A Strange Combination of Possibilities

There are several trends at work in the economy right now. When they are mixed together they create an interesting stew. Possibly the most intriguing aspect of the current situation is several of these trends may counterbalance each other making a cut and dry analysis almost impossible. In this kind of environment I like to focus on what I call the "predominant effect."

The application of this type of theory can be quite flawed, however it may also be very useful - while you are operating within a consistent trend. I will try to explain with more depth: at any given time there may be several important factors at work in the economy. These factors may produce diffuse results. Currently we have at a minimum the following factors:

1) Moderately restrictive (trending) monetary policy by the Federal Reserve (note: until further notice)
2) Increasing inflation
3) Deficit spending and catastrophic related additional deficit spending (re: Katrina)
4) High energy prices (see #2)
5) Historically low interest rates
6) Historically high bond prices
7) Historically high home prices
8) Record high trade deficit
9) A foreign war

Several of the abvoe factors may counterbalance each other. The restrictive monetary policy will help to slow the economy and reduce demand for energy prices. This may in turn help to control inflation and maintain lower long term interest rates. Higher energy prices may also help to slow the economy and halt their own rise.

The record trade deficit, deficit spending, the foreign war, catastrophe related spending - are all inflationary and all put pressure on the dollar's strength and purchasing power. However, once again there is a countervailing factor. The Fed's restrictive monetary policy has helped to bolster the dollar over the past several months as short-term interest rates have risen.

Out of all of the above factors I consider the "predominant effect" to be a weak dollar. I think that the factors re: deficit spending, trade deficit, etc. to have a much stronger effect on the dollar than Federal Reserve policy over the course of the coming six months. This analysis is helped in part by considering the inflationary pressures in the economy. If inflation is running at 8% annualized which it appears to be (don't give me the "core" number please.......as I still like to fill my car with gas and eat food and live in a home), even a 4.25% Fed Funds rate (expected by end of year) - is extremely accomodative as it implies an actual real interest rate of -4% (nominal interest rate - inflation=real interest rate).

By applying this type of synthesis I believe again - the predominant effect to be a weak dollar. Thus, I expect the dollar to fall to new lows against the Euro / Gold, etc. over the coming 12 months. Once I have identified what I consider the predominant effect, I can then develop investment ideas to capitalize on that one very simple idea. Then as the weeks unfold, my investment results will concretely confirm or reject my hyphothesis. So far my expectations have been confirmed somewhat. Gold has rallied strongly, however the dollar has strengthened against the Euro. In order for my idea to truly bear fruit, the dollar would have to be in crisis mode and decline against the Euro, during which time gold would likely rise into the $500-600 price range.

I guess an obvious but necessary note about the predominant effect is that it is also what I consider to be the most important contemporaneous guideline that I want to apply to my trading/investing. This is significant because it may change at any time as the combination of economic factors that are considered produce a new and more profitable opportunity.

This change in perception may be driven by concrete fundamentals or it may merely be perceieved to be important by investors temporarily during which time the related share prices become a self-fulfilling prophecy but the actual underlying fundamentals are unchanged. As the fundamentals are reviewed again within due time and recognized to be insignificant, the perception will again shift and a new predominant factor will be identified. This process will continue until a real trend develops which is fueld by both fundamental and speculative aspects. This trend may continue from 1 week to 20 years and may be a mere short-term cycle or secular change.

An obvious change that may become key is the area of interest rates. There has been much discussion of the yield curve and the Federal Reserve in the media and on this blog as of late. If the Fed was to change its plans and drop interest rates instead or merely slow its restrictive policy, the predominant effect may remain an even weaker dollar, however the investment alternatives may broaden to consider other possibilities in the financial sector on the long side as the much anticipated inverted yield curve may never materialize.

That is enough theorizing for tonight, I will try and conduct a more practical survey of the Newmont call options and Wachovia / Financial sector put options tomorrow night as we get geared up ahead of the big Fed Meeting on Tuesday. Just to repeat myself - I need a Fed hike of at least 25 basis points in order to get my portfolio into the desired position the fastest.

Regards,

BG