History…Repeats Itself, Repeats Itself, Repeats Itself
April 4, 2011
Good morning. The market continued its advance last week, with the SPY up 1.5% on the week to close at 133.15. This is the highest closing since March 3 of this year, before the shocks of the Japanese reactor issues and the Libyan conflict. Even though neither of those has shown any improvement the market has moved on. The VIX was slightly down on the week (2.8%), closing at 17.39. Trading continues to be predominantly news driven and with relatively light volume, with extended periods during the day where there is really no discernable movement. The S&P Futures seem poised to at least test the closing highs of 1337.50 set on February 18 of this year, and many of the technical people are anxiously waiting whether the market succeeds in driving through that number. I was a little surprised that the market showed some weakness at the close on several of the days last week, and am wondering if that means that the mutual fund buying might be drying up a little, or maybe just paused a little last week.
Allocating investment resources is never easy, and there is always the drone of advisors or ”helpers” recommending “opportunities” in many areas, usually ones in which the “helpers” stand to profit. Large groups of relatively savvy investors are really at a loss over whether whole general areas of investment, real estate, metals, stocks, or cash balances should be their main choice for the future. I find things equally as troubling to predict going forward, even though some parallels exist. You have heard the old saying “history repeats itself” and the ever popular competing adage “it is different now.” Right now the old adages are not really competing but working together to form a type of confusion different from any situation I have either encountered or read about. We have a Central Bank (the Fed) pouring money into a fairly moribund economy at a rapid rate, with the resultant inflation and inflationary expectations beginning to take hold. At the same time there is tremendous slack in the labor market so there is little, if any, pressure on wages and very little increase in “nominal” income to the average worker. The wash of money entering the system, meeting the rather paltry demand for money for normal investment is causing a risk free return to money balances so close to zero that it might as well be zero. So for the investor the real interest rate as it applies to him or her is actually negative, you are receiving zero interest in your money and by next year at this time your money will be worth something less (probably 2-2.5% or so). Remember that the last time we stumbled into an inflationary period (late 70’s to early 80’s) we saw bank rates on deposits and returns on Government bonds essentially keep up with the inflation with nominal rates of return of 10% or higher in some cases.
In addition, many of the workers in the late 70-80’s (higher percentage of union and public employees) had cost of living adjustments (COLA) in their package, necessitating a salary or wage adjustment fairly rapidly (some quarterly) when prices went up. This phenomenon (COLA adjustments) was also, in the views of many, the start of an almost two-decade-old growing disparity between the growth of wages and benefits of governmental and union workers and that same growth in either the white collar or other positions exempt from automatic increases. At the time (late 70’s) I was employed in a management position in a predominantly union employer (Pullman) and I saw my income decrease relatively to those with automatic COLA adjustments for several years. Another traditional benefactor group in inflationary times are the owners of real property, the logic (and usual outcome) being that as the value of money decreases the value of other types of property (priced in money) will increase. In other words, if a house is worth $100,000 and the Fed essentially devalues the currency (by having too much available) by 10% the value of the house should now be $110,000. The owner of the home has “maintained” his wealth while the person who stuffed $100,000 into the trunk in the closet now has his dollar denominated wealth (in terms of buying power) now worth 10% less. He now needs to “earn” another $10,000 to afford the same house.
So, in terms of “inflation” being the same old historical story, too much money chasing too few goods, it is the same classic phenomenon. However, this time it is different, at least initially, in its effect on different groups. In 1980 the union or governmental worker (read Middle class) who owned his own home and had cash in the bank was a clear winner. His house appreciated (making him a huge relative winner versus renters), his deposits in the bank at least kept up with inflation, and his COLA probably kept up with inflation and may have caused him to gain versus jobs not covered. The stock market, for those that were investors, was in a horrible state, with the Dow bouncing along well under 1,000, and many large companies mired in the struggle of keeping up with costs of capital well in excess of 10% in many cases. This time, however, the effects are surely starting out benefiting a whole different group. The owners of real property have withstood a devastating several years, with the price of real property (and average homes) is down some 35-40% off the peak. So depending on the timing of purchase the homeowner has seen his equity in his house plummet to years ago levels or is actually underwater with a negative equity position. Any money in the bank is virtually useless as an income-generating source, and very few are left with any sort of automatic COLA adjustments. So a lot of those benefiting last time are the most suffering this time.
While it may be to soon to tell how far (if at all in some minds) the next round of inflation might travel, it does seem very clear who the new relative winners will be. Depending on whether you use money supply growth for the last month, quarter, or half year, the rate of increase of M2 varies from around 4.7-7%, so if you assume a growth rate of (maybe way too optimistically) 3% that leaves expected gross inflation in the 1.7-4% range. So what is the big deal, we were over 10% thirty years ago and lived to tell about it? I personally am very wary because the early returns this time seem to indicate huge unevenness as to the inflation effects and benefits. To the extent that the inflation starts by relative movements between international currencies, like the dollar falling versus the euro, some institutions (and maybe some people) can participate in those moves. When the Mexican peso was devalued versus the dollar years ago those wealthy Mexicans that had the combined ability to convert to dollars overnight and were privy to the “warning signs” from their Central Bank did very well on a relative scale versus those stuck in pesos. In essence, the rich got richer. Here, the Fed moves through the markets, and some firms do the Fed’s business, so it would not be a stretch to feel that some with ears could move dollars out or back to their advantage. Second, and probably most important, many industries are way less competitive than they were 30 years ago. This would mean that the price increases would be easier to either “pass along” or initiate than in a more competitive environment. It also would mean that the ability of workers to “demand” wage increases like the COLA of old is less. In fact, I have heard so-called experts say recently that until the large firms have to actually pay out increased wages due to inflation the inflation should be considered a temporary phenomenon. They surely don’t believe that, do they? I think that a sustained inflation this time of over even a 5% “official” number will have the effect of laying waste to the income sharing “arrangement” between corporations and employees (and public versus private sector employees) that Americans feel is normal. In fact, despite the fact that the stock market has so far seemed impervious to these fears and has provided some positive wealth effects, I think the rancor and divisiveness we see now will be just the beginning.
So how do we trade it, and become one of the groups that gain relatively even if the total is less than what we would hope for? It is hard, for a lot of the reasons above. First of all, cash (although good to have versus not have) looks like it will be a relative non-performer. The Banks are so far in bed with the Fed and Treasury (does not matter who is in the White House it seems) that they are willing to trade no income for Joe and Jane on their deposits for profit on the Citi stock owned by the Treasury and huge income to bank executives writing campaign checks. Anyway, my clients sense (as do I) that you have to do something with the cash. The first normal alternative would be real property, and maybe putting together a group here to selectively buy depressed property near solid transportation for rental (rents are going up) would be a solid opportunity. One problem is in finding a group that has not been so decimated by their own property in the last few years that they can see some kind of return going forward. It also seems like we are in the throes of a double dip in this sector, as prices are still falling and whole neighborhoods seem be being caught in the tide. In summary, probably a good idea but surely do not have to start today.
What about just buying commodities? Clearly we would have done well by just buying oil and gold, not to mention corn, soybeans, and copper. There is no doubt that we have seen runs in those areas, but does the average investor really want to have a long term hold of the equivalent of a railroad car of corn? Can the system support massive investment and hoarding of products that are more designed to be grown and eaten? Do we really want huge pension funds owning in storage millions of bushels of corn or wheat for decades? In the short term we probably should have been more aggressive short term in most commodities, surely the oil and gold ETF’s, or maybe in the long term we should put a greater percentage of the PIP Program Funds in the GLD and the XLE. We are certainly considering that, but maybe at prices somewhat lower than here. I believe we will get our chance to put some funds to work at better levels in the broad market sometime this year. In the meantime I am going to be putting some funds to work in a few of the laggard areas. I still like (actually like is the wrong word, think they are relatively undervalued) the financial sector (XLF) and still believe that somewhere in the mad run up of oil prices we will collectively find a way to incorporate natural gas into the mix. A relatively new ETF (FCG) covers most of the stocks in this industry, and we are considering adding it to our list of sector ETF’s we use for the long term. We have had some success using the natural gas ETF, the UNG, but feel that is a short term trading tool due to the problems with being a futures based ETF.
I also am sure that as the market continues to run up with decreasing VIX levels we will have a big winner in one of these weekly long premium positions. We have done several of them so far, and have not had the big move that we would like, but will continue to look for those positions when priced right. I admit to being very nervous about price levels in both the broad market and in the whole commodity area if the Fed starts to slow the monetary expansion, and really worried if something causes them to actually tighten before they would elect to do on their own.