The Two Sides of Inflation

By James J Puplava CFP, July 14, 2003

When we think of the word inflation we have been accustomed to think in terms of rising goods prices. That is how Wall Street and Washington keep score. The main inflation gauge used by the financial community is the CPI and the PPI. Both of these yardsticks for measuring inflation look moderate. Actual goods inflation is running much higher than what gets reported in each one of these indexes.

The cost of everything in food, energy and just about every type of service is rising by high single digits. In some cases, such as energy, it is rising in the double digit range. The PPI and CPI doesn't reflect these figures since they are statistically managed indexes. Even then, the managed version of reporting inflation is going up. The government reported that the wholesale price index in June rose after two monthly declines. The PPI rose by an unexpected 0.5% last month on a seasonally adjusted basis. Excluding food and energy related items, the index actually fell 0.1%.

Unfortunately the average household can't seasonally adjust their monthly budget or exclude items that are food and energy related, not to mention necessary services such as healthcare, which are rising at high single digits. Therefore to make up and pay for the higher cost of necessities more and more consumers are taking on debt. Over 60% of cash taken out from home equity loans is being used to pay for ordinary goods and services required for living from the costs of a dentist to monthly grocery bills. Most households are struggling with higher monthly living expenses at a time personal income isn't keeping pace with the high cost of living. The difference between personal income and expenses is being financed by new debt each month. Households either have to extract equity out of their homes to pay the bills, or tap their credit cards to pay for expenses.

This same debt strapped consumer is what is holding up the American and global economy. The American consumer is all that stands between a global depression and a recession for the U.S. and the rest of the world. America's imports widened last month by $190 million to $41.84 billion in May. Without these imports Europe and Asia would be in deeper recessions, if not depression. At the same time without these imports, goods inflation here in the U.S. would be much higher than it is already.

The goods inflation isn't just at the consumer level. It is also evident at the business level. The only problem is that it isn't reflected in final goods costs because companies haven't been able to pass on rising costs of production on to the consumer at the retail level. They lack pricing power. The Labor Department's report shows that inflation is strong at the initial stages of production; while it is weakest at the final stage indicating little pricing power for companies.

Companies today don't have the ability to pass on costs to consumers which is hurting their bottom line. This inability to pass on costs is hurting the bottom line on profits. Without increasing profits the much hoped for capex spending boom will not take place. Without profits companies don't have the money or the incentive to spend money on new plants and equipment, which brings up an important question regarding the second half recovery. Where will the much ballyhooed profits come from to fire up the second half recovery?

The current run-up in stock prices is based more on hope than it is reality. There has been nothing said or indicated at recent company press conferences that would indicate that a capital spending boom is about to take place in the second half of the year. In fact just the opposite has been heard from corporate CEOs who have been selling stock in record amounts.

According to recent reports out of Thomson Financial and Vickers, insiders have been dumping shares in record amounts from the President of Microsoft, the Chairman of Dell Computer and top execs at Yahoo. The insider selling today is stronger than it was during the tech mania of 1997-2000. (See lead chart.)

What do they know that we don't know?

One would have to ask, what it is that insiders know about the future profits of their companies that analysts and investors don't know? If we are on the verge of a big profit recovery as Wall Street is predicting, then why aren't insiders holding on to their shares? As this next chart indicates, earnings growth for the third and fourth quarter are expected to go parabolic for the tech sector and the rest of industry. Tech profits are forecasted to expand by 54% in Q3 and by 26%. One can only speculate if the profit outlook looks so rosy for the second half of the year why tech insiders are selling their shares in record numbers.

Given the level of today's market, you could say that the current frenzy in the markets is based on an earnings renaissance. This is surprising given the quality of today's earnings and the present level of valuations that tech stocks and stocks in general now sport with the NASDAQ 100 selling at 240 times trailing earnings. It trades at 38 times next year's earnings if those figures can ever be believed. Despite the current evaluations investors and professionals have been chasing tech stocks in a bidding orgy sending the price of many shares up 100-300 percent in the last nine months. The Wall Street Journal ran a story this morning on the front cover of its investing section titled "Stock Rally Seems Like Déjà vu." The article goes on to address the run up in shares as being reminiscent of the Internet mania of 1999. The best performing companies in this latest rally have been in stocks that are losing money, experiencing financial difficulties, or have weak balance sheets and income statements. Companies losing money are doing much better than companies that are actually making money by a 2.5-1 margin.

The outbreak of irrational exuberance is being fueled by hedge funds and mutual funds that are gambling with other people's money. Some of these managers would never invest their own money in this way but are now playing craps with investor's life savings in a game of trying to beat the averages and outdistance their peers. Given the poor quality of today's earnings the present bout of irrational behavior is even worse than 1999. At least back then investors were under the illusion of rising profits. According to today's New York Times, UBS accounting analysts David Bianco believes, "The quality of earnings for the S&P 500, from an accounting standpoint, is the worst it has been in more than a decade." The aggressive accounting practices in regard to special restructuring charges, the failure to account for stock options as a payroll cost, and rosy pension assumptions make the earnings numbers all suspect. What you see is not what you get so caveat emptor. Don't tell that to fund managers who continue to speculate in a bidding war for worthless companies. It is investors who should take on this responsibility because after all, it is their money they are gambling with at the stock casino.

Two Sides to Every Story

The best way of understanding what is going on is viewing the markets as the other side of inflation. We are all too familiar with goods inflation but very few understand asset inflation. When you pay 240 times earnings for a stock index, that figure is nothing more than another manifestation of asset inflation. Asset inflation is commonly referred to as a bull market. When the price of your home doubles in 3-4 years, that is asset inflation. When a stock that is making no money goes up 300%, that is asset inflation. This is typical during a credit boom when too much money is chasing too few goods, or in the case of the financial markets and real estate markets, too few stocks, bonds, and homes.

This cycle is often repeated in the business cycle when a large credit boom begins to falter and the fundamentals begin to deteriorate. In order to keep the boom alive, credit is expanded. Business fundamentals will no longer support valuations. At this point, fundamentals are actually worsening. In order to keep the boom alive, market sellers use substitute measures such as pro forma earnings to sell assets. Wall Street can no longer sell assets based on fundamental data so substitutes replace fundamental data in an effort to keep the boom alive. Credit continues to pour into the markets so there is an abundance of liquidity. This abundance of liquidity stimulates further asset inflation as money chases money driving up the price of paper assets. Market behavior can no longer be reconciled with objective evaluations so future expectations and bogus measures of evaluation are used in order to sell paper assets.

This market behavior results in all kinds of distortion and further malinvestments in the economy. It is never called this by name. Instead, terms such as a "bull market" are used in order to hide its underlying cause, which is nothing more than credit inflation, which as Webster defines it, is nothing more than "an increase in the amount of money and credit in relation to the supply of goods (and assets) and services."

In A Word: Disequilibrium

This credit distortion, which enters the system through the banking system and the capital markets, creates disequilibrium in the economy and the financial markets which must abruptly end some day. The economy and the markets can't remain in disequilibrium indefinitely. Eventually the boom turns into a bust as we saw in tech and telecom between 2000-2002. The Fed, wanting to extend the boom and prevent all of the fallout that occurs during a bust, has fought the bust with even more credit. The result is that we have a boom in real estate which follows the boom in the stock market. The abundance of credit is also resurrecting another asset bubble in the stock market and the bond market. In fact we now have an alignment of forces from credit expansion, technical momentum in the stock market, and a new found investor euphoria that the good old days are back. All three forces are now all operating simultaneously in the markets.

This is most evident in the behavior of today's market participants including the asset mangers and the investors whose assets they manage. The degree of irrational behavior is what The Wall Street Journal was referring to its déjà vu article this morning. The only problem for today's participants in this asset bubble is that very few have defined exit strategies. If they now tried to get out at once they would be selling to each other. This is why a crash in the future is much more likely to be precipitated by some unseen event. The market has gotten too big. There is too much money all playing the same game. So when it comes time to sell, whom will they sell to? The insiders are all getting out. This leaves only the professionals and the investors whose money they manage. When the next selling climax comes it will be another major down leg in an existing bear market. What you see going on today is nothing more than a temporary reprieve created by another credit bubble.

Mr. Bubbles Speaks This Week

Speaking of bubbles, the chief bubblemaker himself will testify before Congress this week in his semiannual Humphrey Hawkins testimony in what will be a formal meeting of the Open Mouth Committee of one. Mr. Bubbles will have to pull off quite a con job. He'll have to convince the bond market, which has been plunging as of late, that the economic recovery isn't too strong so the bond market won't get worried about inflation which is visible everywhere in the run up of asset prices to the cost of food, energy, and services. At the same time Mr. Bubbles will want to keep the current bubble in the stock market inflated so there will have to be plenty of talk about a second half recovery. In order to keep the bond market subdued he'll have to mention that there are plenty of risks in the economy of deflation so the bond market can be distracted from the asset inflation that is currently taking place in the financial markets.

The Fed botched their last effort to clarify exactly which worry they were concerned about, so interest rates have risen by more than half a point. The rise in rates has hurt the refi market and could begin to show up in the housing market as well. Bankruptcies are on the rise at the consumer level and the debt laden consumer is all that stands in the way in keeping this economy from sinking into a another recession. At the last Fed meeting the stock market got the optimistic message, but bond investors failed to take heed of the deflation risk message. Bond yields have pushed back up and if they continue to rise could sink the asset bubbles the Fed has been so diligent in inflating. Rising interest rates have caused mortgage rates to rise, threatening the refi boom which is all that is holding up the economy besides government deficit spending.

So tomorrow's message should contain enough economic babble to confuse just about everyone. It will probably run like this: the economy will pick up steam in the second half and deflationary forces are still in place. The economy steaming should be soothing words for the stock market while deflation should keep the bond market distracted and worried enough not to demand higher rates because of increasing asset inflation and rising credit risk. He'll also try to reassure the markets now that interest rates are heading toward zero that he still has plenty of tricks up his sleeve. He'll try to avoid using the words "unconventional means" for fear of scaring congress and the public the Fed may have to take desperate measures if things don't work out as planned, which they haven't so far. Why else would you cut interest rates 13 times?

Today's Market

Now for today's casino results. The markets stampeded out of the gates at the opening bell triggered by large buying in the futures pit. The buying was supposedly prompted by a better than expected earnings report form Citibank and Bank of America. The two top derivatives-oriented banks reported that profits rose 5% and 23% respectively. Profits came from increased credit card and mortgage lending to consumers. MBNA also said that the company was reducing its loan losses and delinquencies as more consumers kept up their payments.

Stocks also got a lift from more merger activity as Yahoo announced that it was buying Overture Services for $1.63 billion and Boise Cascade grabbed OfficeMax for $1.2 billion. Analysts also helped out stocks by upgrading Dow components Intel, J&J and Merck. The markets pared back gains due to an erroneous sell order in the E-mini futures on the Chicago Mercantile Exchange.

Volume hit 1.42 billion on the NYSE and 1.97 billion on the Nasdaq as stocks undergo distribution. Market breadth was positive by 20-13 on the Big Board and by 21-12 on the Nasdaq. The VIX rose .69 to close at 21.41 and the VXN bumped up 1.09 to 33.89.

Graphic source: BCA Research, The Wall Street Journal, Forbes, StockCharts.com

James Puplava

© 2003 James Puplava

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