When Minyanville asked me to share my opinion on inflation I failed to mention I’d be a terrible source. I trade markets not economies. I don't spend any time joining any debate about the Federal Reserve. I do, however, make time to talk to my Federal Express delivery man who I have learned more from about the direction of commerce and what it costs to move it. The short answer: East and up. But that might make for a fairly short essay.

I would, however, add one word to the jigsaw puzzle of inflation data that is now crowded around. I know some of the smartest money managers in the world who are working with pieces on an entirely different table – deflation - convinced that is our market’s biggest risk instead. I’ve never seen a few of them more convinced. So, if you're scratching your head, imagine a large pension hearing from two of its money managers: not a different story, but the polar opposites.

My outlook? I have found throughout my career that outliers pay more. So when I find concern and conviction huddled like this I often like to trade them against each other.

“Ex-“ Marks the Spot

The most routine complaints about inaccuracies of inflation reports surround the difference between the core versus headline number. Imagine if over the past few years you had a trading strategy built around these complex sets of data and formulas, that in the absence of PHD’s and spreadsheets you would instead take out a yellow legal pad and pencil and for every instance you heard how misleading “ex-food and energy” was, you bought one more block of food and energy assets.

We get table-pounding arguments about how easy it is to see why removing these sectors distort inflation figures. Yet, adding them to a portfolio whose bottom lines benefit from rising prices seems too hard.

Over the past 12 months as the S&P 500 and trillions indexed to it have declined (13%), this “Ex” marked the spot to a +43% gain in the CRB Index.

With endless calls for the top (well below current prices) from many experts, I would simply suggest they're not wrong about high prices but they have been using incomplete sentences. There is much needed context that rarely accompanies these predictions.

The CRB more than doubling in value this decade looks very different when examined through the lens of 250 years of history. This secular bull market, if you believe it began in 2002, would be the sixth during that time. The average of the other five? More than 21 years in length and a 337% move higher. The very shortest of those five I can find was twice as far in time and price as this one, which many experts believe can't continue.

My CPI, and a Material Misunderstanding

Handicapping the CPI is a crowded horse track and many of the outcomes offer poor odds because they are so heavily bet. I use a different CPI entirely: coal, potash, and iron ore. That other one measures stuff I can do without, but my CPI runs in several different directions: through your power generation, meals, and buildings. No hedonistic adjustments needed for exotic trips to the grocery or gentle breezes from my thermostat.

This measurement has not been dancing around tenths of 1% but rather advancing tens of 1%. It’s up just over 100% in the past 12 months. How un-crowded has this scale been to measure with? Next time you want to throw a curveball to a big hitter on Wall Street ask him or her to give you the spot price on any one of those three inputs to the driving force of so many interrelated markets they follow.

I think Materials stocks are under-owned. My firm came to a very similar conclusion about ten years ago when Energy (XLE) made up only 6% of the S&P 500 and decided to triple-weight its energy holdings by comparison. The Materials (XLB) sector now makes up just 4% of the index, a number that my work shows will grow as might the number of constituents that make it up. I've once again decided to triple-weight. My favorite “technology” stocks are considered by everyone else to be Materials stocks as an example of just how misunderstood this trade might be. Companies like Monsanto (MON) and Syngenta (SYT), among many others which do not even have tickers, will solve food inflation better than regulating speculators will. We have tremendous room to increase yield per acre, develop more tolerant crops, and use water more efficiently. Innovation will meet high prices as it always does, with no Congressional testimony required.

Stapled

What do Kimberly Clark (KMB), Pepsi (PEP), Procter & Gamble (PG), Hershey (HSY), Clorox (CLX), and Dean Foods (DF) all have in common? They are often described as defensive and each are members of the S&P 500 Consumer Staples sector, where portfolio managers like to turn to recession-proof their portfolios. The have also each lost twice as much market value, on an equally weighted basis, as the supposedly more vulnerable Consumer Discretion Sector (XLY) year-to-date: (16.6%) vs. (8%).

Certain manufacturers are getting squeezed far more by their rising cost of goods sold than the average consumer who can more easily adjust. The set-up becomes even more interesting when you consider how crowded the Staples have been on the long side with portfolio managers trying to brace for a 1 mile-per-hour on-ramp for this economy just as they get side-swiped with 80 mile-per-hour trucks on the freeway filled with input costs. More interesting still, for those wondering about options/hedging strategies overall, would be the fact that this sector has the lowest implied volatility readings of any sector. We have been finding some awfully cheap puts packaging this vulnerability.

If one looks at the XLP, I would note yet another tradable anomaly. Wal-Mart (WMT) makes up more than 16% of the sector and is a retailer, not a staple. If you also strip out CVS (CVS), Walgreen (WAG), and Costco (COST) as I would, you have subtracted more than one-quarter of the market cap in the sector to trade with, against, or in pairs.

Make It, Take It

While inflation fears in the U.S. grow along with other troubling economic data, I can't help but connect many of those dots back to one bottom line conclusion – our biggest export of all, capitalism, is being bought in size around the world.

A crisis for some, a celebration for more. My firm's trading philosophy is that when the inputs change so should the outputs. Right now, in my research lab I continue discovering trades around what newly minted capitalists will compete to take, while avoiding (or shorting) what they will compete to make.
 

Is there another Bear Stearns out there?
Minyanville's Buzz and Banter- 14 day FREE Trial