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Jack Friedman
Jack Friedman
 

Business Conditions and Investing in Today’s Economic Climate

Here’s how.

October 5, 2009
by Jack Friedman, CPA, ABV

Economic recovery seems apparent. Disaster has been averted. Despite making decisions on inadequate information and without adequate understanding of the implications of their decisions for the economy, the Treasury and Federal Reserve deserve much credit for survival. Decisions made with inadequate study include ones affecting such corporate icons as GM, Fannie Mae, Freddie Mac, AIG Insurance, Lehman Brothers, Bear Stearns, Merrill Lynch and Wachovia. Better decisions might have been made if there had been better data or more time to study each company.

The Federal Reserve is concerned with both employment and inflation. For the past year, it has seemed far more concerned with employment. Maybe inflation will be of greater concern next year than it was last year or than it was in comparison to employment. How each citizen was affected will vary. Certainly, people with many working years ahead favor employment. Retirees, especially those with ample savings, are more concerned about inflation than employment.

Now how does a CPA advise clients to reach good business and investment decisions? Clients include individuals seeking suitable investments and businesspeople reaching for good business decisions in an environment that, though improving, remains murky.

First let’s focus on the overall business economy. Then we’ll consider a few types of investment opportunities.

The reader should be mindful that the economy, as well as investment opportunities, is not analogous to a game. A complex game, such as bridge or chess, is played by rules that are fully known by all players. Games allow models to be constructed to simulate play without inter­ference from outside forces. Thus, a game of chess can be played without concern that an oil embargo will occur to gum up the works or that Congress will pass a new law that changes the way chess pieces are allowed to move or that an earthquake will disrupt players and topple pieces off the board.

A game may be complex, but it has known rules that all players must obey. The economy brings the possibility of unknown outside events.

There is no agreement on what the future will hold. There is heated debate among economists about whether the economic recovery will be a U a V shape. Another suggestion is a Nike “swoosh,” which is a long, slow recovery. A minority of economists are suggesting an L shape — a prolonged flat line along the bottom — while others see the double dip of a W.

Cynics will tell you that economic forecasters were put on earth to make weather forecasters look good. Economists who provide outlooks without an elaborate model would suffer the criticism that their opinions are based on gut feeling or intuition rather than a scientific process. In a scientific process, an opinion could be tested and validated by replication or else discredited.

Economists with extensive skills in mathematics, known as econometricians, have developed highly complex and elaborate computer models that can simulate the economy. However, two obvious flaws in these models:

  1. The inability to include events never previously experienced and
  2. Limited capability to forecast turning points.

Thus, the models work very well to forecast the economy when it continues along the same path. But they don’t work very well when unexpected changes occur.

You will sometimes hear economists acknowledge that their model didn’t replicate the economy as closely as expected because of some unforeseen (and unforeseeable) event, such as the Arab oil embargo in the 1970s or another upheaval — possibilities noted earlier. Thus, the finest-tuned computer models can’t incorporate unforeseeable events, especially those of an international nature.

Given this uncertainty, a CPA could try to answer the question as best he can or refer the client’s inquiry to an economist, tempered with an explanation that the economist operates in an uncertain environment.

One possible approach for a business (possibly with a CPA’s help) is to simulate results under the V, U, swoosh, L and W scenarios. If forecast results that are simulated from one or more scenarios are unacceptable, then perhaps some business weakness can be shored up to protect against the possibility of disaster. This may be done, for example, through a capital expenditure program, product diversification, increased debt or equity or lines of credit.

As for investments, the stock market has partially recovered from the low in March 2009 by more than 50 percent to its present level. Will it recover fully or take a breather? Optimists expect that increased corporate earnings and continued low interest and inflation rates will sustain the market recovery.

Pessimists point to the huge federal deficit as a precursor of inflation. Inflation will bring higher interest rates. Corporate earnings will then suffer from higher costs of capital and the valuation of corporate stock will decline from higher capitalization rates. Potential increases in tax rates on corporate dividends and capital gains, threatened by the Obama administration, will make common stock less appealing.

If inflation returns, long-term fixed-income securities (bonds, mortgages) will also be adversely affected. One protects against inflation by buying tangible assets that don’t wear out. Precious metals are a favorite hedge against inflation. Precious metals have already increased in anticipation of high inflation. Gold, now (September 2009) at $1,000 per ounce, already incorporates in its price some of the most severe inflation expectations for the next several years. Recall that it took 28 years for gold to return to its peak of $800 an ounce, reached in the early 1980s. Perhaps other commodities that have not been driven up by inflation fears can now offer an inflation hedge without gold’s volatility.

The liquidity crisis we faced a year ago seems to have receded. However, the recovery of some banks and nonbank financial institutions may be fragile even though underpinned by Troubled Asset Relief Program (TARP) funds. Many banks are forced to add to capital reserves instead of making new loans. Retightening of credit markets could lead to the W scenario. If the CPA or clients have this concern, then they should avoid investments that may require capital calls and keep adequate liquidity.

Accordingly, a small percentage (5% to 10%) of an investment portfolio might be set up as bookends of the risk spectrum. That is, at one end, have safe, liquid investments such as Treasury bills. At the other end, keep hard assets as inflation protection. In between, the bulk of the portfolio can be allocated between stocks and bonds in a proportion that the investor is comfortable with.

No one, not even the most highly educated economists with the most sophisticated models, can accurately forecast the economy. The economy doesn’t behave like a game will all the rules well known. A CPA business or an individual investor-client stands the best chance for survival in the face of the unexpected by diversification. A model to simulate various scenarios can be helpful, especially to protect against the unexpected.

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Jack P. Friedman, CPA, ABV, CFF, is a real estate author, appraiser and economist in Dallas, Texas. He is a state-certified appraiser, with ASA, MAI and CRE designations. www.realexperts.com. Readers should be aware that the opinions expressed in this article are solely the author’s and in no way represents the views of the AICPA or the CPA Insider™.