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Bin Laden and the Trickle Down Theory

May 2, 2011


Good morning. It was another solid steady move to the upside last week, with the SPY rising 2.65 (2%) to close at 136.43. This move, again, comes under the general umbrella of lower dollar and higher commodity prices in line with the expansionary monetary policy being maintained by the Federal Reserve. Today we have the added bullish sentiment accompanying the raid on Osama Bin Laden’s compound in Pakistan, during which he and several companions were killed by U.S. Special Forces. Last week was also interesting in that it contained the first of the new news conferences accompanying the quarterly Fed two-day meetings by the Fed Chairman Ben Bernanke. It does not seem to matter what the economic news is, for instance bad jobless and first quarter GDP numbers on Thursday, the market continues its relentless (but relatively slow) advance. Having said that, some of the corporate earnings numbers have been nothing short of spectacular, with breakout earnings by the oil companies (XOM, CVX, etc) and some of the multi-nationals (CAT, MMM, etc) seemingly defying the paltry growth numbers affecting the economy at large. For instance, the first quarter GDP numbers advanced a very anemic 1.8% on an annual basis, whereas CAT revenues advanced 57% and earnings 53% on a year over year basis.

Is it sustainable? Can the general economy continue to show slow growth (despite unprecedented fiscal and monetary stimulus) while certain segments of the economy show tremendous pricing power and almost geometric growth? We have discussed this on some levels before; can the rest of the world essentially carry the multi-national firms to lofty levels without the U.S.? If so, what might be the repercussions? What is the Fed’s role in all this? Are they right in their innovative policies (are they innovative?) or are they sowing the seeds of disaster? What about inflation risks? These surely are the questions of the day, and make trading going forward as risky as I have ever seen it.

Let’s start with the unevenness of the inflationary effects being generated by the Fed’s extremely “accommodative” monetary policy. First of all, nothing happens in a vacuum. We have had quite the history of unimpeded monopoly and cartel building through mergers in this country in the past couple of decades. Add to that the normal shortages and economic bottlenecks that are always present in a diverse economy and you have the result of some companies and industries having pricing power while others do not. For instance, in the fairly competitive world of intracity package delivery a rise in fuel prices might have the expected effect of some of the price increase getting passed along (or not) and the rest being essentially absorbed by the delivery company because no one else raised prices and he must remain competitive. Compare that to railroads, where through relentless mergers there is very little competition for whole carload or container traffic in any desired direction. In that case, those companies might well be able to attach a “fuel surcharge” well in excess of their actual increased fuel costs. Or a drought might coincide with the onset of inflation, or an oil supply crisis, that drives the prices of those commodities higher than the general inflation level. In other words, if inflation were to advance to a “level” of 5%, don’t expect everything to go up 5%, expect some things to go up 10-15% or more and other things to have virtually no movement. It is never even.

What about inflation, and the Fed, and denial that (despite huge monetary accommodation) the inflation that we see, right now predominantly in commodities, is “transitory” and nothing more than normal supply chain problems that will ebb in time. I say, “Bull bleep.” In the past year the money supply has advanced between 4.5-5% (5.2% rate in past 2 months), so if you match that up with a growth rate of roughly 2.3% you should expect (according to rough monetary theory) an inflation rate approaching 3%. In fact, if you want to go back three years, we have an average annual growth rate of .3% and an average annual increase in M2 of 5.3%, so the onslaught of inflation should not exactly be a surprise to anyone with even one course in monetary theory. So how are the Fed’s economists, with way more than one course in economics in their past, in denial? Right now they appear to be focused on two things (not the two things, inflation and growth, they are supposed to be focused on), one of which is deflating the dollar for the good of multi-national company pricing and in helping the U.S. Treasury pay off loans eventually with deflated dollars. The second appears to be continuing to provide Banks with low cost money (to the detriment to savers) and in inflating the stock market.

How can they get away with that? One way is by denying there is inflation, even though everyone else sees it every time they make a purchase. Although most are unaware, the Fed does not look at the Consumer Price Index (CPI) or Producer Price Index (PPI) like the rest of us. Those indices contain a relatively fixed market basket of items that are priced monthly. The Fed uses an index called the Personal Consumption Expenditure (PCE) Index. In this index they employ a substitution type algorithm that essentially says that “smart” consumers will substitute other products when faced with rising prices, so are not “as” affected as the other indices (CPI and PPI) might indicate. So what, in English, does that mean? It means that if the price of hamburger goes from $2 to $4 per pound and hamburger makes up 1% of the Consumer Price Index, that index will go up by .5% due to the spike in burger prices. Not so with the PCE, as that index says that the smart consumer, seeing the spike in hamburger prices, will adjust and substitute with ground turkey which has only gone up by 10%. So hamburger no longer makes up 1% of the basket, maybe now only .3%, so the effect of its price spike on the overall average is much smaller. While some of this substitution theory does make some sense, it does make comparisons difficult, and generally makes the Fed Chairman’s testimony and writings very suspect, to the point of being useless or misleading. For instance, last week the Mr. Bernanke made the comment that most Central Banks do not shoot for a zero inflation target, but more like 2%.  That is all well and good, but with his slight of hand PCE Index, what exactly does 2% mean (since the basket of goods keep changing), or 4% if he misses and overshoots? I, for one, have no idea what the PPI or CPI might look like when he reaches his 2% “target” on the PCE. The CPI is up 2.5% year over year, and up 1.5% in the last 3 months, while the PPI is up 5.7 year over year and 3.1% in the last 3 months. According to the “official” number they are looking at, the PCE, it is only 1.3-1.7% (according to the Fed report last week) and they are pushing to get that number to 2%. When the Fed reaches their target of 2%, or messes up and overshoots to 3%, what will that mean to those of us still keeping track by the old numbers? Are we looking at 5%, or 10%, with them still telling us that it is not a problem? I think so, and I also think it would be time for some heads to roll, as that is idiocy on a grand scale.

I have to say it, I am starting to cringe and flash with anger every time I hear our supposedly overly cerebral Fed Chairman speak. I may be (along with my clients, readers, and listeners) a commoner (British term), but I try hard to not be an imbecile. When I hear the Chairman say things like when the price of oil stops going up (essentially settles in at a new and higher level) it will cease to affect the averages and no longer be a problem I have to resist (not really since I do not own a gun) pulling an Elvis Presley and shooting the TV. If you add that logic to his other utterances regarding there is no “real” inflation until you get wages accelerating as well, what do you have but a permanent shift in economic wealth and power from regular people to the oil companies. Gas will permanently “be” $5 per gallon, no longer going up or “causing” inflation, just a permanent adjustment. Same thing with savers making 1% on money balances in banks with 5% inflation, does that effective negative 4% savings rate represent a permanent shift in wealth (read gouge) from savers to banks? This Fed Chairman could be the most ultimate espouser of the trickle down theory I have ever seen in government, what a tool for those in the government who are using him. The only thing for sure with the trickle down thing is that the first ones get theirs, and only maybe it trickles. Don’t tell me there is no inflation, or that you are not deflating the dollar on purpose, or that you care a lot about jobs. What I do not like is getting lied to, I work hard (as do my readers I am sure) to not be that stupid, or as the outlaw Josey Wales once said, “ Don’t Pxxx down my back and tell me it is raining.” I have this feeling that these people are constructing the seeds of an economic disaster, and those responsible will be long gone when it happens.

Next week I will talk more about the nature of some of the corporate profits we have seen, and how anxious we all seem to be to support companies that produce nothing here, but that is next week.

How do we trade it? There does seem to be some end, or slowing, to the monetary accommodation (read expansion) come June (that is assuming someone else will not get the word before then). We have also seen some deterioration in some of the market momentum indicators. We have tried to play things short term with long premium positions, and have managed them pretty well, but have not really had a sufficient “pop” in the market to have a big winner. It is a relentless grind, and it is priced that way. For instance, right now the SPY is priced at roughly $137, and the weekly 137-138 call spread is $.43 and the 137-136 put spread is $.35, yet the 139 call is priced at $.15 and the 135 put is $.21. What the market is saying is that there is a good chance of the upside creep to continue, but the risk of a big move is more to the downside. The general volatility level is way low, with the 137 straddle trading at only $1.50, and that is with the employment numbers coming out this Friday. I am convinced that we will have a bigger move sooner rather than later, so we have been positioning ourselves for that on an almost weekly basis. We have stayed near the break-even mark (down a little) but I am convinced we want to be in a position for a move. I think there is a very good chance that the SPY will move more than $1.50 by Friday night, and if it does I want us to benefit. When we do we will adjust our calls to the upside. The market right now is very smug in regards to risk, an awful lot of money managers and retail investors all are supremely confident that they will be able to exit before any correction takes place. That seems like a lot of people heading for the door at once, and if they are wrong and start a little commotion I want to be there ahead of the problem and benefit by the increased volatility. I think the evidence is showing the market is getting a lot more correlated, meaning between currency, commodity, and stock movements, and I really do think we have to be a little early to participate in any big upcoming move (up or down). We do have to maybe weather a few weeks of being positioned and seeing no move before we are positioned when we benefit greatly. When it happens I want to be the aggressor.

I cordially invite you to register for our complimentary In-Office Protected Index Program Seminar on Saturday, June 11th, 2011, from 9:00am – 12:00pm. My brother Dan and I will be presenting the strategies of the PIP that have resulted in returns for hedged client portfolios. This is an informative no-pressure session. Even modestly funded accounts benefit from this long-term money management program. We will have a nice contintental breakfast available for you. It is free but you MUST register to attend at  http://www.ptisecurities.com/Education.htm or by calling Sarah at PTI Securities toll free at 800.821.4968. I hope to see you there!