Which Comes First? Market Correction or Fed Stimulus with Abating Inflation Pressure

Is inflation or deflation the biggest threat to the economies of the world? In a word: both, in my view when the economy is in Sagflation.

Fundamentally, deflation is the driving force in many economies as poor capital allocations of the past need to be worked off, in my view, potentially pushing us into a depression. However, I believe expansionary fiscal and monetary policies have been offsetting these fundamental forces by pushing up commodity prices, enabling inefficient business activity, and inflating financial assets. These effects from monetary policies increase the risk of hyper-inflation if extended and amplified, in my view. In summary, I believe the combination of fundamental economic forces and activist policies push us further and further into a world of volatile prices and uneven economic activity.

In this entry I again borrow the framework developed by A. Gary Schilling on inflation to breakdown the trends and hopefully glean a bit more insight into the future. His framework breaks down inflationary/ deflationary pressures into seven areas, which are commodity, wage-price, financial assets, tangible assets, currency, fiat, and goods and services. Mr. Schilling has argued a deflationary period is ahead for the world, most recently in his book published in late 2010 titled, "The Age of Deleveraging."

My conclusion is that while inflationary fears are justified for basic necessities, like healthcare, food and fuel, the broader trend is deflationary as growth in wages, commodities, and asset values moderate and even decline. The Federal Reserve has been focused on broad measures of inflation, which include material weighting of asset values and wages, and thus I expect the Federal Reserve to launch another round of quantitative easing should these factors continue to weaken, possibly at the expense of higher prices for fuel and food, which may further erode real economic activity.

Summary Table

Segment	Trend
Commodity	Abating Inflation Pressure
Wage-Price	Abating Inflation Pressure
Financial Assets	Inflation
Tangible Assets	Deflation
Currency	LT Inflation, ST Deflation
Fiat	2012 Inflation, 2013 Possibly Deflation
Goods and Services	Abating Broad Inflation Pressure

Commodity
The pace of growth of commodity prices has been moderating, likely due to weakening demand in Europe as the debt overhang and austerity measures begin to bite. It remains unclear whether the slowdown in Europe spreads to China and resource-rich countries like Brazil should commodity prices continue to fall.

 
Wage-Price
The rate of growth of wages has been moderating to under 2%, putting pressure on spending despite some improvement in the number of people employed. The slowdown in wage growth in itself is deflationary, but its impact is likely uneven as higher prices for necessities like fuel, food and healthcare force both higher consumer debt, aided initially by low interest rates, and stronger deflationary pressures in more discretionary segments.

Financial Assets
Financial assets are modestly inflated, based on historical valuations of total market capitalization to GDP and the Shiller PE ratio. The current ratio of total market capitalization to GDP is above 95%, relative to a historically fair value of 75-90%. The current Shiller PE ratio is about 22x, compared to a historical mean of 16x. The market is relatively over-valued largely due to aggressive monetary policies, in my view, pumping up liquidity in the markets. Furthermore, should the economy slow in order to allow for what I consider to be an over due capital rationalization, the total market capitalization likely retreats 40-60% as both the GDP and earnings compress. While the equity markets may remain fairly-to-overvalued for some time, I believe there is an inflating air pocket under supporting these valuations as GDP is artificially increased through monetary actions.

Valuation	Ratio = Total Market Cap / GDP
Ratio < 50%	Significantly Undervalued
50% < Ratio < 75%	Modestly Undervalued
75% < Ratio < 90%	Fair Valued
90% < Ratio < 115%	Modestly Overvalued
115% < Ratio	Significantly Overvalued

Tangible Assets
Home prices continue to deflate in the country, despite historic low mortgage rates. While there are numerous investors trying to "call the bottom" on home prices, I believe it is difficult to argue for higher home values should monetary policies allow interest rates to rise. As people lose more equity in their homes it is difficult to see from where additional spending can be funded, in my view. Judging by the April Homebuilders' Index reading of 25, anything below 50 is considered negative, a recovery in the housing market is a long way off.

Currency
The longer-term trend is a weakening US dollar, likely driven by the expansionary monetary policy. This longer-term trend adds inflationary pressures to the economy. Shorter-term, however, the US dollar has strengthened as other regions have weakened and pursued more aggressive monetary tactics. This recent strengthening has added deflationary pressures to the economy as the prices of imported goods become relatively lower.

Fiat
The US economy continues to benefit from overwhelmingly inflationary fiscal and monetary policies. Deficit spending, fueled by both relatively low tax rates and stimulus, has enabled economic activity to remain elevated, in my view. Furthermore, expansionary monetary policies have enabled poorly performing businesses to remain in viable and has added to the money supply.

While fiscal and monetary policies have been inflationary, they potentially turn deflationary in 2013 when significant tax increases and spending cuts are expected to come into effect.

Goods and Services
As I discussed in March,  investors should look at the inflation of goods and services through two lenses. The first is the traditional inflationary measures impacting the consumer, which are the CPI and Personal Consumption Expenditures Price Index (PCEPI). These are the measures on which the Federal Reserve typically focuses when determining monetary policies. Both show a trend of abating inflationary pressure.

The second, and better measure of the impact of monetary policies in my view, is the AIER Everyday Price Index (EPI), which highlights increased volatility of prices and higher inflationary pressure on middle to lower class income levels. The EPI increased 8% in 2011, relative to a 3% increase in the CPI,  and increased 1.3% and 1.1% in January and February. The increases in the EPI are also moderating, although AIER expects them to continue to accelerate throughout this year and next. Based on the moderation of commodities, I expect the increase in EPI may moderate as well.

The last point on goods and services is a possible signal that demand is slowing. Industrial production declined 0.2% in March. This data may be a blip, but it is worth following as a sign of whether the economy is again cooling.

Expanded Long Position in Natural Gas Segment

This morning, after the DOE announced that the inventory for natural gas was well below market expectations, I expanded my position in EnCana Corporation (Ticker ECA) and established a position in Chesapeake Energy Corporation (Ticker CHK). At the end of the day I have a combined ~5% position in these natural gas-related companies. I expect these positions to remain in my IRA for at least one year, unless natural gas prices continue to fall or the stock prices appreciate back to near 52-week highs. I may establish additional positions related to natural gas that could increase my exposure to 10-20% of my IRA.

This morning the US Energy Department announced that natural gas inventory increased by 8 billion cubic feet, lower than the anticipated 19-25 Bcf. While inventory remains well above historical averages, my take on the data is that the recent declines in rig count is (1) slowing the growth of inventory, and (2) the market estimates likely are too high for future inventory increases. At this time of year the inventory of natural gas typically increases due to milder weather, but with the glut of inventory many producers have been shutting down rigs, as highlighted in my previous article.

Natural gas prices remained weak during the day. However, I believe the lower than expected inventory build combined with rig closures likely signals more balance between supply and demand and could even lead to a higher rate of draw down of inventory during the summer if the weather is unseasonably hot. All that said, natural gas prices may not appreciate materially until next year, as highlighted by Goldman Sachs today.

Under my Sagflation theme I expect more volatility in prices, thus I would not be surprised if natural gas prices do not remain around $2 for long.

Natural Gas Market Dynamics Suggest Price Rebound

The price of natural gas continues to slide downwards as production remains high and consumers benefit from mild weather, reducing their need for the fuel. This continuing trend would appear unfavorable for many of the natural gas companies, including Chesapeake Energy Corporation (Ticker CHK) and EnCana Corporation (Ticker ECA). Indeed, the stock prices of these companies have continued to slide over the past month as investors worry about the financial impact.

Furthermore, a recent article in the Wall Street Journal highlights that storage for natural gas is expected to reach capacity before the end of the year if production does not slow down and the weather remains mild. This highlights that the price of natural gas in the US is determined more on short-term supply-demand trends due to an inability to store large amounts of the gas. It also highlights that something has to give because companies likely won't simply blow the excess into the atmosphere, accept negative prices, or some other crazy market scenario. Under my Sagflation theme, I expect more volatile prices, especially for commodities, and thus a strong rebound in natural gas prices would not be surprising, in my view.

Investing in a company that produces natural gas would seem foolhardy with the price of natural gas around $2, the lowest in about 10 years, and supply apparently continuing to outpace demand. But, there are signs that drilling is slowing and demand may pick-up. With limited storage capacity, making prices more volatile, this shift in supply-demand potentially precedes a turn-around in natural gas prices later in 2012 and 2013. For these reasons I have begun to build long positions in natural gas companies, initially a small position in EnCana Corp. with a 4% dividend yield.

Let's go through some market dynamics of natural gas:

(1) Demand likely increasing
There are four basic domestic users of natural gas, which are (1) Homes for heating, hot water, appliances, (2) Businesses for heating, hot water, appliances, (3) Commercial for manufacturing, and (4) Electricity production. The only one of these four segments that has grown over the past decade is electricity production. The first two segments have remained relatively flat due to improved efficiency through better furnaces and insulation. Industrial demand has slid, most likely due to the shift of manufacturing overseas.

An increasing number of electric power plants may shift to natural gas as an alternative to coal as the price for natural gas falls. Energy analysts at Sanford Bernstein estimate that electric utilities may increase consumption of natural gas by 13.5% in 2012 as they switch from coal. This is likely driven by the falling price of natural gas. As discussed on the Wall Street Journal, the market is already pushing electricity producers towards building additional gas-fired plants. But, referring back to the fact that natural gas prices are set more based on short-term market dynamics than long-term, there is greater risk relying solely on gas-fired plants because prices may increase dramatically in the future.

Furthermore, if a recent ruling by the EPA stands-up, then more utilities may be forced to shift to natural gas as a greater amount of the externality costs associated with the use of coal, and its larger release of carbon dioxide, are captured in the price of electricity. However, I believe this ruling is unlikely to stand-up to scrutiny by Congress given the outrage from the coal producers.

Another potentially major driver of demand in the near-term is increased exporting of the fuel as more ports come on-line with the ability to export the fuel. To export natural gas is to invite political scrutiny, and some debate about the advantages and disadvantages of creating a world market for natural gas. However, producers likely push hard to open up new markets that are willing to pay three to four times the price in the US. Simple market dynamics suggests that if the US does begin exporting natural gas, and thus creating more of a world market, the relatively low prices in the US likely rise and the relatively higher prices in Asia likely decline.

Longer-term an increasing number of industries may begin relying more heavily on natural gas, should manufacturing in the US continue to pick-up. Additionally, a device that allows fueling of cars with natural gas from the home may eventually prove a major driver of natural gas demand. A stimulant to home refueling could be a tax incentive towards purchasing the home device.

(2) Drilling for dry natural gas slows
There are signs that drilling for natural gas has slowed. Baker Hughes recently announced the company expects lower operating profit in the first quarter due to rapid transition in drilling away from natural gas towards oil. Indeed, the rig count for natural gas has fallen to a ten-year low of 647, relative to the 2011 high of 936 and all-time high of 1,606 in 2008. With production down around 60% from the all-time high, and continuing to decline, I believe natural gas prices should turn around.

Chesapeake Energy Corp, the second largest producer of natural gas behind Exxon Mobil Corp, has allocated approximately 85% of capital expenditures in 2012 toward crude oil and liquid natural gas resources, up from 10% in 2009. Comstock Resources (Ticker CRK), with 85% of its reserves in natural gas, has shifted to oil production with 77% of its 2012 drilling budget devoted to oil production. Devon Energy Corporation (Ticker DVN), with about 60% of its reserves in dry natural gas, has cleared much of its rigs out of natural gas production sites and has said the company is not "investing in new wells in a $2 market."
 
While a significant amount of natural gas continues to be produced as a by-product of oil drilling, this highlights that the trend is downward in natural gas production. It also potentially creates excess supply in the NGL market and may ultimately result in a strong rebound in natural gas prices when demand picks up.

Real Economic Growth Elusive

The NFIB Small-Business Optimism Index fell during the month of March, largely due to lower readings on expected sales and hiring plans. This decline in March followed six successive months of increases in the index. The lower than expected reading was another recent indication that hiring, and therefore the economy, are not as robust as expected. In my mind, the lower than expected sales and hiring amongst small businesses reinforces my earlier comments about a supply-driven economy. The Fed can stimulate the economy by encouraging businesses to invest capital, but the demand-side likely remains weak due to excessive consumer debt. The result is declining productivity and modest-to-negative real economic growth.

I believe the economy may produce increasingly bearish signs, albeit mixed over the next few months. Treasuries may not be the best opportunity, in my mind, since yields have already fallen. Instead, I may focus on the equity market and the potential pullback in valuations.

NFIB’s Small Business Economic Trends is a monthly survey of small-business owners’ plans and opinions. For March, the survey is based on 757 responses from NFIB members. 

Is the Market at a Pivot Point?

A bullish investor would likely argue that the US economy is improving and should continue to improve without additional stimulus. A bearish investor, like myself, argues that the recent improvements in the market are more a result of monetary stimulus than real economic improvement. This week the markets faltered somewhat on the perception that the Federal Reserve may not provide additional stimulus. Was this weakness a momentary blip or a pivot point?

Clearly I have been wrong to date on the markets. While my strategy of maintaining a relatively neutral balance between long and short has avoided any catastrophic losses, my edging towards more weighting of short positions by the end of the quarter clearly hurt the performance of my IRA. For the month of March my IRA declined 1.2%. For the quarter I managed to squeak out a small gain of 1.9%, largely due to healthy performance by my high yield bond positions. This performance has under-performed the markets by a fairly wide margin. On an annual basis, my IRA increased 15.2%, aided immensely by my weak performance during the first quarter of 2011. I guess I am just a slow starter.

So, pivot point or bump in the road?

The job data released on Friday of 120,000 net new jobs created in March was another conflicted data point. It was well below the expected number of over 200,000 and potentially portends declining job growth, and thus weakening economic growth. But, does the number increase the likelihood of additional monetary easing, floating the market higher? So, the question in my bearish mind is: Over the next few months, is the market driven by weak real economic activity or excessive liquidity? Longer-term, I believe the market must ultimately succumb to fundamentals, it is just a matter of how long the Fed allows us to keep digging a deeper hole.

The question, in my mind, is somewhat misleading. To me, the trends of Sagflation continue to act on the economy and markets. Weak real economic growth and more volatile prices is not a friendly investing environment. Debt levels in Europe and weakening economic activity (and political stability) in China may continue to weigh on the markets. The Federal Reserve can inflate the economy for a while, but we are in trouble when the markets begin to question the "realness" of the economic strength. Does this play out as accelerating inflation, falling employment, or both? For now I plan to pursue three steps:

Step 1 - Continue to move the net balance of my portfolio towards short positions.
Step 2 - Opportunistically invest in treasuries, non-cyclical commodities, and consumer staple stocks.
Step 3 - Look for attractive themes, like the aging car fleet in the US and potential rising demand for US natural gas.

The first quarter was surprisingly tame, I doubt the next three quarters can offer the same tranquility.