The Ultimate Bubble Ahead?

If you listen to many of the "smartest guys" you hear the argument that treasury prices will get crushed due to factors including the end of purchases under QE2, the risk of U.S. default due to the debt ceiling political gridlock, risk of contagion impacting U.S. interest rates associated with defaults of Greece, Spain and Portugal, and the bogeyman of the Chinese selling their holdings of treasuries.

Indeed, Bill Gross of PIMCO colorfully argues that investors in treasuries are like frogs slowly boiled to death.

"Much like gradually turning up the temperature on poor froggy’s kettle of water, monetary policy in developed countries has been lowering the temperature and absolute level of yields for the past 2½ years post Lehman Brothers. Teeter-totter yields down, teeter-totter prices up, and froggy’s total return euphoria at present seems to know no bounds. But once the potential for even lower interest rates is minimized by the zero floor, our future frog-legged entrée is left with a rather uncomfortable feeling."

On June 1 Jim Cramer summarized this argument in one very long run-on sentence:

"Stocks got hammered today because your house is dropping in price faster than a popsicle in the hot sun and soon the bank is going to own your drastically underwater mortgage you can’t pay because you are worried about your job or not having a job and you don’t know if they can foreclose on it without getting penalized by judges which gives the banks less money to lend which keeps businesses from expanding so they can’t hire which cuts the federal government’s receipts while it spends causing more inflation including $100 oil and $4 gasoline slowing the economy while building a fire raging with gasoline being shown by Bernanke’s bond program which is about to end which will upset the Chinese and they will dump the bonds because the rates are going as high maybe as Greece which is about to default anyway."

My problem with all of these arguments are the following points: (1) their points (falling stocks, dropping home prices, banks tightening lending, slower hiring, tightening monetary policy, fiscal austerity) are associated with slowing economic growth and deflation (and therefore lower yields), (2) they suggest treasuries are quite risky simply because the yield is low, and (3) most of these arguments end with higher inflation as the final kick in the teeth to treasury prices.

In addition, in most cases it seems like the arguments make a huge leap to economic trends driving inflation. In Cramer's case, inflation is caused by deficit spending policies of the government. But, this is likely about to come to an end either through spending cuts or higher taxes, or both, as both sides of the aisle in Congress agree the deficit spending is unsustainable. Others argue the excess capital infused into the economy by the Fed will drive inflation. Maybe, but I don't believe this argument completely appreciates the fundamental deflationary pressures offsetting the inflationary efforts of the Fed.

Concerning the future direction of treasury prices, here is the core difference between my sagflation theme and dominant arguments in the market:

I believe in the short-term (1-2 years) slower U.S. economic growth, defaults by foreign nations on sovereign debt, and deflation likely trump risks associated with excessive debt levels, the exit of a large buyer in the market and U.S. politicians actually allowing the U.S. to default on debt. Constitutionally, defaulting is a big no-no (see Section 4).

Do high debt levels in the U.S. ultimately force higher interest, most likely yes. However, I believe we have at least one bubble to inflate. The grand-daddy of them all, if I'm correct.

The Treasury Bubble
To start let's re-visit my analysis on April 26 of the deflation versus inflation fundamental trends in the economy. For this analysis, I borrowed a framework from Gary Schilling and broke down economic forces into seven areas, which are commodity, wage-price, financial assets, tangible assets, currency, fiat, and goods and services.

Tangible Assets - Deflation appears to be the over-riding force on tangible assets, as exhibited by the 5.1% y/y decline in house prices. What is likely more concerning than the actual number is the reversal from what appeared to be stabilization to an acceleration downward. The combination of tighter lending standards, high unemployment, and over-supply likely continue to drive prices lower.

Fiat - Yes, the deficit spending by the government over the decade has injected inflationary pressures into the economy. However, austerity is the theme in Washington these days, as well as in many states, and while the details are opaque I believe the country will go through a multi-year belt tightening that will swing these inflationary pressures to deflationary pressures. In addition, the accommodating monetary policy for the past thirty years has inserted inflationary pressures. Now, simply by the Federal Reserve stopping its purchases of treasuries at the end of June, the policy turns less accommodating. If the Fed decides to actually sell any of its holdings, or even signal a rate increase (which I doubt), the deflationary pressures increase even more.   

Financial Assets - With the strong rally in the stock market over the past couple years the pressure applied by financial assets has been inflationary. As people see their brokerage balances improve they are more likely to spend a portion of it, driving our consumer economy. However, with valuations well above historical levels it is hard to see how the rally continues. Especially since top-down earnings estimates are likely to come down in the near future as analysts factor in the recent slowing of the economy. With a significant pull-back in the stock market this area could turn deflationary as people rein-in their spending as they feel poorer.

Wage-Price - Wages have remained flattish-to-down as companies have the advantage in labor negotiations. The unemployment rate returned to north of 9% last month and 14 million people remain out of work. Indeed, unit labor costs increased only 0.7% in the first quarter after declining for two years.

Good and Services - In many ways, this is where the "rubber meets the road" on inflation versus deflation. The most significant area of inflationary pressures has been in commodities, which are a cost to most companies. Companies have been trying to pass on these costs to consumers in order to maintain their margins, and thus drive inflationary pressures to consumers. Some have been able to do it successfully, others are unable, and even others view it as an opportunity to take market share. While there is some inflationary pressure here, as exhibited by a 3.2% y/y increase in the CPI during April, the majority of the increase has been driven by higher oil prices, which produced a 33.1% y/y increase in April, as measured in the CPI. Excluding fuel and food the core CPI increased a more modest 1.3% y/y.

Until the supply of retailers is rationalized through acquisitions, attrition, and store closings, I believe there is simply too much competition to allow inflation to build in goods and services. The fundamental problem is one of demand since wages are flat and consumers can no longer tap equity in their homes after taking almost $3 trillion out of the equity in their homes for purchases from 2004-2006. Now 40% of homeowners with second mortgages are underwater, so where is the money going to come from for these "zombie consumers?"

Currency - The decline of the U.S. dollar due to accommodating monetary policies and weak economic growth has encouraged to inflation. As the dollar declines goods and services imported from foreign countries appear more expensive. In addition, foreigners visiting the U.S. find goods and services within the country relatively less expensive and therefore are encouraged to spend more. With my outlook of declining interest rates, it is difficult to argue why the dollar should strengthen on its own accord. However, as other regions of the world weaken, including the potential for debt defaults by sovereign nations, the US dollar may look increasingly attractive, sparking a rally.

Commodities - Commodities have been the primary reason most people have started to worry about inflation. After the strong rally in prices for most commodities something has to give, either businesses passing on cost increases, cutting costs like labor to offset the increases, or a willingness to sacrifice margin. The last scenario is that commodity prices reverse and begin to slow due to an economic slowdown, additional supply, or changes in speculators outlooks. If commodity prices, especially oil, begins to decline, I would expect most investors to view it as a positive since it relieves cost pressures. In my view, it would signal the final piece driving deflation.

Thus the breakdown has two clear deflationary trends in the future (fiat and tangible assets), three market-related items that have been inflationary but could swing deflationary quickly (financial assets, commodities and currency), and two fundamental items that have great potential to turn deflationary due to excessive debt and over-supply (wage-price, and goods and services). Because of this analysis, I am less concerned about accelerating inflation hurting economic growth next year than I am about accelerating deflation taking the legs out of the economy.

One Way It Possibly Steps Forward
So how does this go down? I think a critical mistake many of the experts are making is jumping to the final outcome, or endgame as some have put it. That is, high levels of outstanding debt force interest rates higher, which in turn hurts the economy and boils all the "frogs" invested in treasuries. Will this outcome eventually be the case, quite possibly, but I think we have a few steps to walk through over the next couple years before Bill Gross is dining on frog legs.

The following steps are one possible path in the future, and possibly one of the dire pathways. I lay them out to illustrate how some of the market dynamics could play on one another. That said, the future is obviously unpredictable and as one of my teachers use to say, "What if aliens landed in the parking lot?"

Step One - Economic Growth Slows as Deflation Pressures Mount, Pushing Yields Down
This step likely unfolds over the remainder of 2011. A slowing U.S. economy due to weak consumer demand is the primary driver of deflationary pressures. We could see slow U.S. economic growth coupled with rising commodity prices due multiple factors, including (1) weakness of the US dollar, (2) poor inventory tracking and controls in developing countries that continue to manufacture products, (3) continued healthy growth in developing countries, and (4) bubble dynamics within the commodity markets themselves. As growth continues to slow the pressure on treasury yields to move lower likely increases.



Step Two - The Weak Fall, Causing Anxiety and Raising Demand for Safety
Greece is on the verge of defaulting on its debt, Portugal is beginning to face up to its challenges, Spain has yet to get its arms around its obligations, and state and local governments with high debt loads and obligations are cutting significantly. These governments are likely the canary in the coal mine as others we do not know about are probably under stress as well. This step likely produces a strengthening dollar, further encouraging deflation and hurting efforts to reduce debt in the U.S., as currencies like the Euro falter.

Step Three - A Giant Unexpectedly Falters, Causing Investors to Panic
By definition, it is the unexpected that causes the most volatility in markets. With a slowing world economy, potentially volatile currency and commodity prices, and pockets of the world less sensitive to market changes, it is quite possible a large economy like Brazil or even China could suddenly get thrown into a crisis. A scary fact is that China does a poor job of collecting and reporting economic statistics, probably due to the significant growth, politically centralized control of the economy, and the lack of a significant economic crisis recently. Of course no one knows the extent of this issue, but if the steel industry provides any indication of the economy, an inventory build-up could happen without the understanding of the markets and cause a rapid slowdown in the economy to work off. If the slowdown is in a commodity-intensive industry, like steel, the country supplying the commodity could suddenly see their demand fall off a cliff. If the commodity accounts for a significant portion of the economic growth, the country has a problem. The point is that developing countries have relatively opaque reporting of economic and business statistics, increasing the potential for imbalances to develop.

Step Four - The Fed Reacts
Bernanke spoke on June 7 of his expectation (hope) of the scenario in which "hiring picks up from last month’s pace as growth strengthens in the second half of the year." The Fed really wants QE2 to produce enough stimulus to enable self perpetuating growth. However, I believe deflation and external shocks may force the Fed's hand into QE3 sometime in the next 6-12 months due to the ending the current monetary stimulus, more supply coming on line for commodities, and the previously discussed deflationary pressures. This likely results in additional massive purchases of treasuries.

If the Fed's actions are large enough and communicated well enough to convince the markets the actions can stimulate the economy, then I believe treasury yields likely rise in anticipation of an improving economy. If the Fed's action are not large enough, then yields likely fall as the market anticipates a large buyer entering the market, driving up prices.

Step Four - Hammered Investors Chase a Dream
All bubbles start with a good story, or dream. If the expectation of long-term deflation takes hold in the economy investors are likely to flock to treasuries to both escape poor performance in equities, realize some real return (even if the nominal yield is below 1%), and in expectation of future price appreciation as deflation worsens.

Step Five - "Bubble, Bubble, Toil and Trouble..."
Not sure I really want to think about the final step, especially after a bubble in treasuries pops, but then we get into forced deleveraging on multiple levels with likely much higher interest rates. Finding a place to hide will be hard.

S&P 500 Below 700...

I believe the stock markets are in for a significant retrenchment based on the deflationary trends of weakening home prices, slowing hiring in a weak employment environment, likely restrictions on fiscal spending, consideration of tightening monetary policy, commodity prices that appear to have peaked, and lack of pricing power by retailers as consumers struggle with debt.

With the S&P 500 P/E ratio almost 50% above its historical median of about 16x in this low inflation environment, I believe the stock markets are particularly vulnerable to a pull-back if deflation begins to dominate market movements. The current multiple of 23x could pull back to 10-14x if the scales tip to deflation, and even further if the economy pulls in significantly. This implies the S&P 500 could test the lows set in 2009 of below 700.

If this case were to prove correct, I would expect the Fed to announce another round of quantitative easing, or QE3, which could help place a floor under the markets and stimulate economic growth.

Should the stock markets tumble I expect the yield on the 10-year and 30-year to come down to around 2% and 2.5%, respectively. In this scenario it suggests the place to make money is in treasury bonds as prices rally as investors flood to the safe haven. The treasury yields likely bottom before the stock market, so investors may need to move to cash or other investments once yields reach the low 2% range. The one wild card is the Russian roulette political game with the debt ceiling, but I believe this likely results in more aggressive fiscal cuts (deflationary) than risk to default. Either way, this political game is hastening the day of reckoning, in my opinion.

This scenario is consistent with my sagflation theme of weak economic growth coupled with increasingly volatile prices. The cause is primarily overly aggressive monetary policies that have been more focused on economic growth than price stability for over 20 years. 

These are my opinions and I do not recommend you follow my actions unless you arrive at similar conclusions based on research independent of my own.

Stagflation vs. Sagflation

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.

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.

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.

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.

The PE multiple of the SP500

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

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.