Inflation Tamed or Skewed?

“Household surveys conducted in April indicated that the median expectation for year-ahead inflation had moved up, consistent with the recent pickup in headline CPI inflation.”
FOMC Minutes – released May 30th, 2007

“Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.”
FOMC Statement – released May 9th, 2007

These are the two main statements from the Federal Open Market Committee’s (FOMC) May minutes and statement highlighting inflation concerns. While reading these two statements, it seems as if the Federal Reserve continues its hawkish tone on inflation. However, just last week we received two more pieces of inflation data that will help fill in the puzzle for the FOMC at its next meeting on June 27-28. The numbers in May were more or less in line with estimates (see below) and the bulls embraced the numbers with more than a 1.5% gain throughout the week in all major U.S. indices. The headline number came in at +0.7%, slightly hotter than the expected 0.6% while the core CPI number came in at +0.1%, below the expected +0.2%. But does that mean inflation is tame, or is there a hidden story within the numbers?

If you have read some of my past posts, you understand that I am not a fan of the Bureau of Labor Statistics’ (BLS) methodology for calculating inflation. They completely overlook food and energy prices which can eventually affect monetary policy decisions. Before I jump completely off the topic and into the BLS’ methodology on owner equivalent rents (OER), let me discuss the omitted energy prices and their affect on the consumer’s pocketbook.

Financial media has been coat-tailing the fact that higher oil prices translate into higher gas prices and less disposable income being spent by consumers in other places such as retail. Although it could be argued that higher oil does not necessarily translate into higher gas prices, we will leave that up to energy traders. Consumer spending has continued to support the market to record levels because, well, consumers continue to spend in the face of higher gas prices. How you might ask?

First, let me remind the readers that as long as the consumer can withstand an increase in energy prices because of an increase in income, it should not hinder the consumer’s spending habits. In reality, the consumer has not felt the increase because they are taking home more income. According to Miller-Tabek research, personal income has been rising at an annual 6% rate or 0.7% more than the 15 year average. If we have above average income, there is a good chance the consumer will go ahead and spend instead of save, but can that 0.7% pay for an ever increasing energy bill? The answer is undoubtedly yes! Let’s see what Miller-Tabek has to say:

“The income numbers have simply overwhelmed, providing the best explanation for the resilience in consumer spending in the face of high energy costs. Incomes have increased $1.7 trillion over the past three years to $11.4 trillion, plenty to handle the extra $50 billion to $80 billion of added expense each year. Interesting also is the fact that the price of oil remains below its peak and hasn't really changed much since Katrina over 20 months ago. Since that time households have seen their incomes growth $1.3 trillion.”

So when discussing higher oil prices, let’s also mention income growth and whether or not the consumer will be able to withstand the increase with their income. The outlook for future income growth will most likely be less than the past three years, so keep an eye on income growth over the next few quarters. Currently, the consumer is still able to foot the bill and high oil prices should not be the media’s escape goat for the market not pressing higher.

Apparently, the markets now believe inflation is contained. Of course, as I mentioned above this ignores both food and energy prices. However, there are some other slick calculations made by the BLS to complain about. The biggest of those is about the BLS’ methodology in calculating OER which enables them to make higher inflation look like lower inflation. I have to give credit to http://www.bigpicture.typepad.com/ for discussing this in their blog.

First of all, why does OER even matter? Well, housing accounts for 42% of the CPI, which is then broken down even further where OER accounts for 23% (see table below). Therefore, OER should not be taken lightly. Here is a short description of the BLS’ methodology:

“The economic rent is the contract rent (including the value of certain rent reductions) adjusted by the value of any changes in the services the landlord provides. A change in what renters get for their rents is considered to be a quality change, which may be either positive or negative. The value of any changes is applied to the current economic rent to make it consistent with the previous data. For example, adjustments are made for most changes in utilities and facilities.”

Essentially, they net out utility payment so if the rent stays constant and utility payments go up; the OER actually drops. So not only does the core CPI remove food and energy prices from their calculation, but they alter the true price of OER due to netting out utility payments (which have been increasing over the past few years). Talk about creative accounting, this is creative deception. Economists are a slick group of people. Argue with a good economist and they could probably show you that we are in a recession at the same time the same economist argues for steady growth.

Sources: Bureau of Labor Statistics, Miller-Tabek research, Briefing.com, BigPicture.blogspot.com

World Asset Bubble: Jeremy Grantham Speaks

“From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it’s bubble time!” By now you have probably heard this quote by Jeremy Grantham in his letter to investors (which includes vice president Dick Cheney and a host of other high profilers) discussing a six week trip around the world and the pending bubble popping events to come (at least by his predictions). Grantham is not the only forecaster that has mentioned the overvalued prices of assets across the globe. Most recently (May 23rd), in one of Alan Greenspan’s consulting appearances he mentioned that Chinese markets were at unsustainable levels.

Remember February 27th, 2007? The 4% drop in the US markets were widely considered to be to the detriment of Greenspan’s comments with regard to his comments that day of a 1/3 probability of the U.S. falling into a recession in 2007-08. Quite possibly he is early, but he obviously wants to go on record with his view just as he did when he was early in his “irrational exuberance” speech in 1996, yet he still has a point. Grantham makes just as good of a case in his letter, which we will take a closer look. Taking into consideration some of the thoughts from Jeremy Grantham, we can see that markets across the globe have been hitting record highs for some time now while others are just beginning to penetrate these new levels. Here’s a list of 10 markets that have posted new record highs in the last week or two (See Chart below). The percentage gains of each market are from the beginning of 2003 through this past week of trading. As you can see, the U.S. markets have been lagging all other indices respecitively.

(There are several other markets that are within a few percentage points of their all-time highs, but I decided to only list some of those that actually broke records).

So what exactly gives? Well, the markets have been driven by steady worldwide growth (see chart below) over the past several years and a liquid credit market making it easy to borrow money and put it to work. U.S. markets have been held up by earnings growth, which has slowed in this past quarter, and a record number of private equity deals or mergers and acquisitions.

See the chart below for an overview of the world’s GDP growth from 1980-2008 projections provided by the International Monetary Fund (IMF). As you can see, since 2003 we have been at a growth rate higher than any of the previous 27 years. That has helped propel worldwide equity markets to the record levels of today.

It is easy to get caught up in all the attention given to markets that are propelling to new highs. Really, who would want to miss out on a major bull market? The problem (as is usually the case) is the timing of the Grantham’s so called “worldwide bubble”. The markets are flatter than ever in terms of connectivity, communication and correlations mainly due to the internet’s rise in accessibility. Does that mean that if our market were to tank the emerging markets will follow? Not likely, as the U.S. markets have been one of the weakest performers over the past 12 months. With that said, we also have the most stable and predictable economy in the world.
Many analysts believe a shock to the Chinese markets may cause a windfall of turbulence for other world markets much like it did in late February.

With that said, the Shanghai index fell 6.5% on May 30th. Those same analysts would have expected a drop in the U.S. markets due to the shock. However, all major U.S. indices opened at the lows only to post record highs. Now, the activity we saw that day is now merely a blip on the screen. Although the world is more globalized and has a horizontal marketplace, one can not assume that market shocks will have worldwide impacts. May 30th is a great example of the isolation to a single financial market with no overflow effects.

If we are truly in an asset bubble at this time, there is always a catalyst to burst the bubble; what is it going to be this time? Jeremy Grantham says that “We (GMO, his investment firm) haven’t agreed yet on a catalyst for 1929, 1987, or 2000, or even the South Sea bubble for that matter.” He does however offer two main areas of concern; inflation and lower profit margins. Inflation may prompt the Federal Reserve to take monetary policy actions; whereas, the drop in profit margins over time could hinder financial market’s ability to maintain these high levels.
It will be interesting to see if either of these two factors come to fruition, but one thing is for sure…market’s around the globe have enjoyed a great amount of growth in the past five years.

Whether we come to a screeching halt or slowly contract these gains over time and the timing of either of these scenarios is the question that no one really knows. That is why the financial markets intrigue so many intelligent individuals. Until next time, enjoy the ride.

Market Momentum Indicating Overbought Levels

Four straight record closes for the SP 500 and six consecutive days of gains leaves us at a point in the market that things have started to diverge. As the SP posts new highs, the yield on the ten-year note has approached its yearly high and sits near 5% for the first time since last June. Interest rates are not a problem until they are. Has the market overlooked this fact?
Today, the market has seen some selling activity mainly because of three factors. First, there are no catalysts to push the market higher and second, the ten-year note approaching 5% has some investors acting a little finicky. Ben Bernanke spoke this morning from South Africa and effectively reiterated the FOMC minutes from last week. He sees economic growth picking up to more normal levels in the coming quarters and although inflation has moderated, the risks are still to the upside. And last, but not least, the market momentum indicators are showing some overbought conditions that need to be relieved.

In this chart of the SP e-mini futures contract I want to take a look at two momentum indicators; Stochastic Oscillator & the Relative Strength Indicator (RSI). First, notice that the market has made a considerably steep rally over the past several months to reach new all-time highs on May 30th. The green circles highlight the market’s buying pressure. The red lines point to “relief” points when the market dropped and relieved an overbought level only to continue moving higher and into overbought territory again.

Another highlighted region is the negative divergence of the RSI line and the market. Eventually, the RSI line will begin to level out when buyers and sellers meet the supply and demand for each other. With the current overbought conditions, there is a chance the market would begin to follow the RSI. Remember, this is not the first time we have seen a negative divergence as the market climbed higher. Just look at December 2006 through early February and you will see similar action.

It is not uncommon for a bull market to be in overbought territory for long periods of time; however, eventually the market needs to rest. One of the things to watch here is how the markets close each day. Yesterday, the market closed near its highs for the day (flat), but it is the buying pressure into the close that is keeping the markets near these overbought levels. Personally, I don’t believe the buying pressure at the end of the day will continue for much longer. We would like to keep an eye on any sharp moves downward that end on high selling pressure. This could lead to the 3-5% correction we are looking for over the next week or two and an interesting summer of trading. Enjoy!

Mirror Mirror on the Wall - Does Margin Debt Predict Them All?

Recently, I was reading an article that was began discussing the record levels of margin debt on brokerage accounts. It made a deft point that record levels of margin debt “is a red flag that the market is over-inflated by speculation”. This is a bold statement; however, it is on the right path. Let’s take a deeper look into what they might have meant by that statement and what it may mean for today’s markets.

Since 1970, on a monthly basis the NYSE has been reporting the aggregate debits in securities margin accounts in which they kindly organized into tables and excel sheets. The chart below shows this data since 1996 plotted with the S&P 500 cash index.


As you can see in this chart, the margin debt (in $ mils) and the S&P 500 have a very closely related relationship. The record margin debt in February 2007 was $295,870; whereas the previous record was $278,530 in March of 2000. Is it a coincidence that the previous record was also at the peak of the dot-com bubble just before the markets began to crash? Maybe so, but I wouldn’t bet the farm on it.

The most logical reasoning/theory behind the close relationship (if you look at it, their activity almost mirrors each other) is that when the market is racing higher, market participants want in on the action and therefore leverage their brokerage accounts to take advantage of the rally. A high amount of margin debt also means there is a high level of bullishness. On the flipside, margin debts decrease as the market retreats due to a plethora of margin calls and participants having to get out of the way of an incoming steamroller.

Margin debt can be healthy during bull markets as it provides fuel for further market gains. The problem comes in when excessive speculation comes during a “false” bull market, which is where I believe we might be right now (the latest retest of the highs since Feb. 27th is a false rally in my opinion). The pitfall is when a steep decline in stock prices exposes investors to margin calls, requiring them to post additional collateral or sell securities resulting in even steeper declines such as February 27th, 2007. With so many questions in the marketplace; housing, inflation, interest rates, credit tightening, a weakening U.S. economy, trade deficits, budget deficits, weakening dollar, higher energy and commodity prices and equity markets at or near all-time highs, one has to wonder if a decrease in margin debt is necessary to bring the market to less prone levels.

At these levels, a doomsday may not necessarily be in the works, but it does make me wonder how long or how much higher both margin debt and equities can go. Since they mirror each other so closely, both of them are important to watch. At the same time there is a second voice in my head that tells me to be weary of false rallies in the market and to look for opportunities to hedge positions. As always, I hope you enjoyed the read and let’s see where the next few weeks take us. Tomorrow is the release of more inflation data (Produce Price Index) and it will be a market moving event. Which direction the market will go next is anyone’s guess. To paraphrase the JP Morgan, the only thing I know is that the market will oscillate with incoming data and news.

Sources: NYSE, eSignal

Market Analysis

The early part of this week seems to be void of any major economic data releases. However, it is the beginning of earnings season (led by Alcoa’s $0.79/share gain, $0.03 ahead of analysts expectations) and a key inflation report is due on Friday morning. Last Friday’s job report reported an unexpected 180k increase in nonfarm payrolls and a 4.4% unemployment rate, which is low enough to raise concerns about insufficient labor supply and rising labor costs. Since inflation has been a key headache for fed officials, I thought it would be prudent to talk about inflation today.

The continually strong commodity prices we are seeing across the board from heating oil to wheat will certainly have an affect on inflation concerns. The trickle down effect of higher commodity prices may lead to higher inflation, a worried Federal Reserve and a multitude of other problems for the weakening U.S. economy. Before diving into the discussion, let’s take a look at some of the commodity price charts. There are quite a few, but just take a look at each of the price trends. I have taken monthly charts from a basket of commodities from the agricultural, metals and energy sectors.

Aluminum
Copper
Corn
Gold
Heating Oil
Live Cattle
Oil
Wheat

As you can see, each of these charts points have the same trend over the pas 5-8 years; significantly higher. This basket of agricultural commodities, energy products, and base metals has increased substantially. Take a look at the price increases in percentage terms since 2000:
· Aluminum: +88.22%
· Copper: +357.41%
· Corn: +86.5%
· Gold: +135.52%
· Heating Oil: +210.50%
· Live Cattle: +43.37%
· Crude Oil: +132.32%
· KC Wheat: +65.86%

Those numbers make me wish I would have been invested in a basket of commodities from 2000-2007 during the time the S&P 500 has been flat. Either way, I believe these trends could continue in the near future because of strong demand, weather storms disrupting supplies and a general need for commodities. As commodities guru and world traveler Jim Rogers might say, “We are in the greatest commodity bull cycle our generation has seen”

The question is whether or not commodity prices and inflation can be linked. When considering the relationship between commodity prices and inflation, commodity prices have a positive correlation with inflation. Prices can be argued to be a leading indicator as they are quick to reflect economic changes in supply and demand. The resulting higher prices we see today compared with even 2-3 years ago is tremendous and will eventually be reflected in the final product purchased by consumers; and therefore, higher inflation.

Arguably, crude oil prices (and therefore energy prices) have a robust history of influencing inflation measures the most. As all of the commodities I looked at are currently priced within the top quartile of their six year highs, it makes me wonder how much further prices can reach before negatively affecting the economy (that is, more than it has already). Crude oil will be the most influential as prices seem to be supported be a continuation of global tensions with oil exporters and world demand increases.

The Produce Price Index (PPI) will be released on Friday morning. The consensus estimate is for a 0.8% increase in the headline number and a 0.2% increase in the Core PPI. With that said, I would not be surprised to see the core PPI come in slightly hotter than expected given the deluge of higher commodity prices across the board. As the Federal Reserve seemingly reiterates its hawkish tone on inflation, this number could signal a short-term direction for the market.

Capital Spending Whoas

Lately, I have been writing about the market’s latest push toward the highs as a false rally. Maybe it’s just my nature to scrounge around looking for evidence to support my contrarian views, but I am adamant about backing up my opinions. Most recently I said the reaction to the FOMC policy statement was overblown as traders and investors misread the policy to the effect they saw a rate-cut in the near future. To the contrary, the statement had obviously stated that it plans to maintain the current fed funds rate at 5.25%. The markets react and anticipate, yet sometimes they anticipate incorrectly. This is why we are so fascinated with financial markets and this is why things can become ugly in a hurry.

I don’t believe things will get ugly, but I do think the markets have been overlooking certain aspects of the economy that are suggesting weakness, yet are captivated by other aspects in order to keep the “Goldilocks Scenario” alive. Eventually, according to efficient market theory, all information will be accounted for and the market will price accordingly. That said, the markets should currently be pricing in a modest economic growth of 2-2.5%, slower corporate earnings, higher energy prices, a slowing housing economy (which by the way pushed economic growth for the past several years) and a federal funds rate of 5.25%. However, I don’t think we have seen this. The market is sitting within 1-2% of their 6 year highs and nothing is being discounted. An extremely optimistic market will sooner or later catch up with the real information being released leading to less optimistic markets with a sense of risk.

One of the aspects of the economy the market has simply overlooked is the slowdown in capital spending. Capital spending is the capital spent to acquire or upgrade assets. Think buildings, computers, planes, trucks, equipment and other machinery. Before providing the numbers, let me explain why capital spending is important. When businesses are growing (and the economy expanding), they need equipment and machinery to let their business flourish. Orders are placed with vendors to provide the products and then the businesses begin producing their goods for consumers. If they decide to not invest in their infrastructure then they are not producing more goods; therefore, the economy has fewer goods on the market and it slows the overall business cycle. This is an elementary crude explanation, but it should do for now. On to the numbers.

This morning, the numbers for February factory orders were released. They did nothing to make me believe that the downtrend will be interrupted by a sudden surge of new orders being placed. The first quarterly decline in capital spending in nearly four years was posted in the fourth quarter of 2006, but it passed with hardly a mention. Although Feb. orders were up 1.0%, this was well below the consensus estimate of a 1.9% gain following a -5.7% drop in January orders.

This doesn’t bode well for the overall expansion of businesses growth. Take a look at the chart below. You can see that the drop has the look of the drop in orders from the last recession in 2000.

Factory orders consist of durable and non-durable goods. Non-durable goods
include items like food, clothing, and tobacco products. Durable goods are
products that maintain non-durable goods such as washers and dryers, computers
and machinery.

The drop in capital spending is happening at a time of near-record corporate profits. It has been known for some time that CEOs remained cautious in their spending plans, yet they have spending all those profits on share buybacks. That creates some shareholder value, but how does that help an economy that is beginning to show more signs of weakness?
Ben Bernanke has taken notice of the lack of spending by businesses hoarding cash as he gave his testimony to the congress last week adding that there was “an additional downside risk” to the economy if the weakness in business investment continued. I know we have ignored some weaker data points along the way to these multi year highs, but this is not something that we want to ignore.

The lack of spending may have similar effects on the economy as a weaker housing market. It will take some time to see, but as early as next month more capital spending data will be released. Another quarterly decline would mean two consecutive quarterly declines in capital spending at the same time the economy is modestly expanding. Take note that the market has yet to account for this and it again overlooks a vital piece of forward-looking information reflecting the state of the economy. I have not forgotten the 6.5% drop near the beginning of March; however, it took the market no more than ten trading days to recover almost all that was lost during that “correction”. That is not convincing enough for me and the wall of worries is continuing to grow. Maybe I am overly cautious, but I doubt it.

Friday Slough

It is Friday afternoon and the market's have again been very volatile. It was a strong start this morning as the marktes received a deluge of solid data; consumer spending defies the economic slowdown, incomes are up, and the Chicago PMI set a whopping record, jumping from 47 to 63 (largest historical monthly jump); however, inflation (Core PCE) was up 0.3%, or 2.4% yoy (about as expected).

The Chicago PMI number is what is surprising. How does the manufacturing index jump so much in a single month? Was it extremely warm in Chicago in March? Possibly, but we still don't know why this came out so hot.

The morning news crossed the wires and the selling began shortly thereafter when the US government posed tarriffs on Chineses importing paper goods (10-20%). That will mean higher prices for Chinese importers, yet it also means that we are trying to cut into the trade deficit with China. In fact it is interesting to note:

"The action reverses 23 years of U.S. trade policy by treating China, which is
classified as a nonmarket economy, in the same way that other U.S. trading
partners are treated in disputes involving government subsidies."

Oh well, life goes on for the Chinese. Life goes on in America. As the markets are holding steady near the breakeven point, I don't see a whole lot of change happening near the end of the day, unless of course traders decide they don't want to hold on to any long positions over the weekend (could be likely) with geopolitical tensions as they are and oil prices continuing to hover near YTD highs.

That's it for today and I hope everyone enjoys the weekend. I am headed off on a six hour drive to southwest CO to Silverton, CO. I'll leave you with this.

"One Lift Servicing Heaven" Silverton, CO (www.silvertonmountain.com)

Five Day Rally, For Real?

Just looking at the charts for the S&P 500 today, I am a little surprised at the move we are seeing so far today. We are coming off of a down week last week, but nothing too surprising given the circumstance that the market was trading off. Since a new low was made last Wednesday at 1364 (and a subsequent reversal rally that day), the market has rallied nearly 50 points (3.5%) from those lows. That is a pretty substantial move in a market that reading the media, you would have thought the world’s economies were crumbling. Quite to the contrary, world markets look to have stabilized, although it could very well be a head fake in another move lower. The Shanghai Index, which fell 9% on February 27th, has regained 5.2%. Hong Kong’s Hang Seng index has regained 3.1% in the past five trading days and even the German Dax index has increased 3.7% in the last week. These are all great rallies, but what is the core reasoning behind the move?

Let’s focus on the U.S. since that is really what we know most about. First, last week was an expiration week; therefore, historically it has a bullish bias. Could that be the main reason for the market’s gains? The follow through the first two trading days this week has me thinking that something else is behind the move.

The data that has been presented in the past week has been mixed at best, so this might not be the greatest catalyst. On Tuesday, retail sales came in at +0.1% vs. +0.3% expected, while sales ex-auto were -0.1% vs. a +0.3% estimate. These are weak and the downtrend in consumer spending has continued (see chart below, click to enlarge).

Wednesday is what I believe could have been a key reversal day, yet it was the same day that Asian markets were down 2-3% and European markets were down 1-2% respectively. It looked like the morning weakness was based on overseas trading and the subprime mortgage mess, but midday, the markets reversed. Why? It is possible that all the sellers were washed out and the bulls took control, but there was no real catalyst to the move. With inflation numbers out the next two mornings, it could have been ugly. When the PPI and CPI report came out slightly hotter than expected the markets continued to try and push higher, but the end of week volatility and expiration closed the markets near 1400, or about the same point the key reversal day closed its interesting day. No change for the last two days of trading for the week.

That brings us to yesterday and today. Yesterday, the morning gap of 10 points was never filled in throughout the day as the market traded higher just as overseas markets had done the same morning. The slow grind upward lacked both volatility and the presence of sellers. Why wouldn’t the sellers have come in at any point and started pressuring the market? It could be because they are waiting to hear what the Fed has to say on Wednesday during the FOMC announcement. They are expected to keep rates at 5.25% (a 98% chance, according to the markets), yet their statement may have some indication of the latest subprime meltdown. If the statement is upbeat, it will be good news for the bulls, but if it has any tone of worry, we may see the sellers come back to play and drive the S&P back to its lows near 1364 or even lower.

Take a look at the chart below. You can see the market is sitting right at the thick red line, which is one I have drawn as a resistance area. Technically, it is very strong as the red line indicates both a prior resistance area and a 38.2% retracement using the February highs and the first low made in March (see below, click to enlarge). This number is critical as it also happens to come into play during the FOMC meeting. It could very well be a re-test before breaking lower. We will see what happens tomorrow afternoon, but keep in mind the intermediate trend is still downward, even with a 3% gain in the past five trading sessions.

Source: Briefing.com, eSignal