Is It Really Inflation?
by Paul J Nolte CFA, Dearborn Partners. May 14, 2008
Inflation – where? According to the data released this morning, prices are not going up. Now everyone has an opinion about prices – yes food/energy prices are rising rapidly and they are purchased often by everyone. There are also prices that are falling, and questions about real estate deflation also plays into the inflation question – for when home prices were rising, many were complaining that it skewed inflation higher than it otherwise would have been – today the reverse is true. We'll take a look later at the report from the Dallas Fed and what it shows about inflation.
How now the markets? We continue to be surprised by the banter about energy prices, stock prices and interest rates. It has been mentioned in many places, but bears repeating – if you were told energy prices would rise by 50% over the past 18 months (using national pump price data), what would your guess be as to the direction of interest rates? The short-term rates (that the Fed controls) have declined by 350 basis points – the long bond (more sensitive to inflation fears) is down by 50 basis points. The relationship between bonds and commodities that existed during the 70/80's has changed. If we look at the 5 year correlation between the performance of the Lehman Aggregate Bond index and the CRB index (shown below) we see that instead of being very negatively correlated, there exists today a higher correlation between these two than ever existed.
The correlations between nearly all of the "major" asset classes, foreign stocks, domestic stocks, real estate, bonds and commodities are higher than they have been in the past and many mirror the chart above, with the correlations today at higher than ever levels. So what you ask? The implications are important for those looking at constructing portfolios that are heavy in low correlated assets to avoid the inevitable correction in the SP500. As investors saw just over the past few years, the declines in stocks are matched by declines in various indexes – sometimes even falling further. What was thought of as a well diversified portfolio is no longer so diversified and may force investors into asset classes that many would not have considered in the past – including high yield, foreign real estate or a narrowing of the broad asset classes (separating gold from energy or agricultural commodities). Again, many of these indexes are only recently available and trading history to the masses has only a small sample from which to draw inferences.
Switching gears a bit – let's look at the strong rally in stocks since the Jan/Mar lows. The SP500 has retraced just over half of the decline since October, with the next logical test coming in around the 1450 level – the peak in Feb '07 and near the bottoms made in '07. But if we look beneath the markets, there is plenty to worry about. First, we are not in the camp that says we are beginning a new bull market; if we are, we are doing so from very high valuation levels that we believe does not accurately reflect the current condition of the markets and earnings power. That being said, one of our favorite indicators is a modification of the classic On Balance Volume (OBV) that has been popularized by Joseph Granville. Instead of just looking at an accumulation of volume, we are interested only in those days where volume EXCEEDS that of the prior day. The two charts below show some of the similarities and differences:
While OBV continued to rise through mid 2007, the modified chart shows that it actually peaked with the market in February and declined throughout the year, indicating investors were much more willing to aggressively sell declines while tepidly buying during the advances. Today, the modified chart is very nearly breaking the small peak in early October, setting the stage for a run higher – meaning investors are more aggressive buyers and reluctant sellers. Unless this test fails in the weeks ahead, we would argue that the markets could run much higher than many originally believe could be the case, especially looking at the economy and commodity prices. So while we are willing to give the market the benefit of the doubt over the short-term, the longer term picture remains negative. From overall valuations (20x trailing 12 month earnings) to a loss in price momentum on long term charts – see below:
Finally – inflation. There is a decent gauge that has been created by the Dallas Fed that attempts to get to a "core" rate of inflation without simply skipping food and energy. Their method looks at eliminating the monthly "outliers" and creates a "trimmed" PCE that focuses on the more consistent inflation figures – sometimes that includes food and energy, sometimes not – depending upon the distribution of the components within the index. Below is a chart of the trimmed PCE available from the Dallas Federal Reserve.
What it reveals is inflation, without the monthly "noise" has remained within a well traveled range between roughly 1.5% and 2.75% over the past 15 years. We also saw inflation rates come down with the last recession – and we believe we are beginning to see that again (as we believe we are IN a recession) with the most recent releases of data. The release of the CPI was enough to put a bid into the stock market, however the bond market is not necessarily "buying" it, as yields remain relatively high – and in fact we are seeing indications in the market that the Fed MAY raise rates sometime this year, something that has not been a part of the Fed Funds market this year.
Stocks were strong in today's market early in the day, but faded into the close as the kings of the OTC market – Google & Apple -- declined into the close. Weakness was also seen in the commodity pits, as gold declined a few bucks while energy prices fell on better than expected builds in distillate inventories. The stock market continues to struggle closing significantly above key resistance levels with emphasis, so until gains can be made with well above average volume, any large gains should be viewed with a jaundice eye. Bond prices also fell, with the 10 year bond rapidly approaching 4% after hitting 3.5% only 4-6 weeks ago.
© 2006 Paul Nolte