Economics Memo August 2010

I am updating my class lectures and currently rewriting my Economics of Investing book.  Following my belief that everyone (the butcher, baker, wine maker, and candlestick maker) needs a real good understanding of the economics today to survive in the economic ocean we live in, I thought you might be interested in some of the economic principles that apply currently.

This memo is not intended as individual investment advice and is only for educational purposes.

Of course, you do not have to agree with my economic logic, and I am always happy to entertain questions and the occasional arrow. 

So let’s get on with it.

The Current State of the Economy (according to Hill).

Today was not a good day so far on Wall Street. The market is down 175 points as I write this memo. It was the third straight week that first-time jobless claims rose. A half million people filed initial claims last week.

Housing starts went up a little but less than expected. Building permits went down by more than expected. Industrial production went up more than expected.

Construction firms are letting go of more workers as the housing sector slumps and federal stimulus spending on public works projects winds down. State and local governments are also cutting jobs to close large budget gaps.

All these indicate that the economy is going to continue to limp along at a very slow pace but do not yet indicate a double dip recession is on the way.

The Keynesian Macro economist in me says: “Guys, this cries out for another big time stimulus unless you want to continue in this stage of the business cycle for years. We have the tools and the proven studies, just listen to us.”

But last week at lunch one of my good intelligent friends was royally upset with Congress passing a $26 billion dollar aid to state and local government bill (in effect, a stimulus). He and another friend could not understand how Congress could do such a thing without a way to pay for it other than borrowing. Neither of them would even entertain my thoughts on the issue.

Unfortunately, this indicates the conservative far right is gaining support with its “the debt is $13 trillion and how are you going to pay for it. My grand children are going to pay for it in higher taxes and inflation. Cut wasteful spending (anything that is spent that does not benefit me) and lower taxes to the small businesses (which they overlook the fact that OBAMA and congress have already done).”

Now if you think about the logic of the “conservative” (I’ll call it: the “Chicken Little” economic view), you have to ask yourself:

Have you ever seen a man wrestling an alligator (Alligator Zoo, in Kissimmee, Florida has a great wrestling show) where he is sitting on the prehistoric beast holding the giant jaws shut with his hands and asks: “Which end of the alligator can do the most harm? Is it the tail or the mouth with all the big zillion teeth? I’ll give you a hint, I not holding the tail!”

Guys, it is not inflation or the prospect of worrying about inflation that I am concerned about right now. I prefer having my grand kids working (if I had any) and getting the economy going right now. Consumption is 73% of the economy and government and business split the rest. If the consumer does not have the money or a job, they are not going to spend.

The problem is that no matter how much economic logic that is used a lot of people are not listening. Now that is frustrating!

In any case, I think “Chicken Little” is going to make a significant impact on the coming elections and even if they don’t win they will certainly kill any real “stimulus”. That leaves the Federal Reserve to carry the burden of stimulating the economy which they have a reduced capacity to do. With interest rates at all time lows (which, of course, results in lower debt payments and means their grandchildren will not be paying much more) they can only increase the money supply limitedly.

What can I do with my Investments given the current State of Affairs

Now frankly, I have been betting my limited funds on the “Chicken Little’s” carrying the day. The way I see it, if they want to run around in circles hollering about the skyrocketing debt, then there is more chicken feed for me.

So what do I do with my investments, 401K, 403B and the like, given an economy that is going to limp along? Well, remember this is an educational memo not an investment advisor service, but I can give you some economics tools to help you decide which investments to make.

I or any investment advisor (which I am not) can say: “Invest in this or that”, but remember the Basic Hill rule: “IT IS MY MONEY, STUPID!” That means if you do not understand the investment and can not explain it to an 8 year old and have them explain it back to you then don’t do it.

So what economic tools do I need?

Keynesian Demand for Money and Investment characteristics

I would start with the Keynesian demand for money. Lord John Maynard Keynes hypothesized that people demanded money for three reasons: Transactions (daily needs), precautionary (insurance, nest egg for rainy day when I get sick or laid off), and speculative demand (money that if I lose it my life style will not change. Note, that doesn’t mean the wife, husband, or partner will be happy with you losing a bundle).

Next, I would consider the three main characteristics of an investment: Risk (how bad am I going to feel if I lose it). Liquidity (how quick can I get it back), and yield (how much will they pay me for my bet).

The Hill Investment Cube

I have combined those concepts into the HILL INVESTMENT CUBE (Hey, I thought it up, I can name in anything I want). I have included the cube below. As you can see, it is easy to fill in. Generally, transactions demands like food, shelter, etc. is money you don’t want to risk and will need fairly soon. As a result the market which values high risk and long term commitments will not pay very much for it. The rest of the cube follows the same logic.

Now you have to decide what kinds of investments will match the requirements of that type of demand for money. The investment alternatives are pretty straight forward given the risk, liquidity, and yield requirements.

The only investment that will match low risk, high liquidity, and low yield are checking accounts (most banks call them money markets but the one I am describing have no time limits) and saving accounts.

In the case of Precautionary money: saving accounts, Money market or checking accounts, short term Certificates of deposit, low to moderate risk bonds (not junk bonds), or bond funds will satisfy the low risk, high liquidity, and low yield requirements.

In the case of Speculative money: Growth stocks, Real Estate, Puts and Calls, Commodities, Gambling and a host of other investments will satisfy the high risk, varying liquidity, and high yield requirements. This is  really an exacting type of demand. You get the challenge of taking risk and making it yield high returns. There are many theories of investment that try to achieve maximum yield and minimum risk. It is a real challenge.

Note, depending on your own preference for risk and estimation of liquidity the individual characteristics can change.

Before you invest in anything you should sit down and list three columns: Transaction, Precautionary, and Speculative. Now list all your bills and place them in the appropriate column. Next to each column place the four columns for amount, risk, liquidity, and yield. I have given you an example below.

Keep in mind that before you ever invest in Speculative money investments you should follow the principles listed in the attached table.  

Let’s take a look at what should be considered for retirement funds as an example. Assume we have $10,000 and we determine the risk is high, liquidity does not matter, and we want a yield to be over 6%.

The best investment in current economy

Remember our discussion of the business cycle in the last memo. Currently, we would probably want to consider recession or at least low creeping inflation investments. Experts tend to believe those are: Utilities, Gold, bonds, financial services, and high dividend stocks.

Now I have a friend who has made a lot of money investing in gold the last couple of years but according to the Hill Investment Cube this is high risk money normally so the shoe fits for him.

As I indicated before IT”S YOUR MONEY, STUPID! In my case, I don’t really understand the gold market and there are so few real players in the market that this investment exceeds my preference for risk. In fact, I will probably not invest the whole $10,000 in high risk investments, but will break them up into packets of $2,500 each and assign risk to each. This is what I mean by it is your money stupid. You have to be able to explain it to yourself so you can sleep at night.

Ok, so I have given you a lot of things to think about but your next question is: “Well, tell me how I choose a specific investment. If you are suggesting Utility stocks because they fit the cube and current state of the economy requirements, then how do I choose say:  Duke Power over NICRO? How can I determine their risks and yields?”

If you are interested in those questions and you who have signed up to receive the economic memo’s you will get those answers in the next economic memo.

If you have not signed up, simply email me or Kathy Hettinger in College of Business and we will put you on the list. If you have someone else who like the memo’s too, let us know.

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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