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Frequently Asked Questions for the Week of
March 17-21, 2008

Edited by Gary L. Alexander, Executive Editor, John Dessauer's Investor's World ®

I. Questions of General Interest: Mostly on Inflation

Question #1: As I watch the credit market unwind a little more each week, I am wondering how much longer before the stalwart money market funds become the next victim. The amounts that Fannie and Freddy can take are being raised, but it takes money to buy this paper from the original lender, which is overpriced and no longer risk-free, so it is not being bought. Therefore, there is no "real" money to fund new real estate mortgages. There has to be a solution to this. What is John's solution, if he were king? – Ludy L. (March 11)

We don't really care for a solution from on high, from a "king" or a financial czar. Eventually, the market will sort all this out, but I realize it can be messy, in a sort of "creative destruction" that embodies capitalism's maddening process of following the game's score. You are raising the basic question of liquidity: Who can afford to buy the new mortgages? We are here to remind you and other terrified investors that there is no shortage of cash in the economy now. Good credit risks can borrow all the money they want, even though the liars and crooks can't.  That is good.

John pointed us to Ken Fisher's column in the current (March 24) issue of Forbes. I will cite some more facts from that column, to put the current "credit crunch" in a larger perspective:

• Total corporate borrowing was higher in 2007 than in 2006. Corporate borrowing in January 2008 exceeded that of January 2007. Investment-grade borrowing is up 12% from a year ago.
• In a credit crunch, interest rates would rise, but investment-grade (AAA) debt now yields 4.63%, vs. 5.68% a year ago.  Rates are also down on AA, A and BBB investment-grade bonds.
• Mergers and takeovers are up, not down. Look at Microsoft (MSFT) chasing Yahoo. Fourth-quarter takeovers totaled $478 billion, up 32% from the $362 billion in the previous quarter.
• Share buybacks in January reached $59 billion, up 16% from January in 2007. The last four months of 2007 totaled $276 billion in buybacks, up 63.5% from the same period in 2006. A lot of our stocks announced buybacks recently, and IBM announced a recent $15 billion buyback.

The talking heads and the financial headlines want to scare you, to increase ratings, but we want to present the other side of the situation, so that you can invest for the long-term with confidence.

Question #2: I may have missed a discussion about this issue in your letter, but I wonder why John uses M1 money supply to talk about the inflationary effects of the Fed's policy. It seems that M2 money supply is more relevant? Thanks! – Donna B. (March 11)

We monitor the Monetary Base most closely, but M1 is more important than M2, since it is closer to the source (the Fed).  M2 contains a lot of the results of consumer choices of investments. We are most concerned about what the Fed controls, not the choices of investors with their money.

Question #3: I notice that Wachovia fell almost 6% on a day when Don Truslow, their Chief Risk Officer, suggested the housing downturn is "far from over" and could get much worse. On the other hand, John says that things could get better sooner than later. In light of WB's Risk Officer painting such a gloomy picture, do we still buy WB now, or sell it to cut our losses? In other words, do we take Mr. Truslow's comments at face value or is he simply covering management's collective derrieres against the possibility of future lawsuits? If the latter is true, perhaps his title should be Risk Aversion Officer. – Jim B. (March 12)

Your question is well put, as is your closing zinger about the "Risk Aversion" officer's overly cautious dance steps. I am surprised that any executive ever says anything good about his firm, given lawsuit threats.  Wachovia Bank (WB) insiders bought a lot of stock at much higher prices in the last few months. On November 13, 2007, Don Truslow bought 13,000 shares at $41.70 per share, so he is down 39% in the last four months, losing $210,000.  You have to ask yourself if all these managers at Wachovia are totally inept, drinking the Kool-Aid, or do they know a little bit more than most Wall Street analysts, who pretend to know everything about hundreds of stocks.

Question #4: What hard data or evidence can you offer to prove that the peak of the sub-prime mess is now upon us and that it won't be long until this is just a bad memory and the markets (and our portfolios) will fully recover? By hard data/evidence, I do not mean some rosy comments from IMB and CFC. I have no doubt that at some point the markets will fully recover. But, quite frankly, you have been repeating this "almost all clear" forecast for almost a year now. I do not mean to back you in a corner and sling rocks, but I am now convinced that trying to call a bottom is like trying to catch the proverbial falling knife. While the markets will surely recover at some point, it is quite another matter to hope that CFC and IMB will recover. We will probably never see a recovery in CFC because they sold out so cheap. IMB might recover, if they don't sell out cheap or go bankrupt. At some point, isn't it better to admit we missed the boat on this? Thanks for listening. Jay S. (March 12)

You want "hard" data, but the world doesn't always give us perfect answers when we demand the absolute answer to what the future holds.  In the real world, we have to wait for the best data to emerge. We certainly have some early clues, which John passes along to you in each hotline, but we have no definitive answers until the facts on mortgage resets are available. This is what we have said all along. We have never pretended to have all the answers, but we are committed to the necessary patience to wait for reality to come clear with each new clue. What you demand of us is understandable, but not reasonable. We can't know how this will come out yet. That may offend some people, but it's the nature of reality. We make our best guesses based on experience.

My own expertise is not about what happens today, but what has happened over the last 40 years of my career as a financial journalist. My baptism of fire came 40 years this week with the sudden devaluation of the British pound, the meeting of the G-7 (seven Gold Pool nations), the two-tier market in gold and the severing of the dollar from gold—all happening March 15-20,1968. I was on the air and in print as a fresh college graduate then. I was in the forefront of describing all the severe financial crises of the last 40 years, first as a doomsday prophet (until 1989) and then as a student of hope and optimism, under the tutelage of John Dessauer since the late 1980s. If facts are not yet available, I can tell you about how we resolved a dozen other crises in the last 40 years: The 1966 credit crunch, the 1968 gold and currency collapse, the 1970 recession, the 1973 oil crunch and inflation, the 1974 market crash, and so on, all the way through the current crisis.

Question #5: As a former economics major, I agree that Milton Friedman's statement is true, that inflation is always and everywhere a monetary function. However, inflation (in the public and political mind) is measured by the CPI, and that is reflected in rising prices.  In my opinion, these two definitions—monetary inflation vs. the CPI fixation—have diverged in a way that I don't see being recognized by the market.  This may either present an opportunity reflected by a "mistake" in the marketplace or a danger reflected in Fed over-reactions that are not warranted by reality.  For example: (1) Food prices have been going through the roof.  Under normal conditions, food prices have been pretty stable but the supply/demand equation has been whipsawed by the Ethanol mandate.  This impacts virtually every food price, not just corn.  (2) Gold is viewed as a key warning inflation sign and it topped $1,000 this week; and (3) Oil is at record highs. As you say, that is based on speculation and escalating fear/risk premiums. Given these observations, what is the real rate of inflation, and how can one know with any confidence? – Robert H. (March 13)

The Consumer Price Index (CPI) varies widely from month to month, but we seldom hear about the flat numbers.  January's big rise made big headlines, but February's flat prices, released last Friday did not make any headlines, to my knowledge.  In February, according to official numbers released by the Labor Department last Friday, CPI inflation fell to the lowest rate since November 2006.  For instance, energy prices fell 0.5% in February, but subtracting controversial and volatile energy prices, the core CPI (excluding food and energy) was flat.  The overall CPI was also unchanged in February, which was a big surprise, since economists were expecting a 0.2% rise. 

Looking at the details, apparel prices fell 0.3% in February.  Transportation costs declined 0.7% in February, including a 0.3% decline in airfare and new car prices. Electricity costs declined 0.5% in February, the biggest decline since December 2005. I only bring this up because I don't recall any headlines about flat or declining prices in the February data released last Friday.

The best news in the February CPI was that owner's equivalent rent, which accounts of over 40% of the CPI, rose by only 0.1%, so it appears that deflation in the housing market is finally showing up in the CPI.  We hear a lot about housing price declines, so how can people still believe in rising inflation? You can't have it both ways. Housing prices can't decline, along with falling interest rates, while at the same time we worry about higher inflation, or am I crazy?

As you say, the accepted wisdom is that the high inflation trend is correct, but the low inflation numbers are somehow a conspiracy by the government to mislead us.  You say the markets tend to believe the CPI, but they don't.  They only believe rising CPI data. They ignore flat or falling prices, just like most of our recent questions ignore falling prices, citing only rising prices.

Gold is no longer a reflection of inflation expectations, but a currency hedge. Its price rise reflects the decline of the dollar in the last seven years, not an increase of inflation. The price of gold is not up that much in euro terms, nor is it up in "real" (after inflation) terms. To reach a new "real" high, gold would need to trade above $2,200 per ounce. Since 1980, stocks are up 15-fold, but gold has barely eked out a new nominal high, while remaining far below its inflation-hedge price.
 
Question #6: Do you feel that the Fed can continue to keep lowering short-term rates without weakening the dollar and boosting commodity prices? It's seems to be a Catch 22. Swapping Government notes for mortgages or creating a new government asset class may bring confidence back to that secondary market, but at what cost? – Steve J. (March 13)

Ben Bernake has been testifying a lot before Congress, but he sounds increasingly like Tevye from Fiddler on the Roof—a role I recently played in my community theater (photos available on request).  Tevye is famous for arguing, "On the one hand….on the other hand." President Truman wanted a "one-handed economist," one who would tell him what is the "right" answer, rather than both sides of the argument.  But most academics argue their options out loud, and Bernanke is no exception. In his February 27 testimony to Congress, he outlines the Fed's two-handed dilemma, facing inflation threats and recession simultaneously.  On the one hand, he said, the right treatment for recession and a financial crisis is lower rates. On the other hand, he said, inflation is rising and the dollar is falling, and any further drastic rate cuts could exacerbate both problems.

Obvously, Bernanke's Fed has chosen the "one hand" of lower rates, but he has also balanced that answer with the "other hand" of low-to-slow monetary growth.  It is unlikely that inflation will rise if he keeps the brakes on monetary supply, but the dollar could keep falling if he cuts rates so drastically below the prevailing rates for the euro, British pound and other currency options.

Question #7: On page 5 of my 1040 forms & instructions, 2007 tax-year booklet, under "What's new for 2008," is the following statement; "Capital gain tax rate reduced. The 5% capital gain tax rate is reduced to zero." Can this possibly be true? – J.E. McS. (March 14)

It is true that taxes on capital gains fell from 5% to zero for the lowest tax brackets in 2007, but this is basically a benefit for retired and low-income investors in the overall 15% tax bracket. It is not applicable for those in the higher tax brackets. Theoretically, this tax cut runs through 2010, but the future of tax laws is highly uncertain this year and next. This is one more example of how recent tax cuts benefit the middle class and low-income investors rather than the maligned "rich."

Question #8: After the collapse of Bear Stearns and the Fed's response, what happens to all the money the Fed has lent to these failed firms?  Could this seriously damage the Fed?  If so, that would seem to be a major problem, not just for the financial firms but for all of us in every facet.  I guess I'm confused about how all the Fed actions work to our benefit and would appreciate some enlightenment. Thanks for all of your help!! – Eric H. (March 16)

The danger, as I see it, is way too much reaction to Wall Street's pleadings. I know it is sad to see Bear Stearns die and hear the stories of their employees losing out on their stock portfolios, but did these workers forget the headlines about Enron six years ago? Why would any investor or any Bear Stearns employee put all his/her retirement eggs in one basket? The key is to diversify our stock holdings and not be overly reliant on any one sector or any five (or fewer) stocks.

Speaking nationally, the Fed has marshaled its resources over the last few years, refraining from higher rates of monetary creation, so they have plenty of leeway to respond to crises.  There could be some fallout for taxpayers in failed loans, but I must remind you that all past financial crises resulted in far lower taxpayer losses than were bandied about by the doomsday press in advance.

II. Upcoming Subscriber Services

• John's Next Hotlines:Wednesday, March 19, 2008, from Naples, Florida
• The next issue will be mailed Friday, April 4, 2008. It will be live on the Web site that day. 
  
• The next Q&A column on the Web: Tuesday, March 25, 2008.
• John's Next Personal Appearance: Investment Cruise to China and Japan, March 30 to April 14. Call 1-800-435-4534 for information or reservations.
  

2008 Track Record through March 10, 2008

Top 10 Stocks for 2008: Through March 17, 2008

Note: In each weekly Q&A, I use John's past advice to answer specific subscriber questions sent to us each week, but I can only generalize from John's past printed advice for everyone's general benefit, not offer specific advice to any specific questioner. I am not technically qualified to provide personal advice to subscribers of John Dessauer's Investor's World. In fact, I am legally prohibited from providing personal advice. If you want personal advice, we recommend that you seek a professional financial advisor. Thank you for your understanding in this matter. – Gary Alexander.

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