A Relevant Tale Of The Mouse, Frog And Hawk

A Relevant Tale Of The Mouse, Frog And Hawk
Jim Oberweis, Oberweis Report 08.06.09, 5:40 PM ET


If fable-teller Aesop sat down with China's President Hu Jintao and Federal Reserve Chairman Ben Bernanke, the meeting would begin with the story of the Mouse, the Frog and the Hawk:

"A mouse who always lived on the land, by an unlucky chance, formed an intimate acquaintance with a frog, who lived, for the most part, in the water. One day, the frog was intent on mischief. He tied the foot of the mouse tightly to his own. Thus joined together, the frog led his friend the mouse to the meadow where they usually searched for food. After this, he gradually led him toward the pond in which he lived. Upon reaching the banks of the water, he suddenly jumped in, dragging the mouse with him.

"The frog enjoyed the water amazingly, and swam croaking about, as if he had done a good deed. The unhappy mouse was soon sputtered and drowned in the water, and his poor dead body floating about on the surface. A hawk observed the floating mouse from the sky, and dove down and grabbed it with his talons, carrying it back to his nest. The frog, being still fastened to the leg of the mouse, was also carried off a prisoner, and was eaten by the hawk."

Ah, but who is the frog and who is the mouse? Is the mouse an allegorical depiction of the U.S., with the death of its manufacturing powerhouse catalyzed by the subsidies and currency manipulation of the Chinese frog? Or is China the mouse, whose export-based economy remains susceptible to the unsustainable and careless spending of the overleveraged western frog? In the latter scenario, the Chinese mouse's life (or at least savings) lay in the hands of the frog, steep in danger, an eventual victim to the hawk of Inflation.

Let us not forget that most unhappy final twist: the frog dies too, bound at the leg to the mouse. And so might the film roll, with an unhappy ending for the American frog. As the U.S. inflates away the burden of its debt (jargonized as "quantitative easing"), we may have fooled the Chinese this time, but future creditors will vanish, and the U.S.' ability to finance deficit spending on absurdly attractive terms will be relinquished for the foreseeable future.

It doesn't take an expert in game theory to realize that the mouse will try to untie itself before it gets dragged under water. In fact, China recently made waves with a proposal for alternatives to the U.S. dollar as a reserve currency. Bernanke, in fulfilling his patriotic cheerleading duties, recently sought to quell inflation worries with a promise to maintain harmony and balance throughout the universe: "I think that they are misguided in the sense that … the Federal Reserve is able to draw those reserves out and raise interest rates at an appropriate time to make sure that we don't have an inflation problem."

Borrowing a line I recently heard from a Harvard-educated economist, "That's bunk!" How popular will it be to raise rates and curtail economic growth just as the economy edges out of the worst recession since the Great Depression? More important, how will he do that as election season approaches and political pressure intensifies?

Besides the potential for intentional deception, one must also consider the chance for unwillful error, or being too late to the punch. In the same way that it is possible that an elephant guided by a troupe of chimpanzees might learn to ride a bicycle, it just isn't particularly likely. The Fed won't get the equilibrium just right. Bernanke has himself suggested it is better to err on the side of inflation rather than deflation, and it is inflation we expect to see, yet significant inflation is not yet imputed into bond prices, likely because the Fed itself is propping up prices for the moment by scooping up bonds to keep yields low. That sounds a bit like the mouse helplessly trying to stay afloat as the hawk lurks overhead.

Inflation is coming. In an inflationary world, stocks outperform bonds and long-term bonds fare particularly badly. Foreign stocks with undervalued currencies outperform stocks denominated in inflating currencies. For these reasons, equities will outpace fixed income for the decade to come (though not so in every year). Chinese equities will continue to offer their outsized gains over the next several years, even after its amazing run thus far in 2009.

That's not to say there won't be plenty of micro-cap stocks in the U.S. that have carved out growth opportunities, but don't ignore the low hanging fruit. Small-cap growth stocks in China--companies like Asia Info Holdings (ASIA), E-House (EJ), Baidu.com, Ctrip (CTRP), American Dairy (ADP), Perfect World (PFWD) and Rino (RINO)--as well as diversified China mutual funds, offer the benefits of foreign currency exposure and higher Chinese GDP growth to your aggressive growth portfolio.

So what's the moral of the story of The Mouse, the Frog and the Hawk? Be the hawk.

Jim Oberweis, CFA, is editor of the Oberweis Report and manager of several mutual funds focused on small-cap growth stocks and China.



http://www.forbes.com/2009/08/06/baidu-ctrip-asiainfo-personal-finance-investing-ideas-inflation-china_print.html