Chutzpah

It has been a busy couple of weeks on the business side, which is why I haven’t been writing many articles. However, I wanted to be sure and pen a quick one today.

The main economic data is due out later this week: Existing Home Sales on Wednesday, New Home Sales on Thursday (both of these more interesting for the home price indications than for the volume figures), and Durable Goods on Friday. (Some of us also get excited about the 10-year TIPS re-opening on Thursday, with real yields at a 1-year high after a 35bp selloff over the last three weeks). But Monday and Tuesday have been relatively bereft of news, except for the occasional Fed speaker.

It is that “occasional Fed speaker” that I want to mention today.

St. Louis Fed President James Bullard today gave a speech in Europe, about the need for the ECB to pursue “aggressive” QE in order to prevent a long period of low inflation and deflation such as that experienced by Japan over the last few decades.

What word am I searching for here…would it be “chutzpah?”

I realize that Chairman Bernanke has already been featured on a magazine cover as a Hero. It bears remembering that Greenspan was also called the Maestro at one point, although we are now all aware that his management of the Fed helped to precipitate a massive crisis. History isn’t written in real time by bloggers. It’s written by historians, years later.

But hasn’t the Fed, after all, been really successful? Isn’t a victory lap deserved? Haven’t they earned the right to lecture to other central banks about the proper execution of monetary policy? After all, the Fed brought down the unemployment rate while inflation remains tame. Case closed.

Perhaps that would be a good argument if Earth was hit by a comet tomorrow and all life ceased. But in the event life continues, we will need to wait until the cycle is complete. Celebrating now is like pumping one’s fist in celebration in the middle of a motorcycle jump over 25 buses. Nice trick, but we’ll hold our applause until you stick the landing if you don’t mind.

There seems to be great faith in the Federal Reserve that the tough part is over. All that they need to do now, it seems they believe, is to just start tightening before inflation gets going; they can do it very gradually, supposedly, because of the great credibility the Fed has and because they understand how inflation responds to rates.

But in fact, inflation doesn’t respond to rates but to money. And not to reserves, but to transactional money. Transactional money responds not to total reserves, but to banking activity and the resulting level of required reserves…which the Fed is unable to directly affect. When the Fed begins to taper, and then to somehow drain reserves, I predict it will have almost zero impact on the inflation process until the excess reserves have been drained.

Indeed, if interest rates rise when the Fed begins to do this, it will perversely tend to increase the velocity of money, which tends to vary inversely with the opportunity cost of holding cash balances (that is, velocity goes up when interest rates go up, all else equal). It’s not the only thing that matters, but it’s pretty important, as the chart below suggests (I think I have run something like this chart previously).

Now, ordinarily when the Fed is raising rates, they’re also draining reserves – so the increase in money velocity is balanced by the decline in money to some degree. That won’t happen this time. When rates go up, velocity will go up, but the quantity of (M2) money will not change because it is driven by a multiplier that acts on required reserves. That means inflation may well rise as interest rates increase, at least for a while.

I might be wrong, but I am willing to wait and see how it plays out. If I am wrong, then you don’t have to put me on the cover of a magazine.

To conclude that inflation is fully tamed at this point, anyway, is remarkably optimistic. Home prices are skyrocketing at rates only rarely seen, and it would be incredible if that did not lead to higher rents and higher core inflation…literally within a couple of months from now, judging from the historical lag patterns.

But, again, I should return to my main point: it isn’t that the Fed is wrong, it’s just that they are so completely certain that they are right even though the difficult part of the trick – unwinding the extraordinary policy without any adverse effects – lies ahead.

Sit down, James Bullard. Let the ECB manage its own affairs. I am sure they can mess it up on their own, without your help. And certainly, without your condescending advice!

A Broken Record But It’s A Good Song

There has been a bunch of new data over the last couple of days, but I am afraid that all of the new stuff will not keep me from sounding like a broken record.

Consumer Confidence jumped yesterday, but more interesting is the fact that the “Jobs Hard to Get” subindex rose to the highest level since late last year, suggesting that weak jobs data isn’t entirely a one-off. Today, the ADP report was weaker-than-expected, at 119k (versus expectations for 150k) and a downward revision to last month. The Chicago Purchasing Managers’ Index on Tuesday was the weakest since 2009, but the ISM Manufacturing report today was on-target. Still, neither manufacturing index is generating much confidence that the economy is about to take off, and the early-year bump has been entirely reversed (see chart, source Bloomberg).

The Shiller Home Price Index, reported on Tuesday, was higher-than-expected at 9.3% year-on-year, rather than the 9.0% expected (and versus an 8.1% last!). What’s really interesting about this is that the recent surge in year-on-year growth has come because the usual seasonal pattern that sees prices sag in the springtime hasn’t been in evidence this year – accordingly, the year-on-year comparisons have gotten easier as prices have gone sideways rather than falling as they tend to do between August and March (see chart, source Bloomberg).

That’s interesting because such a phenomenon was also a condition of the bubble years prior to 2007 – prices generally rose steadily with only a hint of seasonality. Post-bubble, if you wanted to sell your house in February you had to offer a concession on price. Those concessions aren’t happening any more, which is a back-door confirmation of the overall price action.

As I have said before, ad nauseum, we are seeing slow and/or falling growth and firm and/or rising inflation in the pipeline, and that’s not at all inconsistent. Mainstream economists, and journalists of all stripes, seem to accept as a fundamental verity the linkage between growth and inflation, but the only minor problem with this firmly-held belief is that it ain’t so. Growth is bad, and inflation is still going to go up. In Q1, core CPI rose at a 2.1% pace, and I still think that for the full year core CPI will rise at 2.6%-3.0%.

I want to add a quick word here about a thesis that has been advanced recently. The thought is that if the abrupt housing demand is coming from investors rather than consumers, then rising housing prices might be consistent with pressure on rents. I think it’s important to clear up this confusion. Microeconomics tells us that when the price of a good goes up, the price of a substitute tends to rise as well. It is possible, if the overall price level is flat, that a phenomenon such as is described in this hypothetical could happen, with home prices rising and rents falling. But what is much more likely is that rents simply go up more slowly than home prices, so that they decline relative to home prices, rather than declining absolutely. This is, in fact, what we see historically: large increases in home prices tend to lead to increases in rents, but not of the same magnitude, and vice-versa. Whether the mechanism for this is a systematic institutional investor presence or just a large number of one-off instances of individuals renting out their second “investment” homes doesn’t really matter. Accordingly, I don’t expect to see a drastically different course carved out by the rental/home price relationship from what it has been historically. The main difference may be that the lags between home prices, inventories, rents, and so on might get screwed up somewhat, if institutional investors cause this to happen in a more organized way than the organic way in which it usually happens.

Another aside: there has also been a lot made recently, especially in commodity markets, about weak data from China. It is amazing how important it is to global commodity markets that China grows at 9% and not 8%. If I were a member of Chinese leadership, I would be trying to convince my data bureau to release slightly weak figures, since every time it does the hedge funds of the world offer large amounts of commodities as discount prices, which is just what a growing economy needs. It’s not like anyone believes the figures when they are reported to be high; I wonder why we believe it when they are reported to be low?

In addition to the data today, the Federal Reserve finished its meeting and announced no change in monetary policy for now. And there isn’t one coming for a while, either. There was no important change in the statement, although the Fed did take care to remind us that it “is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” [emphasis added] That’s comforting. But the simple fact is that the economy isn’t going to be booming any time soon, and the Committee isn’t going to taper its purchases unless it does because they labor under the delusion that they’re helping. Perhaps next year.

For the rest of the week, investors will be focused on Friday’s Employment Report. I am not really worried about the report being weaker-than-expected, because from everything I read it seems that the market is already anticipating something close to Armageddon (or at least, that’s how they are explaining the continued pressure on breakevens and commodities). So far, this is a routine slowdown that might be slipping into a renewed recession. Meanwhile, expectations on Friday are for Payrolls of 145k, up from 88k but down from the pace of the last year. And the ‘whisper’ number seems to be lower than that. I suspect the more likely surprise is that there is an upward revision to the 88k and the number exceeds estimates. Somehow, that will be also perceived as a negative for breakevens!

TIPS suffered today, even as nominal bonds rallied. Our Fisher yield decomposition model currently suggests that TIPS are as cheap, relative to nominals, as they have been since early September last year (when 10-year breakevens were at the same level they are at now). I am quite bullish on breakevens from here.

Why Inflation Futures Matter

The Chicago Mercantile Exchange (CME) is currently having discussions with market participants and is considering launching in 2013 two new futures contracts related to inflation: a Consumer Price Index (CPI) futures contract and a deliverable TIPS futures contract. My company has been an advocate for these contracts and involved in their construction. We expect to be involved in making markets in them. Our interest is therefore no doubt obvious. But are these contracts important, in a larger sense, for the market? The answer is yes, and here is why.

It is a fact of financial life that most mature markets enjoy three legs of a liquidity ecosystem: cash markets, over-the-counter (OTC) derivatives, and exchange-traded derivatives. For example, in the nominal interest rates market Treasuries provide a deep and liquid cash market, there is a large and well-functioning market for LIBOR swaps, and there is efficient and transparent pricing in the futures markets as represented by Bond, Note, 5-year Note, 2-year Note, UltraBond, and Eurodollar contracts.

The presence of three legs, rather than only one or two, in this ecosystem is important. With two legs, there are only two directions of liquidity transmission: A to B and B to A. But with three legs, there are six ways that liquidity can be transferred: A to B, A to C, B to A, B to C, C to A and C to B. By adding the third leg, the avenues of liquidity transmission aren’t increased 50%, but threefold.

This richer liquidity ecosystem matters the most in crisis situations, such as during the credit crisis of 2008. Consider that during the crisis, credit and inflation markets became quite illiquid at times while equities, nominal rates, and commodities remained (comparatively) liquid. The main difference between these two sets is that the latter three markets all have cash, OTC, and exchange-traded instruments while the former two have only two (in both cases, cash and OTC derivatives).

Accordingly, while the inflation-linked bond market has become truly huge (see chart below, source Barclays Capital) and the inflation-linked swap market has enjoyed an almost uninterrupted rise in volumes since 2006, investors need the third component of the ecosystem: exchange-traded futures contracts on inflation and/or real rates. It is interesting to note that one analysis of the original CPI futures contract traded on the CSCE (many years ago) suggested that a prime cause of the contract’s failing was that “…the CPI futures market, unlike other futures markets, has no underlying asset which is storable or traded on an active spot market, which reduces the opportunities for arbitrageurs and speculators to participate in the market.” (Horrigan, B. R., “The CPI Futures Market: The Inflation Hedge That Won’t Grow”, Federal Reserve Bank of Philadelphia Business Review , May/June 1987, 3-14).

Adding these products will likely increase the volumes and the liquidity of all inflation products, including (perhaps especially) the liquidity of off-the-run TIPS. This liquidity will also remove the main lingering concern among those investors who have not yet made meaningful investments in the market.

Inflation-related futures are not a new idea. Since at least the 1970s, economists have anticipated that these instruments would one day be available. Several previous attempts, dating back to as early as the mid-1980s, have failed for various reasons – too early, too different, bad structure. But futures that present a different method of investing in, trading, or hedging inflation and real rate exposures are needed, not only because they create opportunities to make different sorts of trades or to trade more efficiently but also for the good of the market itself. Healthy markets in CPI futures and TIPS futures will create a better liquidity ecosystem for the entire inflation market, including for off-the-run TIPS bonds and seasoned inflation swaps.

Unfortunately, at the moment the CME appears to be afraid of launching new products that might not immediately work. It wasn’t always that way – once, a CME official told me that since it cost them virtually nothing to list a contract, they favored launching lots of them and seeing what the market took to. This has changed, and the pendulum has swung in the opposite direction. Now, although many market participants are asking for these futures and there are market-makers willing to make markets, the CME is deferring a decision on them until later in the year. I remain hopeful that they will launch, because they are sorely needed.

Some Useful Charts And Thoughts About Personal Investing

I just finished a paper called “Managing Laurels: Liability-Driven Investment for Professional Athletes,” and I thought that one or two of the charts might be interesting for readers in this space.

An athlete’s investing challenge is actually much more like that of a pension fund than it is of a typical retiree, because of the extremely long planning horizon he or she faces. While a typical retiree at the age of 65 faces the need to plan for two or three decades, an athlete who finishes a career at 30 or 35 years of age may have to harvest investments for fifty or sixty years! This is, in some ways, closer to the endowment’s model of a perpetual life than it is to a normal retiree’s challenge, and it follows that by making investing decisions in the same way that a pension fund or endowment makes them (optimally, anyway) an athlete may be better served than by following the routine “withdrawal rules” approach.

In the paper, I demonstrate that an athlete can have both good downside protection and preserve upside tail performance if he or she follows certain LDI (liability-driven investing) principles. This is true to some extent for every investor, but what I really want to do here is to look at those “withdrawal rules” and where they break down. A withdrawal policy describes how the investor will draw on the portfolio over time. It is usually phrased as a proportion of the original portfolio value, and may be considered either a level nominal dollar amount or adjusted for inflation (a real amount).

For many years, the “four percent rule” said that an investor can take 4% of his original portfolio value, adjusted for inflation every year, and almost surely not run out of money. This analysis, based on a study by Bengen (1994) and treated more thoroughly by Cooley, Hubbard, and Walz in the famous “Trinity Study” in 1998, was to use historical sampling methods to determine the range of outcomes that would historically have resulted from a particular combination of asset allocation and withdrawal policies. For example, Cooley et. al. established that given a portfolio mix of 75% stocks and 25% bonds and a withdrawal rate of 6% of the initial portfolio value, for a thirty-year holding period (over the historical interval covered by the study) the portfolio would have failed 32% of the time for, conversely, a 68% success rate.

The Trinity Study produced a nice chart that is replicated below, showing the success rates for various investment allocations for various investing periods and various withdrawal rates.

Now, the problem with this method is that the period studied by the authors ended in 1995, and started in 1926, meaning that it started from a period of low valuations and ended in a period of high valuations. The simple, uncompounded average nominal return to equities over that period was 12.5%, or roughly 9% over inflation for the same period. Guess what: that’s far above any sustainable return for a developed economy’s stock market, and is an artifact of the measurement period.

I replicated the Trinity Study’s success rates (roughly) using a Monte Carlo simulation, but then replaced the return estimates with something more rational: a 4.5% long-term real return for equities (but see yesterday’s article for whether the market is currently priced for that), and 2% real for nominal bonds (later I added 2% for inflation-indexed bonds…again, these are long-term, in equilibrium numbers, not what’s available now which is a different investing question). I re-ran the simulations, and took the horizons out to 50 years, and the chart below is the result.

Especially with respect to equity-heavy portfolios, the realistic portfolio success rates are dramatically lower than those based on the “historical record” (when that historical record happened to be during a very cheerful investing environment). It is all very well and good to be optimistic, but the consequences of assuming a 7.2% real return sustained over 50 years when only a 4.5% return is realistic may be incredibly damaging to our clients’ long-term well-being and increase the chances of financial ruin to an unacceptably-high figure.

Notice that a 4% (real) withdrawal rate produces only a 68% success rate at the 30 year horizon for the all-equity portfolio! But the reality is worse than that, because a “success rate” doesn’t distinguish between the portfolios that failed at 30 years and those that failed spectacularly early on. It turns out that fully 10% of the all-equity portfolios in this simulation have been exhausted by year 19. Conversely, 90% of the portfolios of 80% TIPS and 20% equities made it at least as far as year 30 (this isn’t shown on the chart above, which doesn’t include TIPS). True, those portfolios had only a fraction of the upside an equity-heavy portfolio would have in the “lucky” case, but two further observations can be made:

1. Shuffling off the mortal coil thirty years from now with an extra million bucks in the bank isn’t nearly as rewarding as it sounds like, while running out of money when you have ten years left to lift truly sucks; and
2. By applying LDI concepts, some investors (depending on initial endowment) can preserve many of the features of “safe” portfolios while capturing a significant part of the upside of “risky” portfolios.

The chart below shows two “cones” that correspond to two different strategies. For each cone, the upper line corresponds to the 90th percentile Monte Carlo outcome for that strategy and portfolio, at each point in time; the lower line corresponds to the 10th percentile outcome; the dashed line represents the median. Put another way, the cones represent a trimmed-range of outcomes for the two strategies, over a 50-year time period (the x-axis is time). The blue lines represent an investor who maintains 80% in TIPS, 20% in stocks, over the investing horizon with a withdrawal rate of 2.5%. The red lines represent the same investor, with the same withdrawal rates, using “LDI” concepts.

While this paper concerned investors such as athletes who have very long investing lives and don’t have ongoing wages that are large in proportion to their investment portfolios (most 35-year-old investors do, which tends to decrease their inflation risk), the basic concepts can be applied to many types of investors in many situations.

And it should be.

All Men Are Mortal

Hugo Chavez, dictator of Venezuela and socialist extraordinaire, passed away on Monday in Caracas. The world will little note nor long remember what Chavez did for/to his country, and yet we care about his passing – not because of what he was, but because of what Venezuela could be and could have been.

I visited Venezuela in 1997 or so – pre-Chavez – when I was the main US fixed-income strategist for Bankers Trust. I had dinner with several members of the central bank, who said quite frankly that if they chose, they could easily pay off Venezuela’s external debt with their oil revenues. And that, mind you, was with oil prices around $20/bbl. It was also approximately the high point of Venezuelan production, which has fallen from 3mbpd to 2.4mpbd since then. Venezuela provides about 3% of the world’s supply of crude, despite the fact that it has among the biggest, if not the biggest, reserves of oil in the world. And yet, according to Capital Economics as cited by the Wall Street Journal, oil prices below $100/bbl could trigger a balance of payments crisis. The dictator milked his nation’s natural resources for billions upon billions – some of it went to “the people” in ways that were wasted by the typical inefficiencies of a socialist economy, and much of it to secure his own power.

It’s not quite as easy as saying that the next Presidente should develop Venezuela’s oil resources. Venezuela isn’t just a member of OPEC; it is a founding member of OPEC along with Iran, Iraq, Kuwait, and Saudi Arabia. So it isn’t as if the country can just start pumping wildly and change its fortunes through improved revenues. For the good of the country, most of what will need to happen under Presidentes in the future will be structural and expenditure-side. (Where have we heard that before?)

Accordingly, oil prices are likely to remain relatively undisturbed by this development, unless it appears that the next Presidente is a pure capitalist who plans to exit OPEC. Don’t hold your breath for that. In fact, to the extent that there is any unrest or confusion in the country because of a power vacuum, it might increase oil prices in the near-term. For now, Chavez’s vice president (Nicolas Maduro) will become president and a new president theoretically elected in thirty days. However, the history of Chavez, Maduro, and their party does not make most observers comfortable that this will necessarily happen in the way it is written in the Venezuelan constitution.

Meanwhile, Venezuela’s inflation is a hardly-worth-noticing 21.6%. They must have a really positive output gap, right? Of course, such inflation might have something to do with the fact that the money supply is up 600% since the end of 2007…nah, couldn’t be. The chart below (source Bloomberg, with my annotations) shows M2, GDP, and CPI for Venezuela, normalized to January 31, 2008 (just after a redenomination of old Bolivars into Bolivar Fuerte at 1000:1, which would have made the chart look screwy).

Notice a couple of things. First, notice that the huge money-printing has done nothing whatsoever to Venezuelan growth. Second, note that the huge money-printing has, however, drastically increased prices in Venezuela. Third, notice that the increase in prices has been similar in magnitude to the increase in money (technically, the increase in money divided by GDP, but as I said GDP didn’t move much) – which is just exactly what theory predicts, and what has been seen time and time again in hundreds of countries spanning scores of years.

This isn’t an instance of “hyperinflation;” rather there has been consistent inflation in the 20-35% per annum range since 2008. That’s high, but not so high that it’s completely divorced from our experience of the reaction of prices to monetary policy. It is, or should be, a precautionary lesson. As bad as Chavez’s mismanagement of the Venezuelan economy was, which helped produce the stinky growth, it was the mismanagement of the money supply that caused the inflation.

It is interesting, too, that since inflation tends to increase wealth inequality if the wealthy can own assets other than money, the inflation itself tended to keep the poor – the main constituency of a populist – in a position of greater need and greater reliance on the State. Increasing inequality and plausible deniability as to whether it is the leader’s policies that are creating that inequality: that’s a delicious cocktail if the leader has a desire to hold and increase his power.

So we take notice of Chavez’s passing, for its potential impact on oil markets but even more for the opportunity it gives us to reflect on the lessons we could have, and should have, learned from the operation of his regime.

Gold, and Dilemmas

At the start of another Employment week, the same refrain echoes: higher equity markets, soft commodities markets (because changes in China’s policies will hurt the demand for commodities…but I suppose that it will not hurt the profitability of U.S. shares?), and continued negative news from Europe that is mostly ignored during Employment week.

Actually, maybe the news from Italy is being mostly ignored here because it is hard for Americans to truly fathom what is going on. Remember that the basic issue is that a majority of Italians voted for one or another party that favored ending austerity measures and/or leaving the Euro, but left no single party controlling both houses of parliament. Until this morning, it appeared that no single party would be able to form a government, which meant that a new election would likely be called soon. But now it appears that the Five Star Movement (Beppe Grillo’s party) is offering to stage a walk-out from the senate. Now, that sounds negative, right? Well, actually it’s progress (and Grillo’s party would have to be given some policy concessions in exchange for walking out, which sounds like “lovely parting gifts” to me) since Five Star doesn’t have enough delegates to prevent a quorum from being established if they leave (with no quorum, the body cannot conduct business) but their absence would allow a majority to be established on a lower number.

In the U.S., the approach would be different: the Senators would reach a deal and then vote on the deal, with no one having to manipulate the process in an arcane Robert’s-Rules-of-Order fashion. On the other hand, they had a senate in Rome about 2,500 years before we had one, so who are we to question their parliamentary process?! And our institutions are no less clownish at times…such as right now, since despite so many dire threats the world apparently did not end over the weekend once the budgetary sequester went into effect.

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Since the markets were quiet today (and likely will remain relatively quiet until the Employment report on Friday, if recent patterns hold true), I thought I’d take up a topic I’ve been meaning to discuss for a while: a look at the relative value of gold and a link to an interesting new paper on gold.

First, let me say that our systematic metals and mining strategy is currently approximately neutral-weight on gold itself, overweight on industrial metals, and deeply underweight on mining stocks. But that strategy relies on metrics I am not discussing here; nothing, moreover, that I discuss here should be taken as an indication of whether Enduring Investments would suggest an investor should add or subtract to his or her particular exposure.

Disclaimer completed, let’s look at the yellow metal relative to other assets, as I first did in this space back in August of 2010 when I concluded that gold did not look particularly overvalued. Gold subsequently rallied another 60%, then slid (in case you haven’t heard!). It is currently still 30% above where it was in August of 2010. So is it overvalued?

Some observers have noted that the ‘real price of gold’ (that is, gold deflated by the current price level) has recently risen to levels not seen since the peak of the gold market in the early 1980s (see chart, source Bloomberg, which shows gold in constant December 2012 dollars).

This is true, of course, but measuring the ‘real’ price of gold is a funny concept. The gold price relative to the cost of the consumption basket is a metric that has meaning, because it tells you how much consumption you displace to buy an ounce of gold, but unless you’re evaluating the consumption of gold I am not sure that’s a relevant metric.

On the other hand, it makes more sense to me to look at investments relative to gold, since that’s what is likely to be displaced by a purchase of gold. Some of these relationships are not particularly useful analytically, though, or at least appear at first blush not to be. For example, looking at gold versus the stock market (see chart, source Bloomberg) you can’t tell very much except that gold was rich or stocks were cheap (or both) in 1980 and gold was cheap or stocks were rich (or both) in 2000. Or, so I wrote in 2010.

However, I subsequently noticed another chart that looked somewhat similar. Below (source: Enduring Investments) I have put the data from the chart above alongside a measure of the volatility of inflation expectations, as taken from the Michigan Sentiment Survey. (As I’ve written previously, surveys of sentiment are not satisfying ways to measure true inflation expectations, but they’re all we’ve got and they might nevertheless be valuable in measuring the volatility of inflation expectations, which is what we’re trying to do here).

The notion is this: when inflation expectations are becoming both lower and more stable, then stocks become more valuable and gold less so as an investment item. But, when inflation expectations are rising and/or becoming less-stable, then stocks become less valuable and gold more so as an investment item. I haven’t worked very carefully to refine this relationship, but the Michigan series begins in 1978 so that’s the main limitation. Yet, without any lags nor tweaking of period lengths, the R-squared here (on levels, not changes) is 0.745, which is firmly in the “interesting” category.

Having said that, unless we’re able to forecast the volatility of inflation this isn’t particularly helpful in assessing whether gold is rich or cheap relative to stocks (although on the regression, not shown, the ratio of gold/S&P is 1.04 but ought to be more like 1.07, so gold looks slightly cheap to stocks). The main thing we can do with this is explain why gold prices have risen relative to stock prices over the last decade, and it makes sense. In this context, the recent slide in gold/rally in stocks can be attributed to a soothing, perhaps temporary, in consumers’ concerns about inflation.

The champion relationship, although less creative, is the ratio of gold to crude. Over a long period of time, an ounce of gold has bought between 15 and 20 barrels of crude oil (West Texas Intermediate), with occasional spikes wider and at least one lengthy period between 7 and 12. The chart below (source: Bloomberg) shows this classic relationship. It makes some sense that two hard commodities, both exchange traded and having no natural real return to them, ought to broadly parallel each other over time. Again, this isn’t a very good trading relationship but it is a decent sanity check.

By this measure, gold is approximately at fair value, although an argument could be made that WTI is no longer the fair price for crude. In terms of Brent Crude, Gold is only 14.3 barrels and so arguably slightly cheap.

None of this will delight the gold bulls, but it also won’t delight the gold bears. Gold, at least the way I look at it, seems to me to be somewhere between slightly cheap to roughly fair value versus a pair of comparables. Of course, it may be that stocks and crude oil are slightly expensive, on the other hand!

Gold bulls and bears also will both find things to like and things to dislike in a paper by Erb and Harvey called “The Golden Dilemma.”  Given that gold bulls tend to be more, er, passionate about the subject, they will likely be more strident in their disagreements but it is a capable attempt to tackle many of the well-known arguments for owning gold and put them to logical and empirical test.

These gentlemen (who have some serious chops in commodities research) conclude that as an inflation hedge, gold is (1) not an effective short-term hedge, (2) not an effective long-term hedge, (3) might be effective over the very, very, very long-term, and (4) probably effective in a hyperinflationary situation. Although this depends somewhat on your meaning of “hedge,” I concur that gold is not a hedge. It can, with some work, be made into a smarter hedge, which works better (especially in conjunction with other metals, and mining stocks). But they make a fairly powerful argument that if there’s even a teensy chance that hyperinflation happens, a high gold price can be rational since the tail of an option contributes quite a bit to its value.

Incidentally, a slide-show version of the paper is here and is pretty good even if you didn’t read the paper.

A Bad Day At The Federal Reserve

There will be many more days ahead for the Fed, and many of them will have plenty of good news. It is a mistake to trya and read too much into one day’s economic releases. With that said, here is my attempt to do exactly that.

I tweeted the following real-time reactions (@inflation_guy) following the CPI release this morning:

• Ready for an exciting day…CPI, Claims, Philly Fed, a 30-year TIPS auction, wild commodity swings, 3 Fed Presidents…buckle up!
• Hello! Core inflation +0.3%, higher-than-expected. Look out above.
• Apparel +0.8%. Some will pooh-pooh the number on that basis, but Apparel has been trending higher for more than a year.
• To be fair, core inflation BARELY rounded up to +0.3%. But the market was looking for +0.16% or +0.17%.
• Core Services remains at +2.5% y/y, but core goods ticks up to +0.4%. The recovery of core goods has been something we’re looking for.
• Somewhat surprisingly, the +0.251% rise in core inflation did so without having a rise in Owners’ Equiv Rent. Went from 2.1% y/y to 2.08%
• Accel Inflation: Housing, Apparel, Educ/Commun, Other (54.7% of basket); Decel: Food/Bev, Transp, Med Care, Rec (45.3% of basket)
• In Transp, the drag was almost all fuel. New/used Cars, maintenance, insurance, airline fares, inter- and intracity transp all up.
• What’s amazing in the CPI today is how much it did with how little from the main driver of housing. That uptick is yet to come.
• …and, next month, headline will get upward pressure from the steep rise in gasoline, which also dampens discretionary spending.

The primary takeaway from the CPI release is this: yes, core inflation surprised a little bit on the high side. But it did so without the support of the main factor that I think will push core inflation almost certainly higher going forward: housing. Rents (both primary and OER) neither accelerated nor decelerated this month from the prior year-on-year pace. And yet, there is really no temporary factor that pushed inflation higher this month. It was fairly broad-based. Apparel stood out on the month-to-month change perspective, but here is the chart (source Bloomberg) on Apparel:

This month doesn’t appear to me as too much of a true outlier. The underlying dynamic there has simply changed.

So this month core inflation stayed at 1.9%; next month it is very likely to return to 2.0% as we are dropping off the weak February change from last year. And all of that, before the housing inflation hits the data.

Speaking of housing inflation, there is no sign yet of that abating. In today’s Existing Home Sales report, the year-on-year change in Median Existing Home Sales Prices rose to 12.61%, another post-2005 record, and the highest real price increase ever, outside of 2005. This is happening because the inventory of new homes has dropped to almost a record low – really! Sure, the chart below (source Bloomberg) ignores “shadow inventory,” but it is starting to look more like the inventory of new homes now.

Some of that is seasonal, but there’s no doubt that lower inventories are now helping the home pricing dynamic. And, as I’ve shown previously, the inventory of existing homes actually has a nice relationship with shelter inflation 1-2 years later (Source: Enduring Investments):

The current level of inventories translates into a 3.6% expected rise in CPI-Shelter over the course of 2014. So you see, we’re not only firing inflationary rounds but we’re also continuing to feed more ammunition into the gun for next year. Our model of housing inflation projects Owners’ Equivalent Rent no lower than 3% by year-end 2013. And if that happens, there is no way that overall core inflation is going to be at 2%.

Now, in addition to the bad news on prices and the news on home prices that are probably seen at the Fed as a guarded positive (after all, it means the mortgage crisis is essentially over as more borrowers will be ‘above water’ again every month hereafter), there was also a mild surprise on the high side from Initial Claims (362k versus 355k) and a bad miss on the Philly Fed index for February. This latter was expected at +1.0 after -5.8 last month; instead it dropped to -12.5. Philadelphia-area manufacturers have reported softening business conditions in three of the last four months, suggesting that December’s pop to +4.6 was the outlier. Now, there were similar one-month dips in August of 2011 and June of 2012, so we’ll have to see if it is sustained…but it is consistent with the report out of Wal-Mart and the worsening of business conditions in Europe.

Higher prices (and more coming, on the headline side, as retail gasoline prices have now risen in 35 consecutive days) and lower business activity. This is exactly the opposite of what the Fed wants. It has been a bad day at the Fed.

However, it is exactly what traditional monetarism expects: accommodative monetary policy leads to higher prices (check), and has no effect on real activity in the absence of money illusion (check). So score one point for Friedman today.

And so, what else would you expect after such a day? Bond yields are declining, inflation breakevens are narrowing, and industrial commodities (metals and energy) are sliding. As with so much else these days, that makes no sense, unless you just don’t know what’s going on. When we encounter these bouts with irrationality (or, more fairly, thick-headedness), the market can be frustrating for a long time – and the ultimate denouement can sometimes be jarring. As I said earlier in this post: buckle up!

 

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).

Dropping the Anchor

The S&P managed to hit the seemingly-important 1,500 level today, before fading to close unchanged. The market took heart early from the print of Initial Claims at 330k. This is of course good news, although some blame may be due to the holiday-shortened week (the BLS had to estimate claims for some states, including California, which were unable to submit their figures in time) and the still-volatile seasonal pattern. Traditionally, this is the week I start paying attention to ‘Claims, but each subsequent number matters more than the last. I’d love to hear that the post-holiday layoffs weren’t as significant as they usually are, implying that more ‘seasonal’ workers are being retained. I’m skeptical of it, though, until we see a few more weeks of such evidence or confirmation in the survey numbers.

This is a good time to remember that economic data aren’t “right” or “wrong”; they are experiments, like taking the heights of five random motorists and trying to guess the average height of the people who drive on a particular freeway. We never know the true underlying state of the economy, or the true underlying trend rate of any particular economic datum. We come into an economic release with a null hypothesis, and that hypothesis may either be rejected or not rejected (economic data can never really confirm your hypothesis, but they can support your hypothesis). It is for this reason that I ignore the first few Initial Claims figures of the new year. The error bars on them are so wide that it is almost impossible to reject any halfway-rational null hypothesis. Once we have seen a couple more Claims figures in this range, or gotten support for the notion of an improving job market from Consumer Confidence figures (for example), it will be easier to reject the null hypothesis that the economy is still bumping along in a nearly-jobless recovery.

Also today, the TIPS auction produced strong results despite the fact that the market never priced in a ‘concession’ for the size. At 1:00ET, the bid in the market was -0.62%, but the U.S. Treasury sold $15bln at a lower yield (higher price) of -0.63%. Moving $15bln in size without hitting the bid is a fair sign of hunger in the inflation market.

And why shouldn’t there be hunger? If you think the economy is heating up, you can’t really short bonds unless you want to sell them and hope the Fed is just about done buying. But the Fisher equation says:

(1+n)=(1+r)(1+i)(1+p), which we usually simplify to say

Nominal rates = real rates + expected inflation

If the Fed is holding nominal rates constant, and investors are expecting inflation to rise as growth heats up (note: I am not changing my view that these are unrelated…I’m merely observing how investors behave in the market), then TIPS ought to stay comparatively well-bid because investors will buy breakevens as the bearish trade, rather than selling Treasuries in a Quixotic attempt to outlast the Fed. I think breakevens and inflation swaps, which remain near the highest levels since 2006 (in the 10-year sector) and near the highest levels since there have been TIPS, are going to remain pretty well bid.

The last data of the week are the New Home Sales (Consensus: 385k from 377k) from December. The forecast is for the highest level of sales in several years, and the biggest hurdle seems to be that inventories of homes remain very low.

One quick observation about home prices and “inflation expectations” that is interesting. Pollster Rasmussen reported today that 29% of Americans expect their home’s value to rise over the next year. While this is close to the highest levels the survey has recorded (it was only started in April 2010), it is strikingly low considering that both new and existing home sales prices are up at a double-digit pace over the last year, and even the slower-moving Case-Shiller index has home prices up at over twice the rate of core inflation (4.31% as of October, the last available data, with next week’s release expected to be 5.6%). The point simply being this: the Federal Reserve relies mightily on the assumption that inflation cannot really get started when inflation expectations are well-anchored. But nowhere are inflation expectations better anchored, probably, than in home prices – and yet, home prices are rising at something not far away from the peak rates of a couple of years ago.

That’s something to think about. Maybe it’s time that the Fed dropped the whole notion of anchored inflation expectations, which no one has ever demonstrated since there are no good measures of consumer inflation expectations. The idea of an inflation-expectations anchor was developed to explain why inflation did not accelerate in the 1990s even while the economy did, causing previously-estimated models to breakdown. There are other explanations that don’t require positing an anchor that cannot be measured (for example, the private/public debt ratio plays an important role in my company’s models), but the imaginations of the academic community became…well…anchored to the idea. It’s time to drop that anchor…at least until we develop a way to measure those expectations, and then to test the idea.

Greed Over Fear?

Desperation is unattractive, and desperate greed – needing to have a big return, quickly – is dangerous when it comes to investing. But investors appear to be getting increasingly desperate to swing for home runs rather than to try for singles and doubles, if the increased stampeding of retail investors’ monies into equities is any indication. Again today, stocks rallied steadily for most of the day. As the S&P reaches a new 5-year high with every advance, and is not terribly far away from an all-time (not inflation-adjusted) high, investors are increasingly throwing caution to the wind and plunging back in to stocks. Blackrock’s CEO, Larry Fink, observed today that “…the move back into equities is one of the mega trends we witnessed in the fourth quarter, and that has continued into the first 15, 16 days of the year.”

According to Fink, investors are doing this because of disdain for bond returns, not because of a desire to go “risk on.” And yet, risk-on they are going. They are going risk-on with corporate margins at post-WWII highs and following a Q4 that will be exaggerated by the tax-related movement of income from Q1 into Q4 (for example, via the payment of special dividends), and a Q1 that will end up looking weaker than the underlying fundamentals really are. Are these desperate investors ready to see a few months of weak data when they’re buying in at the highs?

Today’s data offered both the good and the bad. The good was the December Housing Starts number, which achieved the highest level since 2008 (see chart, source Bloomberg). To be sure, building activity is nowhere near the levels that were common in the 1980s, 90s, and 00s, but it is recovering. This should continue, as the inventory of new homes is at a very low level. The bad was the January Philly Fed index, which was expected to rise but which instead declined. The index of current conditions (at -5.8%) is the worst for a January since 2009.

Much was made of the sharp decline in the Initial Claims figure, which was expected at 369k but instead came in at 335k. My advice is to ignore any Claims figure in the second half of December until late January, as the seasonal adjustment factors are actually much larger than the net number – that is, the report should have a huge error bar around the weekly number, which is a seasonally-adjusted figure. If this is why stocks rocketed higher, then the desperation is even more disturbing. No one ought to ever invest on the basis of a weekly economic number.

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After yesterday’s CPI report, I expected to see a number of denunciations of “inflation-phobes,” and I was not disappointed. David Wessel’s column in the Wall Street Journal was one example. Although Wessel came to the wrong conclusion (he agreed with Bernanke that there isn’t “much evidence” that the monetary policy of the last several years is going to be inflationary), at least he did undertake to “weigh…arguments on the other side.”

But he almost lost me straightaway, when he said that “the link between the money supply and the inflation rate is hard to discern in data…” Take a look at the chart below (source: Enduring Investments) and tell me if it’s really hard to discern the link in the data.

Oh, and on a longer-term basis there is this, which I wrote about in this great article.

What is hard to discern in the data is any link between inflation and growth, other than the spurious one that comes from the fact that the 2008 crisis was caused by an implosion of housing prices, which then impacted core inflation with a lag. (See chart, source Bloomberg)

Or, more consonant with the NAIRU theory, any link between the unemployment rate and core inflation (see chart, source Bloomberg).

This last chart is fun. If you run core CPI as a function of the unemployment rate from 2000-2012, you get a good correlation that looks like the right thing. But again, it’s spurious: if you look at the same relationship from 1990-2000, you also get a good correlation…but exactly the opposite slope to the relationship (that is, implying that lower unemployment causes lower inflation). Showing them both together makes the point that…you can’t see much in this data.

These latter two relationships are absolutely accepted without question in large swaths of the economics profession, such as when Wessel argues that “it would be difficult to spark and sustain inflation with so many unemployed workers, empty stores and offices and underused factories.” Where does he see that in the data?

I shouldn’t be so hard on Mr. Wessel, because he does make a reasonable effort to give some arguments about why people fear that the Fed will either intentionally or unintentionally make a mistake. But I think his best argument is one that he doesn’t make on purpose: policymakers and many economists just don’t understand what inflation is and how it works, and that creates a very high likelihood of error in the future. Moreover, they not only don’t understand, but they greatly overestimate their degree of understanding. I recognize, as an investor, trader, and economist, that there is some chance that my forecasts are wrong. Furthermore, since I understand that overconfidence is a very common cognitive error, I even recognize that I am most likely underestimating the chances that I am wrong. As a consequence, I am very conservative with my approach to investment when the consequences of an error are very high. Most good investors are very wary of overconfidence.

No such wariness afflicts the economic profession, unfortunately, especially at one particular address on Constitution Avenue Northwest in Washington, DC.