Somebody once said, "Don't tell me the problems without telling me a solution."

We take the same approach to investing. Sure there are problems. There are always problems. Problems in the economy and markets only open up solutions somewhere else. For the first time in history, investors can take either side of an investment. For example, if you think the market is overvalued you can buy a bear market fund or an index option to profit from the decline.

"We're not bearish, we are bullish on the solutions." - John Riley of Cornerstone

The Problems

You have nothing to worry about the market and economy if high P/E ratios, low dividend yields, rising interest rates and ballooning debt loads don’t bother you.

The fact is that there are always things to worry about when investing. There wouldn’t be risk if it were a sure thing. But today’s environment has lead to a new set of concerns not seen before.

Market risks:
The market is overvalued by any measure. According to various sources including Yahoo! and Standard and Poors, P/E ratios are still well in the 20’s, dividend yields are still below 2% and price to book ratios are well above previous bull market peaks. For perspective, bear markets have historically bottomed when the p/e ratio is below 8 times earnings, dividend yields are above 6% and price to book ratios are around 1 times. We are a long way away from there.

Economic risks:
It all comes down to one issue – too much debt. The massive increase in debt over the past 9 years has lead to the stock market boom, the housing boom and the consumer boom. But the dark side to these booms is that they were not driven by real economic activity and growth but by the increase in debt by the consumer, corporate America and the government.

Along with the increase in debt has come an increase in our trade deficit and current account deficit. This means we are buying more goods from overseas than we are selling them and we owe them more money than ever before. Foreigners have helped fund our growth by buying almost 50% of our Federal debt.

The rise in debt has had a corresponding rise in the money supply. This dilution of the money supply has weakened the Dollar putting the US in a very tight spot. Because foreigners own so much of our debt, if the Dollar doesn’t strengthen, they have every reason to sell the US bonds they own on the open market to get back at least part of their investment, before the Dollar drops further. This would force interest rates much higher in the US choking off whatever recovery was going on and send the bond market into a severe bear market.

Ironically, the only way the Fed can keep this from happening is to raise rates. But the Fed controls short term rates. The open market controls long term rates. If the Fed raises short term rates, that can be a signal to the bond market that they are fighting inflation and want to bring the money supply under control.

The problem with that is that there is little the Fed can do about inflation since it is being driven by forces overseas. Two contradictory things are happening because of what is going on overseas.

The first is that foreign countries are exporting their deflation to the US. They do this by sending us cheap imports that compete with domestic goods. What is the number one car sold in America every year? It isn’t a Ford or Chevy. It is a Honda, Toyota or Nissan. (Yes, they do have factories in the US, but those profits go back to Japan, they do not get re-invested in the US.) My kids turn over everything they get to see if it was made in China. Much of it is.

Because cheap foreign goods keep prices low in the US, few domestic companies have any pricing power left. They can’t raise prices as needed because of competition.

With its origins on foreign shores like a tsunami rushing across the ocean is inflation. Because so many countries have turned to capitalism and are increasing their standard of living, commodity inflation is heating up. Just about every commodity from beef to copper to oil has foreign demand at the root of its higher prices.

The increase in demand should not be expected to be a short term situation. A change in consumption of chicken in China will have lasting effects for coming generations. It spreads out from the chicken producers to the grain suppliers to the shippers and food services. The increase in oil consumption in China is growing so fast that in a few years, according to some predictions, they will consume all of the Middle East’s petroleum supply by themselves.

The impact on American businesses couldn’t be worse. At a time when they are having difficulty competing with foreign goods, their raw materials costs are rising. Couple that with the burden of higher interest rates and you don’t get a very good picture for Corporate America.

Bond risks
Rising interest rates hurt bond prices across the board. So whether is it’s a corporate, muni or federal bond, they are going to have a tough time with rising rates.

But there are more problems than just rising rates. A slowing economy adds more pressure on corporate bonds. Municipalities are dealing with lower revenues and higher expenses. They will be in need of a combination of higher taxes and new issues of debt. And the Federal Government is back to running deficits again. Adding higher taxes into the economic mix does brighten the corporate outlook.

The Economic Engine
For years, the housing market has been a source of economic strength. But again, if you look closely, the single most important cause of the housing boom has not been economic prosperity but cheap money. Low interest rates have allowed homeowners to buy homes with mortgages that would choke a horse because the monthly payment was low enough. The plethora of homebuyers with easy money has pushed housing prices into the stratosphere in most parts of the country.

But now with rates starting to tick up, that boom could be coming to an end. Two concerns arise from this. The first is the economic impact. As housing slows, one of the key sources of economic strength disappears. This could cause a ripple effect throughout the economy.

The second is much more difficult to understand, but could have even more dire consequences. There is a term - “velocity of money” - that Fannie Mae and Freddie Mac live by. They are the single largest suppliers of cheap mortgages in the country. Velocity of money deals with money in motion. As long as it keeps moving, you don’t have the scheme fall apart. But if it slows, the whole scheme could grind to a halt.

Enron’s schemes were miniscule compared to Fannie’s. They direct and indirect guarantee on half of all the mortgages in the country. But there finances have found them upside-down several times recently. IT seems they’ve loaned money out at rates lower than they were paying for the money they borrowed to loan out as mortgages. This means they were paying more than they were collecting. Add on top of that an unregulated derivatives portfolio that doesn’t have to be disclosed even to Congress and you have the potential for something very bad.

The Trigger
The Dollar is likely to be the trigger for everything. Its decline seems to be inevitable. The reason is simple. Since dilution of the Dollar is the main reason for its decline, and the money supply is not expected to slow anytime soon, the Dollar’s decline seems pre-ordained. Why do we not expect a decline in the money supply?

The last time the Fed was raising rates was in the early 2000’s. But the money supply continued to grow, unabated, thanks to the diligent work of the aggressive mortgage bankers at Fannie Mae. So while the Fed was trying to slow the growth of the money supply, ol’ Fannie and Freddie kept churning out new cash from re-financings and new mortgages.

Is there any reason to expect they won’t do the same again? Of course not, since they need to keep the money flowing to keep themselves afloat. Since the Fed recently raised rates, I’ve told people to expect an even stronger push by mortgage brokers to re-finance and for realtors to push buyers to buy now “before rates go higher.”

When will it happen? That is the question. It is all in place now. But so are the investment solutions.

We at Cornerstone are not fazed by the problems in front if us, rather we see them as opportunities. And the best investments are made before the masses see them as such. We see them clearly. The next article discusses them.

The Solutions

Buy n’ hold is not a solution.
Neither is not looking at your statements.
Hoping and wishing are not solutions.

Understanding market cycles is. Understanding the proper asset allocation for the cycle is the solution.

If rates are rising, don’t own bonds.
If stocks are overvalued, don’t own stocks.

These may seem pretty obvious, but in the brain-washed world of the average investor that is bombarded daily by CNBC, the press and their friends telling them about the fortunes they’ve made, the continual chants of “buy n’ hold is the only way” and “stocks always go up” ring in their ears and don’t let much else in.

Independent thinking is viewed as heresy by the media’s talking heads and as a lawsuit in the making by Wall Street’s platoons of lawyers. Anything different than the Wall Street chant is ridiculed and laughed at by the geniuses on CNBC, so the last thing Jane and Joe Investor want to do is invest differently than the mainstream.

So if you are to read further, open your mind to the possibilities that there are other investments outside of the limited menu of stocks, bonds, mutual funds and cash offered by Wall Street’s devotees.

Logic takes over at this point. Since there are two sides of many issues, why not be on the winning side? Here’s how Cornerstone plans on handling the major issues. (As with all investing, nothing is guaranteed. On a day to day basis, anything can happen, so we view these as long term solutions.)

Is this guaranteed? Of course not. Does it meant that as soon as X happens, Y will happen? Absolutely not. (Also, the list of issues is not complete nor is the list of solutions. This gives you an idea of what is available and how to deal with some issues.)

There have been many times, in the short run, when the Dollar was declining and so were foreign bonds. I’ve seen, in the short run, the market decline and bear market funds not respond. Rates can go up on the short end, but bonds still rally on the long end. These all happened in the short term. Day to day, week to week, anything can happen.

It is not science or mathematics. It is economics and investing, and investors play the game with emotions. So irrational behavior can last much longer than you would expect.

Fortunately, rationality and logic prevail. History shows that while short term movements can be unpredictable, long term cycles are clear. Markets move from undervalued to overvalued and back again. And the cycle can last decades. The last time the market bottomed out was 1982. The time before that was the 1930’s. The last peak in the market (prior to 2000) was 1966, the time before that was 1929.

Interestingly, there is an inverse relationship between the stock market value and the value of hard goods or commodities. Tobin’s Q-Ratio shows that as paper asset decline in value, hard assets increase. (Andrew Smithers in London has done some of the best recent work on Tobin's Q. If you would like to know more about the Q-Ratio, let us know.) So if the stock market is overvalued, the commodities market is probably undervalued. Moving from paper assets to hard assets is the logical move.

The shift from one cycle to the other is going on right now, all around us. For investors, there may be fewer investment choices as the new cycle becomes clearer, but that is only because it may take Wall Street some time to catch up.

There are thousands of equity mutual funds for investors to choose from. There are only a handful of natural resource funds and even less commodities funds. There are hundreds of Gov’t bond funds, just loaded with Fannie Mae debt, but there are only a few TIPs funds. Equity index funds have become very popular with investors, number in the hundreds, but bear market funds still number less than 25.

While the choices may not be extensive, we like to think of it as more focused. Whatever the specific investment is, one of the most successful strategies is to be there first before the crowd shows up. Once the mainstream catches on, the investment has usually already moved significantly. Then when they pour their money in, they drive prices even higher.

We are very bullish on many different things. The key word is “different” - different than what the mainstream is bullish on. They are basing their bullishness on hopes and wishes, we are basing it on historical data, cycles, logic, rational thought and value.