Archive for February, 2012

Zombies Multiplying But At Least We Learned Something

February 29, 2012 2 comments

While some elements of the economic and financial landscape seem to be clearing up, others are getting murkier. This is always the case, of course – our knowledge about the true state of the underlying economy and markets is always imperfect, so we are continually moving through shades of murk – but it seems to be more turbulent at the moment. A couple of weeks ago, all that the markets were concerned about was the Greek drama; now, some people believe that drama to be winding down (I myself am not at all sure of that; while Italian Prime Minister Mario Monti can opine with great confidence about the level of sovereign yields, we should take into account the fact that not a single soothing pronouncement of any politician or central banker in Europe has been correct for at least a year. Besides, while Italian yields are back near 5%, Portuguese bonds are over 13% again and headed in the wrong direction).

But at the same time, the economic data are getting less uniformly upbeat. Since December, the Citi Economic Surprise Index (see Chart, source Bloomberg) has been well over 50 most of the time, indicating that the data was routinely surprising on the high side. And yesterday, there was a significant upside surprise in Confidence, continuing the theme of an improving albeit not massively improved labor market. But there was also a horrendous downside surprise in Durable Goods Orders, which clocked an abysmal -3.2% ex-Transportation. Economists tried to soothe investors by saying the downturn was the product of expiring tax incentives, but that doesn’t change the fact that (a) knowing the tax incentives were expiring, they predicted 0.0%, and (b) no matter the reason for the decline, the decline was real and has real economic consequences. Is it encouraging that we obviously moved some growth into 2011, where it can no longer do us any good?

Markets in any event didn’t respond to the weak Durables number. I’m merely pointing out that if the Durables data is a prologue, we’re about to leave the steady-strong data period we’ve just enjoyed for the last three months. We’re overdue for some negative surprises. I am not sure this is necessarily bearish for equity markets being buoyed by ample liquidity, but it doesn’t help.

On Wednesday the ECB announced that it had allotted €529.5bln in the 3y LTRO conducted on Tuesday, bringing the total liquidity it has flushed into the market to about €1trillion. One observer pointed out that the ECB provided enough liquidity through these two LTRO operations to cover 72% of all bank debt that is maturing over the next two years, reducing the roll risk that banks would otherwise have faced.

Now, the roll risk is not to be taken lightly, but we should also not cheer too loudly that this element of market discipline has been removed. For a long time, banks have made the basic error of making long-term funding commitments and receiving only short-term funding commitments from depositors and purchasers of bank commercial paper. This need not create a balance sheet mismatch if the bank hedges with interest rate swaps, but the rollover risk doesn’t go away. Enron failed because they were unable to roll short-term debt. Lehman failed in part because of its inability to fund short-term. Some leverage in banking is inevitable, but locking up the leverage for longer terms is critical to surviving rough periods like this…unless, that is, the central bank is willing to bail you out when you get in that situation, and let you live as a zombie for a while.

Weirdly, the commodities markets ignored the wall of money surging in Europe and precious metals plunged today (-5%), supposedly because Bernanke in his semi-annual Monetary Policy Report and testimony before the House Financial Services Committee  did not indicate that QE3 was on tap. I’m not sure why that would be a surprise, since no one has been recently hinting that QE3 in the U.S. was imminent, and with three months of high-side surprises on the data it wouldn’t be my base hypothesis…but it’s very strange in my view that these same markets would ignore that the fact that the ECB is providing more than enough QE for both central banks at the moment. European union may not be true union, but European money is money just the same and LTRO1 and LTRO2 will support inflation globally in the same way that QE1 and QE2 did. I am not a fan of focusing exclusively on gold and silver, but commodities still have a following wind despite the setback today.

Why am I so worried about this wall of money, when so few people seem to be? The answer is that I am afraid for the same reason you’re afraid when that huge, mean-looking guy comes sauntering down the street and looking right at you. He might not actually do anything, but you’re well aware that he could do something, and it’s not really in your control. At least I am not the only person worried; for the first time (at least, that I have seen), there is someone actually in the Federal Reserve system who understands and has articulated the argument publicly. In a short “Economic Synopses” publication entitled “Quantitative Easing and Money Growth: Potential for Higher Inflation,” which is located on the research website of the St. Louis Fed, economist Daniel L. Thornton raises the issue that I’ve raised in this column before (for example see here and here). Summing up:

“While discussions of the money supply are nearly nonexistent in modern monetary theory and policy, both economic theory and historical experience suggest that a significant and persistent expansion in the money supply will be associated with a significant increase in the longer-run inflation rate.”

Dr. Thornton doesn’t say that the expansion of the money supply is automatically going to lead to inflation, only that it is plausible that it may because it has historically done so, and that this is a significant risk that is – as the quote above rather remarkably suggests – essentially not discussed in a serious way within the Fed.

I find it fascinating that more mainstream economists are finally asking these questions. You can also see a version of the argument I made last year via this link to an article by Dr. Steven Cunningham at the American Institute for Economic Research (I must confess that I don’t know anything about the AIER, but they have some interesting articles on the site). The difference is that Dr. Cunningham actually put hypothetical numbers that could result from the dynamic that Dr. Thornton (and I) have mused about.

Maybe I shouldn’t be surprised, but delighted, that this discussion is developing. I’ve said often enough that this crisis was going to serve as a rare opportunity to pit monetarist dogma against Keynesian dogma, at least with respect to inflation. The monetarists have scored a complete knockout, as inflation has risen despite massive output gaps (and prices were rising even in the absolute teeth of the crisis – take out energy, and the housing sector whose bursting helped cause the crisis, and inflation didn’t even decelerate very much). I think the chart in my comment here is the one that Keynesian orthodoxy just has a hard time explaining. In any event, what we are seeing is that thoughtful economists, rather than trying to force models to fit reality,  are migrating to models that make more sense and asking the questions those models provoke. That’s encouraging.

Now, whether these ideas are spreading or not, it’s not going to affect central bank actions any time soon. Philadelphia Fed President Plosser can say as often as he likes, as he did today, that the first hikes may come in 2012 (despite the Fed’s promise), but it’s not going to happen unless the economy simply explodes to the upside. While we would all love that outcome, it’s not likely when overburdened debtors are simply being turned into zombie companies, zombie banks and zombie countries. As everyone ought to know by now, the real healing begins…once we kill the zombies.

Spooky Action At A Temporal Distance

February 27, 2012 Leave a comment

The parallels of the current equity market rally to the August 2010-February 2011 rally following Chairman Bernanke’s hints about QE2 (a parallel I mentioned first about a month ago here) continue to mount. I can’t call today’s rally (a mere 0.1% on the close) a ‘cheerful’ rally except in the context of what might have been. Over the weekend, the G20 met in Mexico City, partly to discuss whether to increase the global commitment to a European solution (via funding for the IMF, which would then pitch in more than it has pledged to do so), and in very clear terms said no. That anything “in clear terms” would come out of a G20 communiqué is in fact unusual, but there seemed little doubt that further aid will not be forthcoming unless the Eurozone members themselves increase their commitment further.

Stocks were mildly irritated about this surprise in the overnight session, but only mildly, and that negativity was erased when the German parliament approved the Greek rescue package this morning. There was no doubt that it would do so, and yet there was a relief trade anyway.

Again, this reminds one of the mood in Q3 2010, when there were plenty of reasons for stocks to stay down (if not to fall further) and yet the market climbed; not only that, but it climbed inexorably. (It should be noted that core inflation bottomed in the month immediately preceding the month that QE2 was formally announced, although the precise timing is surely spurious.)

Another parallel is worth exploring here. The August 2010-February 2011 rally was actually in two parts. The first part ran from late August, when Chairman Bernanke delivered the Jackson Hole speech in which he all but promised QE2, until the week of the November FOMC meeting and the announcement of QE2. It covered 70 days and around 175 S&P points. Through the end of November 2010, while QE2 actually began, equities nevertheless declined about 50 S&P points; beginning in December and continuing through February 2011, the next leg tacked on another 175 S&P points over 79 days.

So far, this equity rally has covered 69 days and 167 S&P points. The similarity so far in pace and scope has been striking, with the main difference being the extremely weak volume on the advance. Now, there is no FOMC meeting tomorrow, and so the parallel is surely going to break down. Moreover, there seems not much chance that the Fed will announce a QE3 at the March 13th meeting. If there is a parallel, are we going to rally until the Fed actually announces QE3, or are 70 days and 175 points the measure to compare?

I suspect that the market has extended itself enough that, QEx or not, it is due for some turbulence. And, frankly, a 50-point setback wouldn’t exactly crush the bull swing any more than the 50-point correction in November 2010 did. Leveling off and correcting into the end of the quarter, or at least into late March when we will find out for sure if Greece navigated one more payment bulge, seems reasonable to me especially with the cyclically-adjusted P/E up above 22 and the S&P dividend yield down below 2% (now 1.99%) again.

The parallel in bonds is somewhat more interesting. Bonds had rallied into the 2010 Jackson Hole speech, with 10-year yields falling from 4% in April to around 2.5% when the speech took place. So the rally in fixed-income had already taken place, and little else happened in nominal yields over next couple of months (see chart, source Bloomberg). But inflation breakevens rose sharply and real yields (not shown) fell, so that while nominal yields were not moving in the aggregate, inflation swaps actually rose about 50bps and real yields fell about 50bps between August 27th and the Fed meeting in November. I first wrote about this divergence here and here.‎

While nominal yields were not registering anything in particular between Bernanke’s loud hints about QE2 and the formal announcement thereof, there was considerable action below the surface. With that back story, consider the history of yields and breakevens since last summer, illustrated in the chart below.

The divergence is more subtle, to be sure, but at least since the beginning of the year breakevens have been moving steadily higher while real yields steadily fell. The tale of the tape: 10-year inflation swaps since year-end, +37bps (was as much as +44); 10-year real yields -32bps (was as much as -35bps).[1]

Coincidence? I don’t think so. This rally has all the hallmarks of being money-induced, whether it’s the perceived promise of QE3 or the actual LTRO from the ECB and other monetary actions from other benevolent central banks. (Oh, how interesting. LTRO2 is the day after tomorrow, about 71 days after the beginning of the first leg.) Had this been an actual rally on strong economic fundamentals, we should have seen real yields rise.

There have been a couple of other developments worth noting in inflation-land recently. One is that the short end of the curve has risen appreciably, so that the 1-year inflation swap rate is above the 2-year swap rate – something which hasn’t happened since March and April of last year when oil prices were also on the rise (and 10-year nominal yields were about 150bps higher than they are now). Actually, the whole shape of the swap curve is different than it has been for a while (see Chart, source Enduring Investments).

Although you can’t see it from the chart, 5y inflation 5 years forward (aka 5×10 inflation) is above 2.90% and is threatening 3%. That hasn’t happened since last August (when 10-year nominal yields were 50bps higher than they are now).

Oh, and what happened to 10-year nominal yields after the first leg of the QE2 trade, and their long period of quiescence? Between November 4, 2010 and December 15, 2010, they rose by 100bps.

Incidentally, in 22 of the last 31 years, 10-year yields have risen in the 30 days following February 27th. While 10-year note yields have fallen some 1200bps over those 31 years, they have risen, on average, about 20bps between now and early May (see Chart, source Enduring Investments).

It is, in short, an inopportune time to be long fixed-income. And, frankly, I’m not too sanguine about stocks, as I have said. Our model continues to allocate quite heavily to commodities in this environment, as do I in my personal accounts. Among ETFs, I am long USCI, GSG; long INFL and RINF as long-inflation expectations plays, and long TBF to be short nominal bonds. I also own SPY puts and FXY puts (which is unrelated to what I discuss above) in small amounts.

[1] Note that I’m correcting the 10-year real yield for the substantial roll to the new TIPS issue, as otherwise it looks like real yields have fallen less than they actually have.

Model vs. Reality: Reality Wins

February 23, 2012 6 comments

The bond market ended Thursday nearly unchanged, although short TIPS did very well because energy markets continued to trend higher. Gasoline rose 0.8% to $3.1136/gallon and NYMEX Crude added 1.5% to $107.83. Precious Metals were also higher. Stocks gained 0.4%. It is hard to believe this can merely be enthusiasm over growth and a “risk on” trade associated with the purported resolution of Greece’s troubles. In fact, I will say that with the almost unanimous acceptance of the notion that “the crisis is over” among the mainstream media makes me very nervous. Apple has recovered its losses from last Thursday, although on a fraction of the volume it had on the selloff, but I am accumulating equity hedges. Implied vols are at a 7-month low, but I don’t think risk is.

That is all I am going to say about market action today, because I want to mention a research publication that crossed my desk today and discuss what it means to a trader who is also an econometrician.

Goldman Sachs Global Economics, Commodities and Strategy Research today produced a piece called “The Top-Down Logic for Our Inflation Forecast.” In it, the economics team explains why they are calling for core inflation to fall to 1.5% in 2012, and 1.3% next year. Their reasoning is the “the combination of labor market slack and anchored inflation expectations should reassert itself in lower core price inflation over time.”

Frequent readers of this column will know that I have rebut the labor market slack hypothesis a number of times, and while I haven’t explicitly rebut the ‘anchored inflation expectations’ argument (mainly because modeling this requires complicated regime-shifting models that make it hard to refute null hypotheses) I am highly critical of them since the evidence in support of the notion that inflation expectations matter is based on measures of inflation expectations that demonstrably fail to measure inflation expectations.

So, you would think that these few paragraphs would be criticizing the forecast of Goldman Sachs. But that’s not really my point. Really, I want to point out the really hysterical part of the note, and observe why sell-side economic analysis is so useless (although some economists at Goldman, to be fair, are quite good). Goldman says “Although the model failed to capture the sharp pick-up in inflation in 2011, our bottom-up analysis suggests that this deviation was chiefly driven by special factors outside of the scope of the model, including pass-through from surging commodity prices and a spike in auto prices.”

Yes, that’s right: if there’s a discrepancy between reality and the model, then obviously it is reality at fault and not the model!

To make the hilarity of this point clear I reproduce below the chart from their piece:

So all the model failed to do is to pick up the most-dramatic rise in core inflation in the last 35 years or so.

To make this fair, here’s my own model (now Enduring Investments’ model) covering the same period. Note that the model forecasts are actually finalized about 12 months ahead.

As I’ve said frequently, the current surge in inflation has not been fully captured by our model (although if we distributed the lags, rather than doing a simple lag, it would probably have done better, as the strange spike in late 2011 suggests). But at least it got the direction right, and began to rise at the right time, and for the right reasons. And, unlike Goldman, I think the reason for the difference is that our model isn’t quite right and is missing or underestimating some effect – so I expect our model will catch up with reality, rather than the other way around as Goldman does.

If an economist is highly confident in the model, then it can be reasonable to expect minor deviations to be mean-reverting. But it’s the model that’s mean-reverting, not reality (it is a model, after all – it isn’t supposed to capture all the nuance of reality). And if there is a significant deviation in reality from the model, then it can make sense for an economist to hew to the model if he’s 100% confident in the model. But then, if he’s 100% confident in a model, he’s an idiot. Which reminds me of this:

Bernanke: Well, this fear of inflation, I think is way overstated. We’ve looked at it very, very carefully. We’ve analyzed it every which way…We’ve been very, very clear that we will not allow inflation to rise above 2% or less…We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time…

Pelley: You have what degree of confidence in your ability to control this?

Bernanke: One hundred percent.

Aside from the irony that we’re already above 2% (although not in core PCE, which he will claim should be understood), the other commonality (besides utter confidence in the model) between Goldman’s economists and this Princeton economist is that they’re absolutely confident that they have the right model: labor slack and inflation expectations. So far, we have seen from neither one of these sets of economists any deep introspection about whether maybe, perhaps, labor slack and inflation expectations don’t really matter, but things like money supply do.

Incidentally, while our model’s forecast for year-end is 2.10%, if we’re right on the trend but wrong on the starting level (that is, if the effect we missed was around the bottom and isn’t something persistent) then the more-relevant figure is the 0.8% acceleration in y/y core CPI our model expects in 2012. That would put core inflation at a cool 3%. Interestingly, if we remove the dampening effect the high level of private debt has in our model – that is, if we simply hypothesize that the ratio of private/public debt has a discontinuous effect so it either dampens (at high private/public ratios) or does not dampen (at moderate or low private/public ratios), then we also get 3%. That hypothesis, obviously, is difficult to test, which is why it’s important to not be 100% confident or reliant on your model, and to always be skeptical that you may be missing a key dynamic. Life is not linear. The reason that these economists don’t know that is that they’ve never tried to trade a model! If you are an investor who relies on models, a healthy – and continuous – skepticism is your best defense against reality diverging from your model.

I suspect something in between our model’s forecast (2.1%) and our model’s forecast for acceleration (implying 0.8% acceleration) is right, and so 2.7%-2.8% is our official forecast. By the way…not that it matters, if labor slack and inflation expectations are all that matters…but M2 rose $27.9 billion in the latest week and continues to grow at a better-than-10% pace year/year. It first hit that pace exactly half a year ago.

On Friday, New Home Sales for January (Consensus: 315k from 307k) is due out at 10:00ET. More interesting is that a number of regional Fed Presidents are in NY to speak at a conference on monetary policy. The conference begins at 9:00ET, so be prepared for tape bombs all day from San Francisco Fed Williams, St. Louis Fed President Bullard, Philly Fed President Plosser, and NY Fed President Dudley – a former Goldman Sachs economist, by the way. It will be interesting to hear if any of them is interesting in examining his model, or if they all expect reality to conform to the model.

It being Friday, we are supposed to have some rumors about a Greek deal over the weekend, but I am not sure how to play that since we supposedly have a Greek deal already. Perhaps this means that there won’t be such great expectations, and we can all enjoy the weekend for a change.

Neither Trumpets Nor Bomb Blasts

February 22, 2012 Leave a comment

Today, finally, we can focus on the domestic situation. While the matters in Greece are far from resolved, and are generating the usual amount of chaotic-looking discussion about what exactly the “deal” is supposed to mean, and for who, and whether everyone who needs to be a party to the deal actually has in fact signed off on the deal. So far the early returns are not promising, but there were neither trumpets nor bomb blasts today and we will therefore leave it behind for a day.

It seems odd to actually think about the economic data for a change. Today’s Existing Home Sales data, though, are worth thinking about. With good weather providing a boost, January Existing Home Sales ran at only a 4.57mm seasonally-adjusted pace, below expectations and with a hefty downward revision to last month’s data. Unless the seasonal adjustments are being made based on the previously-misreported-by-NAR data…and I can’t imagine that mistake being made…this is simply a weak number. Bloomberg’s initial take was “Sales of Previously Owned U.S. Homes Increase in Sign Recovery Taking Hold,” but then they realized that the 4.57mm was below the previously-reported pace of December. That is, the only reason there was an “increase” is that last month’s data were revised lower. (Bloomberg later dampened down the headline).

The good news in the report is that housing inventory dropped to the lowest level since 2005. This provides a bit of support for home prices, but it also suggests that bank REO property isn’t yet coming to the market in any quantity. If that is the case, then one interpretation of the low sales figures could be that homebuyers are waiting for the foreclosed inventory to begin to hit the market. It’s not a bad strategy, if you see shadow supply that is suddenly freed, to let the supply be listed before negotiating on your dream home.

But perhaps I am reaching. European PMI data, out this morning, fell unexpectedly into contraction territory. It would not be a difficult stretch to imagine the economy stumbling over the next quarter or two; in fact, many observers have predicted just that. I suspect the U.S. will withstand a Greek default and potential Euro exit, but I also don’t expect strong growth. Weak growth, rising inflation is what I expect.

Consistent with that theme, for the second day in a row, equities struggled (today -0.3%) while commodities rallied (DJ-UBS +0.4%). Industrial metals led with a 2% gain while Energy commodities rose 0.6%. Front gasoline is now up 25% since mid-December.

The 10y Treasury note rallied a surprising 6bps to 2.00%; TIPS rallied more, so that 10-year breakevens (or inflation swaps) rose about 1bp. Again, this is somewhat interesting in the context of weaker housing and European PMI data, stronger bonds, and weaker equities. It is consistent with the notion that the underlying inflation process has some momentum. I want to share a chart here of one component of CPI, the Apparel major subgroup. Many of the economists who are calling for core inflation to moderate point to housing supply (as do I), but many of them also point to Apparel as a component that has recently been rising but which they expect to correct because everyone knows that Apparel prices never go anywhere. Or at least, they haven’t gone anywhere for a long time. The chart below (Source: BLS) illustrates the point.

From 2003 to 2011, Apparel prices were unchanged to lower. And from 1999-2003, they trended lower. Indeed, since 1994 or so Apparel prices have gone sideways or down. So it’s not an unreasonable supposition that a rise in Apparel prices ought to mean-revert, so any effect on core CPI ought to be ignored. Except for one thing, and that is that you can see from the chart Apparel prices haven’t always trended lower. It isn’t somehow a law of nature that Apparel prices decline all the time. Over the last two decades, as more and more clothing was produced and exported from developing Asia, there was a constant downward competitive pressure. But that may no longer be the case. The recent rise in the Apparel subcomponent looks to me a lot more like the pre-1993 period than it does the post-1993 period.

By the way, I picked from 1987 just because it was enough data to make the point. But so you don’t think 1987-1993 was the unusual part, here’s the whole chart back to 1960.

Rising apparel prices are much more normal than declining apparel prices, in the grand sweep of history.

Here’s another inflation-related story. The Atlanta Fed’s “macroblog” posted an item today entitled “Weighing the risks to the inflation outlook: Two views.” Since any hint that there might actually be two views among the one thousand economists at the Federal Reserve gets my attention, I read this story. It’s interesting for a couple of reasons. The humorous reason is that the authors seem to see nothing curious about their first chart, which shows that the respondent firms to their survey have had incredibly stable expectations for short-term inflation. Unreasonably stable. Suspiciously stable. As an econometrician, I’m tempted to throw out such obviously useless data, unless I first investigate and find there is a good reason that, with oil prices gyrating wildly and Europe imploding, business owners don’t change their opinions about year-ahead inflation.

But that’s not the main point here. The main point is the authors’ observation about the reason for the fact that longer-term expectations are higher, by a full percentage point, than the shorter-term expectations. They conclude that while they agree on the central tendency for inflation over the short and long term being in the 1-3% range, in the short-run the respondents give a slightly higher chance for a lower outcome than they do for a higher outcome…but in the long-run, the respondents give a much higher chance for a higher outcome (more than 3%) than for a lower outcome.

This is interesting because the Fed cannot affect prices in the very short term, and the respondents seem to be saying that they believe the Fed to be asymmetrically biased to increased inflation in the long-term. Of course, this comports with history, and it is a theme I have been hammering on for a while: whatever you think the likely outcome for inflation over the next 10 years, almost all of the long tails are to higher inflation rather than lower inflation. Accordingly, you can think of long-term inflation swaps or breakevens as consisting of a forward contract plus a call option on inflation. And I think that means market prices for long-term inflation ought to be a lot higher.

Subprime Sovereign Europe Still the Focus

February 21, 2012 Leave a comment

Like everyone else, I want to believe that the Greek bailout this time really is ‘done.’ Of course, my main reason for wanting that outcome is that I am weary of writing about all of the deals, which turn out not to be deals, which get trumpeted as deals again, and so on.

Over the weekend, we were assured that there was finally a solution to the Greek crisis. The ECB (and it turns out today, other European central banks) will swap their bonds for new Greek bonds that will not be subject to haircuts. Meanwhile, private bondholders will take a haircut and get new bonds worth a lot less, although this afternoon the head of the IIF (the group responsible for the PSI negotiations) told the BBC that this will only work if CDS owners don’t choose to trigger their payouts. So, as long as private-sector bondholders choose to take less money, this is all good. The IMF is also reportedly contributing less to the deal than had previously been expected. And all of this is subject to approval by a number of legislatures.

So the problems of subprime sovereign Europe have not yet been put wholly to rest. The markets seem unsure on this point. Stocks ended essentially unchanged after hitting new highs in the morning, on continued low volume. Bond yields rose, with the 10-year nominal bond up 5bps to yield 2.06% and 10-year TIPS 2bps higher to yield -0.24%. That would seem to indicate some marginal lessening of tensions, but with volumes thin and equities near-unchanged I think such a read would be premature. The VIX was higher on the day, although it remains lower than it was last week.

Commodities had a banner day, relative to equities, with the DJ-UBS index +1.35%. Precious Metals led the way with a 2.75% gain and Industrial Metals rose 1.6%. Energy, however, will get the headlines. Although Nat Gas blunted the performance of the group, NYMEX Crude rose to $105.50, the highest level since May and 40% above the October lows; Brent reached $121. Gasoline jumped a nickel to $3.0661/gallon, the highest since driving season and the highest print ever for the March 2012 contract.

This seems like the first time in a while that commodities have simply smoked equities, but since the beginning of the year they have kept pace…if you leave out Nat Gas. Our preferred ETF, USCI, is up 8.98% year-to-date compared with 8.32% for the S&P. The correlation has been far too high for our tastes, suggesting that both markets are trading QE3 rather than inflation expectations. But they too are higher: the INFL Deutsche-issued ETN is +5.0% year-to-date.

While all markets move in lock-step, it is hard for me to believe that the earthquake has happened. Whether it’s the earthquake of Greece failing and banks coming clean about their losses therefrom (and a potential unzipping of other subprime sovereigns), or it’s the earthquake of Greece getting bailed out successfully and causing the line of sovereign supplicants to extend around the block, there’s some kind of resolution coming that should fracture, at least for a while, these high correlations. I believe that in such a circumstance, commodity indices are the best-valued and most likely to come on top…but we will see.

However, Bloomberg claims that the S&P is the cheapest relative to bonds it has ever been, since 1962. I enjoy the presumably-unintended bias in construction. Why not say, “Bonds are the most-expensive, relative to stocks, that they have been since 1962?” Both would be true, if the metric they’re pushing (the spread of the ‘earnings yield’ to the 10-year Treasury rate) is the right metric, but one headline implies that stocks are cheap on an absolute basis while the other headline doesn’t imply that. Our equity culture is alive and well, sadly; but there are many more arguments to be made that both bond and stock prices are too high than there are to be made that both are too low. And of course, as I’ve pointed out before, saying that stocks are cheap relative to something else is not the same as saying they are cheap, in the sense they will have better-than-average returns. By the same token, TIPS are extremely cheap relative to nominal bonds, but I would not suggest owning them outright at a -0.25% real yield. So if you want to buy stocks and sell bonds, or you want to buy TIPS and sell bonds, you may have a winning trade…if you weight the trade right. Be assured that the correct weight is not equal notional amounts. That is, if you sell your short-term bond portfolio to buy an equity portfolio dollar-for-dollar, you probably have more risk to markets returning to fair value even though bonds are expensive to stocks.

On Wednesday, after an overnight session filled with updates, clarifications, exceptions, and corrections to the so-called Greece deal, we will get to enjoy the happy news about January Existing Home Sales (Consensus: 4.66mm from 4.61mm). Since the weather in January was better-than-average, it is fair to expect a strong number, which means the market ought to react more to any downside surprise than to an upside surprise. But the magic number is 5 million. Existing Home sales haven’t been there, except for a brief spike in late 2009, since 2007. But prior to 2002, a pace of 5-5.5mm Existing Home Sales was a fairly typical level (see Chart, source Bloomberg), and would imply that properties are finally starting to clear at something like normal rates. The data may be a little messy for a few months as bank REO property gets put back on the market (potentially driving up both inventory and sales numbers), but 5mm is the level to hope for.

Inflation: As ‘Contained’ As An Arrow From A Bow

February 17, 2012 5 comments

Is 15 months in a row of rising core inflation ‘contained?’

Year-on-year core CPI has now risen for 15 consecutive months. At some point, it will seem reasonable to let it have a month off, but until now it hasn’t needed it. Fifteen months in a row. That’s impressive. It’s so impressive, in fact, that it hasn’t happened since 1973-1974, when prices were catching up from the failed experiment of price controls imposed by President Nixon in 1971-73. Core inflation has never, in the history of the data (which exists since 1957), accelerated for 16 consecutive months. So, next month we have a chance for a record!

Headline inflation was softer-than-expected by 0.1%, even as the NSA CPI index itself came in higher-than-expected. As I pointed out yesterday,  that was a semi-predictable consequence of the change to new seasonal adjustment factors. Core inflation was 0.218% month-on-month, however, which actually generated a rise in the rounded year-on-year index to 2.3% (2.277% to three decimal places). The table below shows the evolution of the year-on-year changes for the eight major subgroups from 6 months ago to 3 months ago to last month, to now.

Weights y/y change prev y/y change 3m y/y chg 6m y/y chg
 All items






  Food and beverages
























  Medical care












  Education and communication






  Other goods and services






Compared to last month, Apparel, Medical Care, Recreation, and Education/Communication accelerated, groups which total 23% of the consumption basket. Transportation and Food & Beverages both decelerated, and they total 31.5% of the basket. Now, notice that Transportation and Food & Beverages are the two groups that are most affected by direct commodity costs – energy and food, respectively. So…don’t get too excited by the deceleration there, although new and used motor vehicles and other components of Transportation also decelerated and that doesn’t have much to do with energy prices. In Food & Beverages, “Food at home” is decelerating (about 57% of the Food & beverages category) while “Food away from home” and “Alcoholic beverages” (the balance of the category) are accelerating.

Yes, you can get eyestrain looking too closely at these figures, but doing so does help.

For example, one theme I think the Fed is counting on is that the “Housing” component of CPI is expected to decelerate due to the still-high inventory of unsold homes and the fact that foreclosure sales can now proceed. It has been a conundrum why rents have been rising while home prices stagnate (actually, not much of a conundrum: there is an underlying inflation dynamic that in the case of the housing-asset market is being overwhelmed by a decline in multiples. But this is a conundrum to the Fed, and to be fair I also expected Housing inflation to be lower than it has been recently). And in this month’s data, you can see that the year-on-year increase in Housing CPI flattened out. But, as the table below shows, the Shelter component wasn’t what flattened out. Housing only went sideways because the “Fuels and Utilities” component declined – again, a commodity effect.

Weights y/y change prev y/y change 3m y/y chg 6m y/y chg












   Fuels and utilities






   Household furnishings and operations






I still expect Housing inflation to level out and probably to decline, but so far those expectations have been dashed. It will be uncomfortable for the Fed if it remains this way; a significant part of their expectations for a visually-contained core inflation number is (mathematically) due to the expectation that housing inflation isn’t going to keep rising. As you can see in the chart below (Source: Enduring Investments, the rest of core inflation outside of Shelter is continuing to rise. Inflation is not ‘contained’, except maybe for housing. Maybe.

I am fairly confident, though, that if Housing inflation does not decelerate as expected, then the Fed will find some other reason to ignore the very clear acceleration in inflation. The economists at the FRB are for the most part true believers in the notion that the output gap constrains any possible acceleration in inflation, despite ample evidence that output gaps don’t matter (or, anyway, matter far less than monetary variables). For another view of this proposition, see the Chart below, taken from this article by economist John Cochrane.

Fed economists also feel strongly that “well-anchored inflation expectations” means that they can ignore 15-month trends in core inflation, despite the fact that by Chairman Bernanke’s own admission we aren’t really very good at measuring inflation expectations (to be kind).

They have time. The Fed has recently begun to treat 2% (on core PCE, not core CPI) as more of a floor than a target, so it will be some months, even if core inflation doesn’t pause for a month or two pretty soon, before the Committee starts getting at all warm under the collar about inflation. Even then, they are extremely unlikely to take steps to reduce liquidity while Unemployment remains high. The Fed is in a political bind, and the only easy path for them is to “see no evil” on inflation while hoping that Unemployment drops swiftly enough for them to act before prices really get out of hand. We will see.

Mister Market Is Cheery For Now

February 16, 2012 Leave a comment

There was no news from Greece today, although optimistic journalists penned excited articles indicating “progress” such as the idea that the ECB (headed by Mario Draghi, not Mario Monti as I incorrectly wrote yesterday) might exchange its Greek bonds for new Greek bonds. It is unclear to me if this is progress, but it certainly isn’t big progress. The latest rumor is that “the deal will be completed on Monday,” with a little asterisk that “the deal” is the offer to Greece that has 24 preconditions that need to be completed by the end of the month. And “the deal” doesn’t include the private sector initiative. And “the deal” hasn’t been signed off on by any of the legislatures that would have to actually approve it. To me, it doesn’t sound like a lot of progress, but investors are clearly predisposed to be excited by anything that anyone calls “the deal,” even if it’s not.

Mister Market was cheerful today, though, and looked kindly on the positive economic data. Initial Claims recorded a new post-Lehman low at 348k, and Housing Starts approached a new high by printing 699k. The Philadelphia Fed was good, except for the “Number of Employees” subindex, which actually looks a little weak at the moment (see Chart).

That small blemish is no reason to toss out the entire carton of apples, though, and investors were justifiably upbeat about the data. I have more trouble explaining why Mister Market was so willing to ignore the awful news that Moody’s is preparing to slash bank credit ratings soon. I don’t think investors understand the implications, perhaps figuring that since a downgrade of the US didn’t cause any alarm then why should a downgrade of Morgan Stanley? I explained yesterday why it should, but today bank and financial shares outperformed the rest of the market.

No doubt, U.S. commercial banks are further away from insolvency than they have been in a while, and loan growth is showing it. The chart below (Source: Federal Reserve Board, H.8 report) is updated as of the latest available data: commercial loan growth is now growing at a 4.2% pace year/year, the fastest pace since November 2008.

Incidentally, that also means that the enormous cache of sterile reserves the Fed has added is no longer just sitting there. It is starting to circulate, which is one reason that M2 growth is still at +10% y/y, where it has been essentially since August.

But, getting back to the market: while current loan volumes are better than they have been in a while, that’s partly because banks don’t have many other ways to make a buck these days. And this data is backward-looking, while a downgrade is negative in the future. It isn’t as if these banks are good values even before a downgrade: Goldman is at 16x earnings, with revenues down 20% over the last year and ROE is 5.5%. Bank of America is at 8x earnings, with revenues -14.6% and ROE of 0%. I should add that Goldman is up 27% year-to-date and Bank of America is up 45%. (This is not an investment recommendation, and I’m not long or short either stock.)

The rally in stocks helped push bonds lower, and the 10-year yield again reached for the 2% level. Since November, the 10-year note hasn’t been outside of a 1.80%-2.10% range, which is amazing quiescence. There are two obvious pressures on bonds. On the bullish side, you have the fact that Europe is and will continue to be a basket case for some time. But on the bearish side, you have 2.2% current (core) inflation and the Fed targeting approximately that level; 2% nominal yields is clearly a losing proposition and clearly too low absent a significant deflation. At some point, this tension will be resolved and yields will move sharply. I will observe that the inflation and Fed targeting arguments aren’t going to go away for a long time, while the Europe story will eventually fade. I remain short fixed-income.

The crowning economic data point of the week (well, at least from my perspective) will be the CPI, released tomorrow. The consensus call for headline inflation month/month is +0.3%, and +0.2% on core inflation, leading the headline figure to drop to +2.8% year/year and leaving the core year/year number unchanged at +2.2%.

That actually implies that the market forecast for core is for a “soft” +0.2%, meaning something that rounds up to that figure. A true 0.2% should cause the year/year core rate to rise to 2.3%. Since we haven’t had a true 0.2% since August, this seems like a reasonable guess. I think it is a reasonable guess, but not because of the recent below-trend prints. The housing subindex of CPI has been rising at a faster pace than it probably should be, given the inventory overhang, and last month it decelerated on a year/year basis. I think this will probably continue for at least a few months, keeping core apparently tame. That also, though, means that we need to be careful to look at core ex-housing. The expected softness in housing is a wonderful gift to the Federal Reserve here, who could point to the core number and pretend they don’t know it’s because the unwinding bubble is still dampening the cost of housing. It means there may not be much pressure to reduce their accommodation even if inflation in the non-bubble economy continues. Core inflation ex-housing rose at a 2.5% pace for 2011, up from 1.1% for 2010. I expect a continued rise there although probably at a lower rate of acceleration.

Tomorrow’s report also involves revised seasonal adjustment factors, which happen to suggest that either the m/m headline figure will be a little softer than 0.3% or else the actual CPI index itself will be a little higher than 226.573, which is the consensus estimate (this latter figure matters only if you own inflation-indexed bonds; the rest of you may ignore it).

The U.S. markets will be closed on Monday, which also means that this author is unlikely to write then (I will probably write something after the CPI report, but then use the weekend and Monday to work on our firm’s Quarterly Inflation Outlook). Thanks to all of the readers who made last night’s article one of the most-viewed I have written in a long time. Do pass along these articles, or better yet links to them, to your friends. Tweet them! (And follow @inflation_guy. On Bloomberg, you can type NH TWT_INFLATION_GUY<GO> for my Twitter feed, something I just discovered). And let me know what you think about them.

An Umbrella, Just In Case

February 15, 2012 6 comments

Greece, Greece, Greece. I’ve had it up to here with Greece. I’m tired about writing about Greece. Apparently, I am not alone; after the conference call today, Jean-Claude Juncker said that he was confident that a “decision” on a bailout for Greece will be made at the next meeting…on February 20th. Gee, that would be great, Jean-Claude. If it’s not too much trouble, you know.

I grow more confident by the day that the Greek default is reasonably imminent. Today there was also talk about the possibility of a ‘bridge loan’ to get Greece past the March bond payments. Aside from the fact that the mere possibility of a bridge loan will keep holders of the March debt from agreeing to the PSI (gee, get paid at par or get paid 30% of par. Hmmm.) in the hopes that they get paid out, and the fact that (as TF Market Advisors points out) paying the March redemption would add about €8bln to the total cost of the bailout, my question is: what good does more time do? Have the last months and years not been enough, so that another month will allow you to reach a solution? If that’s the case, then by all means fritter away another €8bln, but that’s one heck of a leap of faith if the only thing they could resolve on the conference call today was to have another meeting on February 20th. Can I hear an ‘Amen?’

More likely, the foot-dragging now is to figure out how best to effect the default so that it has the most salutary (or least-hurtful) effect on the political careers of those currently on the stage. For example, a certain French President announced today that he is going to seek re-election, a prospect which is fairly dim at the moment since Sarkozy is trailing the Socialist candidate (Hollande) by a healthy 7-9 points in the polls and, more importantly, losing by a huge 59-41 margin in a hypothetical head-to-head runoff matchup with Hollande. It isn’t clear what Sarkozy can do to salvage his re-election, although with two months to go anything can happen, but I can’t imagine it would hurt to stop shipping French taxpayer money to Greece. What do I know, I’m not French, but my point is that the political pain of keeping Greece may finally be outweighing the political pain of sending her on her way.

There are more reasons to be wary of the equity market here. As readers know, I’ve been reluctantly long in this rallying (but expensive) market, but this is no time to be a hero.

One of the other reasons is the news this evening that Moody’s is considering cutting the ratings of Morgan Stanley, Credit Suisse, and UBS three notches, and Goldman, Barclays, BNP, Deutsche, JP Morgan, Credit Agricole, HSBC, Macquarie, RBC, and Citi two notches each. Oh, and for good measure, Bank of America, Nomura, RBS, and Soc Gen are potential single-notch downgrade targets. They also acted today to cut some European insurers’ ratings. While we all know that ratings should be taken with a shaker of salt (if not altogether ignored and replaced with actual analysis), in a world of CSA (collateral support annex) ratings triggers, downgrading the whole financial system would have the effect of pulling a Lehman/AIG on the whole mess. All of these counterparties would suddenly have to post large amounts of additional margin with each other. Financial companies’ leverage has declined markedly over the last few years (in contrast to households, for example, where leverage hasn’t changed much), but this could still conceivably require a strong, concerted central bank liquidity injection of massive proportions.

A 3-notch downgrade to Morgan Stanley would put them at Baa2, which it might share with Citi and Goldman only slightly better at Baa1. Now, in 2008 both MS and GS became commercial banks, so they have access now to the Fed window – a Bear/Lehman moment would thus be unlikely. However, either or both could conceivably be in a BOA/Merrill shotgun wedding situation.

I don’t want to sound alarmist, because no ratings actions have yet been taken on the banks. And I obviously don’t disagree with Moody’s reasoning, when I have said as much here myself. They said

Capital markets firms are confronting evolving challenges, such as more fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions. These difficulties, together with inherent vulnerabilities such as confidence-sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms.

Yes, agreed, but the point here is that the ratings downgrade itself can cause a contagion, because of the existence of (well-intentioned) credit triggers. Those credit triggers are the papier mâché palm trees in the Coconut Grove.

I haven’t the faintest idea where those triggers are, and which ones may be triggered. And because no one else does either, it will not surprise me a bit if interbank lending grinds to a halt again. And this time, JP Morgan can’t step in as the big man on campus, because they’re in the same boat.

That’s not the only reason that the landscape suddenly looks less inviting for investors. Let’s talk about Apple. Now, I am a big fan of Apple products. I will note the Graham and Dodd admonition that a good stock differs from a good company in that a good stock is also cheap, but I’m not passing judgment on the valuation of Apple stock. Frankly, it’s not even a stock I watch very much, because it doesn’t pay a dividend and stocks of that type don’t generally interest me (firms that distribute dividends historically have tended to have a higher ROE). But today, when a highly-touted stock hits a new high and then reverses on huge volume – especially in an otherwise-somnolent market – it is a bad technical signal. When I say huge volume, I don’t just mean it was the highest share volume since January of last year. Keep in mind that the price is also some 45% higher now, and also keep in mind the aforementioned sleepy-market context. The chart below shows what I mean: Apple’s dollar volume today (with no news evident that I could see), on a day it set a new high and then reversed, was an absurd 5.2% of the total dollar volume traded on the Nasdaq. And frankly, that understates the point since I valued the dollar volume as the total shares traded times the closing price, and the closing price for Apple was the low of the day and more than 5% below the day’s highs.

So this is bad behavior from one of the generals.

Finally, back in geopolitics, Iran threatened to cut oil exports to six countries.  It didn’t cause much distress in the oil markets, since these are six countries that were already planning to embargo Iran in the summer. So Iran’s “you can’t fire me because I quit” routine should have scant effect. That said, Brent Crude was already at highs not seen since last summer, and NYMEX Crude was near the top of its recent range as well. I don’t expect any spike (although the ideal time for an Iranian provocation would be in the midst of a Greek default-related turmoil in global markets, wouldn’t it?), but it’s another risk that is turning acute at the moment.

None of this stuff is deterministic. They are all warning signs, and they might be completely ignored tomorrow, outweighed if there is a strong report from Initial Claims (Consensus: 365k), Housing Starts (Consensus: 675k), the Philly Fed Index (Consensus: 9.0), or all three. But the possibility of a very bad payoff, and a worsening edge/odds calculus, implies that investors should be scaling back long-stocks bets. (I wrote something similar back on March 1, 2011 in a piece called “The Market’s Pot Odds,”  which references in turn one of my all-time favorite article from back in 2010, “Tales of Tails,” talking about the implication of the Kelly criterion for investing. I submit these may be worth reading if you are interested in the edge/odds reference I just made.)

Implied volatilities, as represented by the VIX, have recently begun rising again, but protection is still relatively cheap considering the risks. If you feel this is a passing thundercloud, it still might make sense to buy an umbrella just in case.

What Have You Done For Us Lately?

February 14, 2012 1 comment

So the EU laid down the law last week: Greece had to prove that it was serious about austerity measures. It had to get all political parties who might win in elections this year to agree to maintain the austerity measures, and they did. It had to pass a bill detailing the austerity measures through parliament, and it did. The government and the major political parties went further, and sacked anyone who voted against the measure – displaying a fairly hair-raising resolve to ditch democracy if that was necessary to make a buck. And it had to find a few more hundred million in austerity measures, which it was working on.

Then a group of Euro finance ministers was to meet on Wednesday, sign off on the deal, and move the process forward so that the March bond payment would be covered (assuming a few other things, like the IIF agreement, moved forward as well).

Well, that meeting has been canceled. It is being replaced with a conference call. Jean-Claude Juncker said that they had not received “assurances” from Greek leaders about the cuts. You may read between the lines here with some ease: it is hard to imagine how greater assurances could have been given than sacking all of the dissenters and passing a law despite protestors outside threatening to burn the ancient city down.

The Euro ministers may have been surprised by the report that Greece’s economy contracted by 7% (annualized) in the latest quarter, but although that was larger-than-expected it wasn’t so different that it should completely change the EU’s perspective. To me, Juncker’s downgrading of the meeting looks like a fairly clear indication that the EU is not at all united about whether Greece should be saved, allowed to default while remaining in the EZ, or kicked summarily out of the EZ (or even the EU). It sounds like an excuse. It is hard to see how Greece could have done more than they did this weekend. I don’t believe Greece can be prevented from defaulting, and I have said that now for a very long time. I think that enough in the EU have come to the same conclusion that the default is going to happen, probably in March – and the way the EU has gone about it, frankly, is going to cause bad blood in Athens for a generation.


Meanwhile, in Japan the Bank of Japan overnight added ¥10 trillion (about $130bln) to their version of QE, and declared that it now has an inflation target of 1%. The BoJ didn’t state over what period inflation is to return to 1%. I will say that it’s about time – the country that has had the most need of QE, the most reason to weaken its currency, has for the last couple of decades refused to apply meaningful monetary stimulus to its deflation problem. I’m fond of saying that the BoJ correctly diagnosed the disease (deflation) and correctly prescribed the treatment (more money) but completely blew the dosage. “The body economic has cancer: radiation is prescribed. Here is a prescription for one hour in a tanning bed.” With this action, they are finally starting to increase the dosage.

I showed a couple weeks ago that core inflation in Japan, just as in Europe, the UK, and the US, has been rising (in Japan’s case, rather fitfully) for several years. But that is mainly from global factors – the rising money tide raises all prices, no matter its source. The quickest way for Japan to increase its own inflation is for it to intentionally weaken its currency. That they’ve never done this is hard to understand, and must be tied to a sense of national honor and pride in the currency. A weaker Yen would help growth and raise inflation. It boggles why a more-aggressive monetary policy hasn’t been pursued before now.

If Japan is serious, then currency-hedged Nikkei is going to finally be an interesting investment. Since 1989, the only way you wouldn’t get smoked being long the Nikkei was because you were usually buying Japanese stocks with cheaper yen than when you went to sell. While the Nikkei in Yen terms has lost about 77% over the last quarter-century, in dollar terms it has only lost about 57%, thanks to the ever-appreciating currency. If the BoJ is really going to print, and has the guts to outprint the U.S., then the Nikkei may appreciate while the currency actually weakens.


The economic news in the U.S. continues to be okay, but not great. Today’s Retail Sales report was better-than-expected as core Retail Sales was +0.7% versus expectations for +0.5%, but December’s numbers were revised lower and essentially offset the weakness. These are not depression numbers, but they aren’t also robust expansion numbers. We continue to stumble forward economically…but at least we’re stumbling forward.

On Wednesday, the pace picks up a little further. In addition to finding out what comes out of the conference call of the EU ministers, the February Empire Manufacturing report (Consensus: 15.00 from 13.48), January Industrial Production (Consensus: +0.7%) and Capacity Utilization (Consensus: 78.6% vs 78.1%), and the minutes of the latest FOMC meeting will be released. This last will be carefully scrutinized for details about how to interpret the new communications from the Fed, but I actually don’t expect we will learn much new: the FOMC went out of its way to tell us exactly what they wanted us to understand from the new approach.

Greek Spring

February 13, 2012 2 comments

Ah, spring is in the air, and that must mean: firebombs.

Yes, last year we had the Arab Spring, with violent protests and governments overthrown in Libya and Egypt with others tottering. This year, it’s Athens that is in flame against autocratic leaders. The fact that the Greek parliament passed resolutions that the people are so fervently opposed to, in the country where democracy (literally, ‘people rule’), has been remarked upon by many observers as ironic. It is even more ironic than most people think, since the idea we have today about democracy is of representative democracy in which elected representatives sometimes pass laws that contravene what the people desire…for a recent example, see Obamacare, which has never been supported by a majority of Americans. But the democracy that developed in Athens was direct democracy in which the people (or, anyway, the adult male citizens who had completed military training) voted on each piece of legislation. So the midnight passage of austerity measures was even more offensive to the Athenian sense of democracy than to ‘newer’ democracies.

And it was even worse than that, since representatives that did not vote the party line were booted from representation by the party bosses. Some 43 representatives will no longer represent their constituencies (it’s unclear how or if they will be replaced), along with a half-dozen or so members of the government who resigned before the vote. But, in the end, the legislation was approved and after the government adds a few more austerity measures demanded by the EU, the EU will pass judgment. That is scheduled to be Wednesday, but don’t be shocked if this firm deadline shifts a bit.

Greece fatigue is clearly in the air. With that news, the stock market managed to print the lowest-volume day of the year. February’s volume is running at an even slower pace than January’s volume. And perhaps it is more than just Greece fatigue, and more than political fatigue. Maybe there’s some price fatigue as well. As strange as it seems, the stock market is currently sporting its best 3-year performance since early 2000. Think about that. With only a weak recovery so far realized, stocks are up about 75% from 156 weeks ago (see Chart, source Bloomberg).

Bulls will say that this validates their boundless faith in America and will cascade “I told you so’s” onto the heads of poor benighted bears. The bears will say that this represents a triumph of hope over mathematics and wonder whether how bulls can still see stocks as cheap. And, of course, real-value investors will note that relative to the growth in the money supply, the stock market bears far more resemblance to the Nikkei from 1990-2009 than we’d like to believe (see Chart, source Bloomberg, showing the S&P divided by M2, scaled by 100).

So perhaps that means that stocks are cheap, although to me it looks at best like they are back in real, raw price terms to where they were in 1996 or so and that’s not necessarily an endorsement unless 1996 was cheap. That’s a topic for a different letter, but consider what it means about the 2002-2007 market rally: the S&P in price terms made it back to the old highs, but only because of the Fed’s serious easing over that period. Relative to the amount of cash in the system, stocks recovered only 1/3 or so of the real value lost in the 2000-2002 bear market.

Of course, the picture looks similar but less dramatic if you use the Consumer Price Index. In terms of the number of “consumption baskets” a given equity investment will buy, the 2002-2007 rally restored 68% of the wealth destroyed in 2000-2002 (see Chart, source Bloomberg, of SPX divided by the NSA CPI price index, monthly).

However, I like the SPX/M2 version because it highlights just how much our wealth has been diluted by something directly caused by the Federal Reserve. Certain purists, like Jim Grant of Grant’s Interest Rate Observer, hold that the increase in money is the only measure of inflation that matters. I don’t fully agree, but looking at it in these terms does abstract from changes in money velocity. If velocity is mean-reverting over some long time frame, then the second chart is the one that matters most. M2 money velocity is currently at the lowest level on record (see Chart, source Bloomberg), which is the only reason that the extended period of M2 money growth greater than 10% per annum hasn’t caused more inflation than we’ve already seen. However, the same share of the stock market buys a much smaller share of the money in circulation – in a real sense, that is why we feel poorer with stocks near recent highs. I wonder whether the current declining trading volume is consistent with a 1995 attitude about stocks, and if so…if we have finally returned to the old normal.

Aside from such abstract musings: the ratings agencies have been busy over the last couple of days. S&P downgraded 34 Italian banks on Friday and 15 Spanish banks today. Santander dropped to A+ from AA-, but is actually above the sovereign A rating of Spain. I can understand why an industrial conglomerate might trade above its sovereign rating, but a large bank? That seems odd to me. Moody’s, the laggard agency who still has France at AAA, begrudgingly put that country on outlook negative today while downgrading Italy, Portugal, Spain, Malta, Slovakia, and Slovenia. Moody’s also put UK and Austria on watch for a downgrade from their current AAA ratings.

On Tuesday, the beginning of a heavy tide of economic data sweeps into town when January Retail Sales (Consensus: +0.8%/+0.5% ex-autos) is released at 8:30ET. Regional FRB Presidents Plosser and Lockhart are speaking on the economic outlook, but that’s not likely to garner much attention at the moment. Wednesday, Thursday, and Friday have much more data, so enjoy your Valentine’s Day but not too much.

I remain reluctantly long equities (although long less than my neutral policy weighting), aware that on a valuation basis I have much less than the margin of comfort I normally demand. But our models at Enduring Investments continue to be quite overweight in commodity indices, and show both nominal and inflation-linked bonds as expensive (but nominal much more so), so I hold USCI and DBB on the commodity side, TBF (short 20+ year Treasuries) on the bond side, and both INFL and RINF on the long-inflation side.

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