Note: Professor Fleckenstein provides his commentary every Wednesday evening for educational purposes - his insights are not intended as investment advice.
Stagflation, Inflation, or Bust?
The Rap's format will once again be different today, as I attempt to make sense out of the action in the various markets that matter (to me). To dive right in, Intel's news last night was more or less a nonevent (more about that near the end), superceded by the macro developments that ruled the day. Our equity futures were a nonevent last night, though the foreign currencies and fixed income were a bit weaker. Likewise, the metals were lower, in a continuation of the liquidation we saw yesterday.
A Hot-Money Exodus Chills Currencies/Metals
At 8:30 Eastern time, the CPI was reported at 0.5%, vs. expectations of 0.3%. Not that the small difference matters so much, but the news caused the dollar to jump, as folks seemed to have concluded that the group of lunatics running the Fed would react to these inflation numbers. In any case, that spiked the dollar, which hurt the metals. Bonds took a beating, which appeared to drag down equity futures. I'm sure a lot of folks were scratching their heads over why the metals were being hit on the news of inflation pressures. The reason is that in the short term, momentum rules, especially in markets where there's leverage and/or hot money, or both. These days, all our markets have both, in spades.
In light of which, since the metals and foreign currencies have been under pressure, when "good news" for those markets didn't help them go up, the selling was exacerbated. At one point, gold was down $10 to $397, and silver was down about 60 cents to $6.85. But for the most part, silver didn't spend much time under $7, and gold didn't spend much time under $400, which is roughly where they closed.
Forethought, as the Engine of Opportunity
I took advantage of those price breaks to buy silver (I plan to buy more tomorrow, perhaps aggressively), gold, and some gold calls. Because I was fortunate enough to have planned ahead, via my purchase of gold puts a while back, as previously described, I was able to buy this plunge without incurring a great deal of risk. (Yes, I already had a gold position, but that is a position I don't plan on trading, anyway.)
I describe this, not to call attention to my 15 minutes of modest success, but to point out that in foreign-currency and commodity markets (and in short-selling), where trading is often required, it's very helpful to plan one or two steps ahead. Just as I had bought puts so that I could aggressively buy gold, I have now bought calls so that once gold gets up around $430, I can sell part of my position, but keep the upside.
This is one of the ways that I try to manage risk for myself. It's meant as food for thought -- not as a suggestion that others do the same -- in terms of helping folks assess how best to manage their own positions in these markets, which as we have seen, can be very volatile. With silver basically having traded $8.20 and $6.85 in the space of about four sessions, I think this is the first time many folks have seen how violent its moves can be. While silver went up in a steady, stair-step fashion, this plunge has been very white-knuckled.
Arm's Length from an Argent Bull
That happens to be what bull markets do: They grind higher and higher and higher. Then, when they collapse, they collapse mightily to shake people out. This is one of the reasons why I had not been long silver: I had not found the right juncture to get long where I thought I might be able to do so and have my risk somewhat under control.
I also took advantage of today's weakness in foreign currencies to buy more Australian dollars. The correction in the foreign currencies may not be over just yet, but my hunch is that it will have come to an end sometime in the next few weeks. There's not all that much more damage to be done, though as we saw in the metals today, the tail-end of a correction (if this is in fact the tail end) can be quite violent. Though the euro is $1.19 and change, it could still trade to $1.16 in the blink of an eye. We're not very far from the 200-day moving average, and if that cracks, there will probably be selling.
Meanwhile, I have not done anything in the euro yet, but rather kept my allegiance to the Australian dollar. The central bank there seems to be the most legitimate of any major country, and furthermore, one gets a pretty nice yield for owning Australian paper, as I have described in the past.
Will Greenspan Play Tight End?
Turning to the stock market and fixed-income market, today's reaction has convinced a lot of people that the Fed is about to tighten. I'm not sure the Fed will tighten, though as I noted a few days ago, the market could tighten for the Fed. To me, the outcome of the Fed's policies, the insanity within the real estate market, and the speculation in the stock market mean that we are probably headed for a bust in both markets.
However, I suppose that the economy could somehow manage to hang on for a while, with inflation picking up as well. I believe that the best-case outcome for our economy is stagflation. Not that you'll see inflation in the government numbers, but I think that a muddling along of economic activity and more inflation would be the best that I could foresee from the circumstances that we have.
The more likely, uglier scenario would be that the economy simply runs out of gas now that the stimulus is behind us. As the stock market comes under pressure and the refi game ends, that will further weigh on the economy. If by some miracle the economy does do better than I expect, I would think that inflation would become very heated and interest rates rise pretty dramatically, since even this Fed would have to respond.
What an Inflection Point Will Inflict
The refi game and government stimulus have been the only glue holding the economy together. If this last move in the bond market has shut the door on refi activity once and for all, as I believe it has, then the Fed is basically trapped. It is my view that we have reached the inflection point -- where it's game over for stocks, real estate, and the economy. That doesn't mean everything will stop on a dime, but we may look back at this period in time and say that it was an inflection point.
It looks like the equity market may be experiencing a failing rally, though today's performance was a bit on the macho side, as folks tried to shake off the fact that the market didn't go up on good news yesterday, and tried to build on the belief that a stock such as Intel shouldn't go down because it was going to be a second-half story.
Intel Fails to Enthrall
On the subject of Intel, the company said revenues were pretty much what I was looking for, i.e., slightly more tepid for the next quarter than had been expected. The innards of its news were a tad bit worse: Receivables grew sequentially, as did inventories in a flat sequential quarter. Folks seem to forget that Intel's production costs essentially stay the same, no matter what. Therefore, if the company can increase revenues, this all falls to the bottom line, ergo, margins go up. If Intel overproduces and can't sell the stuff, it goes into inventory. With this not showing up in the costs, Intel's margins get a lift while the stuff sits in inventory. But if the company guesses wrong, continues to run production, and demand doesn't pick up, it has a real problem for later on, which is where I think Intel is in this process.
Bottom line: I think that the numbers people expect to see for Intel in the second half will be difficult to come by -- and that's in addition to the growing competition from Advanced Micro Devices. I don't mean to make too much of Intel. We could have a similar discussion about lots of different ideas. It just happens to be one that I think lots of folks know about, care about, and obviously it matters to me because I have a position.
A Reader Crumbles Wafer-Thin Theses
Meanwhile, as tech bulls try to promote Intel's second-half thesis, and the PC upgrade story, an astute reader with a keen understanding of tech did a fine job of debunking these notions:
"According to the tech bulls, we are supposed to be in the throes of the PC upgrade cycle. So, if we are and everyone in the U.S. and Europe are upgrading 1999 PCs hand-over-fist, what will happen toward the end of 2004, and 2005 and 2006? Of course, these blowhard analysts have PC unit growth continuing in 2005 and 2006, and they are basing their price targets on 2005 numbers. But of course, if we are going through an upgrade cycle now (as they claim), therefore, 2005 and 2006 will have to be down for PCs -- just like the years 2000 and 2001 fell off the cliff.
"Just a bit of intellectual dishonesty once again by sell-side bulls, as they buy the PC upgrade cycle hypothesis, not to have the PC down-cycle in the numbers in 2005 and 2006. And again, they are valuing all these stocks on 2005 numbers that include up PC units! (They actually assume PC units up in 2005 the same as in 2004, the upgrade year. Now how does that work?) Why don't people shrink PC unites in 2005 and 2006 from 2004, which is what they should do, given that we're coming off the much-talked-about 'upgrade cycle,' and see what that does to their model." Answer: Because then, they couldn't rationalize buying the stock!
Tallying the Final Ticks
Back to a summary of the day's action, fixed income bounced from its lows, but yields still went out higher on the day. Currencies, for the most part, finished near their lows. The euro, however, did come off its lows quite a bit, to actually turn positive (though that may not be at all meaningful).
As for equities, after opening on the lows, the market burst to the highs by midday, traded back down to the lows and, with about half an hour to go, saw a rally into the close that took us out not far from the day's best levels. Suffice to say, financials were the weakest. I think today's action can best be described as sloppy, though a check of the box scores will reveal little in the way of major damage. Tonight will bring a bevy of earnings reports and, more importantly, tomorrow we'll learn how they are digested by the market.
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