Jeff Saut Presents: "We are for 'flation."
...this manic emphasis on the "core" inflation rate is laughable...
"We are for 'flation."
. . . Dr. Herbert Stein, 1974
Recall that Herb Stein was Chairman of President Nixon's Council of Economic Advisors between 1972 and 1974. It was a depressing time with inflation rising and an attendant ascent in interest rates. Given his position, Dr. Stein was at the center of the economic maelstrom and consequently had to repeatedly respond to the inflation questions from a persistent press. After months of such questioning, a frustrated Herb Stein, when asked by a reporter to explain why inflation was getting so high, put on a straight face and said, "If you take out all the things in the Consumer Price Index that have gone up, the index would actually go down." At another press conference, when he got irked with relentless questions on the same topic, Herb announced that, "The Nixon Administration is against inflation and it is against deflation. We are for 'flation."
We recalled Herb Stein, father of the irascible Ben Stein, as last week's inflation reports painted the tape. Almost immediately the "talking heads" focused on the "core" inflationary numbers rather than the stronger than expected headline figures. Indeed, Tuesday's PPI report showed that Producer Prices rose 0.5% in March, but that the "core" PPI (ex-food/energy) was up a mere 0.1%. Likewise, Wednesday's Consumer Price report (CPI) came in at +0.4% for March, yet hereto the "core" rate rose just 0.3%. Lost in the no inflation euphoria was the fact that the Cleveland Fed's median inflation index tagged an 11-year high and that half of the goods/services in the CPI are now inflating at a monthly annualized rate of 5%. Also lost in the commotion was the fact that certain cities, like Miami, are experiencing an inflation rate of 6.1%! Moreover, as the astute GavKal organization notes:
"Beyond the (rising) rent story, there is some interesting information in the recently released U.S. inflation data. Put simply: an increasing number of sectors seem to be gaining pricing power (a fact that might help to explain the impressive earnings growth of recent quarters). . . . And these steady gains in pricing power are further confirmed by our P (read: price) Indicator (which is rising)" (the italics emphasis are mine).
And that, ladies and gentlemen, was confirmed by NABE (National Association for Business Economics) on Friday as they stated, "Our recent survey shows that U.S. companies are more successful at passing along price increases."
To us, this manic emphasis on the "core" inflation rate is laughable because the argument is that we need to eliminate the "volatile" components of food and energy, for those of us that don't eat or drive, from the inflation reports. Okay, fair enough, let's examine that view. Historically it is true that food and energy have been volatile. But, we would argue things have changed, at least with regards to energy. So consider this, for three and a half decades crude oil prices have indeed been volatile. Yet, averaging crude's price for the past two years finds that oil prices have maintained an average price level of $53.35 per barrel. We think two years is a sufficient time horizon to support our premise that energy prices have reached a permanently higher plateau and therefore should be included in the inflation statistics.
Consequently, when we use the "headline" inflation figures, we find that the inflation rate is notionally above the yield on the benchmark 10-year T'Note. The implication is that despite the Fed's nearly two-year tightening campaign, "real" (inflation adjusted) interest rates may still be negative, implying that while the Fed may pause in its rate-ratchets, higher interest rates could still be in the offing.
Our sense was reinforced by portfolio manager Bennet Sedacca last week, on the "must have" Web site minyanville.com, when he stated:
"Remember when we were all focused on an inverted yield curve? And how that was bad for financials (well - nothing seems to be bad for financials the way the stocks trade)? . . . For the first time in YEARS, the spread is above the 50 and 200 day moving averages and the 50 day (moving average) has turned upward, confirming the trend. So far, it is a bearish move across the curve, with 10's moving higher faster than 2's. This to me, is a further sign of inflation expectation on the rise, along with commodity price increases. If this continues, inflation fears continue. On the other hand, it is possible, that the economy could weaken, and later on in the year, the steepening continues, if the economy weakened and the fed CUT RATES and 2's fell faster than 10's. I personally give these two possibilities a 50/50 possibility of occurring."
Nevertheless, last week Wall Street focused on the "non inflationary" core-figures and took the collective "bit in its mouth" and inflated stock prices emboldened by Tuesday's trifecta of events. First was last Tuesday's "tame" core-PPI report; followed by gleanings from San Francisco Fed Head Yellen that the Fed was nearly done with its rate-ratchets. That was followed by last month's Fed Minutes Report, which confirmed Janet Yellen's earlier statement. However, there were some other "things" that, in our opinion, were equally important in causing Tuesday's stock surge.
To wit, almost unreported by the media were certain market-moving announcements from China. First was the report that China's 1Q06 GDP had grown at a 10.2% rate. That was above the estimates for a slowdown and actually showed an acceleration from the previous quarter's + 9.9% growth rate. No wonder commodities, metals, and energy stocks streaked higher. Second was the fact that China is going to allow Chinese Banks to convert their clients' local currency to buy foreign fixed-income securities. Moreover, beginning in May Chinese individuals will be permitted to buy up to $20,000 of foreign currency, up from the previous "cap" of $8,000. Yet by far the most bullish Chinese announcement, in our view, was that China's new series of financial deregulation will allow its domestic pension funds to invest in foreign markets. Given China's near $1 trillion of U.S. dollar reserves, is it any wonder our equity markets soared?
And said soaring plainly caught us flat-footed since our proprietary indicators have been deteriorating for weeks. Or, as the Lowry's service opined Tuesday night:
"A buy signal for aggressive traders was registered today when the 14-day Stochastic crossed above its 3-day moving average. At the same time, preliminary data identifies today as a 90% upside day. Historically, isolated 90% upside days, particularly those that occur when stocks are not deeply discounted due to intense Selling Pressure, are frequently associated with blow-off moves. Consequently, investors should not assume that prices are headed dramatically higher but should remain alert."
Over the previous weekend Lowry's took it one step further by stating:
" …since early Jan'06, each new high in the major price indexes has been accompanied by a steady erosion in our Buying Power Index (Demand), which dropped to a new multi-year low this week. At the same time, the Selling Pressure Index (Supply) has consistently increased, to a new multi-year high this week, showing that investors are selling into rallies with increasing resolve. During periods of weakening Demand and expanding Supply throughout our 73 year history, investors have been well served to exercise caution."
Now, we have read the Lowry's service for more than 30 years and been particularly impressed with their buying power/selling pressure indices. Consequently, when we combine our cautionary proprietary indicator readings with theirs, we have had to remain timid on a trading basis. One place we have NOT been timid, however, is with our five-year abidingly bullish stance on the "stuff stocks," most of which are currently tagging multi-decade highs in the investment account. Many of you have made good profits in our stuffstocks, and related mutual finds playing to the stuff-stock theme, over the past few years and we think that theme extends. As one particularly prescient money-manager recently emailed us:
"You guys are probably all over this, but just in case, check out closed-end fund DWS Global Commodities Fund (GCS) trading at a 15.8% discount to net asset value (NAV) and just broke-out to the upside in the charts." And we would add, "don't look now but the CRB Index is at all time highs!"
So where does all of this leave us? Well, it leaves us "wicked long" the stuff-stocks (oil, gas, coal, base/precious metals, agriculture-centric stocks, cement stocks, water stocks, timber stock, etc.) in the investment account. Yet, we were clearly caught flat-footed by Tuesday's stock triumph given our cautionary stance on the trading account. However, as the brilliant Jason Goepfert, of "The Sentiment Trader" fame, notes:
"The old saying is that the most vicious rallies occur in bear markets, and perhaps that's true… one month after the six other occurrences since 1997, the S&P 500 showed an average return of -3.6% with four of the six being negative."
Obviously, we remain cautious in the trading account. In the investment account, however, our strategy of buying the flops continues to bear fruit as our scale-in buying on Chicago Bridge & Iron's (CBI) priceflop is starting to work. Consequently, we are scale-buying another currently controversial "flop," namely Outperform-rated United Healthcare (UNH). Following United Healthcare's conference call last week our fundamental analyst, Michael Baker, noted:
"Management offered preliminary 2007 EPS guidance of 15% baseline growth compared to 2006 levels, equating to EPS of $3.31 to $3.36, which is slightly below Street consensus of $3.38. We remain comfortable with our estimate. We believe the stated range will prove conservative given the potential for the realization of additional synergies from the recent PacifiCare transaction, moderating medical cost trends, and further penetration of the uninsured market. We reiterate our Outperform rating."
The call for this week: We think it will be interesting to see how the equity markets perform this week now that Friday's witch-twitch is behind us.
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