"Safe Haven in the Storm"

06/09/2006 12:00 am EST

Focus:

Mark Skousen

Editor, Forecasts & Strategies, High-Income Alert

"The date I have written this, 06/06/06, might be appropriate, as I'm deeply concerned about the direction new Fed chairman Ben Bernanke is taking," cautions Mark Skousen. Here he looks at Federal Reserve policy and warns investors about potential risks ahead.

"Fed chairman Ben Bernanke is showing extreme efforts to curtail inflation an inflation, by the way, that the Fed engineered in the first place by lowering interest rates and flooding the system with money after 2001. He recently warned in a speech that the new Fed policy-makers would not tolerate current inflationary pressures. ‘We will be vigilant,’ he said. Not surprisingly, it was not what Wall Street wanted to hear, and the market fell sharply yesterday.

"It could be the beginning of a major slide in the markets across the board (except Treasury bonds and other safe havens. It could even mean another stock market crash. A coming bear market or crash could hit all sorts of financial assets stocks, gold, commodities, and real estate. We've seen this sort of thing before, when the Fed has overreacted to an inflation and irrational exuberance that the Fed engineered in the first place. Several dates come to mind: 1966, 1987, 2000.

"In fact, the summer of 2006 is eerily similar to 1987, Alan Greenspan's first year as Fed chairman. What happened in October 1987? The stock market fell 23% in a single day! I remember it well, because October 19, 1987 was my 40th birthday. Fortunately, I warned investors six weeks before to ‘sell everything,’ but few followed my advice. The stock market collapsed in 1987 because the new chairman talked tough about inflation and raised interest rates. The Treasury secretary also said he supported a weaker dollar. It was not what the markets wanted to hear.

"What's the cause of this bear market and potential crash? The Fed chairman is much more powerful than most people think. Financially speaking, he's more powerful than the president. Ben Bernanke has followed his predecessor Greenspan by raising rates further, and now he is doing something even more dramatic. He is taking away the punch bowl by withdrawing money from the system, an event nobody is talking about except us. Specifically, the Fed has slowed the growth of the money supply (M2) down to a crawl. M2 was growing at a healthy 6% rate a year ago. Now it's down to 1.2%.

"This topping out of the money supply is a clear indication that the Fed is serious about fighting inflation. The impact could be felt in the next few months: a slowdown in the economy from 5% to under 3%, maybe even 2%, a possible drop in corporate profits, and a fall in stocks, gold, and perhaps even oil. Given that the economy is already heavily burdened by massive consumer, mortgage, and government debt, the Fed's latest effort could spell big trouble on Wall Street and Main Street. In short, the Fed could create a financial crisis here in the US and abroad. It's a delicate situation.

"For all those gold bug pundits who said that Bernanke was soft on inflation, remember that he made his reputation as an economist for his work on ‘inflation targeting.’ Every country that has adopted this "inflation targeting" rule has seen a slowing down of inflation. Ben's reputation as ‘Helicopter Ben’his eagerness to flood the country with dollar bills was made in the context of a fear of another Japanese-style deflation in the US. Clearly this fear is no longer present. Inflation, not deflation, is the prime concern.

"I have already suggested a change in your portfolio to protect yourself from a bear market, including a 40% position in cash, prime rate funds, and other alternative income investments. Now I'm recommending that you increase your cash/income position to 50%, and take profits on some of your stock positions. Let's reduce our stock position to 40%. We’ve also taken profits on gold stocks and reduced our natural resource position from 15% to 10%. This is a time to take safe haven in the storm."

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