Investment Showdown: Where is the Market Going? and What is Inflation?

A recent investment question was posed to a group of wealth managers online.  I answered the question to my understanding, based upon my austrian-monetarist investment philosophy.  Opinions got a bit carried away and my opinion was ridiculed.  I have included the question with his response and my rebuttal.  Because I don't really know the guy, and I don't have his permission, I will call him Phil. 
Which is the most over-valued asset class?  Long-term bonds? Any kind of equity sector? Gold or oil? Spanish Real Estate? Is there a "green-bubble"?

My Answer: 
All US financial assets, i.e. all stocks and bonds (more on that later).
The US Rally has been significant when examined by itself, but it doesn't hold up when compared against all other asset classes, (see .

(Especially)... US real estate. Ignoring the looming foreclosure crisis, the Fed's actions have not allowed US real estate to find a bottom and is already causing inflation that will be felt when they stop. The two activities that the Fed is engaged in are purchasing MBS and other whole loan backed notes. The Fed's engaging in asset purchases has neccessarily caused the siezure of the secondary market. Why sell when the fed will buy them at a higher price? This has caused inflation in the MBS/ABS/CDO market.

The other form of intervention has been in the form of purchasing Treasury securities, thus reducing the interest rate for longer term assets. This has the effect of reducing the US debt, while at the same time US Congress and the US President are increasing the debt. In this case the monetary and fiscal policies are at cross purposes. When the Fed slows down, interest rates must increase. Since 22% of leveraged real estate prices can be explained by the interest rate, residential and commercial real estate will both fall in real prices (See

For this same reason, all US financial assets are overvalued, as they all are correlated with the long term rates. Equities less than Fixed income but both will fall.

Also note, that inflation is an expansion of the money supply. CPI and PPI are only attempts to capture that expansion. To me it was amazing that from 2001 - 2006 the Fed said that there was no inflation while, the home prices continued to double. It is true that expansion of the money supply be lumpy, i.e. money can make preferences for one asset vs another. So while the price of the largest purchase that almost everyone makes in their lifetime was increasing at an unsustainable clip, since bacon prices held firm, no inflation. It makes no sense.

So while the Fed has said that there is no inflation, there has necessarily been an increase in the money supply. It has yet to plainly manifest itself though. Perhaps all the cash is sitting on the sidelines, perhaps it is going to Brazil and China. But it has to pop up its head someplace. If it goes where Jim Rogers and Peter Schiff tend to think it will go, i.e. into tangible assets, commodities, etc. We will see inflation show up in the CPI numbers.

That is why I continue to think that hard assets will outperform all other financial assets. Not just gold, but sugar, coffee, etc. That would also be expected as interest rates rise because it shifts our investment preferences with the steepening of the yield curve from long-term to shorter-term assets. And, what is shorter term than tangible assets, you guessed it, nothing.

I have this and other economic information available on my blog at

Phil's Response:
Dear Taylor,

The idea that Fed actions prevents markets from reaching natural bottoms is absurd. The Fed is part of the economic system. Its actions and other factors can arrest markets from falling off or prevent markets from well as cause bubbles to form and deflate. There is far too much debate on Fed action..forget about such personal view, and look at the market action and participate when your observations and measurements are giving comfort. If one is inclined to listen too much to other people, one might as well give money to them to manage. Take Jim Rogers. He has been making the case for commodities for the last 10 years and look what happened. Last year was a good time to enter. Until 2011 to 2012 the odds are that longs in softs will make money. Jim makes money when people are long or short of commodities. More when people are long. His views will always have a long bias on commodities. Don't listen to people who sell their books. Still, Macroeconomic, Fundamental and Microeconomic factors appear to be aligned for most asset classes (except perhaps long dated bonds) to continue to perform. Even there I don't, for the time being, see inflation as a concern. A bit of inflation would still be good for equities, commodities, housing, but not perhaps for emerging markets.

CPI is not a measure of price increases for sectors or houses. It is an Index consisting of many constituents. I don't know why you are amazed, Overall prices, as measured by the CPI have remained and will remain relatively stable with a slight upward bias.

What exactly is a hard asset? House? Copper one can argue is a hard asset. Are Copper futures hard? Or is exposure only to the spot price of Copper is a hard investment? Does one mean unleveraged assets or assets that are not renewable as hard assets? Are factories and machinery hard assets? Are soft commodities hard or soft assets?

Sorry if I am too direct. Phil

My Rebuttal: 
Dear Phil,

Thanks for your comments. I can take a good debate.

I don't know how you can take the actions of the main player (the Fed), and say that they have no effect on what the market does. Yes, they are a player, in many cases they are the only player. The point that I was making was that the Fed has been propping up assets by buying when no one else was willing or able to buy. Had it not been for the actions of the Fed, the prices would now be lower. I think that proponents and opponents of the Fed's action can agree about that.

To say that the Fed, who sets overnight rates and basically owns the short end of the yield curve has no affect on the economy is ignoring reality. An inverted yield curve has ben followed by a recession 9 of the last 10 times. You would be foolish to ignore the Fed.

Much of your comments about not listening too much to other people is right on the money, but I don't know why you said it. Maybe you think I am getting my information from other sources. I don't know what is wrong with listening to people whose investment philosophy is similar to your own.

Perhaps the real reason that I think that Real Estate is overvalued is because I know the correlation between long term rates and real housing prices. If inflation were to raise it's ugly head and long-term rates would increase, every financial asset would be affected, fixed income and stocks. I don't need Jim Rogers to tell me that.

You are almost correct in what goes into the CPI, but dead wrong on its intent. The intent of the CPI was always to capture increases in the price level as a proxy for the money supply (M2). It does not include housing prices. There is something included in the CPI that is called "mortgage equivalent rent", which attempts to capture the effect of housing on the money supply was not captured because housing kept rising while rents stayed flat. (Yes that piece of research I did myself).

As far as Macroeconomic, Fundamental and Microeconomic factors appearing to be aligned for most asset classes you can also argue that people haven't been more bullish about the market in general since 1987 right before that crash. Indeed, it is usually when there is a healthy skepticism that the market does well. I don't see that skepticism in anyone but myself.

As far as a definition of hard assets. The first place I usually go when I have such a question is wikipedia (See .




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