Magic Trees

Imagine an island on which magic trees grow. These trees, as it turns out, are exactly like the trees everywhere else, except for three things. First, these trees never die. Second, the trees always grow to exactly 100 feet tall eventually. And third, to pass time on this boring island the villagers place bets on which specific trees in a given acre of land (on which all trees were planted at the same time) will grow the fastest over the next ten years.

Right after an acre is planted, there is much activity that can only be termed purely speculative. Without any obvious difference in the first shoots, the villagers place their bets based on which of the tree-market brokers tells the best story about a particular tree. These brokers do tend to change their minds frequently, however, so it turns out that there is rapid trading.

After a few years, some trees have clearly started to grow faster than other trees. Villagers tend to invest more on these trees that have “momentum.” And this trend continues, because the further in the lead a given tree is over its rivals, the more momentum it clearly has. There is, however, a class of investors who like to invest in the smaller trees, since the bet is on the rate of growth over time, and these investors think that the smaller trees are likely to revert to the mean (indeed, because all of these magic trees end up at the same height, they are correct on average).

The villagers who “own” the taller trees are generally happy, since their trees are “in the lead.” They don’t much care for the villagers who “own” the smaller trees, because they think these folk are just negative ninnies. The value-villagers are fairly confident, though, because they understand the math; and many of them are dismissive of the momentum-villagers and call them “lemmings.”

The odd thing is that both of these “investors” have their time in the sun. Early on in a tree’s growth pattern, the ones quickly out of the gate do tend to grow more rapidly. Consequently, momentum is a viable strategy. But the bigger the lead gets for these trees, the worse the bet becomes that the rate of growth will continue. Once the tree reaches 99 feet, for example, there are not many ways that it can beat a 20-foot tree going forward (remember – all of these magic trees always grow to be exactly 100 feet in time). And yet, the momentum-villagers remain true to their investment style, saying “the 20-foot tree must just be sick. And it can’t get as much sun because the 99-foot tree is shading it. The 99-foot tree may only grow 1 foot over the next ten years, but the 20-foot tree might not grow at all.” And, after all, it is fun to have your bet on the biggest tree in the forest. However, the value-villagers almost always win that bet.

This allegory isn’t really about growth versus value in equity investing. It is about asset class performance and, more specifically, the performance of equities versus commodities. There is a significant amount of history to suggest that over long periods of time, the average growth rate of equities and the average growth rate of commodity indices is approximately equal. This happens because the basic sources of both asset classes are fairly steady: aggregate economic growth, in the case of equities, and collateral return plus rebalancing effect, plus some other smaller sources of return, in commodities. So regardless of what you think about equities or commodities, in general when equities are dramatically outperforming commodities, you should be selling them to buy commodities, and vice-versa. But that isn’t how most investors bet. Most investors make up a story about why the tree is stunted, and will never grow, will never catch up, and then turn to bet on the tall tree.

It is a mistake.

It is a mistake, though, that the Street actively encourages because where the broker makes his money is on frenzy. Rallying markets tend to produce more volume and excitement, and that means more money for the broker. This is especially true when the market is equities, since there isn’t much underwriting of commodities to be done but there is quite a lot of underwriting of new equity issues.

Frankly, this over-exuberant cheerleading sometimes results in lies being disseminated to investors. Consider the following snapshot of a Bloomberg page describing the characteristics, including the P/E ratio, of the Russell 2000 index. You will see it says the Price/Earnings ratio is about 18.41. We all know that means that if you pay $18.41, you will get a set of stocks that will have $1 in earnings, collectively. Right?

Well, the following chart is also from Bloomberg, and you get it if you type RTY<Index>FA<GO>. What it says is that the Price/Earnings Ratio is actually 54.86, which means that your $18.41 actually only gets you $0.33 of earnings! What’s going on here? Well, the next line shows you that what Bloomberg considers the “real” P/E ratio – important enough to have on the front page – is really the Price/Earnings ratio if we only count the positive earnings.

So, that $18.41 does in fact get us $1 in earnings. Wall Street doesn’t want us to focus on the fact that it also gets us $0.67 in losses, so that the net is only $0.33. Because surely, those losses were one-time events, and obviously all 2000 companies will make money next year, right?

It may be that stocks are a great bargain here, and that multiples will expand further, the economy will surge in a way we haven’t seen in a decade or two, in an environment of tame inflation but ample liquidity. If that is the case, then equity investors will win over the next five years because they’re betting on the trees that have grown the most in the last two years. But in all other cases, commodity indices should grow faster than stocks as both revert to their long-term growth rates.

Comparisons

With little economic data on the calendar, and the Fed speakers back-loaded at the Chicago Fed conference later in the week, there is time to reflect on other questions (unless, of course, the Israel/Syria back-and-forth turns into something more than the last couple of jabs have produced).

It is interesting to me that analysts and journalists truly enjoy finding comparisons between present situations and actors, except when the comparisons suggest unpleasant conclusions. This is at a time when there are really no comparable periods in history to compare to, at least with respect to major global policy initiatives!

I read comparisons between Shinzo Abe’s pressure on the Bank of Japan and Fed Chairman Bernanke’s campaign to resurrect the American economy with ever-greater monetary policy shocks. Somewhere, I saw an analyst ask “isn’t Abe taking note of the failure of U.S. monetary policy to goose the economy?” But the comparison is not apt because the two men, and the two economies, face very different challenges. Abe doesn’t need to increase consumer spending and reinvigorate the economy with monetary policy. While that might be nice, the main goal of Japanese monetary policy now is to raise the price level and the rate of inflation. They are using exactly the right tool to do so: lots of monetary easing. On the other hand, Bernanke is trying to kick-start the real economy with a monetary tool, while at least in principle avoiding an inflationary outcome. That’s like trying to hammer a nail with a fish. It might work, but it’s the wrong tool for the job. So the comparison doesn’t work: one man knows how to use his tools, the other does not.

Here is another useless comparison: “Bond Buyers See No 1994 as Bernanke Clarity Tops Greenspan.” The myth that transparency really helps markets in the long run is sort of silly: is there any sign that the crises caused by monetary policy have become less frequent since the Greenspan glasnost than they were before? I know that’s the belief, because the Fed has told us that’s the way it is. But my scorecard tells a sorry tale of bubbles and crashes since the early 1990s. It isn’t a lack of transparency that causes routs. It’s leverage, and negative gamma. Mortgage hedgers are more active now than they were in 1994, and they have larger books. Hedge funds are orders of magnitude larger. And Wall Street is smaller, and is able to provide less liquidity – partly because they are more levered (which they think is okay because of “Fed transparency”), and partly because the government doesn’t want them to take bets with the leverage they have (which, since they’re paying for failures under the current system, isn’t wholly absurd).

So will the next bond selloff not be as bad as in 1994, because the Fed will give more warning? Remember that no matter how transparent the Fed is, there is still a transition point. Somehow, the market goes from a state of thinking there will be no tightening of policy, to a state of thinking that there will be a tightening of policy. That requires a re-pricing, whether it occurs because the Fed signaled it in a speech or a statement, or because they signaled it by doing Matched Sales for the SOMA account with Fed funds already trading above target (as was the old way of telling us something had changed). There is no way to go from “not knowing” to “knowing” without a moment of realization. And when that phase change ultimately occurs, the greater leverage inherent in the market and the diminished role of market makers will cause the selloff (in my view) to very likely be more dramatic than in 1994.

One place where we cannot prevent comparisons – nor should we want to – is in the asset markets. Stocks are doing well, despite absurd valuations, because most other markets are either more-absurdly valued (e.g., Treasury bonds) or have horrible momentum that means they’re not popular right now (e.g., commodities). I have no doubt that equity performance over the next 10 years will be very uninspiring, because equity markets that start from this level of valuation never produce inspiring returns. But when people ask me what the trigger will be for a selloff, I have to shrug. There have been plenty of “reasons” for that to happen. But I think the ultimate reason is probably this: equities are perceived as the “only game in town.” I have read several articles recently that echo this one: “Bond Fund Managers are Loading Up on Stocks.” When there is some other asset class, or some other world market, that starts doing appreciably better, perhaps investors will decide to allocate away. Unfortunately, the candidates for that market are pretty few, given the general level of valuations. Could it be commodities, which is one of the few genuinely cheap markets? Or perhaps real estate, which is still only fair value but has some pretty striking momentum? I don’t know – but I am also not sitting around waiting for a “trigger event.” There may well be a selloff without such a trigger.

Short But Sour

A slow Monday, and the S&P could barely manage a +0.3% rally. That’s tantamount to a selloff, these days, as the all-time nominal highs are a mere 20 points away. I’m not joking: with stocks up 9.1% on the year, the S&P is averaging +0.19% per day, which means the all-time highs ought to be reached by next Wednesday.

Meanwhile, our measure of valuation for equities has reached levels not seen since July of 2011. The expected compounded after-inflation return for the S&P 500, inclusive of dividends, is just 2.00% (it got to 1.81% in July 2011 – and, for the record, it stood at 0.83% at the end of 2006).

The VIX tumbled today to the lowest level since April of 2007 (see chart, source Bloomberg), two weeks after Fed Chairman Bernanke told Congress that the “subprime crisis” was likely to stay “contained” (which it did, in roughly the same sense that the universe itself has a boundary).

Now, I don’t want to follow the usual course and list all of the things we could be worrying about (Italy, Cyprus, France, Iran, North Korea…) to somehow argue that prices are too high. After all, there’s always something to worry about. No, that’s not my argument at all. My argument is that prices are too high regardless of what the news is.

Over the next ten years, compounded real returns after inflation will likely be in the neighborhood of 2% per annum. They could reach 5% per annum, but they could be -3% per annum with equal probability. Note that these are real returns I am speaking of, so there is no reason stocks can’t continue to reach new nominal highs especially if consumer prices continue to accelerate.

(And here’s an odd fact: while equity market volumes over the last few years have been shrinking persistently, the gap between 2012 and 2013 has been narrowing over the last month and a half. That is, volumes are still running about 78mm shares/day below the year-to-date pace in 2012, but at the end of January that figure was 113mm shares/day. So volume is still shrinking, but no longer monotonically.)

So I’m not sure when we are going to get a significant correction on the order of late 2011 (~20%), but we are overdue. Frankly, if I thought the correction was likely to be no more than 20%, I probably wouldn’t even be particularly concerned, because 10% and 20% corrections happen in healthy markets. But I can’t discount the possibility of a 2000-2002 or 2007-2008 sort of decline. The conditions are “right” for just such an occurrence, unfortunately.

Gravity Still Works, After All

Mild weakness in housing data (Housing Starts fell to only the second-highest level since 2008) seemed to be a sufficient excuse today to send stocks lower, but really the main culprit was gravity. We will have to see if the market corrects more than the 1.25% it dropped today, but it shouldn’t be all that surprising!

It actually looked a little bit like one of the classic “risk-off” trades we have seen in recent years. Commodities fell, especially precious metals, energy, and industrial metals while agriculture rallied. The dollar leapt to the highest level since November. Inflation breakevens declined a touch, and interest rates slipped a couple of basis points. What’s more, the VIX jumped to match its highest closing level of the year.

Searching for a new story on why commodities fell, a rumor passed along the market (memorialized by Bloomberg here) that a hedge fund was being flushed out of commodities positions. But that made little sense, unless the fund had been long energy and short agriculture – and if they had been, they would have been winning over the last several months, not blowing up! More likely, it was just gravity, which seems to operate more heavily on commodities than on stocks these days. I guess stocks are from Mars, commodities from Venus.

I think this is all part of a corrective move, but the corrections are a bit out-of-sync and that makes me nervous. In the article I wrote on January 31, I pointed out that the dollar index, 5-year inflation breakevens, and commodities were all nearing critical breakout or breakdown levels. I thought they were all about to break those levels and continue trends, but what actually happened was quite the opposite: the dollar index is up significantly (back to near the November highs, as I said), 5-year breakevens are a couple of basis points cheaper (although not much) and commodities have done what commodities have done all too often over the last year: slid to lower nominal, and even cheaper real, levels. Although I didn’t show it on January 31^st, the 5y CPI, 5y forward – an important metric for the Fed – has also declined slightly from 3.09% to 3.04%.[1]

I expect the markets to return to the levels they held at January month-end, however. The FOMC minutes out this afternoon showed that while there continue to be dissenting, hawkish voices at the Fed (notably, Esther George cast the lone dissenting voice this month – how I like this Fed President!), they continue to be completely drowned out by the doves. Again looking for an angle to explain the stock market decline – which started this morning, long before the minutes were released and probably even before they were leaked to Goldman[2] – market headlines bleated about how the “Fed Minutes Show Debate Over Stimulus,” about how the Fed is “uneasy” over QE, and about how several officials suggested varying the pace of QE over time.

This wild and crazy debate, this uprising of the inflation hawks, produced (I note again for the record) one dissenting vote. Remember, even non-voters can participate in debate and appear in the minutes even if they don’t vote. In this case, the “several members” likely included George and Richard Fisher of Dallas (non-voter), with some chance that a third, also non-voting, member joined them (maybe Plosser?) But they are arrayed against a very dovish core of the FOMC, and the minutes contain a clear indication that the Committee prefers to err on the side of keeping accommodation too long rather than remove it too soon:

 “A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred. A few participants noted examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability; they also stressed the importance of communicating the Committee’s commitment to maintaining a highly accommodative stance of policy as long as warranted by economic conditions. In this regard, a number of participants discussed the possibility of providing monetary accommodation by holding securities for a longer period than envisioned in the Committee’s exit principles, either as a supplement to, or a replacement for, asset purchases.”

I similarly wouldn’t read much into the “number of participants” asking for ongoing evaluation of the efficacy, costs, and risks of asset purchases. This sort of debate has been occurring in the minutes of almost every meeting since the Fed first began QE, and it would be striking if there was not any discussion of efficacy, costs and risks  – especially considering that the efficacy of this unprecedented policy action has been fairly unimpressive, to be kind.

I see no reason to doubt the Fed’s word that they will keep accommodation until the Unemployment Rate improves or inflation moves enough higher to concern them. But there is certainly no concern, even among the hawks, about the current level and trajectory of inflation:

“Nearly all participants anticipated that inflation over the medium-term would run at or below the Committee’s 2 percent objective.”

Unless you’re talking about the vague concern expressed by “a few” participants about inflation over the long run:

“Participants generally saw recent price developments as consistent with their projections that inflation would remain at or below the Committee’s 2 percent objective over the medium run. There was little evidence of wage or cost pressures outside of isolated sectors, and measures of inflation expectations remained stable. However, a few participants expressed concerns that the current highly accommodative stance of monetary policy posed upside risks to inflation in the medium or longer term.”

This continues to be where the whole house of cards is vulnerable. A series of bad inflation numbers (and I am sure it would take a series, not just one or two) could alter the debate later this year. Tomorrow’s release of January CPI (Consensus: +0.1%/+0.2% ex-food-and-energy; +1.6%/+1.8% y/y) is not likely to be the first of those bad numbers, but it is coming soon. The consensus expectations are quite soft, essentially +0.05% on headline inflation (the energy spike didn’t really start until February) and +0.16% or 0.17% on core CPI.

But the housing price data are unequivocal: a large portion of the consumption basket is going to see prices rising at an accelerating rate, soon. Our models seem to suggest the inflection point could be another couple of months away, but it is dangerous to get too caught up in model minutae. The big message from the models is that the unambiguously higher home prices (in Existing Home Sales, New Home Sales, the FHA’s Home Price Index, the Case/Shiller index) are leading to higher rents (judging from surveys of apartment rents from REIS and CBRE) and this reflects higher shelter costs that will show up in core CPI within a few months. If it happens tomorrow, then stocks are vulnerable – but if not, then Martian gravity isn’t going to be enough to hold down stocks for very long.

We know that in low-gravity environments, human skeletal structure gradually weakens so that a return to normal gravity can be very dangerous for someone who has been in space for a long time. The stock market has been in space for a very long time. At some point, when “normal gravity” (in the form of a neutral Federal Reserve policy) returns, equities will have a rough transition to make. But that day isn’t yet, so while I don’t have expectations of much higher equity prices from here I also wouldn’t get too excited about looking for a 20% decline, either.

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[1] Technical note: when looking at breakevens, and especially forward breakevens, over a long period of time, it is important to use inflation swaps whenever they are available because there are fewer idiosyncrasies with the structure of the inflation swaps curve than with the breakeven curve. As a case-in-point, while 5y inflation, 5 years forward taken from inflation swaps has fallen 5bps since January 24^th, Bloomberg’s 5y, 5y BEI has dropped some 30bps over the same period, due to changes in which TIPS and nominal bonds make up that index.

[2] I’m kidding, sorta.

Too Much Fuel Will Extinguish The Fire

Stocks continue to climb inexorably: 21 of the 33 trading days this year have seen stocks end the day higher. About the only market that is doing appreciably better is gasoline. Retail gasoline prices have risen 33 of the past 33 calendar days, and front Unleaded has risen 22 of the 33 trading days in 2013.

This brings us, of course, to the question: if gasoline rises every day, then how long will it be until higher gasoline prices start to affect equity prices?

The question is not quite as straightforward as it appears. On the surface, we have two competing effects: first, stronger economic activity will tend to support both gasoline prices and corporate earnings, giving a lift to equities. And some recent data, such as last Friday’s hefty upside surprise in the Empire Manufacturing figures for February (+10.04 when -2.00 was expected), suggests that growth in Q1 may not be slowing too much further although the European, Japanese, and US economies each contracted in Q4.

(By the way, did you realize that? Each of the three biggest First World economies contracted in Q4 and the US equity markets declined -1.0%).

Not that equities necessarily must pull back when growth lags (if they did, then all good economists would also be good traders), but when you’re talking about markets that are pricing in a continuation of historically wide margins and historically high price-earnings multiples, it would seem that a pullback when there is weakness economically is as good a time as any. Stocks can’t go up in a line forever, can they?

Actually, they can, but we’ll get to that in a minute. I mentioned two competing effects that are apparent, with one of these being the stronger economic activity will tend to support both gasoline prices and earnings. The other is that higher gasoline prices have a depressing effect on discretionary expenditures. Along with the higher payroll taxes which manifested in January and the lower Q1 incomes as a result of dividends being pushed into Q4, the higher gasoline prices may have contributed to what a finance VP at Wal-Mart described as “a total disaster” start to February. This is an “automatic stabilizer” effect at work: higher growth tends to produce higher energy prices, which tend in turn to dampen economic growth – and vice-versa.

So which effect dominates? Can gasoline prices and stock prices keep going up together?

The answer is that their nominal prices can absolutely continue to rise together, but their real prices cannot. If I double the price level, then no matter what happens to growth or the marginal rate of substitution between gasoline and all other discretionary goods and services, both nominal gasoline prices and nominal corporate earnings (and therefore, quite likely equity prices) will both rise. However, higher real energy prices imply lower real equity prices eventually. But that’s not a day-trade; in the fairly short run (say, several months) the price level is roughly constant so that one of these two markets is likely to decline in nominal terms.

Frankly, the odds in my mind are on stocks breaking first. But as the chart below (source: Bloomberg) shows, the ratio of gasoline to stocks is not really out-of-whack one way or the other. This is unleaded regular gasoline divided by the S&P level…and what’s fascinating to me is how regular the relationship has been (especially in 2010!).

By the way, the distinction about nominal and real prices also is relevant for the observation some have made that gasoline inventories are reasonably adequate, but prices continue to rise. Gasoline prices are high in nominal terms, but not as high in real terms. In nominal terms, unleaded has risen 105% since the second Bush inauguration, but only 65% in real terms. That still sucks, mind you, and is one reason that growth hasn’t been robust in a while. As of December 2004, gasoline was 3.934% of the average consumption basket; according to the BLS (new numbers are out today!) that became 5.274% as of December 2012.[1] Therefore, we spend about 1.34% less of our total consumption on other things than we did in 2004.

With gasoline, medical care, and college tuition all squeezing us (not to mention taxes, which is not a consumption item and therefore not in the CPI), it isn’t surprising that we’re spending a smaller proportion of our consumption basket on apparel and housing than we used to (for a longer-term view, see my comment from a couple of weeks ago “Fun With the CPI”). These are long-term, secular trends. What could hurt the market in the shorter-run is that when there is a significant move in energy prices, we can’t change the amount of housing we consume to compensate. We stop buying the Wal-Mart things. And we save less.

And eventually, we stop buying stocks. Don’t we?

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[1] N.b.: that doesn’t mean we spend 35% more on gasoline now; as noted, gasoline has doubled in price. But 35% more of our consumption is spent on gasoline, than we spent previously. It is interesting that with a 65% increase in the real price of gasoline, our gasoline consumption has only risen 35% (due to smaller cars, better gas mileage, more air travel, more mass transit, etc).

Breaking Open the Piggy Bank

We have one month in the books in 2013 already; my, how time flies when you’re having fun! But the fun may not last much longer.

I have spent lots of time, over the last year, answering the question “why hasn’t inflation responded to QE?” My response has been that it has: core inflation rose from 0.6% to 2.3% from October 2010 to January 2012, rising for a record-tying fifteen consecutive months – a feat that last happened in 1973-74, as official prices adjusted to catch up for being frozen during wage and price controls. By a bunch of measures, that was an acceleration of core inflation that was unprecedented in modern U.S. economic history. As I wrote at the time (in “Inflation: As ‘Contained’ As An Arrow From A Bow“), the only reason to defer panic was that Housing inflation was overdue to level out and decelerate. Fortunately, it did.

But, as I’ve written extensively recently, that blessing has been rescinded and the question of “why hasn’t inflation responded to QE” will shortly be moot. In the next couple of months, core inflation will begin to re-accelerate, driven by the pass-through of rising home prices into rents. In our view, the best we can hope for is that core inflation only reaches 2.6% this year. Absent a change from the historical relationship between home prices and rents, some 40% of the core consumption basket is going to be rising at 3.5% or better by late this year.

So, when will markets get a whiff of this?

We are primarily motivated by valuations, and we are patient investors. Moreover, we think it makes more sense to focus effort on valuation work, because if your valuation work isn’t pretty good then timing isn’t going to matter much. But nevertheless, it is helpful to look for signs and signals that indicate time may be drawing short. So I’d like to go all ‘techie’ for a few minutes and show three charts that suggest markets are preparing for a new, higher-inflation reality.

The first one is the dollar index (see chart, source Bloomberg). This one is interesting, because I am not convinced that U.S. QE will cause a uniquely American inflation. After all, everybody’s doing it. This chart is technically of a head-and-shoulders pattern, but I’m just pointing to that trendline that keeps bringing in buyers.

A break below the current level (and as a trader, I’d be tentative until the September lows broke as well) projects to a test of the bottom end of a much bigger consolidation pattern that has been forming since the beginning of the crisis in 2008 (see next chart, source Bloomberg – the green oval is the area of detail in the prior chart). Below there be dragons.

Now, at the same time we have inflation breakevens (the compensation, in nominal bonds, for expected inflation – represented as the raw spread between the Treasury yield and the TIPS real yield). I’ve shown this uptrend in breakevens and/or inflation swaps in a number of ways recently, but the chart below (source: Bloomberg) shows a long-term view. In the last three months, the 5-year breakeven has risen about 35bps (and you get a similar picture from inflation swaps, but the data isn’t as clean that far back). Right now, bond investors are demanding a fairly high level of expected inflation compensation over TIPS and their guaranteed return of actual inflation. We’ve got a ways to go before we hit all-time highs on the 5y BEI, but the 10-year BEI is only about 22bps away from all-time highs.

Those prior charts haven’t yet broken out, and so while the timer is buzzing the alarm might ultimately not be set off. But in commodities, there are some interesting signs that the lows may be in even though sentiment remains very negative. The chart below (source: Bloomberg) illustrates that in January, the DJ-UBS commodity index gapped through trendline resistance not once, but twice.

In my experience, technical analysis of commodity indices is a fraught exercise, but commodities have quietly been doing quite well lately. Although the S&P rose 5% in January to only 2.4% for the DJ-UBS, that’s mostly due to the first trading day of the year. Since January 9^th, the DJ-UBS is +3.7% while the total return of the S&P is only +2.6%. Surprised?

Now, the conventional wisdom is that stocks are a great place to hide if there is inflation. That conventional wisdom is wrong. Stocks may do okay if starting from modest valuations, but a rise of inflationary concerns (especially if accompanied by rising interest rates) while stocks are at high valuations would likely be less than generous to equity investors.

So, of course, retail investors have been breaking their piggy banks open to rush into stocks, in a rush not seen for many years. It is tragic, but it is the natural result of the Fed’s misguided[1] crusade to stimulate the economy via the portfolio balance channel (see my discussion and illustration of this topic here). Where does the retail investor turn, when he sees rising gasoline prices, rising home prices, and a shrinking paycheck due to higher withholding rates? The television is telling him that it’s time to jump aboard the equity train. Although he has been prudently suspicious of equity markets for much of the last decade, he is also aware that the cash he has in the bank is evaporating in real value.

And perhaps that’s why total savings deposits at all depository institutions (the main component of non-M1 M2) has fallen more in the last two weeks than in any two-week period…ever. About $115bln has fled from savings accounts in the last fortnight. Now, that’s a volatile series, and it might mean nothing unless we happened to see it show up somewhere.

Like, perhaps, here?

The chart above (source: ICI, via Bloomberg) shows the net new cash flows into equity funds, which just happen to be at the highest level over the past three weeks (about $30bln) of any time during the period of data available on Bloomberg.

Again, it isn’t because the future suddenly looks bright. Initial Claims today was 368k, above expectations and unfortunately putting a big dent in the notion that the ‘Claims data over the last few weeks was signaling a meaningful shift in the rate of new claims. The number is probably still going to go lower, but it is likely to be a drift, not a break. And we will see a similar story tomorrow, probably, when the Payrolls figure (Consensus: 165k) and Unemployment Rate (Consensus: 7.8%, but I think it might tick up to 7.9%) will paint the same sort of picture. No, people are not reaching for their wallets to invest in stocks because they are suddenly flush. More likely, it’s because they’re frustrated and confused; they feel they’re being left behind. Perhaps there is a bit of desperation, if retirement is getting further away as the cost of retirement rises and take-home pay stagnates.

In any event, what you do not want to see, four years and 125% above the S&P lows, is people taking money out of savings to put into stocks. If you are not one of the people putting money in, then consider being one of the people taking your profits out – and looking to those markets that actually do tend to keep up or outperform inflation. I hasten to remind readers that they don’t ring a bell at the top of the market, and so one ought to be careful to rely too much on the “signs” and “timing signals” suggested above. But the sharp-pencil work suggests that core inflation is going to head back up in the next 2-3 months; in my opinion, you don’t necessarily need signs to position for that – you need excuses.

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[1] One is tempted to say ‘evil,’ but I don’t believe the Fed actually is anticipating the pain they are likely to cause to the little guy. Indeed, they may believe that the impact of their actions may fall disproportionally on the rich: an economist at the Federal Reserve Bank of St. Louis recently co-published a paper entitled “Understanding the Distributional Impact of Long-Run Inflation,” which concludes in part that “When money is the only asset, a faster rate of monetary expansion acts as a progressive tax that lowers wealth inequality; when bonds can be traded, wealth inequality is less affected by inflation because the rich hold more illiquid portfolios than the poor.” [emphasis added]

 

Today’s Icarus

It is hard to be the top dog.

Today, despite another low-volume session (incredibly, NYSE Composite volume is already 1.5 billion shares behind 2012’s volume-to-date), investors were looking forward to a slew of earnings announcements. By and large, companies hit or exceeded the hurdles set for them, as they typically do.

Apple (AAPL), which released fiscal Q1 earnings after the close, was among those that exceeded expectations. Sales rose 18%, although falling marginally short of expectations, and the company posted a $13.81/share profit compared with expectations for $13.53/share. Apple guided Q2 revenue estimates downward, and the stock was pummeled more than 6% after the close.

What’s amazing to me is that investors were not satisfied. Bloomberg  gaped that “Apple Inc. posted no profit growth and the slowest increase in sales in 14 quarters…” This is a very large company. How long did people think that the firm could grow at “only” 18%? The same story also suggested the reason for the disappointing reaction: “The results reinforce concern that Apple’s growth is being hurt by higher production costs…”

No, its growth is being hurt because it’s a very large company. (Review the beginning of my January 15th post, where I link the research on the performance of the stock market’s “top dog”.)

Now, Apple is a wonderful, wonderful company. I want to be like Apple. I want my daughter to marry someone like Apple. It only has an 11.7 trailing P/E, and a yield of 2.06%. There’s much to like. But it’s huge. Like Microsoft before it, it is going to transition to a period of large-industrial-concern growth (MSFT has a 10.7 multiple and a 3.33% yield). The difference between MSFT and AAPL is that the former has an almost unassailable position in some of its markets. The latter, while a very cool company, has unassailable positions in … perhaps the iPod, to the extent that market isn’t cannibalized by the smartphone market. On the other hand, MSFT is a ruthless, uncreative company that has historically put out buggy products (although version 275 of Excel seems to crash less). AAPL is an ultra-cool, creative company that is in ‘what have you done for me lately’ product markets. I am not saying that I would do a long-short on MSFT-AAPL, and I’m not even saying that AAPL needs to trade lower from these levels. I’m merely pointing out that the dividend growth model contemplates a transition to lower long-run growth, and AAPL is going to have lower long-term growth eventually. That shouldn’t be surprising. Its main problem as an investment was that it was far too expensive for a company in transition, and moreover that transition was almost assured once it became such a huge company. Gravity isn’t just a good idea, Icarus: it’s the law.

The good news is that if AAPL is on its way to becoming IBM (without the gray-costumed drones of the 1984 advertisements, of course), it may have fallen far enough. IBM trades at a 13.4 P/E and a 1.66% dividend yield. Even Icarus bounced once he’d fallen for a while.

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Thursday’s main economic data will be Initial Claims (Consensus: 355k from 335k). It is getting late enough in January that it is starting to make sense to pay attention to Claims again; however, as always with a weekly figure it will take a few weeks to let the average settle out.

More important, to me, is the auction of the new 10-year TIPS. This is not a re-opening, but rather a January-2023 maturity. The Treasury will be auctioning $15bln of the security, and I believe the auction will go well. The WI is pricing at roughly a 10-11bp pick-up from the current 10-year. That looks like too much, and I would expect that investors who own the current 10-year TIPS would be eager to add 11bps for six months of maturity (and pick up a slightly closer-to-the-money deflation floor in the process). Add to this the fact that the 10-year sector is fairly cheap on the curve generally, and you have the ingredients for a pretty good auction even if the absolute levels of yield are heinous and the breakevens are relatively wide by recent standards.

Learning the Wrong Lessons

According to Bloomberg, investors are the most optimistic on stocks they have been in 3½ years. As is normal, investors mistake a sense of optimism about the economy for a sense of optimism on equities. As is normal, investors are reaching this peak of optimism as the stock market achieves its highest nominal level in five years, and among the highest valuation multiples in … hey!…about five years. What a coincidence! (Incidentally, while we calculate our long-term valuation metrics ourselves this page is a pretty good source for a quick-and-dirty view of valuations. I don’t have any relationship to the company and this is the only page on the site that I’ve used so I am not endorsing any other page!)

Now, while I am probably as optimistic on the economy as I have been in the past few years, I’m still less-optimistic than the crowd since I think the crowd hasn’t yet assimilated the fact that the little growth spurt at the end of Q4 owes quite a lot to the movement of dividends and incomes into Q4 from Q1, and thus the first quarter of this year will probably look rather poor.

In fact, while I am clearly negative long-term on the prospects for nominal Treasury bonds, that’s my investment view. My trading view is that at 1.84%, Treasury bond yields are probably going to go lower before they go higher. That’s partly because the present yields incorporate a lot of enthusiasm about growth – enthusiasm I think will be dashed once the January numbers begin to be reported in earnest. But the trading view is also because the Fed is buying virtually all of the net supply the Treasury is supplying to the market, with no sign that project is ending. I have no illusions that buying 10-year Treasuries at 1.84% and holding to maturity will be an awful investment. But if I was a short-term swing trader, I’d play for the next 20bps to be lower, not higher, in yield.

With respect to January data, incidentally, here is what we have so far (outside of Initial Claims, which as I have pointed out previously are all over the map at this time of year):

Release for January	Consensus Forecast	Actual
Empire Manufacturing	0.0	-7.78
NAHB Housing Mkt Index	48	47
Philadelphia Fed Index	5.6	-5.8
Michigan Confidence	75.0	71.3
Richmond Fed Mfg Index	5	-12

For the most part, these are not just misses but big misses. I wonder how long it will take for investors to notice? Initial Claims on Thursday could get attention as the numbers start to converge on the actual condition of the underlying economy, but the first big January datum is the January 29^th release of Consumer Confidence, which is currently expected to rise slightly from December. That is followed by ADP on January 30^th (but any weakness there will likely be tempered by the advance release of Q4 GDP on the same day), the Chicago PMI on the 31^st, and the ISM PMI and Unemployment on February 1^st. Regardless of what happens over the next few days, I don’t want to be short bonds headed into that gauntlet next week.

I said the January data were big misses “for the most part,” because the NAHB miss wasn’t really a big miss. Housing is even strong enough now to resist downside surprises. As an aside, although it is a December number, the median price of existing home sales rose 10.89% year-on-year. Adjusted for the level of core inflation (so that we’re looking at the real rise in existing home prices), this is the fastest rise in history except for several months in 2005 – see the chart, (source Enduring Investments).

As for stocks, the fact that investors are as bullish as they have been in a third of a decade is sad but not terribly surprising (although this is a survey of Bloomberg users, which supposedly are much more astute since they have to come up with the 1700 clams per month for the service). On a related note, I was recently reading an article, called “I Saw The Movie,” in the January issue of Financial Advisor Magazine. In the article, the author compares the fear that some investors have of the stock market to the (irrational) fear of going into the water after watching Jaws. The author notes that “If your balance in 2011 resembled your balance in early 2008, you lost three years – but you didn’t lose any money, unless you sold out of panic…the vast majority of big losers were those who sold at the ebb of fall of ’08 to the spring of ’09 and parked their boats in the shallows of rock-bottom savings accounts.”

This, it occurs to me, is the real toll that the Fed’s QE has had on the investor class. It taught the wrong lesson. The lesson that has been taught is that you should hold on through all things, good and bad, and things will be okay. It is true that with hindsight, those who sold with the market finally at fair value (but no cheaper) in March of ’09 missed a rollicking rally all the way back to similar levels of overvaluation. But the real lesson should have been that most investors shouldn’t have been overweight in equities in 2008 or in 2007, based on market valuations. In the absence of manipulation of asset prices through the “portfolio balance channel” (see my discussion of this phenomenon in my recent article “A Relatively Good Deal Doesn’t Mean It’s A Good Deal”), those who sold in March of 2009 would have missed an average market return rather than the 21% per annum the market actually delivered since then. So the problem isn’t that they got out in 2009, but that they got in (or stayed in) in 2007 and 2008, and then got out in 2009. Investors who heeded the overvaluation of the market at, say, year-end 1998 and never got back in have earned a compounded return of 2.54% in T-Bills, 7.39% in TIPS, 5.64% in commodities, or 5.77% in the Lehman/Barclays Agg (nominal bonds) compared with 2.94% in stocks.

And that return is based on the pumped-up valuations that still exist in stocks today.

Investors, and their advisors for the most part, haven’t learned the right lessons yet, which is why patient investors are still having to wait to get back into equities even though the Federal Reserve is working very hard to force them back into the market via the portfolio balance channel.

The right lesson is this: investing for the long term is mostly about valuations, and very little about the economic cycle, the news cycle, or the lunar cycle. And two of those three we can’t predict, anyway. Yes, there is a tactical element of trading, but most investors should be (a) rebalancing on a regular basis, (b) paying attention to basic rudiments of asset valuation so as to adjust – mainly at the margin – their basic asset mix, and (c) turning off the television.

It Pays To Be Contrary

At one time, I think most of us assumed that the stock market would have a hard time rallying without its largest component, Apple (AAPL).

Pretty soon, Apple will solve that problem, since it won’t be too long before it is smaller than Exxon-Mobil (XOM) again. It is actually fairly remarkable that the S&P has managed to rally 3.2% this year even though AAPL is -8.7%.

This phenomenon is amazingly timely, considering that in the November/December issue of the Journal of Indexes there was an article by Rob Arnott and Lillian Wu called “The Winner’s Curse” in which the authors noted that “For investors, top dog status – the No. 1 company, by market capitalization, in each sector or market – is dismayingly unattractive.” Later, they note that “the U.S. national top dog underperforms the average company in the U.S. stock market by an average of 5 percent per year, over the subsequent decade.”

Nice call.

That observation follows naturally from Arnott’s work that led to fundamental indexing – his observation, simply, is that by definition if you are capitalization weighting you will always have “too high” a weight in stocks that are overvalued relative to their true prospects and “too low” a weight in stocks that are undervalued relative to their true prospects. There is no way to know if Apple is one of those – it’s a great company, and there’s no reason that the top-capitalization company is necessarily overvalued – but the authors of that article note that when you’re the top dog, more people are taking potshots at you. It suggests an interesting strategy, of buying the market except for the top firm in each industry.

This is why contrarians tend to do well. If you buy what everyone else is selling, and sell what everyone else is buying, there’s no reason to think you’ll be right on any given trade but you are much more likely to be buying something that is being sold “stupidly” and to sell something that is being bought “stupidly.”

Which brings me back to commodities, which are unchanged over the last 9 years (DJUBS Index) while the basic price level has risen 24% and M2 is +72%. But I know you knew that’s where I was going.

Below is a picture of the worst two asset classes of the last nine years (I picked 9 years because that’s the period over which both of them are roughly unchanged). The white line is the S&P-Case Shiller index, while the yellow line is the DJ-UBS Commodity Index.

One of these two lines is currently generating much excitement among economists and investors, including institutional investors, who are pouring money into real estate. The other line is generating indifference at best, loathing at worst, and plenty of ink about how bad global growth is and how that means commodities can’t rally.

One of these lines is also associated with an asset class that has historically produced +0.5% real returns over long periods of time, and consequently isn’t an asset class that one would naturally expect to have great real returns. The other is associated with an asset class that has historically produced +5-6% real returns, comparable with equity returns, over long periods of time. Care to guess which is which?[1]

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Tomorrow, the BLS will release the Consumer Price Index for December. The consensus for core inflation is for a “soft” +0.2%, and a year-on-year core inflation increase for 2012 of +1.9%.

Now, last December’s core inflation number was +0.146%, and last month’s year-on-year core CPI was +1.94%. What that means is that it will be quite difficult to get both +0.2% on the monthly core figure and +1.9% on the y/y change. If get +0.17% on core, then we should round up to +2.0% unless something odd happens with the seasonal adjustments.

In other words, I think it’s very likely that core inflation will pop back up to 2.0%. As a reminder, the Cleveland Fed’s Median CPI is still higher, at 2.2%, so it should not be surprising at all that core inflation has a better chance of going up than going down from here.

The two major subindices to look for are Owner’s Equivalent Rent, which last month was at 2.14% y/y, and Rent of Primary Residence, which was 2.73% y/y. Those two, combined, represent 30% of the consumption basket, and it was the flattening out of those series that caused core CPI to flatten around 2.0%. (Six months ago, the trailing y/y change in OER was 2.1%; the y/y change was 2.7%). Accordingly, watch closely for an uptick in those indicators. We believe that they are going to accelerate further, likely sometime in the next 3 months.

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[1] Hint: the one that has historically provided great returns is one that few investors have very much of. The one that has historically provided bad returns is the one that represents most of a typical investor’s wealth.

One Less Good Reason to Be Bearish On Inflation

If you’re bearish on U.S. inflation, I think your view boils down to one of the following arguments:

1. I think growth will remain soft, or we might even slip into another (global?) recession. You can’t have inflation without too-rapid growth, so inflation isn’t going to happen.
2. I think inflation expectations are well-anchored, and actual inflation only happens if people start expecting inflation and so adjust their demands for wages and/or prices.
3. I perceive that wage growth is weak, and so there is no ‘cost-push’ inflation.
4. Although money supply has been growing at a 7-10% pace for the last couple of years, money velocity has been declining. It is likely to continue to decline while banks and sovereigns are under structural pressure to de-leverage.
5. I trust the Fed to tighten in time. I’m not sure what ‘in time’ means, but I figure they know what they’re doing.
6. I think the whole darn thing is going to collapse.

You are entitled to hold any of those views, of course.

If #5 represents your view, I can’t help you. If #6 is your view, then there’s not much that can be done anyway. If #1 is your view, I won’t bore you with a recitation of the arguments I’ve presented before that suggest growth and inflation are correlated only spuriously and that the proposition that growth is the dominant consideration when forecasting inflation can be considered refuted (for example here, here, and here). #3 is more defensible, in my mind, since the evidence on leads/lags of wages versus prices is not conclusive although it seems to me that wages tend to follow prices, rather than lead them (there are some clear examples of wages following prices, and there are some times that they appear to move simultaneously, but I am not aware of any clear examples of prices following wages). #2 is not disprovable, since we don’t have a way to measure inflation expectations directly that is very useful (see here for a thorough discussion, and here for a shorter discussion). Therefore, while it may turn out to be true, I think this boils down to a question of faith, like #5.

So, to my mind, the most plausible argument that inflation is not going to be a concern – despite the fact that monetary policy stimulus is being applied around the globe to an unprecedented degree – is the supposition that money velocity is going to continue to slide for structural reasons for a long time. While U.S. banks have been growing commercial bank credit again at pre-crisis rates for the last year or so (see Chart below, source Fed Board of Governors), this may partially reflect a gain in lending market share versus European banks because the latter have been under severe pressure for the last year.

Global inflation ought to depend on global velocity as much as global money supply, which led me to write back in August that

If you want to make a case for slowing U.S. inflation, I do not believe you can look to the U.S., but rather must look to Europe. If domestic lending (and hence velocity) is rising partly because European lending (and velocity) is contracting, then some of the inflation potential is being sucked out, at least temporarily, by financial and credit strains in Europe.

In my view, the only plausible way we get appreciably lower inflation is if central banks abruptly stop quantitative easing (I don’t think there’s any measurable chance that they tighten) and the velocity of money in Europe (and Japan) drops faster than the velocity of money in the U.S. rises.

The reason I bring this up now is that one of the ‘negative tail’ outcomes became significantly less plausible yesterday after the Basel liquidity rules were delayed (for four years) and softened (by changing the definition of what assets are ‘liquid’).

Regardless of whether or not that increases the vulnerability of the banking system to another credit crisis (it surely does), it lowers the banks’ cost of funding a loan and thus, all else being equal (which it surely is not), should lead to a greater loan volume at any interest rate. In my view, this significantly reduces the likelihood that money velocity in Europe will collapse further (at least for a while) as banks hoard capital, and thus removes as I said one of the ‘negative tail’ outcomes from the list of active concerns.

Breakevens responded positively to this news, as did the equities of European bank stocks, especially ones such as Natixis and Commerzbank which have been under pressure for a long time. Commodities also rose, for a change: this year, commodities have had an awful start to the year despite the roaring of equities out of the gate. The chart below (source: Bloomberg) shows that the ratio of the S&P to the DJ-UBS index has now exceeded the highest relative valuation of the last year, and indeed the highest relative valuation of the last ten years.

By now, my suggestion should not be surprising – commodity indices are the place to position for a bad inflation event. A continuation of low and stable inflation in conjunction with a generous financing environment (if, for example, core inflation retreats gently to 1.75% or so even though central bankers continue to ease) will push this relationship further in the direction it has recently headed. The market is pricing in just such an outcome. An adverse outcome will likely cause a reversal of this relationship, implying a great outperformance of commodities relative to equities over the ensuing several years.

It’s anybody’s guess when and if that will happen, but as noted above I think one argument for the long-stocks/short-commodities trade has just receded.