Recession a natural correction

Federal intervention worse in the long run.

The Specter of Stagflation

By ROBERT SAMUELSON

'Stagflation" is back in the headlines - but the term is being misused. We're told by eminent commentators that stagflation is the messy mixture of both high inflation and high unemployment. It isn't. Stagflation, at least as the concept was initially understood in the 1970s, meant something different.

Yes, it signified the simultaneous occurrence of high inflation, high unemployment and slow economic growth; but its defining feature was the persistence of this poisonous combination over long periods of time.

Let's see why this is a distinction with a difference. The coexistence of high (or rising) inflation with high (or rising) unemployment is not an abnormal event. But it's usually temporary, because the higher unemployment - stemming from an economic slowdown or recession - helps control inflation. Companies can't pass along price increases; they're stingier with wage increases. It's only when this restraining process is not allowed to work that inflationary psychology and practices take root, creating a self-fulfilling wage-price spiral.

Higher wages push up prices, which then push up wages. Then we get stagflation: a semi-permanent fusion of high joblessness and inflation. Naturally, no politician acknowledges the self-evident implication: that recessions, though unwanted and hurtful to many, are not just inevitable; sometimes they're also necessary to prevent the larger and longer-lasting harm that would result from resurgent inflation.

Interestingly, many academic and business economists who have more freedom to speak their minds suffer the same deficiency. They treat every potential recession as a policy failure when it is often simply part of the business cycle. They thus contribute to a political climate that, focused on avoiding or minimizing any recession, may perversely aggravate inflation and lead to much harsher recessions later.

The stagflation that began in the late 1960s and resulted from this attitude was indeed dreadful: from 1969 to 1982, inflation averaged 7.5 percent annually and unemployment 6.4 percent. What's renewed interest in stagflation is the latest consumer price index (CPI), the government's main inflation indicator. For the year ending in January, all prices were up 4.3 percent. Excluding the temporary surges after Katrina, inflation hasn't been higher since July 1991. Even eliminating food and energy prices (about a quarter of the index), January's year-to-year increase was 2.5 percent.

All these figures exceed the Federal Reserve's informal inflation target of 1 percent to 2 percent a year: a range deemed so low that it constitutes effective price stability. And these aren't the truly disturbing numbers. The more upsetting figures are those for the last three months. In this period, the full CPI rose at a 6.8 percent annual rate. Without food and energy, the increase was still 3.1 percent. Medical services were up 5.1 percent, women's and girls' apparel 7.3 percent (again, at annual rates).

Inflation is accelerating. Price increases of individual items can have many immediate causes: poor harvests for food; OPEC for energy; uncompetitive markets for health care; corporate market power for drugs. But persistent inflation - the general rise of most prices - has only one cause: too much money chasing too few goods.

It's not a random accident. The Federal Reserve regulates the nation's supply of money and credit.

The Fed creates inflation and can control it. Since August, the Fed has been under enormous pressure to ease money and credit. It has. The overnight Fed funds rate has fallen from 5.25 percent in early September to 3 percent now. Politicians are clamoring for the Fed to prevent a recession. Banks and other financial institutions want cheaper credit to enable them to offset losses on subprime mortgages.

There is fear of a wider economic crisis if large losses erode confidence and, by depleting the capital of banks and other financial institutions, undermine their ability and willingness to lend and invest. Unfortunately, the Fed shows signs of overreacting to these pressures and repeating the great blunder of the 1970s. Underestimating inflation then, the Fed repeatedly shoved out too much money and credit in a vain effort to keep the economy near "full employment."

Now, switch to the present. Again, the Fed has underestimated inflation. It expected the economic slowdown to suppress inflation spontaneously. But so far, the lower inflation hasn't materialized in part because, outside of housing, there hasn't been much of an economic slowdown.

It's true that the Fed is treading the proverbial tightrope. No one wants a financial crisis; but no one should want the return of stagflation either.

The American economy - a marvelous but flawed engine of wealth - periodically goes to speculative or inflationary excesses. If most of those excesses aren't given the time to self-correct, we may be trading modest pain today for much greater pain tomorrow.

Trying to prevent a recession at all costs is a fool's errand that could ultimately backfire on us all.

Source: The Washington Post

Key factors to consider when evaluating IPO stock prospects

It's important to factor in risk exposure before investing in stocks.

By OH BOON PING

OKAY, so you've come across an IPO that promises a potential yield of 10 per cent next year. As good as that sounds, as a long-term investor, how can you tell if the stock is a real gem and not just a lot of window dressing?

After all, many initial public offerings start out well on the stock market, only to fizzle a few months down the road. To help you suss out companies with real fundamentals from those window-dressed to sell, here are some key factors to look at.

Earnings track record: This is central to any investment decision, as dividends are paid out of net income. The earnings record is also indicative of management's strength. A weak earnings record may reflect the management's inability to grow the business, while a strong track record is always welcome.

However, investors should be aware that financial numbers can be dressed up for an IPO.

The next thing to note is the company's dividend policy since that is key for an investor looking for regular returns.

But a company that doesn't pay generous dividends may have other attractions. If it uses its spare cash to invest in its business for growth, that could enhance the company's value, and stock holders can gain from future share price appreciation.

Growth strategy: It's also important to look at the company's growth strategy since that is indicative of its business direction and earnings prospects. This not only aids in forecasting earnings, but also has an impact on its stock price.

For example, China Milk, which made its debut in 2006, surged by 57 per cent on the first day of trading. Last Friday, it closed at 98 cents - up from its issue price of 62 cents, despite the recent market turmoil.

Obviously, the company's plans to expand its herd of dairy cows, acquire new production facilities and purchase equipment and machinery had received a strong vote of confidence from the market.

Of course, much also depends on the industry the company operates in and its outlook, which brings us to the third factor.

Industry structure and macroeconomic outlook: Here, the things to look for include barriers to entry and market structure.

A dominant presence in the market is an advantage since it gives the company pricing power. Also, high barriers to entry means that there's less chance of its margins being squeezed because of price competition.

One example of an industry leader is Apple, which dominates the MP3 market. Because of the iconic status of Apple's iPod, the firm enjoys greater pricing power compared with rivals like Creative Technology.

Besides the above factors, attention must also be paid to the growth prospects of the overall industry. A company in a sunset industry would post slower earnings growth in the years ahead compared with one that is in a sunrise industry.

Also, a projected economic slowdown may mean sluggish business for the company going forward. This would hit consumer stocks in particular when consumers rein in spending. When that happens, the company's fair value may have to adjust.

Relative valuation: An alternative approach to determine if a stock is cheap or expensive is to compare its price multiple with the median or average of its comparable group of stocks.

This can take the form of price-earnings (P/E), price-book (P/B) or price-cash flow (P/CF) ratios, even though PE is probably the most widely used measure here.

For example, United Test & Assembly Center (Utac) was once trading at a P/B of 1.4 times for 14 per cent return on equity (ROE) compared with Stats ChipPAC's P/B of two times for 6 per cent ROE.

This was also lower than P/B of 2.7 for the semicon assembly and test sector as a whole. Little wonder then that Utac was deemed to be cheap and has since been bought over a private equity group.

Risk factors: Not to be forgotten are the business risks that the company faces. Finance 101 teaches us that higher returns are accompanied by higher risks. And prudence dictates that an investor factors in the risk exposure before deciding if a stock is a good buy.

For a biomedical firm, for example, risks include the high failure rate in its research efforts, while a structured finance fund is exposed to default risk in its underlying debts.

An example is the Babcock & Brown Structured Finance Fund, which promised a yield of 9 per cent at IPO in 2006. At that time, roughly a third of its portfolio was allocated to assets like loan portfolio and securitisation such as collateralised debt obligations (CDOs).

It is difficult to assess the risk characteristics of CDOs since much depends on the seniority of the tranche. Complicating the picture further is the fact that the default of one underlying party may result, to different degrees, in the default of other parties in the portfolio.

In short, it is important to understand the types and amount of risk exposure in a stock before making your investment decision.

Source: BT Online