There is increasing discussion of the risk of stagflation developing in the economy, making the decisions of the Ben Bernanke more difficult. The argument for stagflation misses the underlying cause of recently rising CPI prices. Namely, higher commodity prices and rising medical costs. Indeed, breaking down the most recent CPI numbers shows that energy prices increased 19% y/y and food prices increased 4.2% y/y. These prices are a direct result of rising oil and certain food commodity prices. However, it should be noted that oil prices have been declining and thus inflationary pressure exerted by oil should begin to slacken. Similarly, commodity food prices have begun to roll-over, also providing inflationary relief.
The core CPI, excluding energy and food, increased 1.8% y/y. This rise is hardly in the danger zone. Broken down further the number reveals its drivers of vehicle sales (used vehicle prices up 5.3%) and medical costs (up 3.2%). The rising vehicle prices likely moderate since there remains excess capacity in the supply chain for cars and trucks and we'll see what happens to medical costs as "ObamaCare" begins to get implemented.
The CPI is a historical looking number and is largely impacted by changes in prices that occurred months beforehand since it takes time for rising commodity prices to work their way through supply chains into higher prices to consumers. Therefore, investors relying on CPI to make investment decisions risk driving while looking in the rear view mirror.
The thesis of sagflation, on the other hand, appears very much intact. I have defined sagflation as weak economic growth due to high levels of debt and structural inefficiencies in the economy, combined with more volatile prices due to aggressive actions taken by the Federal Reserve. In April I argued that deflation is the greater risk going forward, and I continue to believe this argument. In June I argued about the risks of deflationary pressures "taking the legs" out of the economy, which I believe has been happening.
Saturday, August 27, 2011
Thursday, August 18, 2011
Market Turmoil Unfolding Largely as Expected
The dive in the equity markets coupled with the slide in the yields of treasuries is going largely as expected, as outlined in previous posts. A couple unanticipated trends included the sharp rise in gold and the rush of money headed to the Swiss Franc, although in hindsight both of these trends are logical as investors seek out places to hide.
As we likely go through the "thick" of the market turmoil over the next couple months it is important to layout the following: (1) clear signals to begin re-allocating assets, (2) identify potential investments in which to move, (3) a bail-out strategy should trends deviate from the expected.
Signals
As commentary on the markets increasing includes words like "emotion," "fear," and "uncertain," it likely suggests we are getting close to a capitulation. Another sign highlighted in the Wall Street Journal is that the benchmark M2 gauge of money supply spiked up 1.7% during the week ending August 1. This is both a sign of increasing panic and aversion to risk as investors move to cash positions, providing a deflationary pressure to economic growth. Additionally, investors removed $30 billion from equity mutual funds last week, suggesting more funds likely have to do forced selling and increasing the likelihood of downward pressure in the equity markets.
The clearest sign, in my opinion, is when yields on treasuries collapse, signalling desperate movement of money away from equities into treasuries. This may occur before the actual market bottom in equity markets since fundamentals may appear "not that bad" to equity holders. Sharp movements in yields often have severe ripple effects on currencies, debt markets, banks, and ultimately the economic outlook. So my plan is to sell into a panic buying of treasuries and begin establishing other positions.
Potential Investments
Specifically, I'm looking for quality companies at attractive valuations with a brightening outlook over the next year despite a potential economic slowdown. Ideally I would build a portfolio that likely benefits from the initial bounce back in the markets. So, from the top down one way to approach it is that I'm looking for U.S. companies positioned in more non-discretionary segments of the economy with opportunities ahead. An example might be Dunkin Donuts (ticker DNKN), a company hurt slightly during 2008 and with growth opportunities as it expands the number of units. Alternatively, a well managed company that could take market share in uncertain times whose customer base may provide choppy order flow, implying a high beta, but is healthy in a downturn. An example is Eaton Corp. (ticker ETN). Finally, looking for a company coming out of a negative period already that has scrubbed itself clean and sells into a healthy demand environment. An example would by WR Grace (ticker GRA).
Bailout Strategy
The markets are likely choppy going forward, implying there could be days and weeks in which the equity markets rally and provide a gut-check. If the yield on the 30-year treasury were to rise back above 3.75% I would begin to re-calculate my outlook. Since treasuries is over half my portfolio, it is the most obvious one for me on which to focus. It also offers a wealth of information about the economic outlook and money flows.
As we likely go through the "thick" of the market turmoil over the next couple months it is important to layout the following: (1) clear signals to begin re-allocating assets, (2) identify potential investments in which to move, (3) a bail-out strategy should trends deviate from the expected.
Signals
As commentary on the markets increasing includes words like "emotion," "fear," and "uncertain," it likely suggests we are getting close to a capitulation. Another sign highlighted in the Wall Street Journal is that the benchmark M2 gauge of money supply spiked up 1.7% during the week ending August 1. This is both a sign of increasing panic and aversion to risk as investors move to cash positions, providing a deflationary pressure to economic growth. Additionally, investors removed $30 billion from equity mutual funds last week, suggesting more funds likely have to do forced selling and increasing the likelihood of downward pressure in the equity markets.
The clearest sign, in my opinion, is when yields on treasuries collapse, signalling desperate movement of money away from equities into treasuries. This may occur before the actual market bottom in equity markets since fundamentals may appear "not that bad" to equity holders. Sharp movements in yields often have severe ripple effects on currencies, debt markets, banks, and ultimately the economic outlook. So my plan is to sell into a panic buying of treasuries and begin establishing other positions.
Potential Investments
Specifically, I'm looking for quality companies at attractive valuations with a brightening outlook over the next year despite a potential economic slowdown. Ideally I would build a portfolio that likely benefits from the initial bounce back in the markets. So, from the top down one way to approach it is that I'm looking for U.S. companies positioned in more non-discretionary segments of the economy with opportunities ahead. An example might be Dunkin Donuts (ticker DNKN), a company hurt slightly during 2008 and with growth opportunities as it expands the number of units. Alternatively, a well managed company that could take market share in uncertain times whose customer base may provide choppy order flow, implying a high beta, but is healthy in a downturn. An example is Eaton Corp. (ticker ETN). Finally, looking for a company coming out of a negative period already that has scrubbed itself clean and sells into a healthy demand environment. An example would by WR Grace (ticker GRA).
Bailout Strategy
The markets are likely choppy going forward, implying there could be days and weeks in which the equity markets rally and provide a gut-check. If the yield on the 30-year treasury were to rise back above 3.75% I would begin to re-calculate my outlook. Since treasuries is over half my portfolio, it is the most obvious one for me on which to focus. It also offers a wealth of information about the economic outlook and money flows.
Thursday, August 4, 2011
Strategy Going Forward
Increasing concern about the world's economy likely produces further pullbacks in the markets, in my view. The removal of government stimulus in most regions, outright spending cuts or tax increases by many governments, and tightening monetary policies are a recipe of slower economic growth and possibly deflation. Given the high debt levels of many countries, this economic slowdown could prove disastrous as yields on sovereign debt rise and slowly strangle government budgets already under pressure.
"I argue that the fundamental trends should naturally lead to deflation but the Fed is using all its power to stave off deflation and thus causing inflationary bubbles to emerge in the economy, thus causing price volatility."
April 26, 2011 blog entry.
I update this view with the argument that the Fed appears to be hesitating, reluctant to roll-out QE3 due to a fear of encouraging stagflation. Thus I believe deflation is becoming an increasing risk, despite the CPI data year-to-date of inflationary pressures. Or, in other words, price volatility is increasing.
Yesterday the market cheered the decline in oil prices, reasoning that lower oil prices should stimulate the economy. I agree but think prices are long way from stimulation since prices remain above their five-year average. Instead I expect oil prices to continue to fall due to slower demand and possibly more supply, encouraging deflationary pressures in the economy.
Five-Year Oil Prices - WTI Crude Oil
Source: Oil-Price.net
Wages and salaries appear flattish due to excessive unemployment, financial assets are turning deflationary with the pullback in the equity markets, tangible assets are mostly deflationary due to the excess supply of housing and overhang of foreclosed properties, currency has become less inflationary as its decline slows due to austerity measures and the US dollar is viewed more as a safe haven, government austerity measures are likely a deflationary force in the economy, price increases for goods and services likely slow (pushing down CPI) going forward as the economy slows.
Within the broad deflationary investment outlook I have begun to map out potential future steps for my investments.
(1) Maintain 60+% position in 30-year Treasuries maturing in 2041 until yields fall below 3%, unexpected bullish economic signals are announced, or the Fed announces QE3. Additionally I plan to maintain my ~20% cash position and ~20% equity positions in high dividend yield defensive names.
(2) Once I begin to move out of Treasuries my first step is likely to pick up equity positions in high quality companies with attractive dividend yields due to a pull back. I believe the growing risk of deflation likely causes a compression in the average of P/E of stocks, pulling in all names despite quality. This step should occur before the market bottom and on a day when a significant negative surprise is driving the market lower (eg. China's economy stalls, the yield on a major European country's debt spikes, or Japan default risk spikes).
(3) The last step becomes the trickiest. The goal is to move into high beta stocks shortly after the market bottom. The market bottoms well before things begin to look brighter so for this step I likely rely on technical support levels in the SP 500 of 1,000, 800, and possibly even 683 (bottom on March 6, 2009) if things get really bad. The Lehman collapse and financial markets paralysis was really bad, but sovereign debt defaults and mass strikes/ riots in the streets like we have started to see in Greece and the Middle East I think would be worse. Not that I think this will happen, but just to point out there is always a worse scenario.
So I'm the bear but in this increasingly polarized world of jittery debt markets and where hard decisions need to be made about how to shrink deficits and debt I see great potential for very ugly scenarios.
"I argue that the fundamental trends should naturally lead to deflation but the Fed is using all its power to stave off deflation and thus causing inflationary bubbles to emerge in the economy, thus causing price volatility."
April 26, 2011 blog entry.
I update this view with the argument that the Fed appears to be hesitating, reluctant to roll-out QE3 due to a fear of encouraging stagflation. Thus I believe deflation is becoming an increasing risk, despite the CPI data year-to-date of inflationary pressures. Or, in other words, price volatility is increasing.
Yesterday the market cheered the decline in oil prices, reasoning that lower oil prices should stimulate the economy. I agree but think prices are long way from stimulation since prices remain above their five-year average. Instead I expect oil prices to continue to fall due to slower demand and possibly more supply, encouraging deflationary pressures in the economy.
Five-Year Oil Prices - WTI Crude Oil
Wages and salaries appear flattish due to excessive unemployment, financial assets are turning deflationary with the pullback in the equity markets, tangible assets are mostly deflationary due to the excess supply of housing and overhang of foreclosed properties, currency has become less inflationary as its decline slows due to austerity measures and the US dollar is viewed more as a safe haven, government austerity measures are likely a deflationary force in the economy, price increases for goods and services likely slow (pushing down CPI) going forward as the economy slows.
Within the broad deflationary investment outlook I have begun to map out potential future steps for my investments.
(1) Maintain 60+% position in 30-year Treasuries maturing in 2041 until yields fall below 3%, unexpected bullish economic signals are announced, or the Fed announces QE3. Additionally I plan to maintain my ~20% cash position and ~20% equity positions in high dividend yield defensive names.
(2) Once I begin to move out of Treasuries my first step is likely to pick up equity positions in high quality companies with attractive dividend yields due to a pull back. I believe the growing risk of deflation likely causes a compression in the average of P/E of stocks, pulling in all names despite quality. This step should occur before the market bottom and on a day when a significant negative surprise is driving the market lower (eg. China's economy stalls, the yield on a major European country's debt spikes, or Japan default risk spikes).
(3) The last step becomes the trickiest. The goal is to move into high beta stocks shortly after the market bottom. The market bottoms well before things begin to look brighter so for this step I likely rely on technical support levels in the SP 500 of 1,000, 800, and possibly even 683 (bottom on March 6, 2009) if things get really bad. The Lehman collapse and financial markets paralysis was really bad, but sovereign debt defaults and mass strikes/ riots in the streets like we have started to see in Greece and the Middle East I think would be worse. Not that I think this will happen, but just to point out there is always a worse scenario.
So I'm the bear but in this increasingly polarized world of jittery debt markets and where hard decisions need to be made about how to shrink deficits and debt I see great potential for very ugly scenarios.
Tuesday, August 2, 2011
30-Year Treasury Position Exit Strategy
With yields falling the principal on my position in 30-year treasuries has appreciated about 6% since I purchased them in April and May. With this in mind I re-visit the position and plan an exit strategy.
Basically, I'm looking for one of three things to happen:
(1) U.S. economy slows, deflation takes root and equity markets crash, similar to 2008, and thus I would look to exit at a yield below 3%
(2) QE3 is announced, prompting me to likely sell the position unless QE3 involves greater purchases of long bonds, in which case I would have to conduct further analysis on its potential impact.
(3) Crisis over-seas, either in Europe, China or Japan, that causes yields on treasuries to slide. Again, I would be looking for a yield below 3% for an exit.
On the other side, if the U.S. economy began to show signs of unexpected strength then a yield around 4.3%-4.5% would cause me to sell.
Basically, I'm looking for one of three things to happen:
(1) U.S. economy slows, deflation takes root and equity markets crash, similar to 2008, and thus I would look to exit at a yield below 3%
(2) QE3 is announced, prompting me to likely sell the position unless QE3 involves greater purchases of long bonds, in which case I would have to conduct further analysis on its potential impact.
(3) Crisis over-seas, either in Europe, China or Japan, that causes yields on treasuries to slide. Again, I would be looking for a yield below 3% for an exit.
On the other side, if the U.S. economy began to show signs of unexpected strength then a yield around 4.3%-4.5% would cause me to sell.
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