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Pay Attention to the Rhyme

by on May 01, 2011 6:00 AM

In investing, we are always looking for the next big thing.  What will bring the most returns in the coming months, years or even days? To discern this, we look at history and make educated projections on where money is headed. 

A quote attributed to Mark Twain says, “History doesn’t repeat itself, but it does rhyme.” That doesn’t mean that our educated hypothesis will come true or that changes won’t happen. A consistent investment philosophy at Nestlerode & Loy has always been “pay attention.” What should investors be paying attention to now?

The big news is Standard & Poor’s negative watch on U.S. debt. I am surprised by how many people did not hear of this move. It is particularly startling in that this marks the first time since the attack on Pearl Harbor that an American rating agency has put such a negative outlook on all long-term U.S. debt issuance. Unlike then, however, this downgrade is of our own making. The outlook change was due to the United States’ inability to handle our large budget deficit. This move can be interpreted  a warning to the U.S. government to begin managing its budget effectively or face dire consequences.

A negative outlook on U.S. debt is typically a precursor to a lower credit rating. A credit rating on debt decides the amount of interest that needs to be paid to cover the risk the investor takes. A lower credit rating would make the U.S. debt load more burdensome by making it more expensive to finance. For an individual, the higher one’s credit rating, the better rates one gets and the easier it is to get credit. If one’s credit rating is downgraded, it makes it more expensive to buy a house, get a car, etc. It works the same way for our government.   

With the lower outlook for U.S. debt, the American dollar is weakening significantly and the U.S. Dollar Index is down 17.3 percent from June 7, 2010. The Federal Reserve is sticking with its easy money policy that floods dollars into the economy. Economics 101 teaches us about supply and demand. An oversupply of dollars leads to a lower value. With this continued policy, the fear is that inflationary risks are increasing. Anyone who has gone grocery shopping or filled their car or SUV with gas recently has felt the direct effects of inflation. Inflation by definition is the rise in the general level of prices of goods and services in an economy over time. Inflation is natural and has averaged 4 percent over the past 50 years. The danger occurs in a high inflationary environment. Historically, the heavy supply of money that our government has flooded into our economy has led to high inflation, so it looks as though this might “rhyme” with our current situation.

What about our stock markets, as portrayed by the typical indices? They are shaking off the negative outlook of the U.S. debt and the falling dollar. The NASDAQ, which is heavily allocated into technology stocks (think Apple, Amazon and Google), hit a new decade high recently. The Dow Jones Industrial Average, which consists of only 30 blue chip stocks, and the S&P 500, which follows 500 U.S. companies, both reached their highest levels since 2008.

All three of these averages are heavily weighted in large companies. What about smaller companies in the U.S.? The Russell 2000 is a widely followed small-cap index that recently reached all time highs. So small corporations as investments are also doing very well. 

Things are rosy on the U.S. investment front, yet our economy and unemployment, which remains at a high 9 percent, remain weak. This is the best time to pay attention and possibly look to take some gains off the table. You might broaden your investment outlook to encompass foreign securities that may be good deals to diversify more and not be as dependent on U.S. stocks. In addition, look for U.S. companies that get more of their income outside the United States. Dividends also can add to the return on a portfolio, so a decent payout that has been increasing and covered by net revenue is attractive.   

Of course, these are general guidelines and will not be appropriate for everyone. The best advice is still pay attention to what’s happening now and how can you profit from it or protect your portfolio from it.

 



Judy Loy, ChFCâ, is a Registered Investment Advisor and CEO at Nestlerode & Loy Investment Advisors, State College, Pa. A graduate of Penn State University, Loy has been with the firm since 1992, assisting clients with retirement planning, brokerage services and investment advice. She can be reached at [email protected]
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