By Professor Rick Ulivi, Ph.D.

July 2014

I have been pretty consistent over the last two years in warning that financial markets were being artificially inflated by the easy money policy of the Federal Reserve. Yet the markets continue to increase, which means either I have completely misunderstood the new dynamics, or we are just getting closer to the day the markets will plunge. Therefore, this is a good occasion for me to explain my philosophy, so that you can all understand the reasons for my advice.

What I Believe In

I believe in living within one’s means, saving consistently, avoiding overpaying for anything, and taking prudent risks as a way to increase one’s capital. Given these personal and professional financial guideposts, the past two years have been very difficult for me, because I see the country’s finances in a mess, yet the prices of stocks, bonds and real estate keep hitting new highs, and in the case of stocks, all-time highs.

Where’s the Contradiction?

The Federal Government is running massive fiscal deficits, the private sector is fostering huge trade deficits, and Americans have a historically low savings rate. As a result, interest rates should be high, and yet they are super low. What’s going on?

The answer is simple. The Federal Reserve is buying all the debt that the Federal government sells to pay for its deficit. It is also doing whatever else is in their power to keep interest rates super low. The result? Yes, the economy is doing better; people are buying cars, houses, stocks, bonds, gold and everything else. The consequences? They are yet to arrive, but they will. At least, I believe so.

It is very difficult for a financially prudent and cautious advisor like me to see this financial partying taking place. That is, the stock market continues to go up, setting new records and just about every other asset’s prices are also going up. There’s certainly a party going on but I refuse to participate wholly in it. I believe it’s a folly, but my view–which is not at all unique–has been ignored by financial markets for the last few years.

Is Age Affecting My Judgment?

As I am about to turn 65, the obvious question that pops in my mind is this: Is my “old” age affecting my “vision”? Have things really changed to the point that I am just not on top of it anymore? Have I made a mistake by being too conservative? Perhaps–however, I don’t believe so.

The reason I feel so strongly about continuing with my cautious approach is that I am convinced that the current price rally is being fueled by the Federal Reserve’s policy of keeping interest rates extraordinarily low–by truly artificial means. Interest rates in the USA are not exceptionally low because the economy has been growing vigorously, resulting in high profits, and thus large amounts of accumulated capital. We are not like China, where rates could be extremely low because they are awash in capital. They sell to the world and buy very little in return, thus accumulating a huge trade surplus, particularly with the US.

In sum, I continue to believe that taking a cautious approach is the best way to go. Yet, there are some other questions that need to be answered, such as: How long will this party last? How could the potential consequences play out? And finally: Are there any changes to what I’m advising? Let me briefly answer each of these.

How long can this party last?

Based on a consensus overview from a number of major investment houses, the following 12-24 month scenarios are provided:

A likely near term outcome for the US economy is somewhat improved growth as economic and geopolitical risks at home and overseas are mitigated. Metered but continuous improvement in the labor market, and growing demand from other developed and undeveloped countries, shows business leaders that the US and Global economies are indeed improving. As a result, the pace of business investment then ramps-up, thereby increasing organic demand for goods and services. As hiring improves, the labor participation rate rises, absorbing the newly minted labor created through population growth. But, given the large amount of labor slack, the additional demand for goods and services will not immediately be translated into inflation in the near term, allowing that the Fed is able to continue along the path of ending quantitative easing (QE3) on schedule.

Then, in the second-half of 2015, the Fed begins raising interest rates. The market will become considerably more volatile as we get closer to the first interest rate hike, as investors grapple with the size and pace of the rising interest rates. Although, historical data shows that equity returns may not be impacted until interest rates increase to over 3%. As the business cycle matures, and the Fed continues to increase interest rates, the return on equities will become muted.

While the scenario above is the one many financial professionals believe will play out, I think it is too optimistic.

How could the potential consequences play out? At some point, interest will rise to reflect the true cost of credit. Perhaps, too, rates will rise further as a result of inflation accelerating to its historical average of 3%. Imagine the impact on housing prices if a 30 year rate were at 7% instead of the current 4.25% range? You can expect housing prices, as well as the prices of other assets, to drop 15% to 20%.

Are there any changes to what I’m advising? Currently, I am recommending clients reduce their exposure to stocks and bonds. I have been advising this for the last 2 years, so there is no change in my thinking. As for real estate, although prices are high now, the financing is so cheap, that if you have a long term holding period, it is prudent to buy. After all, if you can lock a loan for a fixed rate of 4.25% for thirty years, who cares if prices drop 20% in the next few years? Twenty years from now they are sure to be substantially higher and should have more than made up for that potential drop.

In sum, I continue to believe that the financial situation calls for lots of caution, because the financial markets are being propped up by the easy money policy of the Federal Reserve. Being fully invested today will most likely result in loss of principal in the near future.

If you have a friend in need of some conservative financial and retirement advice, please suggest they contact me.