Dubai and investing

The gap between Thanksgiving and New Year's Eve is the period that I contemplate my investment strategy for the upcoming year. After a second helping of green bean casserole on Thursday, I turned on the computer to find that Dubai is in trouble, the price of gold plunged, and the value of the dollar surged due to spooked investors. Wild swings in investment markets driven by arcane bits of financial news and easy money are commonplace today. How should the average Joe and Jane make investment plans in this environment?

First of all, I recommend heeding my old economics professor's advice---pay attention to money supply. I'll save you a lot of time---the dot.com boom and bust as well as the real estate boom and bust were driven by lots of excess cash created out of thin air by the Federal Reserve. This frothy money flowed into the previously mentioned sectors and set the stage for booms and eventual busts. In response to the 2008 market crisis, the Fed pumped even more money into the financial markets. And various sectors are bubbling again.

OK, so the money supply is a mess. Where do we go from there as we make our plans?

Consider deflation. Thanks to the Fed, there's lots of extra cash in banks and they're not loaning it out. Why? Banks are either nervous thinking that more bad loans may go belly-up and they'll need cash to cover their losses, or there just aren't many viable business loans to make. If the bad loan scenario comes true, expect a period of falling prices driven by business and mortgage failures as well as panicked consumers hanging onto their cash. Believing this deflation scenario could play out, what should an investor do? Do the opposite of Dubai---get out of debt, save, and conserve your cash.

Consider inflation. What if the good times are right around the corner? In a recovery, banks will start to make loans again. Believe it or not, banks can also create money because they only need to keep a small amount of cash in reserve. Typically, they can loan money in a 10-l loan to reserve ratio. And they could create a lot of cash because the Federal Reserve pumped an unprecedented amount into the system following the 2008 crisis. If banks start loaning again and the Federal Reserve doesn't remove the excess funds from the system fast enough (they usually don't), look for inflation to set in. So how does an investor prepare? Consider inflation-sensitive investments such as commodities. This is why traditional inflation hedges like gold have been surging. When the news about Dubai came out, the price of gold dropped $60 an ounce. But the price rebounded significantly because inflation investors saw the drop as a buying opportunity.

Consider potential busts. For example, the Federal Reserve has been using its printing press to buy government bonds, which is keeping prices artificially high. If interest rates start to go up, beware. Bond prices could fall. Are there other bubbles out there? Sure, beware.

We're living in a time when financial news from the tiny emirate of Dubai shakes world markets. Translation: The average Joe and Jane need to be very wise with their investments. In my opinion, the rough ride isn't over yet. Consider inflation, deflation, and bust scenarios and position yourself to be a good steward of your assets.