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Ken Partch: Financial Markets Kept Direction Debate Spinning in 2010

Battle between inflation, deflation far from settled as 2011 begins

In my role as a financial advisor I sometimes take on the job of listening to confessions of an investing nature from friends and family. Invariably, it’s when I’m standing in line at Whole Foods, or at a family gathering, and like a prisoner on a chain gang I see few options but to listen. Time is always short so we both know it will be painfully quick and to the point. I’ve learned to either praise their good financial decisions or allow them to use my imaginary oversized black board eraser — like those used in the late 1960s and ‘70s — to wipe away the fact that whether they were up 10 percent or down 10 percent for the year, this is a new year and all slates are clean. What follows is the first in a two-part series, this part being the forces that investors confronted last year.

While I have a major confession of my own, which I’ll share in a minute, I need not confess that I was quite bullish going into 2010. I believed wholeheartedly that the efforts undertaken by the U.S. government and central banks around the globe to keep economies and financial markets afloat would be a very positive development for both the bond and stock markets. In fact, our diversified portfolios of stocks and bonds and commodities proved to be a very formidable opponent against the major market indexes — the Standard & Poor’s 500 stock index, which rose 12.8 percent to finish at 1257.64, and the Dow Jones Industrial Average, which rose 11 percent to end the year at 11,577.51.

While the financial markets pushed higher in 2010, making the second-year recovery from the financial crisis now a reality, the first half of the year was littered with devastating news that the financial crisis that began here in the United States in 2008 was spreading with reckless abandon to other places around the globe. The second half of the year, however, could be characterized as nearly as ideal as any money manager would wish. Corporate earnings were good, interest rates remained somewhat low, investor confidence was on the rise (slightly), and global uncertainties were beginning to go away (not completely, though). I felt quite confident that the markets would end up on a real high note for the year and never deviated.

January 2010 had all the hopes of a great year, but ended poorly. History says that as January goes, so goes the rest of the year. History was wrong, as we would learn. February saw stocks drop, then recover most of their gains. March and April were great but come May all bets were off. Stocks fell as concerns about global contagion spread. On May 9, the European Union unveiled a huge rescue fund in an attempt to keep Greece’s debt crisis from spreading to Portugal, Ireland and Spain. As a result, the EU managed to turn a very chaotic and scary event into little more than a giant hiccup.

While one crisis abated, summer here in the United States spawned investor fears that what had been seen as an accurate and reliable gauge of economic prosperity during past recovery periods — the unemployment rate index — was now no more help than a cracked gauge out of a junkyard relic. With unemployment stuck above 9 percent and the best estimates forecasting a very slow-moving needle, investors became edgy, forcing selling, driving the major market indexes to losses in excess of 10 percent. To find an optimistic investor you had to go to another country. I wrote a piece in which I said that investors would be better off wearing a set of noise-canceling headphones. The distractions were so bad that you began to wonder if you could actually hear yourself think. The “roar of the crowd” was deafening and the best I could do was deny the pundits their heckling.

Seeing that the “dog days” of summer melted all enthusiasm that investors once had, Federal Reserve Board chairman Ben Bernanke opened the final set of the government’s finely orchestrated moves for another round of bond purchases designed to force the consumer to spend. The maestro had revisited a recurring theme of his and that was that deflation was a bigger animal to harness then inflation is to slay. That wasn’t a quote of his but I thought you would pardon my interpretation. And while many in the crowd of financial literacy seemed to believe that this was lunacy, I didn’t agree. I wrote another piece extolling the virtues of such a move.

As summer came to a close, stocks took off, making September one the best performing months of all time. Writing my clients in September was the best birthday present I could give myself. It was easy; my predictions of a good year were starting to come into full view. October, historically a challenging month for investors, was impressive. Meanwhile, the debate on quantitative easing 2 was heating up. QE2 was having an effect, but it wasn’t clear if it was intentional or incidental. All we knew is that stocks soared — to the delight of investors — but bonds fell as interest rates bolted. Not exactly what was forecast.

So what had been largely seen by money managers as an attempt by the Federal Reserve to lower interest rates — making borrowing more inexpensive, thus driving consumer spending, which drives the wheels of economic alchemy — the exact opposite happened. I was of the opinion that Bernanke was never intending to lower interest rates — and he only wished to take money from the Treasury to purchase mortgage bonds — thus giving banks more capital on the balance sheets from which to lend. Interest rates may be slightly higher, but banks with an incentive to lend can make a profit and keep the Fed happy.

Enter Bill Gross, manager of the largest bond fund in the country. Arguably the most followed, quoted, emulated and rich — I might add — beacon of wisdom on Wall Street. Gross eventually endorsed the Fed’s move but he didn’t actually embrace it, saying that he thought that billions of dollars in asset purchases may not stimulate borrowing or lending because consumer demand is just not there. Gross, a prolific and gifted writer, goes one step further on his Web site, saying that “QE2 is more like a Ponzi scheme.” Click here for the full text.

Gross’ lugubrious style and metaphor-rich way of agreeing with you but casting doubt at the same time might seem a little extreme, so it is hard for investors to know actually on what side of the fence he is standing. Death to bonds would not be good for a bond fund manager. Could he be right and the 30-year run in the bond market is dead? Don’t think so.

Enter Bernanke — smart, articulate, spelling-bee winner and all-around good guy in my humble opinion and a guy who does not have a dog in this fight. Only with his legacy in view, Bernanke has not a financial incentive to steer investors wrong. Bear in mind that Bernanke drives a Ford Focus and made $190,000 last year. Suppose he just wants to get us out of the mess we’ve been in? Gross, on the other hand, is one of the country’s wealthiest individuals — very smart, a little more verbose but an equally good guy. I would have dinner with both of them if I got the call.

Gross is right to say that if the economy cannot produce 2 percent inflation in 2011 then maybe it was a bad idea. Bernanke is right to fight the fight with all the tools he has. He is not near “pushing on a string” yet and still has the “bully pulpit” from which to orchestrate further moves. Bernanke is right to say that without QE2 stimulus, we run the risk of deflation. I think both are right.

Deflation is the snake in a room with the lights off. Inflation is the snake in the room with the lights on. I confess I hope that there is inflation.

Next time: Part Two — where we go from here.

— Kenneth Willard Partch is a registered principal offering securities and advisory services through Independent Financial Group LLC (IFG), a registered broker-dealer and investment advisor. Member FINRA/SIPC. Santa Barbara Wealth Management is not affiliated with IFG. California Insurance #OA5470. Licensed to sell securities in California. Views and opinions are provided as a courtesy. They are intended for educational purposes only and not to be interpreted as specific investment advice. Ken Partch can be reached at 805.563.7699.

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