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Inflation-Related Impressions from Recent Events

September 10, 2018 2 comments

It has been a long time since I’ve posted, and in the meantime the topics to cover have been stacking up. My lack of writing has certainly not been for lack of topics but rather for a lack of time. So: heartfelt apologies that this article will feel a lot like a brain dump.

A lot of what I want to write about today was provoked/involves last week. But one item I wanted to quickly point out is more stale than that and yet worth pointing out. It seems astounding, but in early August Japan’s Ministry of Health, Labour, and Welfare reported the largest nominal wage increase in 1997. (See chart, source Bloomberg). This month there was a correction, but the trend does appear firmly upward. This is a good point for me to add the reminder that wages tend to follow inflation rather than lead it. But I believe Japanese JGBis are a tremendous long-tail opportunity, priced with almost no inflation implied in the price…but if there is any developed country with a potential long-tail inflation outcome that’s possible, it is Japan. I think, in fact, that if you asked me to pick one developed country that would be the first to have “uncomfortable” levels of inflation, it would be Japan. So dramatically out-of-consensus numbers like these wage figures ought to be filed away mentally.

While readers are still reeling from the fact that I just said that Japan is going to be the first country that has uncomfortable inflation, let me talk about last week. I had four inflation-related appearances on the holiday-shortened week (! is that an indicator? A contrary indicator?), but two that I want to take special note of. The first of these was a segment on Bloomberg in which we talked about how to hedge college tuition inflation and about the S&P Target Tuition Inflation Index (which my company Enduring Investments designed). I think the opportunity to hedge this specific risk, and to create products that help people hedge their exposure to higher tuition costs, is hugely important and my company continues to work to figure out the best way and the best partner with whom to deploy such an investment product. The Bloomberg piece is a very good segment.

I spent most of Wednesday at the Real Return XII conference organized by Euromoney Conferences (who also published one of my articles about real assets, in a nice glossy form). I think this is the longest continually-running inflation conference in the US and it’s always nice to see old friends from the inflation world. Here are a couple of quick impressions from the conference:

  • There were a couple of large hedge funds in attendance. But they seem to be looking at the inflation markets as a place they can make macro bets, not one where they can take advantage of the massive mispricings. That’s good news for the rest of us.
  • St. Louis Fed President James Bullard gave a speech about the outlook for inflation. What really stood out for me is that he, and the Fed in general, put enormous faith in market signals. The fact that inflation breakevens haven’t broken to new highs recently carried a lot of weight with Dr. Bullard, for example. I find it incredible that the Fed is actually looking to fixed-income markets for information – the same fixed-income markets that have been completely polluted by the Fed’s dominating of the float. In what way are breakevens being established in a free market when the Treasury owns trillions of the bonds??
  • Bullard is much more concerned about recession than inflation. The fact that they can both occur simultaneously is not something that carries any weight at the Fed – their models simply can’t produce such an outcome. Oddly, on the same day Neel Kashkari said in an interview “We say that we have a symmetric view of inflation. We don’t mind if it’s 2.1 or 1.9, but in our practice, in what we actually do, we are much more worried about high inflation than we are low inflation. And I think that that is the scar from the 1970s.” That’s ludicrous, by the way – there is no way in the world that the Fed would have done the second and third QEs, with the recession far in the rear view mirror, if the Fed was more concerned with high inflation. Certainly, Bullard showed no signs of even the slightest concern that inflation would poke much above 2%, much less 3%.
  • In general, the economists at the conference – remember, this is a conference for people involved in inflation markets – were uniform in their expectation that inflation is going nowhere fast. I heard demographics blamed (although current demographics, indicating a leftward shift of the supply curve, are actually inflationary it is a point of faith among some economists that inflation drops when the number of workers declines. It’s actually a Marxist view of the economic cycle but I don’t think they see it that way). I heard technology blamed, even though there’s nothing particularly modern about technological advance. Economists speaking at the conference were of the opinion that the current trade war would cause a one-time increase in inflation of between 0.2%-0.4% (depending on who was speaking), which would then pass out of the data, and thought the bigger effect was recessionary and would push inflation lower. Where did these people learn economics? “Comparative advantage” and the gain from trade is, I suppose, somewhat new…some guy named David Ricardo more than two centuries ago developed the idea, if I recall correctly…so perhaps they don’t understand that the loss from trade is a real thing, and not just a growth thing. Finally, a phrase I heard several times was “the Fed will not let inflation get out of hand.” This platitude was uttered without any apparent irony deriving from the fact that the Fed has been trying to push inflation up for a decade and has been unable to do so, but the speakers are assuming the same Fed can make inflation stick at the target like an arrow quivering in the bullseye once it reaches the target as if fired by some dead-eye monetary Robin Hood. Um, maybe.
  • I marveled at the apparent unanimity of this conclusion despite the fact that these economists were surely employing different models. But then I think I hit on the reason why. If you built any economic model in the last two decades, a key characteristic of the model had to be that it predicted inflation would be very low and very stable no matter what other characteristics it had. If it had that prediction as an output, then it perfectly predicted the last quarter-century. It’s like designing a technical trading model: if you design one that had you ‘out’ of the 1987 stock market crash, even if it was because of the phase of the moon or the number of times the word “chocolate” appeared in the New York Times, then your trading model looks better than one that doesn’t include that “factor.” I think all mainstream economists today are using models that have essentially been trained on dimensionless inflation data. That doesn’t make them good – it means they have almost no predictive power when it comes to inflation.

This article is already getting long, so I am going to leave out for now the idea I mentioned to someone who works for the Fed’s Open Market Desk. But it’s really cool and I’ll write about it at some point soon. It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.

So I’ll move past last week and close with one final off-the-wall observation. I was poking around in Chinese commodity futures markets today because someone asked me to design a trading strategy for them (don’t ask). I didn’t even know there was such a thing as PVC futures! And Hot Rolled Coils! But one chart really struck me:

This is a chart of PTA, or Purified Terephthalic Acid. What the heck is that? PTA is an organic commodity chemical, mainly used to make polyester PET, which is in turn used to make clothing and plastic bottles. Yeah, I didn’t know that either. Here’s what else I don’t know: I don’t know why the price of PTA rose 50% in less than two months. And I don’t know whether it is used in large enough quantities to affect the end price of apparel or plastic bottles. But it’s a pretty interesting chart, and something to file away just in case we start to see something odd in apparel prices.

Let me conclude by apologizing again for the disjointed nature of this article. But I feel better for having burped some of these thoughts out there and I hope you enjoyed the burp as well.

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Gold Has Barely Beaten Inflation, and That’s About Right

July 19, 2018 1 comment

Okay: I’ve checked my door locks, made sure my kids are safe, and braced myself for the inevitable incendiary incoming comments. So, I feel secure in pointing this out:

Gold’s real return for the last 10 years has been a blistering 1.07% per year. And worse, that’s higher than you ought to expect for the next 10 years.

Here’s the math. Gold on July 19, 2008 was at $955. Today it is at $1223, for a gain of 28.1%. But the overall price level (CPI) was at 218.815 in June 2008, and at 251.989 in June 2018 (we won’t get July figures for another month so this is the best we can do at the moment), for a 15.2% rise in the overall price level.

1.07% = [(1+28.1%) / (1 + 15.2%)] ^ 0.1 – 1

It might be even worse than that. Gold bugs are fond of telling me how the CPI is manipulated and there’s really so much more inflation than that; if that’s so, then the real return is obviously much worse than the calculation above implies.

Now, this shouldn’t be terribly surprising. You start with a pile of real stuff, which doesn’t grow or shrink for ten years…your real return is, at least in units of that real stuff, precisely 0%. And that’s what we should expect, in the very long run, from the holding of any non-productive real asset like a hard commodity. (If you hold gold via futures, then you also earn a collateral return of course. And if you hold warehouse receipts for physical gold, in principle you can earn lease income. But the metal itself has an a priori expected real return of zero). Indeed, some people argue that gold should be the measuring stick, in which case it isn’t gold which is changing price but rather the dollar. In that case, it’s really obvious that the real return is zero because the price of gold (in units of gold) is always 1.0.

So, while everyone has been obsessing recently about the surprisingly poor performance of gold, the reality is that over the longer time horizon, it has done about what it is supposed to do.

That’s actually a little bit of a coincidence, deriving from the fact that at $955 ten years ago, gold was reasonably near the fair price. Since then, gold prices soared and became very expensive, and now are sagging and getting cheaper. However, on my model gold prices are still too high to expect positive expected returns over the next decade (see chart, source Enduring Intellectual Properties).

The ‘expected return’ here is derived from a (nonlinear) regression of historical real prices against subsequent real returns. To be sure, because this is a market that is subject to immense speculative pressure both in the bull phases and in the bear phases, gold moves around with a lot more volatility than the price level does; consequently, it swings over time from being very undervalued (1998-2001) to wildly overvalued (2011-2013). I wouldn’t ever use this model to day-trade gold! However, it’s a useful model when deciding whether gold should have a small, middling, or large position in your portfolio. And currently, despite the selloff, the model suggests a small position: gold is much more likely to rise by less than the price level over the next decade, and possibly significantly less as in the 1980-1990 period (although I’d say probably not that bad).


DISCLOSURE: Quantitative/systematic funds managed by Enduring Investments have short positions in gold, silver, and platinum this month.

Categories: Commodities, Gold, Investing

Tariffs Do Not Cause Price Declines

July 5, 2018 6 comments

Adding to a good’s price does not make its price decline.

It’s worth repeating that a couple of times, because it seems to be getting lost in the discussion about tariffs – in particular, in the discussion about tariffs levied on US commodities. Grains prices have been plummeting, as the chart below showing front corn and soybean prices (source: Bloomberg) illustrates.

There are many reasons that grains prices may be declining, but if “tariffs have been levied on US production” is one of them then there is some really weird economics happening. Corn and soybeans are commodities. Specifically, this means that they are essentially fungible – corn from site “A” is essentially the same as corn from site “B.” So what does this mean for the results of a tariff?

If China stops buying soybeans from the US altogether, it means that unless they’re going to stop eating soybeans they will buy soybeans from Brazil. But if Brazil sells all of their soybeans to China, it means that Germany can no longer soybeans from Brazil. So where does Germany buy its soybeans from? Well, it seems that the US has beans that are not spoken for in this scenario…in other words, when we are talking about commodities a tariff mostly just reorganizes the list of who is buying from whom. If soybean prices are falling because China isn’t buying our soybeans, it means a great deal for Russia or Germany or whoever else is going to buy beans from us instead of from China’s new supplier. More than that, if global soybeans prices are falling because of tariffs then it means that everyone is getting cheaper soybeans because China is changing who they’re buying from. If that’s the case, then we really need to slap tariffs on everything and watch prices decline!

Let’s go back to elementary microeconomics. Adding a tariff is reflected in our product market supply and demand curves as a shift in the supply curve to the left: the quantity that producers are willing to supply at any price declines, because the price to the producer declines. Put a different way, the market price required to induce any particular quantity supplied rises by the amount of the tariff. Now, whether that causes market prices to rise a lot or a little, or quantity supplied to fall by a lot or a little, depends on the elasticities of supply and demand. If demand if fairly inelastic (which seems reasonable – you may be able to substitute for “beans” but it’s hard to substitute for “grains”), then you will see more of a price response than a quantity response, at least in the short run where the supply of beans is fairly inelastic. But that price response is up, not down.

By the way, this gets a little hard to illustrate with supply and demand curves, because with a tariff what you have are now two separate markets and separate prices for the same good. This is what confuses some people – if China is no longer buying from the US, doesn’t that mean that demand for US beans has declined, and therefore prices should decline? The crucial point is that we are talking here about commodity goods, and supplies are fairly interchangeable. If we are talking about Harley Davidson motorcycles, the answer is different because if Europe stops buying Harleys, they have to buy a different product altogether. In that case, the global price of “motorcycles” might be relatively unaffected, but the price of Harleys will rise (and the output decline) relative to other motorcycles. So, a tariff on Harley-Davidson motorcycles definitely hurts the US, but a tariff on soybeans – or even “US soybeans” since that is not a universal distinction – should have virtually no effect on US producers. And certainly, no effect on the global price of soybeans.

There are other reasons that grains prices may be declining. Since Brazil is a major producer of beans, the sharp decline in the Brazilian Real has pushed the US dollar price of beans lower (see chart, source Bloomberg). In the chart below, the currency is shown in Reals per dollar, and inverted. This is a much more important factor explaining the decline in grains prices, as well as one that could easily get worse before it gets better.

I think the discussion of the effects of tariffs has gotten a bit polluted since the decline in grains seems to coincide with the announcement of tariffs from China. I think the price decline here has fed that story, but it’s bad economics. Piecemeal tariffs on commodity products are not likely to appreciably change the supply and demand outcome, although it will result in rearranging the sources of product for different countries. Tariffs on non-commodity product, especially branded products with few close substitutes, can have much larger effects – although we ought to remember that from the consumer’s perspective (and in the measurement of consumer inflation), tariffs never lower prices faced by consumers although they can lower prices received by producers. This is why tariffs are bad – they cause higher prices and lower output, and the best case is no real change.


DISCLOSURE: Quantitative/systematic funds managed by Enduring Investments have both long and short positions in grains, and in particular long positions in Beans and Corn, this month.

Potpourri for $500, Alex

June 1, 2018 5 comments

When I don’t write as often, I have trouble re-starting. That’s because I’m not writing because I don’t have anything to say, but because I don’t have time to write. Ergo, when I do sit down to write, I have a bunch of ideas competing to be the first thing I write about. And that freezes me a bit.

So, I’m just going to shotgun out some unconnected thoughts in short bursts and we will see how it goes.


Wages! Today’s Employment Report included the nugget that private hourly earnings are up at a 2.8% rate over the last year (see chart, source Bloomberg). Some of this is probably due to the one-time bumps in pay that some corporates have given to their employees as a result of the tax cut, and so the people who believe there is no inflation and never will be any inflation will dismiss this.

On the other hand, I’ll tend to dismiss it as being less important because (a) wages follow prices, not the other way around, and (b) we already knew that wages were rising because the Atlanta Fed Wage Tracker, which controls for composition effects, is +3.3% over the last year and will probably bump higher again this month. But the rise in private wages to a 9-year high is just one more dovish argument biting the dust.

As an aside, Torsten Slok of Deutsche Bank pointed out in a couple of charts today that one phenomenon of recent years has been that people staying in the same jobs increasingly see zero wage growth. Although this is partly because wage growth in general has been low, the spread between wage growth for “job switchers” and “job stayers” is now about 1.25% per year, the highest rate in about 17 years. His point is that as we see more switchers due to a tight labor market, that implies more wage growth (again, the Atlanta Fed Wage Growth Tracker does a better job, so this just means average hourly earnings should increasingly converge with the Atlanta Fed figure).


Today I was on the TD Ameritrade Network and they showed a chart that I’d included in our Quarterly Inflation Outlook (which we distribute to customers). I tweeted the chart back on May 22 but let me put it here, with some brief commentary lifted from our quarterly:

“As economic activity has started to absorb more and more unemployed into the workforce, a shortage has developed in the population of truck drivers. This shortage is not easy to overcome, since it takes time to train new truck drivers (and the robo-truck is still no more than science fiction). Moreover, recent advances in electronically monitoring the number of hours that drivers are on the road – there have been rules governing this for a long time, but they relied on honest reporting from the drivers – have artificially reduced the supply of trucker hours at just the time when more were needed because of economic growth…As a result of this phenomenon, total net-of-fuel-surcharge truckload rates are 15% higher than they were a year ago, which is the highest rate of increase since 2004. As the chart (source: FTR Associates and BLS) illustrates, there is a significant connection between truckload rates lagged 15 months and core inflation (0.74 correlation).”

According to FTR Transportation Intelligence, the US is short about 280,000 truck drivers compared to what it needs.


Remember when everyone said Europe was about to head back into deflation, thanks to that surprise dip in core inflation last month? Here is what I had to say about that on my private Twitter feed (sign up here if this stuff matters to you) at the time.

As Paul Harvey used to say, the rest of the story is that core European CPI printed this month at 1.1%, shocking (almost) everyone for a second month.


I had a conversation recently with a potential client who said they didn’t want to get into a long-commodity strategy because they were afraid of chasing what is hot. It’s a reasonable concern. No one wants to be the pigeon who bought the highs.

But some context is warranted. I didn’t want to be impolite, but I pointed out that what he was saying was that in the chart below, he was afraid it was too late to get on the orange line because it is too hot.

Incidentally, lest you think that I chose that period because it flatters the argument…for every period starting June 30, XXXX and ending June 1, 2018, the orange line is appreciably below the white line and has never been meaningfully above it, for XXXX going back to 2002. For 2002-2011, the two indices shown here were pretty well correlated. Since 2011, it has been a one-way underperformance ticket for commodities. They are many things, but “hot” is not one of them!

I haven’t heard back.

Being Closer to the ‘Oh Darn’ Inflation Strike

April 19, 2018 5 comments

The time period between spikes of inflation angst seems to be shortening. I am not sure yet about the amplitude of those spikes of angst, but the concern seems to be quickening.

This is not without reason as it seems that concerning headlines are occurring with more frequency. This week the Bloomberg Commodity Index again challenged the 2016 and 2017 highs before backing off today (see chart, source Bloomberg).

Somewhat more alarming than that, to people who watch commodities, is how the commodity indices are rallying. The culprits are energy as well as industrial metals, and each has an interesting story to tell. Energy has been rallying partly because of global tensions, but also partly because US shale oil production appears to be running into some bottlenecks on production (wages, shortages of frack sand) as well as delivery (capacity constraints on pipelines), and part of what has kept a lid on energy prices over the last couple of years was the understanding that shale oil production was improving rapidly and becoming lots more efficient due to improved technology. If shale is limited, the ‘lid’ on prices is not as binding as we had thought. On industrial metals, some of the upward pressure has been due to fallout from US sanctions on Rusal, a major supplier of aluminum and alumina. Since those sanctions were announced, aluminum prices have risen around 25%, and alumina (a raw input to aluminum production) about 50%, with knock-on effects in other industrial metals.

Both of these items bear on the market’s recent fears about new pressures on inflation – capacity constraints (especially rising wages for long-haul truckers) and potential fracturing of the global trade détente.

And 10-year breakevens are at new 4-year highs, although it is worth remembering that this is nowhere near the 10-year highs (see chart, source Bloomberg).

Shorter inflation swaps look less alarming, and not at new four-year highs. However, even here the news is not really soothing. The reason that shorter inflation swaps are lower than they have been in the past is because the energy curves are in backwardation – meaning that the market is pricing in lower energy process in the future. In turn, this means that implied core inflation – once we strip out these energy effects – are, in fact, at 4-year highs (see chart, source Enduring Investments).

So there is legitimate cause to be concerned about upside risks to inflation, and that’s one reason the market is a bit jumpier in this regard. But there is also additional premium, volatility, and angst associated with the level of inflation itself. While as I have pointed out before much of the rise in core inflation to date due to optics arising from base effects, that doesn’t change the fact that the ‘oh, rats’ strike is closer now. That is to say that when core inflation is running at 1.5%, stuff can go wrong without hurting you if your pain threshold is at 3%. But when core inflation is at 2.5% (as it will be this summer), not as much “bad stuff” needs to happen to cause financial pain. In other words, both the ‘delta’ and the ‘gamma’ of the exposure is higher now – just as if one were short a call option struck at (say) 3% inflation. Because, implicitly, many investors are.

If inflation is low, then even if it is volatile in a range it can be consistent with high market valuations for stocks and bonds. But when inflation starts to creep above 3%, those markets tend to suffer in non-linear fashion.

And this, I believe, is why the market’s nervousness about inflation (and market volatility resulting from that nervousness) is unlikely to soon abate.

Nudge at Neptune

Okay, I get it. Your stockbroker is telling you not to worry about inflation: it’s really low, core inflation hasn’t been above 3% for two decades…and, anyway, the Fed is really trying to push it higher, he says, so if it goes up then that’s good too. Besides, some inflation isn’t necessarily bad for equities since many companies can raise end product prices faster than they have to adjust wages they pay their workers.[1] So why worry about something we haven’t seen in a while and isn’t necessarily that bad? Buy more FANG, baby!

Keep in mind that there is a very good chance that your stockbroker, if he or she is under 55 years old, has never seen an investing environment with inflation. Also keep in mind that the stories and scenes of wild excess on Wall Street don’t come from periods when equities are in a bear market. I’m just saying that there’s a reason to be at least mildly skeptical of your broker’s advice to own “100 minus your age” in stocks when you’re young, which morphs into advice to “owning more stocks since you’re likely to have a long retirement” when you get a bit older.

Many financial professionals are better-compensated, explicitly or implicitly, when stocks are going up. This means that even many of the honest ones, who have their clients’ best interests at heart, can’t help but enjoy it when the stock market rallies. Conversations with clients are easier when their accounts are going up in size every day and they feel flush. There’s a reason these folks didn’t go into selling life insurance. Selling life insurance is really hard – you have to talk every day to people and remind them that they’re going to die. I’d hate to be an insurance salesman.

And yet, I guess that’s sort of what I am.

Insurance is about managing risks. Frankly, investing should also be about managing risks – about keeping as much upside as you can, while maintaining an adequate margin of safety. Said another way, it’s about buying that insurance as cheaply as you can so that you don’t spend all of your money on insurance. That’s why diversification is such a powerful idea: owning 20 stocks, rather than 1 stock, gets you downside protection against idiosyncratic risks – essentially for free. Owning multiple asset classes is even more powerful, because the correlations between asset classes are generally lower than the correlations between stocks. Diversification works, and it’s free, so we do it.

So let’s talk about inflation protection. And to talk about inflation protection, I bring you…NASA.

How can we prevent an asteroid impact with Earth?

The key to preventing an impact is to find any potential threat as early as possible. With a couple of decades of warning, which would be possible for 100-meter-sized asteroids with a more capable detection network, several options are technically feasible for preventing an asteroid impact.

Deflecting an asteroid that is on an impact course with Earth requires changing the velocity of the object by less than an inch per second years in advance of the predicted impact.

Would it be possible to shoot down an asteroid that is about to impact Earth?

An asteroid on a trajectory to impact Earth could not be shot down in the last few minutes or even hours before impact.  No known weapon system could stop the mass because of the velocity at which it travels – an average of 12 miles per second.

NASA is also in the business of risk mitigation, and actually their problem is similar to the investor’s problem: find protection, as cheaply as possible, that allows us to retain most of the upside. We can absolutely protect astronauts in space from degradation of their DNA from cosmic rays, with enough shielding. The problem is that the more shielding you add, the harder it is to go very far, very fast, in space. So NASA wants to find the cheapest way to have an effective cosmic ray shield. And, in the ‘planetary defense’ role for NASA, they understand that deflecting an asteroid from hitting the Earth is much, much easier if we do it very early. A nudge when a space rock is out at the orbit of Neptune is all it takes. But wait too long, and there is no way to prevent the devastating impact.

Yes, inflation works the same way.

The impact of inflation on a normal portfolio consisting of stocks and bonds is devastating. Rising inflation hurts bonds because interest rates rise, and it hurts stocks because multiples fall. There is no hiding behind diversification in a ’60-40’ portfolio when inflation rises. Other investments/assets/hedges need to be put into the mix. And when inflation is low, and “high” inflation is far away, it is inexpensive to protect against that portfolio impactor. I have written before about how low commodities prices are compared with equity prices, and in January I also wrote a piece about why the expected return to commodities is actually rising even as commodities go sideways.

TIPS breakevens are also reasonable. While 10-year breakevens have risen from 1.70% to 2.10% over the last 9 months or so, that’s still below current median inflation, and below where core inflation will be in a few months as the one-offs subside. And it’s still comfortably below where 10-year breaks have traded in normal times for the last 15 years (see chart, source Bloomberg).

It is true that there are not a lot of good ways for smaller investors to simply go long inflation. But you can trade out your nominal Treasuries for inflation bonds, own commodities, and if you have access to UCITS that trade in London there is INFU, which tracks 10-year breakevens. NASA doesn’t have a lot of good options, either, for protecting against an asteroid impact. But there are many more plausible options, if you start early, than if you wait until inflation’s trajectory is inside the orbit of the moon.


[1] Your stockbroker conveniently forgets that P/E multiples contract as inflation rises past about 3%. Also, your stockbroker conveniently abandons the argument about how businesses can raise prices before raising wages, meaning that consumer inflation leads wage inflation, when he points to weak wage growth and says “there’s no wage-push inflation.” Actually, your stockbroker sounds like a bit of an ass.

Historical Context Regarding Market Cycles

February 5, 2018 4 comments

I really enjoy listening to financial media outlets on days like this. Six days removed from all-time highs, the equity guys – especially the strategists, who make their money on the way up – talk about “capitulation,” and how “nothing has changed,” and how people need to “invest for the long-term.” If equities have entered a bear market, they will say this all the way down.

It helps to have seen a few cycles. Consider the early-2000s bear market. In 2000, the Nasdaq crested in March. After a stomach-churning setback, it rallied back into August (the S&P actually had its highest monthly close for that cycle in August). The market then dropped again, bounced, dropped again, bounced, and so on. Every bounce on the way down, the stock market shills shrieked ‘capitulation’ and called it a buying opportunity. Eventually it was, of course. But if there is a bear market, there will be plenty of time to buy later. This was also true in ’09, which was much more of a ‘spike’ bottom but let’s face it, you had months and months to get in…except that no one wanted to get in at the time.

If it is not a bear market, then sure – it’s a buying opportunity. But what I know from watching this drama play out several times is that you cannot tell at the time whether it’s a buying opportunity, or a dead-cat bounce. It does not help at all to say “but the economy is okay.” Recalling that the Nasdaq’s peak was in March 2000: the Fed was still hiking rates in May of that year, and didn’t cut rates until 2001.  In late July 2000, GDP printed 5.2% following 4.8% in Q1. In October 2000, GDP for Q3 was reported to still be at 2.2%. Waiting for the economy to tell you that all was not well was very costly. By the time the Fed was alarmed enough to ease, in a surprise move on January 3, 2001, the S&P was down 16%. But fortunately, that ended it as stocks jumped 5% on the Fed’s move. Buy the dip!

By mid-2002, stocks were down about 50% from the high. Buying the dip was in that case precisely wrong.

Then there is the bear market of a decade ago. The October 2007 market high happened when the economy was still strong, although there were clearly underlying stresses in mortgages and mortgage banking and the Fed was already easing. Yet, on January 10, 2008, Fed Chairman Bernanke said “the Federal Reserve is not currently forecasting a recession.” On January 18, he said the economy “has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.” In June 2008, he said “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Stocks were already down 19%. It got somewhat worse…and it didn’t take long.

So the thing to remember is this: equities do not wait for earnings to suffer, or for forecasts of earnings to suffer, or for everyone to figure out that growth is flagging, or for someone to ring a bell. By the time we know why stocks are going down, it is too late. This is why using some discipline is important – crossing the 200-day moving average, or value metrics, or whatever. Or, decide you’ll hold through the -50% moves and ignore all the volatility. Good luck…but then why are you reading market commentary?

I don’t know that stocks are going to enter a bear market. I don’t know if they’ll go down tomorrow or next week or next month. I have a pretty strong opinion about expected real returns over the next 10 years. And for that opinion to be realized, there will have to be a bear market (or two) in there somewhere. So it will not surprise me at any time if a bear market begins, especially from lofty valuation levels. But my point in this article is just to provide some historical context. And my general advice, which is not specific to any particular person reading this, is that if anyone tells you that price moves like this are ‘capitulation’ to be followed by ‘v-shaped recoveries,’ then don’t just walk away but run away. They haven’t any idea, and that advice might make you a few percent or lose you 50%.

To be sure, don’t panic and abandon whatever plan you had, simply because other people are nervous. As Frank Herbert wrote, “fear is the mind-killer. Fear is the little-death that brings total obliteration.” This is why having a plan is so important! And I also think that plans should focus on the long term, and on your personal goals, and matching your long-term investments to those goals. Rebalancing and compounding are powerful tools, as is a value ethic of buying securities that have a margin of safety.

And, of course, diversification. Bonds today did what they’re supposed to do when ‘risky assets’ take a tumble: they rallied. As I noted on Friday: “I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities.” The problem with nominal bonds at this point, though, is that they’re too expensive. At these yields, there is a limit to the diversification they can provide, especially if what is going to drive the bear market in stocks is rising inflation. Bonds will diversify against the sharp selloff, but not against the inflation spiral. (I’ve said it before and I will say it again. If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. “What happened to inflation? And What happens if it comes back?”)

Which brings us to commodities. If the factor driving an equity bear market turns out to be inflation, then commodities should remain uncoupled from equities. For the last few days, commodity indices have declined along with equities – not nearly as much, of course, but the same sign. But if the problem is a fear of inflation then commodities should be taking the baton from stocks.

So there you go. If the problem is rising interest rates, then that is a slow-moving problem that’s self-limiting because central banks will bring rates back down if stocks decline too far. If the problem is rising inflation, then commodities + inflation bonds should beat equities+nominal bonds. Given that commodities and inflation bonds are both relatively cheaper than their counterparts, I’d rather bet that way and have some protection in both circumstances.

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