Brighton Perspective

Planadviser.com

Planadviser.com.

Larger DC plans are turning to consultants more frequently to help with plan management. This trend should extend to smaller plans as well. Smaller plans, particularly those in the "micro" market, say less than $25 million in plan assets, can benefit from a consultant's services. The plan trustees are frequently the owner(s) of the company and are more focused on the daily responsibilities of managing the business. The consequence is benign neglect of the 401k plan.

Yet, the 401k plan can be a fantastic recruiting and retention tool. A well-structured plan offering strong investment options and excellent service (24/7 online access, loan management, investment tools, etc) can help employees plan and save for retirement and help improve employee morale. The consultant can help the trustees meet their fiduciary responsibilities and support the success of the plan in several ways - investment policy statement (blueprint for the plan), investment manager selection, plan monitoring and performance reporting, client service (why participate?, economic outlook, investment education, etc).

Smaller plan trustees should give thought to utilizing a consultant as the benefits can be meaningful.

Calculated Risk: The Housing Tax Credit and the Consumer Price Index

Calculated Risk: The Housing Tax Credit and the Consumer Price Index.

Calculated Risk writes great stuff regarding real estate. Here he makes the case that the first-time buyers tax credit should have a negative effect on CPI (deflationary) and is an inefficient incentive (for taxpayers).

Many writers are suggesting lately, really for quite a while, that almost every action the government has taken to counter the recession has been inefficient and ineffective. For example, Hussman (www.hussmanfunds.com) discusses the similarities between our approach to bank loan losses and that of Japan in the early 90s. Amity Shlaes (www.bloomberg.com) writes about treating home buyers as children. The point is that consumers/investors are more rational than government actors believe and will strive to maximize personal well-being. Thus, the cash for clunkers accelerates car purchases but doesn't lead to a new elevated level of car purchases. The first-time buyer tax credit accelerates home purchases but doesn't lead to a persistent higher level of home buying and, in fact, has a offset in falling rental rates. All of this leads to current economic activity looking great, but as El-Erian writes (www.financialtimes.com) doesn't adjust the level of activity permanently. That leads to "irrational exuberance" to borrow a well-known phrase.

The consequence is short-term improvement in GDP and financial markets performance but the potential for great disappointment 6 months from now when current levels are proven unsustainable.

Weekly Update

Market Week: September 28, 2009

The Markets The rally took a breather (or possibly a last gasp?) this week. The Dow backed away from the tantalizingly close 10,000 level with a 177-point intraday swing on Wednesday after the Federal Reserve's discussion of its future bond-buying plans. It was largely downhill from there as the major indexes took back much of last week's gains. Market/Index 2008 Close Prior Week As of 9/25/09 Week Change YTD Change DJIA 8776.39 9820.20 9665.19 -1.58% 10.13% NASDAQ 1577.03 2132.86 2090.92 -1.97% 32.59% S&P 500 903.25 1068.30 1044.38 -2.24% 15.62% Russell 2000 499.45 617.88 598.94 -3.07% 19.92% Global Dow 1526.21 1926.12 1884.05 -2.18% 23.45% Fed. Funds .25% .25% .25% 0 bps 0 bps 10-year Treasuries 2.24% 3.47% 3.33% -14 bps 109 bps Last Week's Headlines After four straight months of increases, existing home sales fell 2.7% in August--a sharp drop from July's 7.2% increase. However, the total backlog of unsold homes was down to an 8.5-month inventory. Sales of new homes were essentially flat after four months of increases, and inventories of unsold new homes fell by 3%. As expected, the Fed kept interest rates steady but will extend its purchases of mortgage-backed securities, gradually winding down the program by the end of Q1 2010. However, Fed buying of Treasury bonds, which has helped support that market, will stop at the end of October as previously announced. Leading economic indicators tracked by the Conference Board were up for the fifth month in a row. The major factors in the 0.6% August increase were supplier deliveries, the interest rate spread between 10-year Treasuries and the fed funds rate, and higher stock prices. Only three indicators--real money supply, weekly jobless claims, and new orders for nondefense capital goods--were negative. Five IPOs that began trading on a single day this week and increased filings for more at the SEC gave another indication of renewed appetite for increased risk. Orders for durable goods fell 2.4% in August after a 4.8% increase the month before. A dramatic drop in commercial aircraft orders was responsible for much of the decline. However, even non-transportation-related goods were down slightly after having increased 0.9% in July, and defense-related spending provided much of the support for that figure. Gold had its first weekly loss in six weeks, and well-stocked inventories pushed oil down roughly 8%, the biggest weekly loss since July. The G20 leaders agreed to promote more domestic consumption by export-dominated China and Japan, a lower U.S. budget deficit, increased International Monetary Fund ownership by developing nations, and reforms in bank compensation policies and capital requirements. However, skeptics noted that the so-called global framework for growth lacks any enforcement mechanism. Eye on the Week Ahead Potential window-dressing on the part of large institutional investors could mean volatility in advance of the end of the quarter on Wednesday. Friday's unemployment claims stats are expected to continue to show job losses. Key data releases: Home prices, consumer confidence (9/29); revised Q2 gross domestic product (9/30); auto sales, personal income and spending, manufacturing (10/1); unemployment, nonfarm payrolls (10/2). Data source: Includes data provided by Forefield, Inc. & Brounes & Associates. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indexes listed are unmanaged and are not available for direct investment.

Deflation or Inflation?

From the recently released IMF report - "World Economic Outlook - Sustaining the Recovery"

c4.pdf (application/pdf Object).

"Looking ahead, the timing for the withdrawal of the extraordinary amount of monetary and fiscal stimulus that has been implemented in many countries will be important. On the one hand, a premature exit could stifle the recovery. On the other hand, delaying the withdrawal of stimulus could be inflationary."

How thinks the government will get this right?

My expectations is the government will err on the side of delaying a withdrawal, thus I continue to hedge expectations of inflation.

Cash on the Sidelines?

Whenever markets decline, talk invariably turns to "cash on the sidelines" and the impact it will have when it returns to the markets. Annaly Capital Management has a commentary that shows several charts regarding "cash on the sidelines". The essence is that cash never leaves the sidelines! I would guess that the cash holding is a policy decision and the few investors that do move to all cash at some point during a downturn don't materially impact the aggregate level of cash. This is an interesting chart from Annaly Capital Management:

To me, it highlights clearly the introduction of leverage into the markets in the late 1970s (Milken?!) and the continued increase in leverage until the mid 90s at which point it more or less stabilizes just over 20%. Cash collateral again declines during 2001 (hedge fund boom) and bottoms last year before turning back up, much as it did in 2000 (post interet bubble burst). Clearly, there remains significant leverage in the equity markets. I think the question is will this de-levering trend continue or will we see a reversal as we did in 2001/2002? If market participants continue to de-lever, markets are unlikely to move materially higher - it stands to reason that "un-levered" markets will trend consistent with earnings trends. If leverage isn't reduced, then we could see markets continue to accelerate a rate greater than earnings growth (more dollars translates to greater demand). I don't know the answer but I do think it needs to be an important consideration for any forecasts of future returns.

I expect participants will continue to de-lever in anticipation of potential inflation (which will increase borrowing costs) and because of a desire to improve balance sheets and reduce risk. To what point I don't know, maybe to 25% from roughly 20% now. That would suggest a 25% reduction in debt still to come. That should dampen returns but suggests that we won't see a true 1-1 relationship between financial market growth and earnings growth. In other words, it is possible that we won't see P/Es return to historical averages (such as 15 on the S&P) but rather some level above that.

Currently, the S&P is trading at 19.6X bottom-up 2009 estimates and 14.5X 2010 estimates. P/Es tend to contract after the economy troughs as real results start to meet and exceed expectations upon which prices are set. If P/Es contract to 15 (historical average), the potential year-end 2010 S&P index level would be 1094. I think many would see that as reasonable given the current economic environment of slow improvement in fundamentals. But if leverage doesn't decline as much as people, including me, have expected, the P/E ratio may contract only to, say, 17.3 (50%). Then the S&P might close 2010 at 1262. That would be a roughly 19% gain over the next 15 months. 

I will continue to hedge downside risk but will be paying close attention to the ratio highlighted in the chart above (as well as to overall economic data). If 09 earnings do hit current S&P estimates, then it may be time to revise my personal outlook.

Hussman Funds - Weekly Market Comment: Strenuously Overbought - September 21, 2009

Hussman Funds - Weekly Market Comment: Strenuously Overbought - September 21, 2009.

I remain wary of current market valuations. I've held throughout 2009 that the S&P will close around 950 which would require a roughly 11% correction from current levels. Hussman makes the case more eloquently than I would so please read.

Hedging downside risk is like an insurance premium. You pay the premium but hope you'll not need the insurance. When you do, you're glad you kept making the payments. If we don't have the pullback I expect then you're return will be slightly below an unhedged portfolio but still positive. If we do have a correction, you won't be immune but will likely see less of a decline than unhedged peers and that will be worth the "premium".

The Policy Views of American Economics Association Members

ejw_derc_sep09_whaples.pdf (application/pdf Object).

Very interesting results of a new survey of AEA members. Results start on page 4. Generally, favor lower taxes, lower artificial trade constraints.

David K. Levine: An Open Letter to Paul Krugman

David K. Levine: An Open Letter to Paul Krugman.

Well said!

Weekly Update

Market Week: September 21, 2009

The Markets What a difference a year makes! The anniversary of one of 2008's most horrific weeks was living proof of the equity markets' resilience. A year after Lehman collapsed and the Primary Reserve Fund broke the buck, investors were determined to push stocks higher yet again. Though they haven't completely recovered to the levels of last year at this time, the major indexes aren't far away. The Dow continued its march toward the 10,000 mark--a far cry from its 6,547 March low--and the S&P 500 rose for the eighth time in ten weeks. Market/Index 2008 Close Prior Week As of 9/18/09 Week Change YTD Change DJIA 8776.39 9605.41 9820.20 2.24% 11.89% NASDAQ 1577.03 2080.90 2132.86 2.50% 35.25% S&P 500 903.25 1042.73 1068.30 2.45% 18.27% Russell 2000 499.45 593.59 617.88 4.09% 23.71% Global Dow 1526.21 1887.15 1926.12 2.07% 26.20% Fed. Funds .25% .25% .25% 0 bps 0 bps 10-year Treasuries 2.24% 3.35% 3.47% 12 bps 123 bps Last Week's Headlines Retail sales were up 2.7% in August--more than had been expected. Cash for clunkers was a major factor; cars and car parts saw a 10.7% increase. However, even if cars and rising gas prices are excluded, other sales were still up by 0.6%. A 9.1% monthly increase in gas prices caused most of the 0.4% August increase in consumer prices. However, gas prices are still 30% lower than last year, dropping the overall annual Consumer Price Index to -1.5%. Not including food and energy, the so-called core inflation rate was up by 0.1% from July and 1.4% for the year (the lowest rate since February 2004). At the wholesale level, prices jumped 1.7% in August--roughly the same amount as June but higher than July's 0.9% decline--though they were still down 4.3% from last August. As with consumer prices, the increase was largely the result of rising gas and other energy costs. Not including food and energy, the core Producer Price Index was up by only 0.2%, though it's up 2.3% from a year ago. Industrial production also was up by 0.8% in August compared to July. Concerns about the specter of trade wars between China and the U.S. surfaced when China said it will ask the World Trade Organization to investigate complaints of U.S. dumping of chickens and auto parts on the Chinese market. The move came after the U.S. imposed stiffer tariffs on imports of Chinese tires. Fed chairman Ben Bernanke said the recession is "very likely over," though he once again warned the recovery is expected to be weak and unemployment figures will be slow to come down. Housing starts rose 1.5% from July's 589,000 but were still down 29.6% below last year's 849,000. New building permits were also up from July by 2.7%, but down 32.4% from last August. Eye on the Week Ahead The tone of the Federal Reserve Board's decision on its target interest rate will be watched, though the rate itself is expected to remain the same. And as the end of the quarter approaches, the ongoing debate between bulls (who anticipate favorable year-over-year comparisons ahead) and bears (who continue to ask how much longer the rally can last without some sort of pullback) will likely intensify. Key data releases: Conference Board leading indicators (9/21); Federal Reserve meeting announcement (9/23); home resales (9/24); durable goods orders, consumer sentiment, new home sales (9/25). Data source: Includes data provided by Forefield, Inc. & Brounes & Associates. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indexes listed are unmanaged and are not available for direct investment.

Calculated Risk: The End of the Official Recession?

Calculated Risk: The End of the Official Recession?.

This post highlights many of my own concerns regarding the economy. Essentially, while the recession may be over, the hangover will take time to wear off. Unemployment appears to continue to increase and many believe it will increase into early 2010 before leveling off. As Calculated Risk notes, personal spending and real estate investment tend to be leaders in recovery (historically). However, the private sector has, in aggregate, continued to curtail spending and real estate investment.

Offsetting that are indications that corporate capital spending is increasing (at least YOY). If it continues, that will prove beneficial. I believe that increases in capital spending improve consumer confidence which leads to increased consumer spending. Consider, if you're with a company that has been squeezing expenses to meet earnings estimates you've likely seen your share of layoffs. As a result, you've been concerned about your own job and, consequently, have cut back on spending just in case. Now, you see your company begin to invest in delayed capital improvement projects, new technology infrastructure, for example. You may continue to manage your spending, but as you see the company increase capital outlays, your confidence in your job security increases and as it does, so does your willingness to spend.

This process takes time. If capital spending continues to improve, I believe we'll see consumer confidence continue to increase and eventually we'll see an improvement in consumer spending (roughly 70% of GDP). By eventually, I mean early to mid 2010.

the-new-roth-rollover-rules-explained.html: Personal Finance News from Yahoo! Finance

the-new-roth-rollover-rules-explained.html: Personal Finance News from Yahoo! Finance.

This is worth considering for many people. One issue to keep in mind is paying the tax due on the conversion. To avoid penalties, the tax payment should be made with assets not part of the conversion.

Weekly Update

Market Week: September 14, 2009

The Markets Traders continued to let the good times roll as equity markets once again edged upward to hit highs for the year before falling back slightly on Friday. The Nasdaq extended its leadership of the domestic indexes and has now rallied 64% from its March low, while the S&P 500 is up 54%. And on Friday's anniversary of Sept. 11, the Dow was a whisker below its close before the towers went down. Gold and the dollar continued their seesaw act, with the dollar falling to its lowest level against the euro since last September and gold perched atop the closely watched $1,000 mark. Market/Index 2008 Close Prior Week As of 9/11/09 Week Change YTD Change DJIA 8776.39 9441.27 9605.41 1.74% 9.45% NASDAQ 1577.03 2018.78 2080.90 3.08% 31.95% S&P 500 903.25 1016.40 1042.73 2.59% 15.44% Russell 2000 499.45 570.50 593.59 4.05% 18.85% Global Dow 1526.21 1808.54 1887.15 4.35% 23.65% Fed. Funds .25% .25% .25% 0 bps 0 bps 10-year Treasuries 2.24% 3.44% 3.35% -9 bps 111 bps Last Week's Headlines For the sixth straight month, Americans were borrowing less--voluntarily or involuntarily. The level of outstanding credit dropped in July at an annual rate of 10.4%. It's the second month in a row that the decline in debt has hit record levels. Almost half the banks surveyed by the Federal Reserve reported reducing credit lines for existing customers, which is unlikely to be good news for the 70% of the economy tied to consumer spending. That sluggish consumer spending showed up in the Federal Reserve Board's "beige book" report. However, all but one of the Fed's 12 districts reported at least some signs of increasing economic stability, and most also saw hints of stronger housing activity. New foreclosure filings as measured by RealtyTrac dropped half a percent in August from the previous month, but at 358,471 were still 18% higher than last August. However, the number of REO (lender-owned) properties was down 13% from July. Meanwhile, the Treasury Department said only 12% of the mortgages eligible for loan modifications under its Home Affordable Modification Program had been revised, and one Treasury official told Congress that some estimates forecast six million more foreclosures over the next three years. Those foreclosures clearly weren't affecting consumer mood as the Reuters/University of Michigan index of consumer sentiment jumped to 70.2 from 65.7 in August. The U.S. trade deficit increased 16.3% between July and August, largely because of oil prices, and now stands at $31.96 billion. That's the steepest monthly increase in the gap between exports and imports in 10 years. Treasury Secretary Timothy Geithner told Congress that about $70 billion of the $250 billion injected into banks in the last year to enhance their liquidity has been repaid so far. He also said the government has received a 17% return on its investment in 23 banks that have completely repaid those loans. Eye on the Week Ahead On Monday, President Obama will address the progress (or lack thereof) in implementing regulatory changes designed to help manage the kind of systemic risk that shook the financial world a year ago. Friday brings quadruple witching options expiration and the demise of the Treasury's guarantee program for money market funds. Key data releases: Wholesale prices, retail sales (9/15); inflation, industrial production (9/16); housing starts (9/17). Data source: Includes data provided by Forefield, Inc. & Brounes & Associates. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indexes listed are unmanaged and are not available for direct investment.

Weekly Update

Market Week: September 8, 2009

The Markets September--historically the cruelest month for the equity markets--ran true to form on its first day with last Tuesday's resounding 186-point thud in the Dow and 2.21% drop in the S&P 500 (worse than the S&P's 1.3% average historical loss for the entire month of September). However, the indexes managed to claw at least part of the way back up during the remainder of the week. The spot gold price shot up almost 4% during the week. Market/Index 2008 Close Prior Week As of 9/4/09 Week Change YTD Change DJIA 8776.39 9544.20 9441.27 -1.08% 7.58% NASDAQ 1577.03 2028.77 2018.78 -.49% 28.01% S&P 500 903.25 1028.93 1016.40 -1.22% 12.53% Russell 2000 499.45 579.86 570.50 -1.61% 14.23% Global Dow 1526.21 1841.91 1808.54 -1.81% 18.5% Fed. Funds .25% .25% .25% 0 bps 0 bps 10-year Treasuries 2.24% 3.45% 3.44% -1 bps 120 bps Last Week's Headlines For the first time in 18 months, U.S. manufacturing activity in August hit a number--52.9%--that indicates expansion rather than contraction. Eleven of the 18 industries measured by the index reported growth. Driven by the need to restock depleted inventories, the new orders index at 64.9% was the highest it's been since December 2004. Service industries contracted again in August, but were less than 2 percentage points from the crucial 50% threshold for official expansion. August was the 20th straight month of job losses as the unemployment rate rose to 9.7%--the highest level since 1983--from July's 9.4%. Including people working part-time involuntarily and those who have given up looking for jobs, the unemployment rate was 16.8%. However, the 216,000 drop in nonfarm payrolls was the lowest number of jobs lost in a month since last August, and better than July's 276,000 jobs lost. U.S. companies got more out of their employees in 2009's second quarter as productivity increased at an annual rate of 6.6%. Hourly compensation was up slightly, but labor costs fell at an annualized 5.9%--not surprising given the 7.6% annualized decline in hours worked (one result of all those layoffs). New orders for manufactured goods rose 1.3% in July--the fifth increase in six months. Much of the gain was powered by the 5.1% increase in new orders for aircraft and other durable goods. However, excluding aircraft and other transportation-related items, new orders fell 0.7%. The head of the International Monetary Fund (IMF) urged world leaders not to end their various economic stimulus efforts prematurely, saying they should "err on the side of caution." Eye on the Week Ahead The holiday-abbreviated week ahead is light on new economic data. However, now that Labor Day has brought summer to its unofficial end, trading volume may begin to increase. That could bring greater clarity about the future direction of the equity indexes. News articles leading up to the following week's September 15 one-year anniversary of the Lehman Bros. bankruptcy, which helped send the markets into a tailspin, might also start to affect investors' psyches. Key data releases: Consumer credit (9/8); balance of trade (9/10); consumer sentiment, Treasury budget (9/11). Data source: Includes data provided by Forefield, Inc. & Brounes & Associates. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indexes listed are unmanaged and are not available for direct investment.

Fiscal Stimulus and Inflation

James Surowiecki has a commentary in the September 14 issue of the New Yorker arguing that some are over-reacting to the prospect of inflation and that we should "wait until the car is actually moving forward before we worry about applying the brakes." The problem with this statement is that Surowiecki ignores the role of expectations in economic theory.

I've noted before that expectations can be more important to economic and financial market performance than actual results. This white paper from the IMF highlights the role of expectations very well. Economic participants will adjust their current behavior to meet their expectations of future results. Many worried about inflation are worried because they expect that government spending, in the form of the fiscal stimulus, will not be curtailed in the near future when "the car" is moving. Consumers and businesses cut back on spending for a variety of reasons - lack of employment, self-preservation, and expectations of future needs for current income such as higher taxes. The current increase in government spending offsets that decline in private spending. Once the car is moving, however, it becomes difficult to "apply the brakes". The paper notes that private spending will increase if expectations are that public spending will fall in the future. That does not appear to be the case in the current environment. Instead, many among the private sector are not expecting public spending to decline. That expectation, in turn, leads to the expectation of inflation. 

Because of the lag in monetary and fiscal policy, "applying the brakes" after the "car is moving" will be too late to prevent inflation. As I see it, economic participants are expecting inflation because they don't expect government spending to fall when private sector spending increases (GDP growth turns positive again). Higher public spending + higher private spending + increased money supply + low interest rates = very high probability of inflation. Hedging inflation expectations makes sense - if I'm wrong, the hedge can be unwound. If I'm right, my portfolio will hold up better than most - especially of those waiting to apply the brakes after the car gets moving.

The Return of Capital Spending - BusinessWeek

The Return of Capital Spending - BusinessWeek.

I think this is the key to a healthy recovery. Yes, consumer spending comprises 2/3rds of U.S. GDP but consumers won't spend until they have a regained sense of job security. As long as the companies for which they work continue to cut costs to meet earnings estimates, consumers will keep their money in their pockets. When they sense companies are opening their wallets, in the form of increased capital spending, consumers will begin to relax. This is so because it suggests to consumers that companies are becoming more optimistic and are spending to support future growth. Increased spending also suggests a lower probability of future layoffs which means consumers sense of job security improves.

So, this is good news.

Rates Will Have to Rise 'Very Rapidly': Fed's Plosser - Economy * Europe * News * Story - CNBC.com

Rates Will Have to Rise 'Very Rapidly': Fed's Plosser - Economy * Europe * News * Story - CNBC.com.

This is the central challenge facing the Fed - if they don't raise rates quickly, inflation is a severe risk. If they do raise rates quickly, the nascent recovery could be choked off quickly and we'll face the potential of a double dip recession.

The first order of business, should be to shrink the balance sheet, which is noted in the story. Shrinking money supply will help reduce the risk of inflation and could mitigate the need for very rapid rate hikes. However, as I've noted before, the real money supply culprit is the fiscal stimulus not Fed activity. The stimulus is likely to increase the money supply rapidly just as the economy moves into a stronger growth phase in late 2010. The increase in money supply coupled with the improvement in the economy, will force the Fed to raise rates very rapidly.

I still believe we'll see a sharp uptick in inflation in late 2010 and that despite the Fed's best efforts, it will take a few years before it is arrested. I believe an inflation hedge is valuable in portfolios and expect that even if I'm wrong on inflation, the hedge could prove beneficial. Inflation hedging strategies could include exposure to TIPS, commodities, real estate, higher equity exposure and bank loans.