Could Deflation Blindside the Market? Sold Gold.

Will the Markets get Blindsided? 
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.

Is Deflation to the Market what Lawrence Taylor was to the Quarterback?

Twenty-to-Thirty Years of Healthy Deflationary Forces I estimate Have Built-up...

(1) Technology advancements - Advancements continue but the pace of economic change relative to the pace during the periods of the personal computer, internet and enterprise software is likely slowing.
(2) Manufacturing outsourcing to China - As wages rise in China, commodity prices increase, and the yuan appreciates the deflationary pressure may actually switch to inflationary.
(3) IT outsourcing to India - Wages in India continue to rise and much of the low-hanging fruit has been harvested.
(4) Business reorganization - Really a derivative of the previous three trends, but as businesses find less opportunities to increase revenue or reduce costs through reorganizations, the economic impact slows.

But, Unhealthy Deflationary Forces are Also Building...

(1) Housing overhang - The Economist estimates that American households have lost a "whopping $9.2 trillion." This loss despite mortgage rates near historic lows that make financing the purchase of a house more affordable.
(2) Excess retail space - From 1999 to 2009 the shopping space per person in the US increased almost 30% from 18 square feet to 23 square feet, driven largely by inexpensive construction financing and unsustainable rising consumer debt, in my view. This increase occurred despite the percentage of online shopping increasing from 5% in 2006 to around 9% currently.
(3) Contracting number of bank customers - Meredith Whitney estimates that the number of "unbanked" Americans is rising, from 1 in 4 in 2005 to close to 1 in 3 currently. The problems facing banks include less access to securitization, increased regulation, and low interest rates. This trend of a shrinking customer base implies higher transaction costs for unbanked individuals and a lower savings rate, both drags on economic activity.
(4) Unemployment - At over 8%, the unemployment rate has been a drag on the economy.

And Bad, but Necessary, Timing of Dissipating Artificial Inflationary Forces...

(1) Diminishing power of central banks - With historically low interest rates I believe the ability of the central banks to boost economic growth through the expansion of credit is nearing an end. Furthermore, I believe the central banks are reaching a point in which printing excessive money is one of their remaining choices to offset deflation. With the GOP proposing "The Sound Dollar Act," which would eliminate the Fed's mandate to promote full employment, I believe the expansionary position of the Fed may lessen.
(2) Fiscal stimulation retreating to austerity - As I outlined in Taxmageddon, at the end of 2012 the US economy is set up to bear significant tax increases and spending cuts. As witnessed in Greece, and increasingly Portugal, fiscal austerity likely results in slowing GDP.

Likely Results in Falling Prices.

(1) Financial markets - Based on the 10-year average earnings, the PE ratio of the S&P 500 is over 40% above the long-term median. While this measurement does include the fallout of the dotcom and housing bubbles, depressing earnings, it does suggest the market does not expect another bubble to burst. I believe the main reason why the equity markets are this high is because of the actions of the central banks and governments.
(2) Commodities - Print more paper money and there is more currency per hard assets like gold, oil and copper, driving up prices. Driving up prices on major resources of the economy (see chart below) results in companies attempting to pass along these rising prices (consumer inflationary) and aggressively cutting costs in other areas (deflationary), enabled by technology advancements, access to lower cost labor, and falling financing costs. As the effects of an expansionary monetary policy diminish the more volatile commodity prices may begin to fall, reducing the bottoms-up inflationary pressure. The annual growth of PPI for crude materials has slowed to below 5% after remaining well above 15% for most of the past two years.

Sold Gold.
Because of my growing worries about deflationary forces driving future market movements, I decided last week to sell my ~5% position in gold. I fully recognize that actions taken by the central banks could offset deflationary pressures, but I simply feel more comfortable following fundamentals rather than possible government actions.

Regulatory Environment Contributing to Sagflation

The Economist has devoted multiple articles of this week's edition to examining some of the issues with the regulatory environment in the US. In the February 14 article titled "Fiscal Stimulation," I argued within the framework of my Sagflation theme that there is a build up of excess capital in the economy due to an aggressive monetary policy over the past few decades, as well as recent expansionary fiscal policies. In this article I highlight the additional costs to businesses created by the regulatory environment, as well as the impact on the economy within my Sagflation theme.

My main point in this post is that I believe perversions in the legislative process are resulting in greater burdens for the US economy, which likely contributes to slowing growth in the future and compressing company margins. 

Regulatory Issues

There are plenty of examples of the burdens of poorly designed regulations, but the cause seems to boil down to a political system rigged more towards dollars than votes. Politicians spend excessive time fund raising and listening to micro interests from their donors, and less time devoted to crafting thoughtful and intelligent laws. I believe a secondary issue, either caused by the dollars or by the politicians themselves, is the effort by the legislative branch to over-step its authority and attempt to dictate to the administration how to administer the government. As a result, lawmakers create overly complex laws that attempt to cover every eventuality raised by their donors, instead of laying out broad goals and focusing only on what is strictly required to achieve the goals. Lobbyists seem to favor this system because overly-complex laws offer opportunities for special interests to insert language favorable to them, in my view. This is not a party-specific issue, in my mind, it is a systemic issue that needs to be addressed.

All this additional complexity costs money, of which there is a growing list of examples. The additional burdens of compliance with Sarbanes-Oxley has resulted in a precipitous drop in the US's share of IPOs, from 67% in 2002 to 16% in 2011. Jamie Dimon of JP Morgan Chase estimates the annual direct costs of Dodd-Frank to the bank will be around $400-600 million. The EPA estimates the cost of new mercury standards may cost businesses $10 billion per year, the interstate air pollution rule an additional $2.4 billion per year, and the ozone rule at least $20 billion per year. However, as The Economist points out, the "real costs may be found in the hard-to-calculate perversion of behavior that over-regulation causes." An example of the perversion is that some regulated companies, which have already sunk the costs into compliance, may actually encourage on-going regulation to maintain a higher barrier to entry against new entrants.

While I do not consider myself a libertarian, I do believe that the process by which laws are crafted has become perverted, resulting in growing inefficiencies within the economy. 

Incorporating Regulatory Burdens into Sagflation Theme

Putting together my previous message of sustained mis-allocation of capital with this post's message of rising regulatory costs suggests return on capital could compress significantly if growth slows. It is likely, in my view, that economic growth slows over the next few years due to austerity. Should interest rates begin to rise due to either a Fed policy change or market forces, companies would also confront a rising cost of capital. Slowing growth, excess capital, shrinking margins, and a higher cost of capital could lead to larger write-offs over the next few years than witnessed in 2008, in my view.

The Wall Street Journal points out that the P/E valuation of the S&P 500 based on Robert Shiller's 10-year average earnings calculation is potentially inflated due to the large write-offs impacting earnings after the dot-com bust and the housing bust. Excluding these write-offs, the P/E under Shiller's formula is 18.9x, about in-line with the 50-year average. I believe the market ignores these write-offs at its own peril because the write-offs are the result of the build-up of excess capital in the economy, partially reported as "overstated profits," associated with an overly aggressive monetary policy. Since the policies have not changed, why should we expect the write-offs to be "one-time?"