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November 7, 2005

How to play inflation today, Mon., Nov. 7, 2005, 8:50 AM

The fact that inflation is rising in the world cannot be denied. The fact that the market is a game that plays people is another undeniable fact.

So here is how to play inflation, and the market.

About half the people of the world are now living in countries where the latest Consumer Price Inflation data shows the local CPI to be growing at close to +10 pct annualized, double the rate from a year ago. That is a problem because no country is an island in terms of being able to operate in an economic vacuum.

Even in countries like the U.S., which have huge international trade deficits, there is a growing inflation problem, which, in the case of the U.S., has concerned the Fed enough to raise the funds rate 12 straight times since June 2004.

Back in 2Q04, when I started to blog, the Fed rate was at a 46-year low of 1 pct, and the commercial bank prime lending rate was at just 4 pct, and there were an absence of inflation concerns. Banks were indeed making good profits on their lending activities.

Now, less than a year-and-a-half later, the Fed rate and the prime lending rate are both at 4 1/2 year highs. Last Tuesday, right after the Fed rate increase to 4.0 pct, commercial banks followed by raising their prime rate to 7 pct.

The Fed is clearly trying to keep inflation under wraps.

The problem is that wealth production is growing slower than the rise of inflation in most countries, so I have come to the conclusion that gold bullion will trend higher, soon to move into the $500+ territory.

And in that case, the gold producers are the place to be. Presently I have a total portfolio weighting in goldminer shares equal to 7.5 pct, and a cash position of 80 pct.

As interest rates and bond yields rise, it gets increasingly harder for the banks to continue earning profits at the rates they had been when the Fed rate was just 1 pct. It becomes harder for mortgage lenders to do the same. And for heavily debt burdened manufacturing companies, debt service becomes more difficult.

So these are the companies that are not the place to be.

Presently, the economy in the U.S. and Canada is relatively healthy, but it is slowing. There is a possibility that if monetary policies continue as they are, then the growth in U.S. GDP could be half the rate of growth in 2004 and 2005.

If the Fed under a new Chair, Ben Bernanke, stops raising the Fed rate at 4.5 pct, and the prime commercial bank lending rate peaks at about 7.5 pct, and the 30-year mortgage rate, which is now up to about 6.15 pct, tops out in 1H2006 at about 6.6 pct, then I think the economy will not go into a recession.

In that case, I believe the U.S. GDP will probably slow to about +2.0 growth in 2006, and the equity bear phase will bottom in the Dow=9200 to 9800 level.

That would be a good time to go fully invested in stocks and bonds, and drop the goldminer shares to 5 pct weighting, but not lower until global inflation is no longer a problem. When global inflation (CPI) growth rates average under +4 pct, which means that U.S. rates would have to be at +2 pct or lower (based on various factors including the methodologies used to calculate CPI), then inflation is not to be a worry.

However, that point might not occur until past the year 2010.

Posted by Posted by Bill Cara on November 7, 2005 08:50:06 AM | Category: Cara Investment Reports

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