SPENCE Asset Management

Dragon Slaying July 2009

In honor of Independence Day, as Americans we are truly thankful. For despite all of our red, white, and blue warts and blemishes, we are lucky to live in a nation where living standards are high, conveniences are many and restrictions are few. The fact that we all have the right to critique our leaders and their actions is simply icing on our firecracker-shaped cakes.

Regular readers have noted that we find certain aspects of the job of monitoring the financial markets to be annoying. But to be successful in our monitoring, we must have at least one eye on the political arena at all times. And if there is one thing that is increasingly un-fun, it is watching Federal Reserve Chairman Ben Bernanke be raked over the proverbial coals by both parties for pouring monetary water on the global financial fire. Current inflation “fears” are based on the reality that there has been a tremendous expansion in the monetary base. This is the job that Ben Bernanke and the Fed have done. And while others criticize the nation’s financial doctor for prescribing water for his patient that is dying of thirst, we think the Fed has done its job well.

Any seasoned investor should be leery of the dangers posed by inflation. And ever mindful of these dangers, we wanted to use this Fourth of July newsletter to offer you our keys to watch, so that we all have good indications as to when the inflation pot has the potential to move to the front burner.

The inflation dragon is a fresh threat that seems to be on the minds of investors young and old. And since we lean more towards the later category, we can still remember the days when hyper-inflation was running rampant during the Johnson, Nixon, Ford, and Carter years. As we move deeper into the new millennium, we are seeing the United States continue to borrow and spend recklessly. Are these activities in themselves enough to cause inflation?

All things considered, we are NOT all that worried about inflation right now. We do not believe that our problem is based on shortages of raw materials, labor, or industrial capacity. Perhaps the only component in the production equation that IS in short supply right now is RISK CAPITAL. And a shortage of risk capital makes it very unlikely, at least for the time being, that inflation is about to rear its ugly head. In fact, we think that unless the supply of risk capital is encouraged and expanded, just the opposite of inflation will be the greatest danger to investments.

In our estimation, inflation will begin to become a risk when the nation (and the world for that matter) is NOT populated by armies of reluctant borrowers and reluctant, risk-averse lenders. Right now in the private sector, which is always the only place where risks are taken, we have tremendous excess capacity. Employment is low, industrial capacity is under-utilized, bank reserves are high, and most raw materials are readily available (except energy which is another story for another day). It is our greatest fear that these slack conditions will persist and not disappear. The chance of an inflationary environment where too much money is chasing too few goods any time soon seems remote to us.

The primary indication that such an environment could become reality is qualified lenders willing to make loans and more qualified borrowers applying for loans. When these two types of participants come out of their proverbial financial bomb shelters then the Fed will have to take anti-inflation action. We have been and will continue to observe the willingness of borrowers and lenders. And when their attitudes return to what might pass for normal, we will also be watching the Fed to see if it is willing to raise the Fed Funds rate and take other measures that make credit more expensive. If these conditions begin to unfold and Fed officials do their job, they should be able to head off any serious bout of inflation.

In the meantime, we will be hoping the upswing in confidence we saw during the second quarter continues because the confidence deficit is the immediate dragon to be slain. Both lenders and borrowers will only become less reluctant with improving confidence. This is the dragon we are fighting right now, not inflation. Happy Independence Day!

—Jim Spence, Registered Principal, Spence Asset Management

The information contained herein is for informational purposes only without regard to any particular user’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors. To determine if investment in a Separately Managed Account with Spence Asset Management is an appropriate investment for you please call 1.800.230.1840.

Investment Advisory Services are offered through Spence Asset Management, a federally registered Investment Advisor. Investment Advisory Services offered through IAR’s of Spence Asset Management, a Registered Investment Advisor to all residents of the United States.

The views expressed here are those of Spence Asset Management and are subject to change with market conditions. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes investment advice or a solicitation for the purchase or sale of any security. Market forecasts cannot be guaranteed. Past performance does not guarantee future results.