Sagflation Theme - Riding Upward Price Instability through the Spring

My Sagflation thesis remains intact as I continue to allocate capital in my retirement account. Here is a quick update on my outlook as it relates to previous comments:

"The U.S. economy has likely entered a period of "Sagflation," defined as sagging economic activity combined with greater price instability."
           - Stock Ideas to Money - Is the Fed Driving Us Into an Age of Sagflation? August 27


(1) Positions deep in the supply chain, especially commodities, likely perform the best. Commodity prices have been rising, as discussed on the cover of today's WSJ and in previous articles. Increasing speculative activity likely continue to drive prices higher into 2011, in my view. Central banks have been aggressively expanding the money supply around the world. However, as I argued last week, the expansion of money and weakening dollar likely pushes up commodities and costs to consumer-related businesses in 2011 and therefore acting more like a tax on many domestic companies. I expect to continue to hold significant positions in commodities, like DBA and PALL.

(2) Likely stock market inflation, especially overseas, driven by aggressive monetary policies around the world, increasing investor appetite for risk as money growth loosens economic activity, and early 2011 over-reaction by investors who see growing momentum in the market. While earnings likely generally improve over the next couple quarter, I expect to see the market multiples expand as money flow shifts more into equities and away from debt. I expect to focus on companies with pricing power, like Huntsman (Ticker: HUN), companies in industries with healthy secular trends, like GT Solar (ticker SOLR), and U.S. companies with exports accounting for a large percentage of sales, like RF Micro Devices (ticker, RFMD). All these positions are also deep in the supply chain.

(3) Decreases in debt prices, driven initially by money shifting to equity as investors' economic outlooks brighten, and later this year by the on-going large treasury issues by the government. I expect treasury prices to continue to slide as inflationary pressure increasingly works its way into the economy. The other side of the argument, at least in the short-term, is that treasury prices continue to rally due to QE2 and a few unusual market dynamics associated with foreign purchases. This outlook is captured in my TBT position, which has performed poorly to date.

(4) Weak real economic performance within the U.S., which may appear like it is improving over the next year as inflation returns to more normal levels. The weak economic performance is the "sag" portion of sagflation. Therefore I expect to have small exposure to the U.S. consumer, in general, with greater emphasis on relatively stronger economies in Asia and South America. My positions in ECH, EWH, and MCHFX are expected to take advantage of this outlook.

I expect price instability to produce a U.S. stock market rally into Spring 2011 at which time valuations become stretched, Fed reins in expansionary monetary policies, real economic growth signals remain weak, and potentially increasing protectionism by countries. This tide likely lifts all boats for a period but also creates shorting opportunities as consumer companies are separated into winners and losers.