Free Lunches Are Hard To Find

2/16/2009


Disappointed by a lack of detail in the government’s bank-bailout plan, investors pushed the Dow Industrials within 400 points of the Nov. 20 low of 7,552.29. A close below that level would reconfirm the bearish primary trend, and a conservative posture remains appropriate. Of the portion of your portfolio committed to equities, hold 30% to 40% in a short-term bond fund like Vanguard Short-Term Investment-Grade ($9.84; VFSTX).

The piper will be paid
As Congress debates a massive spending bill and the Treasury embarks on another huge bank bailout, investors would do well to remember that prosperity cannot be legislated. Whether the final stimulus bill totals $789 billion or more, all the new spending will be financed through borrowing by the Treasury.

The government will exchange Treasury bonds for dollars, then distribute those dollars via public spending. With both capital and labor increasingly unemployed, government outlays may increase total spending in the economy in the short term. But ultimately the increased federal debt will need to be repaid through higher taxes. And if taxpayers respond to expectations of higher taxes by saving more now, even the short-term stimulative effect of higher government spending may be neutralized.

Alternatively, the government can dilute the present value of debt by debasing the currency via inflation. The easiest way to do this is by having the Federal Reserve create new money out of thin air, something called for in the Treasury’s bank-bailout plan. Lending money for practically nothing is another way to add to the money supply, and the Fed is widely expected to maintain its zero interest-rate policy into 2010.

Despite horrendous economic data and expectations of modest near-term inflation, yields on 10-year Treasury bonds have moved above 2.7% from less than 2.1% in December, partly because of worries about long-term inflation risk and massive issuances of new Treasury bonds. The price of gold, seen as a hedge against inflation, has surged since December.

For equity investors, the good news is that stocks remain cheap relative to yields on Treasury bonds. Also encouraging is the widespread bearishness among newsletter editors and other investors, as even mildly good news on the economy could push value-oriented investors into the bullish camp.

Conclusion
Stocks are likely to be choppy until investors gain some confidence in the long-term outlook for the economy. In the meantime, we recommend investors hold sizable cash positions and emphasize stocks capable of swimming upstream, such as Dolby Laboratories ($32; DLB).


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