Approaching the Main Event?

Performance in May was steady, increasing 1.0% for the month and 3.2% for the year-to-date. This performance is relative to the S&P 500 Index decline of 6.2% in May and a 4.2% increase for 2012. Over the past year my IRA has increased 13.2% compared to a decline of 2.6% in the S&P 500 Index.

Finally June!
My excitement may differ from other investors' excitement about turning the page on May. Right from the start of 2012 I believe I have had a clearer outlook about the second half of the year than the first half. By turning to June I believe my thesis for 2012 can begin to play out. First, a brief review of some of my comments:

On September 23, 2011, I wrote:
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.


Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.

On February 27, 2012, I wrote:
The markets are increasingly worried about rising oil prices slowing economic growth. The rise in oil prices appears related to supply worries associated with Iran, rather than strong demand. However, the increase in the PPI for crude materials has slowed to less than 5% annually, after rising at a rate greater than 15% for the past two years. Aggressive actions by the ECB and Federal Reserve may continue to drive inflationary pressures, but I believe deflation may ultimately take over as the market driver later in 2012.

June 2012 and Beyond
Fast forward to the end of May and the yield on the ten-year treasury is near a record low and the yield on the thirty-year treasury is approaching 2.5%. Among the main driving forces behind the declining yields has been the nearing climax of the debt crisis in Europe with money exiting Europe and piling into US Treasuries. However, pricing dynamics in the US suggests inflation pressures are subsiding. Growth of PPI has continued to slow, even turning negative in April although on an annual basis the increase remained positive but slowed to 1.9%. Oil prices are falling and the CPI index is moderating. Without material actions taken by the Federal Reserve, I believe price increases likely continue to moderate and may even turn negative by the end of the year.

In summary, I believe the equity markets may soon follow the lead of the treasury market, implying the continued decline of valuations as deflationary forces increase debt burdens, slow personal income growth, and squeeze corporate margins.

Under my Sagflation thesis, I argue that the Federal Reserve is reaching the limits of its capabilities to spur demand, instead providing short-term stimulant to supply. Consumer debt was $2.52 trillion at the end of March, just shy of the all-time high of $2.59 trillion at the end of 2008. Furthermore, consumer debt increased 10% y/y in March, suggesting debt outstanding likely hits a new all-time high in the near future. Given there are 5 million fewer people working now relative to 2008, the debt outstanding appears unsustainable. The bulls argue that rising debt levels are a strong indicator of a recovering economy, supported by the the highest consumer confidence in 4 years. Fueling the optimism, in my view, has been the ability to re-finance mortgages and a more healthy job market than in recent history. But, with refinancing activity waning and job creation coming in well below expectations for May, I believe this optimism shifts back to fear.