E-piphany

When the murky waters of the loch appear to swirl and boil up in an unusual manner, the statistical reality is that it is much more likely to be a trick of the light, or a manatee-like creature, or something similarly non-threatening. But as a swimmer, doesn’t it warrant being more careful? If the chances of coming face-to-fangs with a sea monster are remote, the penalty is also extremely large. Viscerally, most of us shiver involuntarily when we swim over deep water and imagine what might be looking up at us…there is a reason for this primeval response; perhaps we ought to listen more.

I am starting to feel just such a shiver as I read headlines such as the ones today from Ireland (for example, this one). Cursed with a deficit that is 25% of current-year GDP and a recent crisis at a major bank (Anglo Irish Bank), credit spreads on this one of the PIIGS countries have been widening again and not, I might add, without reason.

The shiver looks as if it hasn’t yet made it into the stock market, which responded to the Irish news with decided indifference. Indeed, apparently bulls and bears called a truce today with stocks, bonds, the VIX and the dollar all closing nearly unchanged. Equity volume was good, but that was solely due to the fact that it was triple-witching Friday.

When both sides have battled to exhaustion and have retired from the fight temporarily, the military strategist looks to see who has the longer supply line; whose front is overextended and more-difficult to sustain. Sometimes, the answer is that no one is – the pugilists have traded punches toe-to-toe in the center of the ring. But that isn’t the case here. Clearly, the equity bulls and fixed-income bears have been the ones advancing over the last couple of weeks. The enthusiasm for pressing the advantage has apparently ebbed, and at an inopportune moment. The position is extended, and I don’t see the equity bulls having the gumption to overrun the Maginot Line at 1131 on the S&P (see Chart). I expect a pullback in short order, and a rally in bonds. As these are the usual seasonal tendencies, those are positions I would actually entertain. However, it does bear repeating that the level of uncertainty right now is quite high and positions should be smaller than normal. I view this as a tactical decision only.

The economic data this week didn’t help much. While the Michigan Confidence number today was surprisingly weak, down to 66.6 versus expectations for a rise to 70.0, that is a second-tier number a best. Interestingly, the respondents’ expectations for inflation 1 year ahead fell 0.5% to 2.2%, the lowest number in a year. This sounds like it ought to be a big concern, but it’s not. If you look at the Chart below, which shows the Michigan 1-year-ahead inflation expectations against year-on-year CPI, it looks like Michigan does an awesome job.

But alas, all this shows is that respondents are giving as their answer to the survey question the number they heard on TV today. The Chart below shows the Michigan results shifted forward a year (so the point that respondents are supposedly forecasting matches up with what happened). You can see that the responses are close to random. In 2008, the year-ahead forecast of the Michigan Survey missed by 7% what actually happened. Several months later, they missed 1% the other way. All the Michigan Survey tells you about inflation expectations is how closely people are following the current financial news.

So let’s look at the real CPI. The headline change was +0.254%, barely rounding up to 0.3%; the core change was +.046%, barely rounding down to 0.0%.[1] The modest downward-surprise on the core CPI was apparently due to aggressive seasonal adjustment factors that were unexpected. The year-on-year core CPI remained at 0.9% (actually 0.890%) and is actually at some risk of squeezing out another tenth decline over the next month or two before it begins to rise.

The question we all want answered, of course, is whether this is good for stocks and bonds both since it makes deflation appear closer and hence enhances the chances of QE2? Alas, probably not. The downtick was by the slimmest of margins, and it certainly sounds as if the Federal Reserve is looking more at indicators of activity (and omens of activity to come, in particular the actions of Congress), and as long as CPI doesn’t look to be plunging or soaring immediately it probably isn’t relevant to near-term policy deliberations.

On the topic of Congress: while I try to keep raw political observations out of this commentary, this will sound like one. I have begun to notice that politicians on the left side of the aisle who have joined the push to extend the Bush tax cuts are calling the action of extending them “the Obama tax cuts” rather than “the extension of the Bush tax cuts.” (see for example here) I would think that it is naked cynicism except that it is the same approach as the Administration has taken with the “jobs created (or saved)” metric. The Administration, and now the Congress, are basically taking one of the worst practices of the asset management industry and applying it to politics. In the last couple of decades, so much attention has been paid to the performance of asset managers relative to a pre-selected benchmark that most compensation is awarded based on relative performance. If the stock market is down 35% and you were down 34%, you’re a hero because you added 1% of value to what was assumed to be the baseline. The Congress here is saying that because the rise in taxes would happen as a result of existing law, if Obama acts to keep rates unchanged it is effectively a tax cut over what would have happened otherwise.

But to me, the taxpayer, it rings as false as when the fund manager tells me he did great by shaving a point off my loss. If the bill were to pass, my tax rates would stay the same. How is that a tax cut to me? If the bill fails, then my tax rates will rise. That sure sounds like a tax increase, but according to the spinmeisters, it isn’t.

Do these bozos have any idea how sickening it makes us all feel to realize they don’t even care enough about our opinion to come up with a clever dissimilation?

Well, I apologize. I hope that reads more as a harangue against the dolts in power (who at the moment happen to be predominantly Democrats) than against one political party. I am sure the Republicans mostly wish they’d thought of it first.

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[1] It embarrasses me to admit an error in yesterday’s comment. I stated that an 0.3% change month-on-month should be associated with 1.3% year-on-year; red-faced, I confess that I was looking at the wrong cell on my spreadsheet. The 0.254% change seasonally-adjusted came from a non-seasonally-adjusted change of 0.14%, which drops the year-on-year figure to 1.148%. I apologize for that goof, which is ostensibly in my area of expertise and so doubly embarrassing.