Note: Professor Fleckenstein provides his commentary for educational purposes - his insights are not intended as investment advice. You can find his daily comments at www.fleckensteincapital.com
Please also note that this is Prof. Fleckenstein's Rap that was published yesterday afternoon, however given Fleck's focus / expertise in the area, we still find it helpful.
Prestidigitation, Government Style!
Yesterday we found out that the GDP data were a little stronger than initially reported, but I don't think that makes a whole lot of difference, and it had no impact that I could see. Stocks bolted out of Wednesday's starting gate, with the Sox leading what I expect to be a dead-cat bounce. Internet stocks were firm again, with Google (GOOG:NASD) powering that surge, and some cyclicals were strong again in the early going. As I said Tuesday, this is quarter-end, and what sweeter time to attempt to manipulate the stocks one owns, so as to make things look better than they are?
Paint We Must, In Chips We Trust
Indeed, the little Rembrandts were at work all day. The market finished close to its best levels, though the moves in the averages themselves weren't terribly epic. That said, certain stocks that have been the favorites of speculators, i.e., the Internets, were chased pretty hard. Chip stocks were also muscled nicely, with various and sundry other names pushed upward as well. Just another day in the mismanagement of other people's money.
If I sound slightly disgusted, it's because I am. Between the open secret of tape-painting and corporate America flouting the rules to make the numbers, or beat them by one or two pennies, is it any wonder we've bred a culture that has no regard for the rules?
Away from stocks, currencies were back and forth across unchanged, but the metals were initially firm, with gold up 0.5% and silver up 1.5%, before closing up 50 cents and 1%, respectively. Oil crossed $50 in the early going and then dropped 3%, before closing down 1% at $49.51. Fixed income was a little on the heavy side, with long-bond futures down almost a point.
A Mini-Oeuvre on Numerical Maneuver
Now I would like to turn the microphone over to Bill Gross, who recently wrote a piece titled "Haute Con Job." He has weighed in on subjects that I've been rather vociferous about for the nearly eight years I have been writing this column -- the understatement of inflation in our country (and the attendant overstatement of GDP and productivity) -- and how this con is accomplished, via two of the government's favorite little pranks.
I have made these points many times, but since he is considered the country's foremost authority on bonds, perhaps the story will get some legs. If so, this thought process is negative for fixed income, negative for the dollar, and bullish for the metals, as it of course undermines the credibility of all the government data distorted by these machinations.
I am going to quote liberally from Gross's article (but here's the link, if you want to print it out and read it yourself), starting with his conclusions, just so you'll know from the outset where he comes down on these subjects:
"The CPI as calculated may not be a conspiracy, but it's definitely a con job foisted on an unwitting public by government officials who choose to look the other way or who convince themselves that they are fostering some logical adjustment in a New Age Economy dependent on the markets and not the marketplace for its survival. If the CPI is so low and therefore real wages in the black, tell me why U.S. consumers are resorting to hundreds of billions in home equity takeouts to keep consumption above the line. If real GDP growth is so high, tell me why this economy hasn't created any jobs over the past four years.
"High productivity? Nonsense, in part -- statistical, hedonically created nonsense. My sense is that the CPI is really 1% higher than official figures and that real GDP is 1% less." Gross backs up his 1% estimate with some work his firm has done. I wouldn't be surprised to find out that it's even higher, though there's really no way to know for sure.
Next, before hacking away at the hedonic and substitution fiddles used by the government, he pops off about the whole nonsense of core inflation -- which is of course another subject near and dear to my heart, and completely and totally absurd -- because it strips out food and energy, two things that everybody must have:
"[There's a] con job perpetually foisted on the American public about the low level of inflation. 'Inflation under control' (ex food and energy, of course) shout the carnival barkers. 'The CORE is running at just under 2%,' the barkers shout with glee because a low CORE number tells us that we can continue to run monetary policy with negative real interest rates and fiscal policy with $400 billion deficits. A low CORE number allows us to pretend that American productivity is the best in the world, that the dollar should be strong, and that the markets, by golly, are going up. No matter that a gallon of gasoline is over two bucks or that a half-gallon of milk will set you back $3.69; the CORE is under 2%."
Inflation Ointment: Slather on Affected Areas
But as you'll see, the core rate is not Gross's major beef. It's the nonsensical extremes to which hedonic adjustments have been taken, something that my good friend Jim Grant has written about on many occasions as well. Though the hedonic adjustments began as a way to turn computer horsepower into price reductions, they have since been applied to lots of other goods. As Gross notes:
"In 1998, the methodology was adopted for computers -- surely the biggest step backward in realistic inflation calculations. Since then, the BLS has expanded the concept to include audio equipment, video equipment, washers/dryers, DVDs, refrigerators and, of all things, college textbooks! Today, no less than 46% [my emphasis] of the weight of the U.S. CPI comes from products subject to hedonic adjustments." That's 46% and probably growing.
Speaking of college textbooks, I bumped into a young man I know who is attending college, and he mentioned that his new math book cost $175. (Having been a math major myself, I don't recall paying much over about $30 a book.) It would be interesting to know how one calculates that the book has become six times better. Meanwhile, Gross notes that if you were to strip out some of the hedonic magic since 1987, as his firm has done, the PCE (or personal consumption expenditures, which is Greenspan's favorite inflation statistic) would turn out to have been between 0.5% and 1.1% higher every year. Obviously, that number adds up over time.
Continuing on, he tackles the government's other intellectually dishonest stratagem, namely, substitution: "In addition, when 'substitution bias' (a BLS maneuver that follows your preference for Chicken McNuggets vs. a Quarter Pounder) is eliminated, the gap gets even worse. For those of you sophisticated economists who feel the substitution bias is more than justified, chew on this for a second: If you substitute a pound of chicken for a pound of beef because it's cheaper, then switch back to beef later on because it came back down in price, the overall round trip which resulted in no ultimate substitution and no relative price change winds up reducing the stated PCE. Oh man, what a con."
He then discusses the motives behind the government's (and Greenspan's) reasons for believing these rather unbelievable numbers: "Deceptive hedonic/substitution adjustments also serve a government burdened not only with hundreds of billions of annual deficits as far as the eye can see, but ladened with a demographically aging U.S. workforce rapidly approaching Social Security time. By fudging on inflation, they pay less, and the amount could cumulatively run into the hundreds of billions over the next few decades."
The Uncle-Sam Flimflam
Lastly, he points out who is penalized by this cheating: "They disserve, of course, all of those who receive social security, as well as other private pensioners dependent on an accurate accounting of prices paid. They disserve buyers and holders of TIPS -- inflation protected securities -- which adjust inadequately to a faulty and near fraudulently calculated CPI that one day could total billions of dollars per year for TIPS holders. And they disserve all owners of U.S. Treasury obligations -- including foreign central banks and institutions. . . . "
One of these days, the world is going to figure this out. There will be a run on the dollar, and at some point, Treasury yields will be affected. One of my favorite expressions (besides: In a social democracy with a fiat currency, all roads lead to inflation) is: We know the government is going to cheat us, via inflation. The only question is whether they are offering us a rate, in terms of interest on government debt, that compensates us for this cheating.
That's the reason I find fixed income unattractive. Bill Gross's arguments are the very same ones I have long made for why I don't like TIPS. Yes, maybe they're the best of a bad lot. But I would prefer not to buy longer-dated fixed income until such time as I thought I was being compensated for the risks.
That is not to say I am willing to short fixed income. I wouldn't, because I think the upcoming economic weakness may benefit that market. However, I don't consider bonds a sound investment. For folks who need income, I would not want to own anything longer than just a few years, a position I have maintained for quite some time (not advice).
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