In an editorial by Mr. Ronald McKinnon in the WSJ, he argues we have entered a period of stagflation. This period is marked by high inflation, low economic growth, and high unemployment. He seems to somewhat cherry-pick his data to fit his thesis since he uses PPI of 6.8% and the prices in foreign countries to support his inflation claim, avoiding the housing, wages, and CPI. He argues the central reason for inflation is: "the proximate cause of the rise in U.S. prices is inflation in emerging markets, but its true origin is in Washington." His central reason is "Since July 2008, the stock of so-called base money in the U.S. banking system has virtually tripled." He goes on to argue the printing of money and low interest environment created by the Fed has exported inflation to emerging markets, a point on which I agree.
However, he seems to then bend himself into a pretzel as he argues that the low interest rates are creating credit constraint, which should drive deflation not inflation.
"That the American system of bank intermediation is essentially broken is reflected in the sharp fall in interbank lending: Interbank loans outstanding in March 2011 were only a third of their level in May 2008, just before the crisis hit. How to fix bank intermediation is a long story for another time. But it is clear that the Fed's zero interest-rate policy has worsened the situation."
In the end he seems to argue it both ways, easy money is the cause of inflation and weak economic growth, thus stagflation. A pretzel of an argument that fails to identify fundamental causes or a pathway forward.
Under my Sagflation thesis, I argue many of the fundamental economic trends in the future are likely deflationary, including technological advances, high debt levels, and over-supply of housing and retail space. Offsetting these deflationary pressures is an aggressive Federal Reserve that appears hellbent on avoiding deflation. The loser in this equation is price stability, as witnessed in bubbles in specific market segments and foreign economies.
Our pathway going forward is to work off the excess capital, re-focus investments on higher return projects, and reduce debt. Until then, we are in a low return environment that will make sustainable economic growth difficult. Working through these issues could happen gradually over ten to twenty years or could occur in less than five, depending how dramatic we want to make it.
Tuesday, May 24, 2011
Monday, May 23, 2011
Currency May Turn Deflationary
Interesting editorial in the WSJ about a rising dollar driving deflation. The editorial highlights recent comments by Nobel Laureate Robert Mundell, who predicts a strengthening dollar once QE2 ends. Mr Mundell points to two examples that produced a strengthening dollar:
(1) The summer of 2008 when the Fed paused in lowering the fed funds rates and the dollar appreciated 30% in a few weeks, and
(2) November 2009 with the end of QE1 that saw a strengthening dollar relative to the Euro.
With the end of QE2, the prediction is that the dollar strengthens against the Euro unless the government acts aggressively, resulting in deflationary pressures as imports become relatively cheaper.
Currency deflation would add additional downward pressures to the outlook for prices. I believe there may be growing downward pressure on prices from fiat actions (government austerity and tightening of monetary policy as QE2 ends), commodities if prices continue to pull in, goods and services due to excess supply and a leveraged consumer, tangible assets from declining house prices, and potentially wages due to high employment and employers seeking out lower cost labor. If financial markets roll-over, as I expect them to, this would provide one more deflationary weight on prices.
Inflation dominates the headlines today, but I expect deflation to dominate the markets through the end of the year.
(1) The summer of 2008 when the Fed paused in lowering the fed funds rates and the dollar appreciated 30% in a few weeks, and
(2) November 2009 with the end of QE1 that saw a strengthening dollar relative to the Euro.
With the end of QE2, the prediction is that the dollar strengthens against the Euro unless the government acts aggressively, resulting in deflationary pressures as imports become relatively cheaper.
Currency deflation would add additional downward pressures to the outlook for prices. I believe there may be growing downward pressure on prices from fiat actions (government austerity and tightening of monetary policy as QE2 ends), commodities if prices continue to pull in, goods and services due to excess supply and a leveraged consumer, tangible assets from declining house prices, and potentially wages due to high employment and employers seeking out lower cost labor. If financial markets roll-over, as I expect them to, this would provide one more deflationary weight on prices.
Inflation dominates the headlines today, but I expect deflation to dominate the markets through the end of the year.
Wednesday, May 18, 2011
The Contrarian
Apparently I am the contrarian based on the following "insight" by Fidelity. A position I much prefer since the herd is often wrong and the herd realizes at best average performance.
Fidelity argues that many people are avoiding Treasuries due to anticipated inflation and the end of QE2, which means a large buyer of treasuries (the U.S. government) exits the market. Fair enough, this is an active debate in the market right now on which I happen to take the opposite view of slower economic growth and deflation dominating U.S. government buying trends.
Fidelity goes on to argue that every portfolio should have some exposure to Treasuries to reach the magical "efficient frontier" in which the risk/ reward of the portfolio is maximized. This is a powerful theory that has many positives points. But I have always had one problem with it: it assumes the markets are in a state of information efficiency that reflects the proper valuation. I humbly disagree with this assumption and believe that many securities are mis-priced due to either fundamental oversights, lack of research, herd movements, or even emotional entanglement.
Operating under the assumption that securities are always seeking the efficient price, but often not obtaining it, I ask a simple question. If through research you know a security is materially mis-priced, offering an opportunity for a move that far exceeds the market performance, and you can identify a catalyst that will likely cause the security to become priced efficiently (such as reporting earnings), why would you not significantly over-weight this security in your portfolio?
Granted this is hard to do and requires significant insight into both the fundamentals of the business and the market expectations. But it is accomplished daily. Therefore, I much prefer to look at Treasuries through the following prism: The majority of the market appears to focus on inflation risk and the exit of a major buyer, likely pushing down prices of Treasuries. If my analysis of deflation and an economic slowdown proves correct then Treasury prices likely rise (yields fall) as the market prices in this scenario. Furthermore, a fall in the stock market likely hastens a rally in Treasuries since money likely floods into Treasuries.
To quantify it, at current yields a 1% decline in the yield on the 30-year treasury results in a 15+% increase in the price. So if the yield moves from 4.3% to 3.3%, I should see a over a 15% increase in my principal. Not bad, especially if stocks decline amongst a deteriorating earnings outlook and worries about deflation. This is why I have such a large position in 30-year Treasuries and also highlights my level of conviction about the risk of deflation increasingly dominating the markets for the remainder of this year.
Fidelity argues that many people are avoiding Treasuries due to anticipated inflation and the end of QE2, which means a large buyer of treasuries (the U.S. government) exits the market. Fair enough, this is an active debate in the market right now on which I happen to take the opposite view of slower economic growth and deflation dominating U.S. government buying trends.
Fidelity goes on to argue that every portfolio should have some exposure to Treasuries to reach the magical "efficient frontier" in which the risk/ reward of the portfolio is maximized. This is a powerful theory that has many positives points. But I have always had one problem with it: it assumes the markets are in a state of information efficiency that reflects the proper valuation. I humbly disagree with this assumption and believe that many securities are mis-priced due to either fundamental oversights, lack of research, herd movements, or even emotional entanglement.
Operating under the assumption that securities are always seeking the efficient price, but often not obtaining it, I ask a simple question. If through research you know a security is materially mis-priced, offering an opportunity for a move that far exceeds the market performance, and you can identify a catalyst that will likely cause the security to become priced efficiently (such as reporting earnings), why would you not significantly over-weight this security in your portfolio?
Granted this is hard to do and requires significant insight into both the fundamentals of the business and the market expectations. But it is accomplished daily. Therefore, I much prefer to look at Treasuries through the following prism: The majority of the market appears to focus on inflation risk and the exit of a major buyer, likely pushing down prices of Treasuries. If my analysis of deflation and an economic slowdown proves correct then Treasury prices likely rise (yields fall) as the market prices in this scenario. Furthermore, a fall in the stock market likely hastens a rally in Treasuries since money likely floods into Treasuries.
To quantify it, at current yields a 1% decline in the yield on the 30-year treasury results in a 15+% increase in the price. So if the yield moves from 4.3% to 3.3%, I should see a over a 15% increase in my principal. Not bad, especially if stocks decline amongst a deteriorating earnings outlook and worries about deflation. This is why I have such a large position in 30-year Treasuries and also highlights my level of conviction about the risk of deflation increasingly dominating the markets for the remainder of this year.
Tuesday, May 17, 2011
Positioned for Stock Market Pullback
As commodity prices continue to pull back, I believe it is more and more likely that we enter a period of deflation since the scales in my previous analysis begin to tip towards price declines. This potentially has a material impact on stock valuations with an outlook of slower earnings growth and smaller PE multiples. It also favors bonds since the real yield on bonds will increase in a deflationary environment.
The length and depth of the deflationary period may be determined by the future actions of the Fed. If the Fed aggressively pursues QE3, then we could see a relatively short and shallow dive into deflation of under a year and less than negative 1% as measured by CPI starting in 2012. If the Fed chooses to let the markets run their course, then the deflationary period could be longer and deeper and stock market compression results in slower consumer spending due to a decline in wealth. Since I do not expect the Fed to voice any opinion on the QE3 for at least a few months, I believe the markets may increasingly factor in deflationary pressure going forward.
Source: http://www.multpl.com/
Borrowing from Schiller, the PE multiple of the SP500 is about 23x, relatively high compared to the mid-teen historical average. As outlined by Ed Easterling of Crestmont Research, during periods of stable prices the PE of the market increases. If, however, either inflation or deflation occur the PE of the market likely declines. See the following chart, which highlights the impact of inflation/ deflation of PE ratios.
Source: Crestmont Research
Under my sagflation thesis, I expect prices to fluctuate between inflation and deflation as fundamental economic forces and an activist monetary policy increase price instability. This implies wild gyrations in the stock market as the discounting of future earnings swings significantly due to changing expectations about future price trends and passes through the PE sweet spot of 0-4% inflation to either 5+% inflation or deflation, which typically result in low teens to single digit PE multiples.
So where is my money? A large weighting towards Treasuries with exposure to consumer staples whose costs likely decline, utilities in the domestic natural gas markets (where prices have remained low), tech companies with good dividend yields and that provide stable cash flow, fertilizer materials for growing food with a high dividend yield, and generic pharmaceutical.
The following is summary:
62% in 30-Year Treasury
6% IBM
5% BWP
5% KMB
4% TNH
4% FGP
4% CALM
3% UTL
2% TEVA
2% CA
The length and depth of the deflationary period may be determined by the future actions of the Fed. If the Fed aggressively pursues QE3, then we could see a relatively short and shallow dive into deflation of under a year and less than negative 1% as measured by CPI starting in 2012. If the Fed chooses to let the markets run their course, then the deflationary period could be longer and deeper and stock market compression results in slower consumer spending due to a decline in wealth. Since I do not expect the Fed to voice any opinion on the QE3 for at least a few months, I believe the markets may increasingly factor in deflationary pressure going forward.
The PE multiple of the SP500
Borrowing from Schiller, the PE multiple of the SP500 is about 23x, relatively high compared to the mid-teen historical average. As outlined by Ed Easterling of Crestmont Research, during periods of stable prices the PE of the market increases. If, however, either inflation or deflation occur the PE of the market likely declines. See the following chart, which highlights the impact of inflation/ deflation of PE ratios.
Under my sagflation thesis, I expect prices to fluctuate between inflation and deflation as fundamental economic forces and an activist monetary policy increase price instability. This implies wild gyrations in the stock market as the discounting of future earnings swings significantly due to changing expectations about future price trends and passes through the PE sweet spot of 0-4% inflation to either 5+% inflation or deflation, which typically result in low teens to single digit PE multiples.
So where is my money? A large weighting towards Treasuries with exposure to consumer staples whose costs likely decline, utilities in the domestic natural gas markets (where prices have remained low), tech companies with good dividend yields and that provide stable cash flow, fertilizer materials for growing food with a high dividend yield, and generic pharmaceutical.
The following is summary:
62% in 30-Year Treasury
6% IBM
5% BWP
5% KMB
4% TNH
4% FGP
4% CALM
3% UTL
2% TEVA
2% CA
Wednesday, May 11, 2011
Re-Positioned for Deflationary Market
In the previous post I broke down inflation/deflation pressures into seven categories, which were commodity, wage-price, financial assets, tangible assets, currency, fiat, and goods and services. Three were inflationary - commodity, financial assets and currency. Two were deflationary - tangible assets such as housing and fiat pressure resulting from federal fiscal and monetary policies. Two were relatively stable - wages and goods/ services. With the recent sell-off of commodity prices it appears as though volatile commodity prices may turn deflationary should the trend continue.
The market appears more concerned about inflation than deflation, however this may change dramatically should deflationary pressures spread to currency through a strengthening dollar, financial assets in a broad retrenchment of P/E, and goods/ services if the U.S. consumer slows spending.
In anticipation of this swing occurring in the markets, I have re-balanced my portfolio with heavy weighting to high quality U.S. bonds with a long duration (~40%) and relatively high dividend yield (>4%) stocks in the segments of consumer staples, domestic natural gas distribution, and productivity enhancing companies (~30%). I also remain about 25% in cash for a larger market correction.
The market appears more concerned about inflation than deflation, however this may change dramatically should deflationary pressures spread to currency through a strengthening dollar, financial assets in a broad retrenchment of P/E, and goods/ services if the U.S. consumer slows spending.
In anticipation of this swing occurring in the markets, I have re-balanced my portfolio with heavy weighting to high quality U.S. bonds with a long duration (~40%) and relatively high dividend yield (>4%) stocks in the segments of consumer staples, domestic natural gas distribution, and productivity enhancing companies (~30%). I also remain about 25% in cash for a larger market correction.
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