Bernanke's big dilemma

• Sell all shares of Select Sector SPDR-Financial (XLF, news, msgs), Medicis Pharmaceutical (MRX, news, msgs) and National Instruments (NATI, news, msgs) at the open.

• Buy $3,500 worth of GeoEye (GEOY, news, msgs) at the open.

• Buy $4,000 worth of PPL Corp. (PPL, news, msgs) at the open.

• Sell short $2,000 worth of Belo Class A (BLC, news, msgs) and Riviera Holdings (RIV, news, msgs) at the open.

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"Be not angry that you cannot make others as you wish them to be, since you cannot make yourself as you wish to be." -- Thomas à Kempis

I will never stop being amused by investment-related headlines. One day we read a news report about a bubble popping in the oil market; the next day there's an article about oil prices possibly going to $250 a barrel.

You see the same divergence on interest rates, investment banks or anything else that emerges as a "soup du jour."

It is an almost bulletproof strategy: Throw a bunch of things against a wall, make lots of extreme statements, see what sticks, and, in the end, declare you were right.

Recently, forecasting the shape of what seems to be an inevitable recession has been a popular topic of conversation. Following are some of my opinions on the subject -- described in medialike terms in hopes I won't be too boring.

The shape of things to come

Some believe the U.S. economy is in for a V-shaped recession: a quick and painless slump followed by a fast recovery. Others think we might see a W-shaped one, with one quick dip followed by a short recovery and then followed by another larger dip with an eventually inevitable upward move.

A third group, the Elliott wave crowd, thinks that we are destined to live in an L-shaped world, with the U.S. economy entering a decade-long, Japan-like period of stagflation.

I'll start by eliminating the third scenario. In my opinion, a Japan scenario here in the U.S. is pretty much impossible because, first, we are nation of spenders, not savers, and second, because we are as far from seeing deflation as we could be. Have you seen the inflation numbers lately?

On the other hand, I believe the first two shapes of economic downturn are still very possible.

The Fed's choices

The end result could very well depend on the next move of a Washington wizard named Ben Bernanke at the Federal Reserve. What follows is an exercise to make sure that my portfolio is ready for the eventual outcome:

• The U.S. economy is seeing its highest inflation in more than a decade. All the talk about core versus noncore inflation is irrelevant. You can call high energy and food prices noncore and temporary only if they last for a short period.
• Inflation is always a direct result of excess liquidity, or easy money. High commodity prices are merely a symptom and are not likely to be cured until excess liquidity is drained.
• A healthy financial sector is a fundamental requirement for any well-functioning, growing economy. Without normal access to credit, the economic system cannot function.
• Banks are very unlikely to start lending in a normal fashion until they become confident that the value of their collateral is no longer eroding.
• The financial sector, especially investment banks, will face a significantly more restrictive regulatory environment and lower leverage.
• It is rare to see a combination of persistently high inflation and accelerating deflation of the core collateral, real estate, held by the financial sector.
• The longer the current restrictive credit situation drags on, the more likely it will spill over to new areas. The Fed has to force banks to start lending again.
• The Federal Deposit Insurance Corp. is now going to virtually force banks to raise more capital, whether they need it or not, in the short term. So expect them to cut dividends and dilute the value of shareholders' stock.
• Thus one set of stakeholders in the financial sector is going to suffer more than the others: shareholders.
• In addition to that, the Fed is now facing another trade-off: trying to protect as many banks as possible from insolvency and to buy them some more time with lower rates, while at the same time trying to contain inflation.
• Achieving both objectives is virtually impossible, so the Fed could either:
• Own up to its mistakes, raise interest rates swiftly and bankrupt many of the smaller and midsize banks, but kill inflation and deflate the commodity bubble. This would send the global economy into a deep but relatively short recession -- the V shape.
• Keep talking a good game but not take any real action. Force banks to raise more capital whether they needed to or not. Keep interest rates low and pump more liquidity into the system until commodities or some other bubble was blown out of proportion. In this scenario, inflation likely would enter the next stage of the cycle, with workers demanding higher wages due to higher prices, in turn moving prices even higher. Eventually, the Fed would be forced to raise rates higher than in the V-shaped scenario and would send the economy into a more severe recession. That's the W, as the media would say.
• Neither option is pretty. The first is clearly the more logical, but it is also very politically challenging. With election season in full swing, interest rates would be tough to raise. So the Fed will go with Option No. 2, which means regulators will go into a brutal "raise more capital at all costs" mode, hurting even healthy banks' shareholders.
• Thus my decision to buy into the financial sector last week -- even in a small way -- was not correct, and I am reversing it. It also means that the S&P 500 Index ($INX) and the Dow industrials ($INDU) could very well move below the January lows, which means that adding a few more short positions and defensive plays like utilities might not be such a bad idea.

On the positive side, however, corporate health outside the financial and consumer discretionary sectors still looks OK, and income tax withholdings as released by the U.S. Treasury actually picked up in the last few weeks of May and in early June. The most recent data in my interpretation is consistent with growth in gross-domestic-product equal to, or even slightly higher, than in the first quarter.

(After playing with the data, I've also found what seems to be an interesting correlation between the S&P 500 Index and growth in tax withholdings. It's by no means bulletproof but certainly seems to point to a limited short-term S&P drop -- 2% to 3% -- with the next move up of roughly 5% to 6%.)

Fear not: Stocks will go up

To finish off with one more opinion, I think that with all the doom-and-gloom noise out there, it is important to dispel any fears. Ten years from now, all the major U.S. indexes will be trading at higher nominal prices than they are today, period. I am willing to make this bet with pretty much anyone, but I doubt there will be many takers. It is pretty much bound to happen for two main reasons:

• The world of "fiat" money inflation is not going away, and though real stock prices might be higher or lower, nominal prices are simply destined to go up.
• The U.S. economy is still the most vibrant, flexible and productive one in the world, and it will find a way to reinvent itself. It will surely grow in real terms.

With that in mind, I think that, assuming one could weather some serious volatility in the next 12 to 24 months or so, pulling money out of stocks and reinvesting in cash or money market funds is very likely to be the most counterproductive thing a passive investor could do.

But protecting principal should be the most important goal of any investment manager, so hedging with short positions is, as usual, a very prudent decision.

Stay safe out there, visit my blog, The Skeptical Capitalist, and e-mail me at skepticalcapitalist@gmail.com.

Note: Neither Vad Yazvinski NOR skepticalcapitalist.com are investment advisors and they do not endorse or recommend any securities or other investments. Yazvinski and any entities affiliated with him have in the past and may be in future actively trading the securities mentioned in this article. At the time of this writing, Yazvinski has held beneficial interest in most securities mentioned in his MSN Strategy Lab portfolio.