As the chart below shows, stocks are still in a bull market, begun back in early 2003, and will continue higher until the Fed signals the end of monetary expansion by raising short-term rates again.
INFLATION AND THE STOCK MARKET
If inflation is coming, as we forecast in a previous weblog entry, stocks will outperform bonds by a substantial margin - perhaps as much as 10% - until the Fed realizes how badly it's blundered and starts raising the Fed Funds target again.
As inflationary pressures push into the economy, businesses will use this opportunity to raise prices on all goods and services, fattening income, earnings, and dividends.
INFLATION AND THE VALUE OF THE DOLLAR
Inflation is also lowering the value of the dollar against most trading-partner currencies, making imports more expensive, and raising domestic US prices.
The lower-valued dollar will also make exports cheaper, boosting the sales and stock prices of major US exporters.
ASSET ALLOCATION
For all these reasons Paterson Financial has moved a portion of the portfolio out of two year notes and into the NYSE composite.
The fraction of assets held in fixed income securities should be reduced to no more than 30% of assets and aggressive managers might go as low as 10% in fixed income securities.
Very aggressive money managers will consider dividend-free equities as typified by the NASDAQ 100.
Notice the index has more than doubled since the lows of 2002 and will lead the way as stocks trade higher.
If the index doubles again in the next 4 years prices will approach the highs seen last in the year 2000.
CONCLUSION
Until the Fed sees the error of its ways, prudent money managers will reduce fixed income holdings past the two year note, and will continue money market arbitrage.
STRATEGY
Asset managers must re-introduce growing inflation into their models.
The board must be notified of the potential for increasing input and output prices, interest rates, and the stock market.
Senior managers must review lending policies and procedures to make sure to place a sufficient spread in all fixed income business, and ensure a match of asset and liability maturities.
Hedging programs must be examined for opportunities presented by occasional spikes in long term debt prices.
TACTICS
Extend the amount and maturity of liabilities.
Prepare bond offerings and use the CBOT in advance of bond sales if prices spike upwards.
Increase spreads on all loan transactions.
Be aware of Treasury refundings and take advantage of price changes.
Begin active hedging on a small scale, selling into overbought US Bond futures.
