in the current economic environment. With the high unemployment rate and with the ability of companies to move jobs overseas, workers simply do not have the power to demand wage increases.

Employment analysis:

The total number of unemployed US workers is 15 million (this is the U3 number – see definition below) out of the total work force of 154 million (unemployment rate is 9.7%). If you want to decrease the unemployment rate to 5%, there would need to be more than 7.3 million new jobs created. If the US increases new jobs by 300,000 per month (factoring in 100,000 new employees entering the work force every month) it would take 36 months to get back to 5%. U6 unemployment rate is around 20%. That is another 15 million workers over and above the U3 number. If only 50% of these workers enter the work force, that is still 7.5 million workers. Including the U6 workers it will take 72 months (6 years) to get back to a 5% unemployment rate. If the job growth is 200,000, it will take 144 months (12 years) to achieve 5% unemployment. At no period in US history have we been able to generate job growth at 300,000 for a sustained period of time. It is going to be very difficult to grow jobs at this rate with so many jobs going overseas because of lower labor cost. The unemployment rate will decrease slowly over the next 3 to 5 years.

• U1: Percentage of labor force unemployed 15 weeks or longer.

• U2: Percentage of labor force who lost jobs or completed temporary work assignments.

• U3: Official unemployment rate per ILO definition.

• U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them.

• U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently.

• U6: U5 + Part time workers who want to work full time, but cannot due to economic reasons

Summary:

Over the next 3 to 5 year period there will be an increase in the inflation rate driven by the money supply increasing faster than the real GDP, increases in commodities prices driven by increasing demand of emerging countries and speculation, and the US government wanting higher inflation to pay off the debt of the US government. The unemployment rate will slowly decrease over the next 3 to 5 years. For the next 3 to 5 years, we will be in a period of stagflation.

In next week’s blog I will be talking about best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.

© 2010 Paul Cusick

Paul

Financial Reading Recommendations & Next Blog

This week I am doing research for the next blog in which I'll discuss the most likely future economic environment for the US: deflation, inflation or stagflation (high unemployment rate with inflation) and what the best investments for that economic environment might be. The US may be headed for sustained high unemployment and inflation. Readers who are old enough may remember the aptly named misery index from the 1970s which equaled the unemployment rate plus the inflation rate. If you are interested in the misery index and the historical and current data for the misery index you can check the following website: http://www.miseryindex.us


I read some very interesting documents and websites during the last week:

A.K. Barnett-Hart's Harvard undergraduate thesis about the market for subprime mortgage backed Collator Debt Obligations (CDOs) is a must read. This may be the best, most clearly written and most interesting document about subprime mortgage backed CDOs out there. If you want to understand CDOs and all the problems/issues that caused the financial meltdown this is required reading. Better yet, it should be required reading for every US congress person and financial regulator. President Obama should invite Ms. Barnett-Hart over to the White House for lunch to get a better understanding of the financial regulations needed by the US. URL for the thesis: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf

The Yale 2009 Endowment Investments report (thanks Barry) is a very interesting document with a lot of good financial and investment information: http://www.yale.edu/investments/Yale_Endowment_09.pdf. David Swensen, Chief Investment Officer of Yale’s endowment for the last 25 years, is one the top money managers in the world. His return on investment has been 13.4% per year over the last 20 years. He has increased his allocation goal in real assets (real estate, oil and gas and timberland) to 37% for inflation protection and to capitalize on pricing inefficiencies in the asset class (from 29% in 2008). His allocations in domestic and foreign equities have decreased by 8% from last year. After reviewing the changes he is making in the endowment’s allocations it looks like he is protecting the endowment from inflation vulnerability in the future. Thus it would seem that Mr. Swensen is betting that an inflation environment looms in our economic future.

I reviewed the Feds website on the money supply of the US: http://www.federalreserve.gov/releases/h6/Current. This site lets you check out what is happening with the US money supply. There is a lot of interesting information on this site, for example: the increase of money in saving accounts and the overall increase in US money supply since 2008. It is interesting that the Feds ceased publishing the M3 numbers in March 2006 with the result that it is now harder to track the money supply growth. M3 includes the following: M2 + all other certificate of deposits (large time deposits, institutional money market mutual fund balances, deposits of euro dollars and repurchase agreements). The Feds did this, they say, to save money and because the data was not needed. I will start checking this website once a month for economic information.

The following 3 financial books are ones that I have read over the last 3 months and recommend. If you are interested, you can select the link and get a review of the books from the Amazon website:

The Ascent of Money: A Financial History of the World

The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History

The Big Short: Inside the Doomsday Machine



© 2010 Paul Cusick

Paul