Strudwick Wealth Strategies
"Innovation Equals Opportunity"

Al In Wonderland
by Barry Strudwick

In this Lewis Carrollesque world of "deflation," what once was "good" could be "bad" (tax cuts), and once unthinkable (intentional inflation), a preventative cure. So, if we piqued your curiosity, follow us into the Byzantine rabbit warren of investing in a deflationary world!

Following the dot.bombing of Wall Street in March, we’ve emerged from our fall-out shelters. The Good News? A vital signs check of our Mega-Trends continues to point towards prosperity. Both the spread of Democracy and Capitalism continue to promise expanding new markets and opportunities. Clearly the U.S. of A. remains the epicenter of innovation, from which multiple waves of change are washing over the economies of the world. Last, but not least, our economy remains healthy albeit with a slowdown in productivity gains and just enough growth to avoid the dreaded "R" word of Recession.

Make no mistake about it: The flood of innovations in areas such as Bio-tech, Nano-tech, Alternative Energy, Telecom and a host of other areas has not slowed down simply because the stock market stubbed it’s toe. This rate of change is real and is accelerating. And as our motto says: "Innovation equals Opportunity!"

So why the market’s malaise? We’ve often said our "operating system" of DOS Capitalism is almost idiot proof when left to its own devices. The greatest risk comes in the form of "operator error" when political intervention kluges up the system. The recent market episode is the aftermath of well intentioned Dr. Al tightening interest rates last summer to inoculate us from non existent inflation.

If the good doctor had sought our second opinion, he’d have known "deflation" not "inflation" is the real threat. In the mumbo-jumbo of this dismal science, this is a world where "supply" dominates "demand."

Accepting this seemingly simple conceptual shift sets off a ripple effect which challenges our most basic (and important) investment decision rules. At times it’s like we’ve passed through Lewis Carroll’s "Looking Glass" into an economic world where "up" is "down" and "good" is "bad." So stick with us for a spot of tea, crumpets, and a Mad Hatter’s explanation of why job layoffs and a weaker dollar are "good" and tax cuts and a strong dollar might be "bad" right now or at least too much of a good thing..

Over our past nine issues we have been constructing a framework of how to invest in a world where "supply" dominates and our old rules don’t seem to work quite as well. Numbering now over 35 "Thoughts For The New Age," these have been collected into a single report and are now available on the web through either Barnes & Noble at bn.com or at knexa.com under the keyword "Strudwick".

Here are our latest thoughts and musings to challenge your thinking on investing in a rapidly changing world:

Thought #34. In the topsey turvey world of Global Deflation, The Republican’s cure-all prescription of Domestic Tax Cuts is not the correct medicine. Instead, a small dose of inflation by increasing monetary supply might be the vaccine we need to ward off the very ugly deflationary spiral virus caused by a global supply-demand imbalance.

Before the Red Queen screams "Off with Your Head" for uttering this heresy, please understand we remain card carrying members of Tax Haters Unanimous. But… tax cuts designed to "revitalize" an already strong domestic economy and stimulate consumer demand are not the solution to a long-term global problem. This is a band-aid solution, which neglects the chronic underlying condition.

With "Shop Until You Drop" having replaced "E Pluribus Unum" as our national motto, it’s very clear the root of our problem is not the U.S consumer’s failure to hold up our end of the spending side of the equation. Our negative national savings rate is proof of that.

Instead, we should focus on the global supply side of the equation. Since the Fall of Communism, NAFTA, GATT and the global telecom, Net and IT revolutions, manufacturing capacity worldwide has increased faster than the newly opened markets of China, Russia, and India were able to grow new "consumers." Unfortunately, these billions of people don’t qualify as western style consumers until there is an appetite for, and money to spend on middle class "necessities." Do you need a Palm Pilot in Tibet?

Growing demand organically is a painfully slow process requiring years to convert workers into consumers. You upgrade from rice to chicken before trading in the wok for the microwave.

When viewed through this prism, there are only two remedies to bring supply and demand back into balance long-term. Either decrease global supply by shutting down plants (painful for the U.S investors who financed these plants with the double negative of also stunting the growth of new non-U.S. consumers). Currently the domestic plant closings and layoffs are part of this phenomena. This is "good" because these resources will be reallocated into other industries, helping to decrease the excess capacity.

Or, increase demand from consumers outside of the United States. Clearly a better alternative than mothballing plants, but still a slow process. One way to speed up this process is to make U.S. goods cheaper by lowering the value of the dollar. Deface the greenback?! Heresy! you say, but what if the Buck has gotten grossly overvalued?

Thought #35. Honey, pack dem bags, we’re going to Europe! Relative to other currencies, the Dollar is now clearly too strong. Look for continued interest rate cuts to help drive down the value of the greenback. Investment themes that favor a moderately falling dollar and falling interest rates will excel. These include zero coupon bonds, commodities, and closed end country funds.

Each year the Economist publishes it’s Big Mac Index revealing the price of two all beef paddies on a sesame seed bun in about 30 countries around the world. America’s culinary contribution to the world is now cheaper in 27 of those countries than here in the States. In Australia, New Zealand, Brazil, and Hong Kong a Big Mac costs 40% less than in the States. That’s almost twice the calories and fat grams per buck without super-sizing!

This bit of burger-nomics gives us a valuable clue as to what’s going on right now. With the dollar too dear, Dr. Al is cutting interest rates not to stimulate the economy, but rather to drive down the Buck. Look for as much as 150 to 200 basis points of additional cuts from here. Long maturity zero-coupon bonds are a way to play (American Century Target Maturity 2020 fund –8.79% YTD). Second, equities with currency risk should do well as the dollar falls. Closed-end country funds are a good way to play this. Our positions in funds like Chile (NYSE, CH – up 6.19% YTD), Brazil (NYSE, BRZ –Down 2.98%) and Latin America Discovery (NYSE, LDF up 6.6%) have done well in this environment.

Action Idea: If you owe your wife a trip abroad, those shoes in Paris won’t get any cheaper than this.

Thought #36. Japan is Dr. Al’s monetary laboratory of Dr. No showing us how not to deal with deflation and the price of a missed diagnosis. A 10-year bear market with more pain to come is the price paid for trying to cure deflation by stimulating domestic demand.

After 10 years of denial and 11 prime ministers in 13 years, Japan acknowledged last month that it was stuck in a deflationary spiral. Having gone from being the world’s greatest lender to it’s greatest debtor, it is painfully clear massive government spending (fiscal policy) is a virtually powerless tool to break a deflationary spiral once it sets in. Stimulating domestic demand does not work because it doesn’t resolve the underlying supply glut. When consumers recognize prices are falling, they cut consumption waiting for future price drops. After the most recent shuffling of the deck chairs on the S.S. Sinking Sun, serious problems remain on the horizon with little time to shift course. Look for a major economic debacle next Fall when

the latest team of reformers fail to avert a banking crisis. Ignore the advice of bottom fishing pundits saying " this time it’s different." It’s not. With some "mad money" you can short Japan using the WEBS Japan. (AMEX- WEJ) Continue to avoid the Emerging Tech Tiger theme as a regional banking crisis could torpedo them.

Thought #37. Just as Inflation brings relief to borrowers, Deflation will grind them into dust because they must repay in higher valued dollars. Before stoking the domestic demand engine (and increasing consumer debt), Dr. Al needs to restore the balance between borrowers and lenders.

Here’s why: Our current high "real interest" rates have created an imbalance between borrowers and lenders. Over the last 200 years, people lending money to the government have been paid 3% over the rate of inflation. So a 6% bond yield would imply a 3% inflation rate and a 3% "real rate" of return to the lender. But what if we don’t actually have inflation, and prices are flat or falling? This would imply a "real" rate of return of 6% or greater! In other words, it’s actually twice as expensive to borrow as it has been historically. For large companies, high real interest rates slows down economic expansion as "the cost of capital" becomes too high and they opt instead to grow by only reinvesting profits.

From the little guy’s perspective, these colossal "real" interest rate spreads will slowly grind borrowers into dust as debt payments must be made in more expensive dollars. Pity the consumer with the perpetual balance on the credit card, he’s getting pulverized and doesn’t even know it.

Dr. Al needs to restore this crucial balance between creditors and debtors. Increasing the liquidity (money supply) in the markets will go a long way in this direction. In other words, a small dose of inflation to bring down the value of the dollar is a vaccine against a more virulent form of deflation. Our advice here: aggressively decrease personal debt and pay cash whenever possible. Defer unnecessary purchases because with deflation the prices are cheaper next month. When Dell and Compaq are locked in a price war, do you buy today, or wait until next month for a better deal?

Having jumped down the rabbit hole of this upside down world caused by a supply dominated economy, let’s now sit down for tea with the Mad Hatter and discuss the even more confounding logic of why now might be a great time to invest in the markets.

Let’s start first with a little parsing of terms and differentiate between "The Economy" and "The Market." Though closely related, each moves in it’s own unique rhythmic cycle. Assuming these two gyrating dancers are joined at the hip can be a very expensive mistake. Instead, The Market tends to swirl around The Economy. The leaps and dips of the "Markets" tend to predict the future direction of the "economy," which we refer to as a business cycle.

A classic cycle has 4 distinct phases,

(recovery, expansion, overheating, and contraction). What is surprising is that 90% of the total market action is concentrated in just two of the sectors. Returning to our Mad Hatter logic, the most dangerous time to be in the Markets is not when the Economy is contracting, but rather when it is still expanding but overheating. This typically causes the Fed to increase rates, thereby starting the contraction phase. Stocks lose an average of 17%, the Overheating Period (when corporate profits are still expanding) versus 3% in the contraction phase accounting for 85% of aggregate downside risk in the market.

The Best Time For Different Investments

To further confound common sense, stocks generally have their greatest upside starting about 6 months before the trough of an economic cycle while the economy is still contracting! Why? Because the markets are predictive not reactive. This is when the Fed starts to inject liquidity into the markets to prime the economic engine. Historically, this is the #1 Fat Time to buy stocks. Here’s a stat to chew on: In a typical 3 year stock market rally, over 50% of the entire Bull Market rally is captured in this initial first 6 months with average returns of 36%!

O.K., so for the proverbial $64,000 question: Where are we in this cycle? First, let’s clear some debris out of the way here. Despite the NASDAQ having dropped 60% in 12 months (before the recent rally), the Economy has never "officially" dipped into "recession" which requires six months of "negative growth." We’ve simply had a sharp contraction in our (still) positive growth rate.

Even with the new math, 1% growth doesn’t qualify for the start of a recession. For trend line plotters, the very recent first quarter ‘01 GNP numbers have come in at 2%. How can we have a recession when the last two quarters have had positive economic growth?

Through our looking glass, we see another 3 to 6 months of "profit warnings and layoffs" coming from the tech sector already baked into Dr. Al’s crumpets. But the liquidity numbers are already increasing rapidly, telling us a remedy is in the making. Our conclusion is we’re likely in the very early stages of the sweet spot stock market rally. The 60% decline in the NASDAQ was predicting a recession that never appeared. The 35% NASDAQ rally is the market consensus that Al’s rate cuts and liquidity increases are the right medicine.

The greatest risk is waiting on the sidelines waiting for better visibility in the Fall. Six months from now 50% of the rally will likely be over. We would rather be fully invested and dollar cost averaging into our positions now, then pulling chips

off the table.

But aren’t stocks still expensive at 20x earnings? Perhaps in an absolute sense, but as our Uncle Albert E. used to say "all things are relative." When you look at the inverse of the P/E ratio (known as the "earnings yield"), a P/E of 20 equates to an earning yield of 5%. Relative to its historic relationship with government bonds, this is a reasonable price to pay for stocks. Last time we looked, bond interest rates were dropping with the consensus of the curb watchers agreeing more cuts were on the way.

We want to hear from You!

If you’d like to find out more about our wealth strategies such as tax sheltered investment strategies for both individuals and companies please give us a call. In addition, we manage investment portfolios, and also help companies review option on retirement plans, life insurance. Our number is (410) 727-6444. We’ll be happy to discuss your objectives as well as explore your options.

To close out we thought we’d bring you up to date on several of the stocks that we’ve suggested for consideration in your portfolio.

"A question that sometimes drives me hazy

Am I or are the others crazy."

---- Albert Einstein

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Contact us about our new "Omni-Asset IRA" accounts. If you want to use the trapped liquidity of your IRA to invest in non-traditional such as real estate, mortgages or private companies, we might have a terrific solution for you.

Please call (410) 727-6444 or toll free at 1(866) 4-NOLOAD.

Strudwick Wealth Strategies
12 East Eager Street * Baltimore, Maryland 21202
Tel. 410. 727. 6444 * invest@noload.com