Liquidity Trap
The Federal Reserve has reduced the Fed Funds rate from over 5% in 2007 to 0.19% at the present time.  Yet with Fed Funds at effectively zero, the economy has begun to slow down again.  The United States is increasingly looking like we are in a classic liquidity trap.  The Fed can no longer lower short term rates because they are already at zero.  In its simplest form, the liquidity trap occurs when the Federal Reserve lowers rates and the low rates have no effect on borrowing.  This occurs because people and companies become unwilling to borrow, regardless of the level of interest rates.  To put it another way, the Fed puts liquidity into the system and people refuse to spend or borrow additional amounts of money.  This is also known as pushing on a string.   The Federal Reserve has cut short term rates almost to zero and the economy is continuing to slow down as businesses and consumers deleverage.  We have two problems here for the Fed; are we in a liquidity trap and how can the Fed stimulate the economy going forward?  The answer for the Fed for the latter question is to force longer term rates lower through purchases from the mortgage bond run off of their balance sheet and, if necessary, engage in quantitative easing  ( printing money) to purchase longer term bonds.  This quantitative easing, or QE2, would involve printing money and purchasing treasury bonds to force long term rates lower.  This is something that has been done very rarely over the last 100 years by the Federal Reserve.

We will hear shortly how serious the Federal Reserve is about QE2.  If the economy continues to falter, we believe the Federal Reserve will engage in a program of quantitative easing and thereby increase its purchases of Treasury Notes.  If the Fed begins to engage in QE2, it will have negative consequences for inflation over the long term.  If the Fed begins QE2, it will be negative for the dollar and bullish for gold.

The wild card in all this is whether or not we are in a liquidity trap where even lower longer term rates will have little effect on the economy.  If we are in the liquidity trap, then valuations in stock markets are too high at the present time.  One of the reasons the stock market has held up is that at 2.49% ten year bonds, stocks look attractive.  However, if the economy is in a liquidity trap, then these valuations are incorrect because they have not factored in a liquidity trap in which even extremely low rates do not produce economic growth.   This is what happened in the last depression and that resulted in a much lower stock market valuation.  I want to point out that I do not believe stocks are going to plunge to depression levels in here, but they should move lower.  There is a huge amount of money out there that will put a floor under the market at some point.

If we are in a liquidity trap, we expect additional government stimulus spending programs to be implemented as a way to keep the economy going near term.  This will be bullish for the near term.  Over the long term, this will cause larger deficits and a lower valued dollar.

Gold and Silver ETFs
On the MaxOut Savings Show, we often get questions about investing in gold and silver.  ETFs are one of the best ways to own gold or silver.  This is especially true in IRAs and qualified plans where there are restrictions on holding physical gold—with the exceptions of the US Gold & Silver Eagles.  We first wrote about gold in the MaxOut Savings Report back in December of 2001 where we predicted “gold was about to start off a major bull market that would last over a decade.”  At the time, gold was priced at under $280.  It is now over $1200 and we believe gold will go higher as the US Dollar decline resumes.  This is particularly true if the Federal Reserve engages in quantitative easing (QE2).  Our target for 2011 has been $1500 for last several years, but it could go much higher.  If you want to own physical gold, it can be purchased in two forms: bullion and coins or ETFs (exchange traded funds).

There are 3 Gold ETFs on the stock exchanges: streetTracks Gold Trust (GLD), iShares Comex Gold Trust (IAU) and PowerShares DB Gold (DGL).  The streetTracks (GLD) and the iShares (IAU) are gold trusts that own the physical gold in vaults.  The PowerShares (DGL) owns no physical gold, but creates exposure through the commodity futures market by owning futures contracts and has excess funds in the Treasury Bills.  This method could reduce expenses as the T-Bills pay some interest and you receive a dividend.  We prefer the gold trusts (GLD and IAU) because they own the physical gold and are not subject to the uncertainties of the futures markets.

The silver market offers the same opportunity to invest in silver on the stock exchanges through ETFs.  There are two ETFs for silver: iShares Silver Trust (SLV) and PowerShares Silver Fund (DBS).  The iShares (SLV) is a silver trust and owns the physical silver in vaults.  The PowerShares (DBS) uses the futures market to “hold” the silver.  The PowerShares (DBS) can pay some dividends due to the T-Bills.  Again we prefer the iShares (SLV) because it is a silver trust and owns the metal.

When it comes to owning the metal we would recommend owning the gold and silver coins.  The coins are much easier to value, buy and sell.  In addition, they generally do not need to be re-assayed when sold.   In IRA accounts, only US American gold and silver eagles are allowed to be purchased and held.   We would not recommend gold and silver coins be purchased for numismatic value unless you are a coin collector.  The valuations are too high and the value could collapse for a number of reasons.  For the same reasons we would not recommend the purchase of proof US American Eagle coins.  In both of these cases companies will try to sell you these types of coins because they carry bigger profit margins.  When buying gold and silver coins, stick with regular American Eagles, Canadian Maple Leafs, Chinese Pandas, or South African Krugerrands.

In the equity area, we believe the large cap US gold and silver companies are the best plays.  If gold makes a run to the $1500-1700 range, these stocks should move quite a bit higher.  There is not much of what is known as “market capitalization” in the group and these stocks could go to a much higher valuation.

Outlook
We believe that many asset class valuations are still too high and will move lower over time.  The liquidity trap could negatively affect the price of commercial real estate that continues to be overpriced given the economic conditions.  We would avoid the REITs because we believe they are overpaying for properties because all most REIT investors tend to look at are dividend yields.  We would also avoid high yield bonds and bond funds that tend to be economically sensitive.  All fixed income investors should look at their investments thru the prism of “if interest rates move higher, what will my loss be?”

Large Cap Value
According to a recent study, the top 50 companies in the S&P 500 have typically sold at a 7% premium to the S&P 500.  At the present time, the top 50 stocks are trading at a 20% discount to the S&P 500 average.  This highlights the value in large multinational companies that we have been writing about.  Large cap multinationals rarely trade at a discount to the markets.  With global growth, strong balance sheets and good dividends, they should be at a premium in valuation.  In a company 401(k) plan, you can find these companies in large cap growth or value funds.  An example would be the Fidelity Contra Fund.

The two key things to watch are the ten year US note yield and the dollar.  Four years ago we wrote that the dollar vigilantes would ultimately force the Fed to become more hawkish and the US to cutback spending.  We will know when inflation comes back when the dollar begins to fall.  We believe the dangers of a liquidity trap could cause a sudden revaluation of the stock market to the downside.