Since the previous edition of the Sterling Weekly the Dow Jones Industrial Average gained 198.56 points or approximately 1.8% to 11,190.69 As we have been commenting on in our Daily Blog, despite the recent move back higher, we see the overall market in a sideways trading pattern. Basically a running correction in our minds. Until the Dow Jones Industrial Average closes above 11,613.53 we are going to maintain our position that the Dow Jones Industrial Average, and the overall market, is in a sideways pattern with a downward bias.

This week we have a fairly heavy economic calendar with the important news being the release of Revised 2nd Quarter Gross Domestic Product (GDP). The current expectations are for a very anemic 1.2%, revised from a 1% estimated growth rate. Both very weak numbers. With nearly every forward looking economic indicator pointing to weakening economy and a probable US recession, I could not help but think of last week’s inflation numbers. Last month’s Consumer Price Index came in at an adjusted 0.4% for the month of August. While that may not sound bad, the year over year number is just under a 4% annual inflation rate, and with the exception 2007, this will be the highest inflation rate since 1990. Inflation is not transitory as the Fed likes to say, nor is it the answer to our economic problems as a lot of idiots on the financial channels like to say. Inflation causes real financial pain to citizens and consumers. It affects their spending patterns, economic and growth, as well as our standards of living. Also, it should be noted that inflation is not transmitted equally throughout the system. While inflation is up approximately 11.4% since 2005, the cost per kilowatt charged by my local utility is 40% higher than it was in August of 2005; and my home insurance cost has basically doubled. These are just a couple of examples, but the point of which is that inflation is not transmitted uniformly throughout the system, and some expenses can be cut back on and others cannot. This raises a point of concern, with the rate of growth in inflation, it would not take much more to see with the highest inflation rate since 1980-81 when was much closer to 10% Combine that with our slow growth and we have a real problem.

I have often said that inflation is like a cancer that eats away at the value of your assets and investments. Additionally, much like a cancer, once it takes hold and start to spread, it can increase at what seams to be an exponential rate. Let’s not forget that in 1972 the inflation rate was 3.4%, but then it jumped to 8.9% in1973, and to 12.1% in 1975. After dropping for a couple years inflation then jumped from 5.0% in 1976 (Guess nobody liked what Ford had done to bring down inflation) to 12.4% in 1980 (Jimmy Carter’s last year in office.)

What is troubling is that with slowing economic growth and rising inflation we are likely to see a return to stagflation, where I see one of the side effects of slow to no economic growth being slow to no growth in wages. Couple a lack of wage growth with rising inflation, and the American Consumer (and voter) is about to feel some real pain as their financial health deteriorates. This will force them to cut back on their discretionary spending and they are forced to pay more for items and things they can’t cut back on such as insurance and utilities.

I think this is also very damaging for the overall health of the investment community. Right now, investors in fixed income instruments and bonds are receiving a negative real rate of return on their investments. (A negative real rate of return is when the interest paid is less than the rate of inflation.) In my opinion, the Fed under the Bernanke is creating a bond bubble that could have potentially disastrous consequences world wide when it implodes. With a 4% inflation rate, we should be looking at 5.25% Federal Funds rate, and closer to a 7% yield on the 30-Year Treasury Bond; and we are no where close to these interest rate levels. As a result, when the bond bubble finally bursts, I see interest rates moving far past, and higher, than those target numbers as the market struggles to adjust. This has the potential to dramatically destabilize the financial system in a manner far worse than the bursting of the housing bubble as higher rates flood through the system.

There is a strong contingent of the voting population that believes the Federal Reserve has become politicized and is buying the Federal Government’s debt in order to avoid having interest rates shoot through the roof as a result of the Government’s obscenely deficit levels. This is an exceptionally dangerous game to play. When a change finally comes to the White House, and sooner or later it will, the new resident is probably going to do his or her best to end the Fed’s current bond buying binge; and then like any other binge, we are likely to experience one hell of a hangover. Remember, no bubble is ever sustainable, and their is always tremendous pain when they burst.

I think our current levels of deficit spending our not only reckless, they are dangerous as they are potentially creating a bubble in bond prices that is not sustainable and could potentially lay waste to all sovereign debt markets. This would be the result of our rapidly rising interst rates pushing up interest rates first in sovereign debt markets around the world (and then corporate markets) to levels they are ill-prepared to afford or handle. If this were to happen, our “Great Recession” could become another “Great Depression.” I hope I am wrong, but so far all the evidence points to a bond bubble, and every bubble eventually bursts. I grew up living with my Grandparents who lived through the Great Depression, and for them it was a matter of survival. Historically what we know worked then was to buy equities and try to wait out the economic pain for the eventual recovery. We are continuing to evaluate the situation and advise our clients appropriately.

Sterling Investment Services Site Update

Since the last edition of the Sterling Weekly we have been making some upgrades to our web site (www.sterlinginvestments.com) and the services offered. One of the 1st things visitors to Sterling Investments will notice is a new design to our web pages. We have installed a new content management system and we are in the process of transitioning our legacy pages over to the new system. With several thousand legacy pages this is a time consuming process and will take some time to get fully implemented. We very much appreciate your patience during this process. As part of this process we have cleaned up our graphic images and streamlined our content and hopefully visitors will notice and appreciate the cleaner look to our site. Additionally the improvements to our content management system will allow us to offer more services to our clients; including a daily market commentary blog.

Sterling Market Commentary Blog

As part of our new services we are now publishing a blog. The primary focus of our blog is a daily market commentary. Over the course of the last 12-18 months there have been a lot of changes to the functioning of the stock market. One of the biggest being the growth in computer driven algorithmic and flash trading. While this form of trading serves to help increase the liquidity in the market, it has also dramatically changed the nature of the open of the market; specifically in my opinion it has dramatically increased the swings in the pre-market futures to the point where the expected open could change completely in the last 20 minutes prior to the open. While I still believe it is possible to engage in the form of short term trading I wrote about in the Prime Stock Newsletter, I no longer felt it was possible to publish the Prime Stock Newsletter with enough time prior to the open for it to be of meaningful value to our readers. As a result we have discontinued the publication of the Prime Stock Newsletter. Additionally I have decided to continue to write the daily commentary portion of the Prime Stock Newsletter as the main part of the Sterling Market Commentary Blog, making it free to the general public.

Additionally, the Sterling Market Commentary Blog is available as an RSS feed; and later this week we plan on having our blog available for real time email delivery as well.

Small Cap Research

Prime Update:

We have discontinued the publication of the Prime Stock newsletter in order to focus our efforts on our Market Commentary Blog and white paper research publications. Archived copies of the Prime Stock Newsletter Performance Reports can be found (here).