Let us begin with this: there is nothing inherently healthy about a series of +2% and -2% days within a range.
Having some grey hair (just a little!) is helpful in times like these because markets go through repetitive phases and it helps to have some historical comparisons to be able to guide an investor. At the same time, experience can be limiting if we try to force everything we are seeing into a particular historical comparison.
So, for example, I never view with anything but amusement the charts of day-by-day comparisons between this year’s market action with, say, that of 1929. Or, as another example I have seen: comparing a market to the Nikkei crash in the early 1990s. These are interesting an amusing market parallels, but there is no road map to markets. There is only a contour map.
The contours of this market are reminiscent to me of the end of the tech-led bull market in 2000. The valuation parallels are obvious, but I am not talking about that. In 2000, as the market crested in March and began to head lower, we started to have very large overnight moves – sometimes higher, sometimes lower – followed often by a sharp open, directionless trading during the day, and often a sharp move at the close. This was the signature of fast money, which tends to get more timid during the daylight but which enjoys monkeying about with buy and sell stops overnight. In general, as the market headed lower, it seemed like Mondays tended to be pretty good, and Fridays tended to be pretty bad as no one wanted the weekend risk. There was a lot of volatility, and some spectacular up days. But month after month, the market was more likely to end the month lower than it began.
I think we are in that mode again, although it is hard to tell if we have anything like that kind of bear market ahead of us. Certainly, we can make that point valuation-wise. Also, interest rates have much more room to move higher from here than to move lower. While I think the economy is slowing, and any Fed action is likely to be small, tentative, and probably delayed, my point is that interest rates are not likely to provide a following wind to valuations.
Indeed, while nominal interest rates are still locked near 2% on the 10-year note, real interest rates are near the highest levels in five years (see chart of 10-year real interest rates, source Bloomberg).
The flip side of stable nominal interest rates and rising real rates, of course, is declining inflation expectations. By our calculations, the market is currently implying core inflation to be below the Fed’s target for at least a decade. And this is despite the fact that, measured by median inflation, it is already at target.
I once believed that the Fed could not really control long-term interest rates, although at least in principle they can control Treasury rates like they did in WWII, by simply buying or selling whatever it takes to keep rates at their target (it was easier then, as the market was a lot smaller!). And I guess that, deep in my gut, I still believe that. But I must admit that the evidence that they can control nominal interest rates, at least in normal times (that is, when the weight of the market doesn’t strenuously disagree), is starting to look pretty strong. There is absolutely no rationale for 10-year nominal interest rates at 2% in an environment where real interest rates are 0.65%, current inflation is 2.3%, and there is a large amount of money in circulation – with no plans in place to drain it.
(For anyone claiming a fear of deflation, I just shake my head in disbelief. Choose: Do you want to be a monetarist, in which case you have to construct a case for deflation from 6+% money growth and money velocity that is already at levels below any previously measured; or do you want to be a Keynesian and explain how you get deflation with unemployment at 5.1%? The third way is hand-waving, claiming that large amounts of debt lead mystically to deflation. But large amounts of public debt have never led to deflation in the past, and there is no obvious mechanism for it to do so.)
My reading of the contour map suggests a market valley ahead. It is a deep valley, but the good news is that there is a mountain on the other side of it. There always is.
I may have the lay of the land wrong, but I have been over this ground before. Watch your step.
Officially, Crude Oil has had the worst bull market ever.
According to a headline on Bloomberg on Monday, Crude is in a bull market. The headline screamed “WTI CRUDE CLOSES UP 29% FROM AUG 24 LOW, ENTERS BULL MARKET”! On Tuesday, after a 7.7% fall from Monday’s close (-100%, annualized), the bull market doesn’t seem so…well, ebullient.
Okay, sure, this is a pet peave of mine. I don’t know whose idea it was to call a 20% advance from the prior low a bull market, and a 20% decline from the prior high a bear market, but I am pretty sure that they didn’t intend for that 20% to be applied to all markets, at all times. So a 5-year Treasury Note is not in a bear market until it falls 20 points (or…is that 20% of the current yield? I guess it depends who writes the headlines!), but energy futures which can move 20% in a couple of days, or corn futures which can double literally overnight if there is a drought, can be in bull and bear markets a couple of times per month. Does this make sense?
Add to this the obvious absurdity of the idea that we can know in advance whether an asset is in a bull or bear market. If you are telling me that Crude rallying 20% off the lows means that it is in a bull market, and that means I can be long Crude comfortably, knowing it is likely to rally from here – then you need to quit telling me anything and go make a fortune trading.
We can only know a bull market or a bear market in hindsight. That is, even if 20% is the magic number (and I can’t think of why that would be so), the best we can say is that Crude was in a bull market on Thursday, Friday, and Monday when it rallied about 27%. Does that help us, going into Tuesday?
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. And sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com.
- core CPI+0.13%, softer than expected. Core y/y rose from 1.77% to 1.80% due to soft year-ago comparison.
- Next month we drop off an 0.05%, so we will almost surely get a core uptick. Surprising we haven’t yet. Waiting for breakdn.
- Both primary rents and owners’ equiv accelerated slightly, Which means core EX HOUSING was actually slightly down m/m
- core services rose to 2.6% (mostly on housing); core goods fell to -0.5% from -0.4% y/y. Same story overall.
- Apparel accelerated to -1.64% from -1.85% y/y. Story for years in apparel was deflation; in 2011-12 prices rose>>
- >>and looked like return to pre-90s rate of rise. Then it flattened off, and has been declining again.
- Apparel could well be a dollar story now – it’s almost all made overseas, almost no domestic competition so dollar matters.
- our proxy for core commodities is apparel + cars + med care commodities. all 3 decelerated. Cars went from +0.5% to 0.0% y/y.
- sorry, Apparel actually ACCELERATED to -1.6% from -1.9%, but still negative.
- airfares not really a story. -5.6% y/y vs -5.2% y/y. The NSA number dropped but it always drops in late summer. [Ed note: see chart below]
- airfares was -8.5%, but it was -8.1% last july, -2.9% in 2013, -2.6% in 2012…no story there. didn’t affect core meaningfully.
- Primary rents 3.56% from 3.53%. OEW 3.00% from 2.95%. Both will continue to rise.
- Lodging away from home also rebounded to 2.9% y/y after a one-off plunge to 0.8% y/y last month. Household energy of course down.
- Transportation accelerated (-6.6% y/y vs -6.9%) on small motor fuel recovery. btw, airline fares are only 0.7% of CPI, so 0.9% of core.
- Med Care: goods were dn (drugs 3.2% vs 3.4%,equipment -0.9% vs 0.0%) but prof services up (2.1% vs 1.8%),hospital svcs dn (3.2% vs 3.5%)
- Health insurance only +0.9% y/y vs 0.7%, but more expenditures out-of-pocket under the ACA so higher infl for those categories hurts.
- Median (due out later) might only be +0.1% this month. I have it cuffed at 0.15% but I don’t seasonally-adjust the housing sub-components.
- Last yr Median was +0.17% m/m, so best guess is it roughly holds steady at 2.3%.
- I don’t see how the Fed embarks on a meaningful tightening in Sep, with global economy weaker than it has been in a couple yrs.
- Median inflation and growth plenty strong enough to “normalize” rates but that’s not a new story.
- I’ve been saying they should tighten for a few years but not sure why they would NOW if they didn’t in 2011.
- But Fed doesn’t use common sense or monetarist models.It’s all DSGE;who knows what those models are saying?Depends how they calibrated.
- FWIW our OER models diverge here. Our nominal model says pressures on core start to ebb in a few mo; our real model predicts more rise.
- I like the real model as it makes mose sense…but it’s not tested in a real upswing.
- US #Inflation mkt pricing: 2015 0.8%;2016 0.7%;then 1.6%, 1.7%, 1.8%, 1.9%, 2.0%, 2.1%, 2.2%, 2.3%, & 2025:2.2%.
- …so inflation market doesn’t see inflation at the Fed’s target (about 2.2% on CPI vs 2.0% on PCE) until 2023.
- The market is not CORRECT about that, but another reason the Fed can defer tightening if they want to. And they have always wanted to.
First, let’s start with the airfares chart. One of the early headlines was that airfares plunged by the most since some long-ago year, which held down core. Well, here is the chart of airfares, non-seasonally adjusted. You tell me whether this is unusual to have airfares fall in July.
Because this is part of a normal seasonal pattern, the year-on-year figure was only slightly lower, as I note above. And airfares are a tiny part of CPI, less than 1% of the core. This is not a story.
More important will be the median CPI. This is a much better measure of the central tendency of prices than headline or core, both of which (as averages) can be skewed by a few categories having outsized moves. Median inflation has been ticking higher (see chart below) but will probably go sideways this month.
Finally, the most important chart. There are lots of ways to model housing. If you model rents as lagged versions of the FHFA Home Price Index, or Existing Home Sales median prices, then you get one model and that model suggests that rents should begin to moderate over the next 6-12 months. Not that they will decelerate markedly, but that they will stop accelerating and therefore stop being the driving force pushing core CPI higher. But if you use those models, you have to recognize that you are calibrating over a period of very slow inflation, so that you are effectively ignoring the knock-on effect of higher inflation on rents. That is, if core inflation is around 2% and rents are 3%, then if core inflation rises to 5% you wouldn’t expect rents to be at 3%. So, you need to use a model that recognizes the interrelationship between these variables. And that sort of model implies that rents will continue to climb. Both models of Owners’ Equivalent Rent are shown in the chart below. I prefer the “real” model to the “nom” model, but we don’t know the right answer yet.
Even if OER moderates it doesn’t mean that CPI will stop rising; it just means that the story will stop being all about rents. Core goods still have a long ways to go to normalize, and that might be the next story. But for now, I am still focused on rents.
As I said, I really don’t see how the Fed can think about hiking rates in September based on the data we have seen recently. Yes, inflation is on the border of being an issue, but that has been true for a long time. In 2011, there was plenty of growth and while high rates would not have been warranted, it is hard to argue that normal rates were not called for. And yet, we got QE and more QE. This will end up being the biggest central bank error in decades, regardless of what the Fed does in September. I doubt they will hike, and if they do then it won’t be a long series of hikes. This is still a very dovish central bank, and they will get skittish very quickly if markets balk at more expensive money – which, of course, they are wont to do.
As I have mentioned, I have been hard at work on my book and am approaching completion of the raw manuscript. The title of the book is What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. Even better, you can pre-order it already, even though it’s not due out until later this year or early next year.
Yesterday, I finished up the draft of the second section, which is the “where are we now” section (there are three sections in total, and I am part-way through the “investing” section). I really enjoyed writing the following section and I think the charts are fun. So I thought I would include a snippet of Chapter 9 here for you:
If a length of steel is flexed, it is impossible to know exactly when it will fail. We can, however, figure out when that critical point is approaching, and estimate the probabilities of structural failure for a given load. These are just probabilities, and of course such an estimate depends on our knowledge of the structural properties of the piece of steel.
With economies and financial markets, the science has not yet advanced enough for us to say that we know the “structural properties” of economies and markets. And yet, we can measure the stress markets are under by measuring departures from normalcy and make observations about the degree of risk.
Didier Sornette wrote a book in 2003 called Why Stock Markets Crash: Critical Events in Complex Financial Systems.[i] It is a terrific read for anyone interested in studying these questions and exploring the developing science of critical points in financial markets. His work goes a long way towards explaining why it is so easy to identify a bubble and yet so hard to predict the timing of its demise.
So in that spirit, let us look at a few pictures that illuminate the degree of “departures from normalcy” in which economies and markets currently are. Figure 9.6 shows the nice relationship between the increase in GDP-adjusted money supply (M/Q from Figure 3.1) and the increase in the price level (P) over the nice, regular, period between 1962 and 1992. I’ve added to this plot a dot representing the latest ten year period, and (for fun) a dot representing the ten years ending in the heat of the stock market bubble in 1999. Do we appear to be out of normalcy?
Figure 9.6: Compounded money growth versus compounded inflation, 10-year periods
Figure 9.7 shows the relationship between stocks and spot commodity prices, as represented by the S&P 500 and the Bloomberg Commodity Index. The curve is from 1991 to 2007, excluding the period around the equity bubble (1998-2002). The two dots show the current point, and the point from December 1999. Do we appear out of normalcy?
Figure 9.7: Stocks versus spot commodity prices
Let’s try one more. Figure 9.8 shows the same commodity index, but this time against the money supply. It makes sense that spot commodity over time should move more or less in relation to the aggregate amount of money in circulation. The relative prices of two items are at least somewhat related to their relative scarcities. We will trade a lot of sand for one diamond, because there’s a lot of sand and very few diamonds. But if diamonds suddenly rained down from the sky for some reason, the price of diamonds relative to sand would plummet. We would see this as a decline in the dollar price of diamonds relative to the dollar price of sand, which would presumably be stable, but the dollar in such a case plays only the role of a “unit of account” to compare these two assets. The price of diamonds falls, in dollars, because there are lots more diamonds and no change in the amount of dollars. But if the positions were reversed, and there were lots more dollars, then the price of dollars should fall relative to the price of diamonds. In this case, dollars have been raining from the sky and yet their price relative to commodities has not fallen – that is, the nominal price of commodities has not risen, as we would have expected. Figure 9.8 shows that the price of money, relative to hard assets like physical commodities, may be in the greatest bubble it has ever been in. And since, unlike stocks and unlike real estate, everybody holds money, this may be the biggest bubble of them all.
Figure 9.8: Commodity prices versus money supply
All three of these figures – and I could have chosen many others – show a highly-flexed economy and highly-flexed markets. A break in this steel bar is almost assured; the only question is when.
Moreover, while we hear so much today about the “coming deflationary depression,” I have to say that with the quantity of reserves in the system and the direction in which the monetary pictures are flexed, there is in my opinion as much chance of a deflationary outcome as I have of being appointed Prime Minister of Egypt.
[i] Sornette, Didier, Why Stock Markets Crash: Critical Events in Complex Financial Systems, Princeton University Press, 2003.
It is obviously time for another update. I haven’t been an active poster recently, because as many of you know I am busy working on a book for the Wiley label. I am about 80% done; however, it is very time-consuming! The title of the book is (tentatively) What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. Even better, you can pre-order it already apparently, even though it’s not due out until later this year or early next year. (No pressure, huh?)
So, I have been embroiled in the writing and editing process, and not posting much. This will change soon, but China’s overnight move to (slightly) devalue the yuan is significant enough to warrant a post. There are also some other topics that need a quick mark-to-market, but I will save those for another day.
China’s move is possibly qualitatively significant, but I don’t believe it is yet quantitatively significant. A two-percent move in a currency is barely worth recording – it is almost within the daily standard deviation band of some currencies! So, when you have read about how this dramatically changes the inflationary concern of the Fed to a deflationary concern…that’s nonsense. The Swiss Franc strengthened by 20% against all currencies, in a single day, back in January. Since then, the core Swiss inflation rate has moved from +0.4% y/y to -0.6% y/y. Also note that Switzerland’s imports amount to about 50% of its GDP.
Let’s take that as a back-of-the-envelope scalar just to do a rationality check. A 20% change in exchange rate affecting about 50% of goods and services caused a 1% move in core CPI.
The U.S. imports about $40bln in goods from China per month, out of an annual GDP of $16.3 trillion. So in this case, we have a 2% move in exchange rate affecting about 2.9% of domestic goods and services. So if the effect was linear, we would expect about 1/10th * 1/17th * 1% of a move in core CPI as a result of the Chinese action. Check my math, but that would seem to be about 0.006% movement in expected core inflation as a result of China’s revaluation. Negligible, in other words.
Now, qualitatively the effect might be higher if, for example, this presages a more-significant move by China. But even assuming that the exchange rate moved ten times as much, you are still talking about rounding error on inflation. Sure, the effect might not be linear but the essential guess is that from a price perspective we don’t care.
Certain companies and industries and goods, of course, will see a much bigger effect (it would be hard to have a much smaller effect), but it shouldn’t be a big deal – even if it is part of a larger move. From the standpoint of economic growth, it may matter more…but even so, a 2% change is unlikely to matter as much as a 10% change in shipping costs, and moves like that happen all the time.
China is a big economy, and a big trading counterparty of ours. But the U.S. is still a significantly-closed economy. While China represents about 20% of all of our imports, imports as a whole only amount to 14% of US GDP. So, in summary: this is an interesting moment politically, if China is signaling a willingness to float her currency. It is not a particularly interesting day macro-economically, at least from the standpoint of the effect on prices of this move.
The recent commodities sell-off has been breathtaking. This is especially true since the most-recent downturn occurred from a level where the expected future returns from commodity index investment were reasonably good – and, as a spread above expected equity or bond returns, probably around the best levels ever.
But investors have a strong tendency to use the current level, rather than some esoteric measure of value, as the level from which expected market moves are evaluated. What I mean by that is this: in theory, if some event happens in the capital markets, the reaction in the market should depend on whether that event has already been “discounted” in the current price. That is, if we are all expecting Microsoft to raise its dividend, then the price of Microsoft should reflect that change already, and when it subsequently actually happens it should have no effect on price. Indeed, if the market has overestimated the change in fundamental value, then the price of Microsoft should retrace somewhat when the news is actually announced. From that, we get the old saw that one should “buy the rumor, sell the news.”
The fact that this isn’t really what happens is not exactly news. In the early 1980s, Bob Shiller demonstrated that the volatility in the equity marketplace was much greater than the changes in the real underlying values should support.
In practice, investors don’t behave rationally. The same event can be discounted over, and over, and over again. Each investor, it seems, hears news and assumes the current price does not incorporate that news, no matter what has happened previously to the price. Based on my own unscientific observation, I think this is more true now that there are more retail investors, and news outlets that benefit from making everything sound like new information. If my supposition is true, one implication is that markets can deviate further and further from fundamental values. In other words, we get more bubbles and inverse bubbles than we would otherwise.
As a great current example, we might consider commodities. The slowdown in China’s economic activity is discounted anew almost every day, as more information comes out from that country that its economic engine is (at least) sputtering. One would think that China was the only consumer of industrial metals and energy, and that its consumption is going to zero, based on the behavior of these markets. And with every tick higher in the dollar, every commodity seems offered. It’s risk-off, then risk-off again, then risk-off again, ad infinitum.
Now, there is no doubt that commodities in 2008 were overvalued, and arguably in 2011 they were also expensive. But the four-year beat-down of commodities – pretty much the only asset class that has declined in value over that time period – is breathtaking in its depth and, as it turns out, its breadth. I was curious about whether the recent break of major commodities indices to new lows – below the lows of 2008, when it felt like the world was ending (see chart above, source Bloomberg) – was broader, in that it seemed like every commodity was participating. So I put together a chart that shows the proportion of commodities (considering only the 27 major traded commodities that are in the Bloomberg Commodity Index) that were above their 200-day moving averages. The chart is below (Source: Enduring Investments).
It isn’t quite as bad as I had thought. The recent slide has taken the proportion back to 18% (meaning 82% are below their 200-day moving averages), but commodity prices have been sliding for so long that the 200-day averages are now generally declining pretty smartly. Notice in general the post-2011 average, compared to the pre-2008 average. Even without seeing the price chart, you can tell the 2011-2015 bear market from the 2002-2008 bull market!
One other observation about commodities, to be fair. The chart I showed, above, of the Bloomberg Commodity Index, incorporates carry in commodities. That is, it adds the futures roll, and collateral return, to the movement in spot commodities. Over the last few years, the collateral return hasn’t been very good and the roll return has actually been substantially negative, so that the return of spot commodities has in fact been better than the return to commodity indices. The chart below (source: Bloomberg) shows the Bloomberg Spot Commodity Index; you can see that we are still above the 2008 lows.
Being “above the 2008 lows” doesn’t strike me as a strong performance. Stocks are also above the 2008-09 lows, by 200% or so. LQD, the investment-grade bond ETF, is about 45% higher. HYG, the high-yield ETF, is 41% higher. Heck, M2 money supply is around 50% higher than it was in early 2009.
And yet, every time we hear more news about China, investors behave as if it is new information, and sell commodities off some more. As I said above, these moves can last longer these days than they did in the past – but this is unsustainable. With commodities, an added complexity is that investors don’t know how to evaluate expected return (since there are no cash flows), and so it is hard for them to compare “value” to other asset classes. But the value is there.
In an excellent (and free!) daily email I receive, the Daily Shot, I ran across a chart that touched off my quant BS alert.
This chart is from here, and is obviously a few years out-of-date, but that isn’t the problem. The problem is that the chart suggests that gold prices rise 5.5% every year. If you buy gold in January, at an index value of 100, and hold it through the flat part of January-June, then you reap the 5% rally in the second half of the year.
No wonder people love gold! You can get a 10% annual return simply by buying in July and selling in December!
The problem is that this is not the way you should do a seasonal chart. It has not be detrended. We detrend data because that way, we can express the expected return for any given day as (the normal expected return) plus (the seasonal component). This is valuable because, as analysts, we might have a general forecast for gold but we will want to adjust that forecast to a holding period return based on a seasonal pattern. This is very important, for example, with TIPS yields and breakevens, because inflation itself is highly seasonal.
Now, the seasonal chart done correctly still suggests that the best time to own gold is in the second half of the year, but it no longer suggests that owning gold is an automatic winner. (It is a separate argument whether we can reject the null hypothesis of zero seasonality altogether, but that’s not my point here).
Frankly, I would also use real prices rather than nominal prices, since it is much easier to make a statement about the expected real return to gold (roughly zero over time, although it may be more or less than that based on current valuation metrics) than it is to make a statement about the expected nominal return to gold, since the latter includes an embedded assumption about the inflation rate, which I would prefer to strip out. And I would also include data from the 1970s.