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September 25, 2006

Is Inflation Really Falling?

John P. Hussman, Ph.D.
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Two months ago, the year-over-year inflation rate in the CPI hit 4.3%. Seems like a lot has changed since then. In the two most recent monthly CPI reports, consumer prices have increased by 0.7% overall, which represents an annualized rate of… well … 4.3%.

How exactly have we arrived at the notion that inflation pressures have measurably subsided?

Well, it's because of core inflation, of course. Two months ago, stripping out food and energy, the year-over-year rate of “core” CPI inflation was running at 2.7%. In the past two months, however, the annualized rate of core inflation has been 2.7%.

Somehow, the data seem underwhelming.

“Core” inflation is an interesting animal. The notion of “stripping out volatile components” isn't too objectionable, provided that deviations in those volatile components average out to zero over modest periods of time. But over the past 4 years, for example, the annualized inflation rate in the CPI has been 3.07%, while “core” inflation has averaged just 2.00%. The "core" figure is clearly doing more than just reducing volatility – it's leaving out components that have been in clear uptrends, and is therefore understating an index that's probably already understated due to factors like “hedonic” adjustments, “rental equivalent” housing costs, and the like.

The best we can say is that over the past two months, various inflation figures have been coming in a few pips below “consensus estimates.” That's good news as far as it goes, but with, for example, intermediate goods prices up 8.72% over the past year (though a smaller 5.94% annualized over the past two months), it's a far cry from a major reversal in inflation trends.

That said, credit spreads have popped wider in the past 2 weeks as measured by the spread between Moody's BAA yields and 10-year Treasuries, by 6-month commercial paper yields versus 6-month T-bills, and other spreads. That sort of behavior is typical of pre-recession market action, and though we're still not yet at the point where a recession appears inevitable, the risks continue to mount. Wider credit spreads, as I've noted before, suggest early concerns about default risk. If those concerns become more severe, the resulting flight to government liabilities (cash and Treasuries) as safe-havens could suppress inflation pressures. For now, though, we probably haven't seen enough widening in credit spreads to accomplish that.

In the meantime, we have a combination of an inverted yield curve and Treasury bill yields narrowly above the rate of inflation. That pair of conditions has generally been associated with hard upward inflation pressures. Now that the weak Philly Fed report (as well as relentless weakness in the leading indicators) has thrown some cold water on the “growth” part of the “Goldilocks” thesis, the inflation side has become that much more interesting to monitor. My impression is that the whole theme – both the “resumed economic growth” and the “subsiding inflation” parts are wrong. Investors, both in stocks and in bonds, have impounded the Goldilocks thesis into prices, so there's a lot riding on the next couple of months of data.

No forecasts required

As always, our investment positions are driven by the prevailing, observable condition of valuations and market action. There's no hope of escaping a lot of economic analysis and personal impressions in the weekly commentary of someone who's an academic economist by training. Invariably, though, my opinions are driven by my evaluation of the Market Climate, not the other way around. The measures of valuation and market action that define each “Market Climate” are factors that can be tested in decades of historical data, are objective, observable, and have strongly affected the average profile of return and risk in the markets over time.

Every Market Climate we define has historically included both market advances and market declines – it's just that the average return and risk profile substantially differs across Climates. When the Climate shifts, so does our investment stance. Since we generally observe about two shifts in the Market Climate per year, on average, there tends to be some persistence in our investment positions, but it's incorrect to think of these as “forecasts.” It's more accurate to say that each week we have a small, statistically insignificant and wholly unreliable forecast for the coming week's market direction, but that when grouped over a large number of instances, the differences in the average return/risk profile of different Market Climates are highly statistically significant.

In any event, we don't require price inflation to persist, or wage inflation to accelerate, or profit margins to narrow in order to conclude that valuations in stocks are unfavorable. Current, objective measures of valuation are already enough to support that conclusion. It's just that inflation pressures and narrowing of profit margins will make things worse. On the subject of wage inflation, Rudolph-Riad Younes recently noted, correctly I think, that in recent years, “wages, plus equity withdrawal from your house, was enough to support your living standard. Once that sort of financing dries up for the consumer, we will see significant wage pressure.”

Likewise, my impression is that U.S. gross domestic investment is likely to stagnate in the coming years. Foreign capital inflows have financed all of the growth in U.S. domestic investment since 1998, and it is becoming increasingly difficult to expand an already massive current account deficit. Our current investment position isn't driven by that thesis, but again, a contraction in foreign capital inflows will certainly make things worse. The surprisingly steep drop in net foreign purchases of U.S. securities last month shouldn't go unnoticed.

As a side note, if some factor in the current economic or financial environment seems to contradict the prevailing Market Climate, part of my job is to get a boatload of historical data and check whether the factor actually matters, and reliably matters, and if so, to fold it into our investment approach. After more than two decades of those efforts, not a lot of new factors make the cut, but research is an ongoing commitment here.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance.

Presently, it would take less than a 10% advance to take the S&P past 19 times record earnings on record profit margins (a level that has few historical peers outside of the 1929, 1972 and late 1990's bubble peaks). In contrast, a 10% decline is already long, long overdue. Given that a favorable shift in the quality of market action at these valuations would prompt us to remove perhaps 25% of our hedges, the “best case” benefit from an exposure to market fluctuations here, even assuming a perfect exit, would probably be just 2-3%.

Until we observe a reasonable (10% or deeper) market decline, the stock selection aspect of our investment approach will probably have a more reliable potential to drive Fund returns than a speculative exposure to market fluctuations could. So while we can't rule out the possibility of lifting a portion of our hedges if the quality of market action improves, I expect our returns to be driven primarily by the difference in performance between the stocks we hold and the indices we use to hedge (primarily the S&P 500).

Short term advances on narrow breadth, dull volume and rich valuations aren't terrible for us, but are far from ideal conditions. Fortunately, such conditions rarely persist. Over time, investors' attentions ultimately return to stocks whose likely future cash flows are worth their price. That is where most of my own attentions are currently placed.

In bonds, the Market Climate remained characterized by modestly unfavorable valuations and relatively neutral market action last week, holding the Strategic Total Return Fund to a short 2-year duration, primarily in Treasury inflation protected securities. At present, the Market Climate for precious metals shares remains very favorable, with a combination of falling interest rates, weakening economic growth, still persistent inflation, and reasonable valuations (the simple Gold/XAU ratio is currently at 4.68). Given those conditions, the potential for substantial, possibly abrupt weakness in the exchange value of the U.S. dollar shouldn't be understated. Again, however, our investment positions don't rely on such forecasts. In the Strategic Total Return Fund, prevailing, observable conditions are sufficient to warrant an exposure of just under 20% of assets in precious metals shares.

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