November 2005

Welcome To The Real Word

“Welcome To The Real World”, She Said To Me Condescendingly.  Take A Seat…For some time now in the subscriber portion of our site we have been counseling folks to expect much higher headline CPI numbers for the second half of 2005 than had been expected even a few months ago.  It was only a few months back that we suggested a 4.5% year over year CPI number prior to year-end.  We’ll, as you clearly know by now, the September CPI headline came in at a year over year rate of change of 4.7%.  This is moving faster than even we had anticipated.  We now expect to see a 5% handle on the year over year change in CPI before 2005 is out (incredibly courageous forecast given the recent data, right?).  A few very quick comments on the recent headline report and then we want to have a look back at history and leave you a few anecdotes to contemplate as we move forward in the rather bumpy financial markets of the moment.  Markets that clearly were not prepared for this type of acceleration in headline CPI, among other things.

As you probably already know by now, the month over month September CPI number of 1.2% was the largest monthly increase in this reading in 25 years.  Was the increase probably 90% related to energy costs?  Of course it was.  Although there’s been a bit of a back off in energy prices post the hurricane peaks, we’re not too sure the September CPI acceleration is going to be a one off event.  The survey for the CPI report is taken early in the month (early in September, in the most recent case).  There’s a darn good chance the September survey missed a portion of the rise in gasoline prices during mid-September, that has as of now retraced its steps a bit.  We’re just going to have to see what happens as the October report rolls our way.  Before going any further, we just want to show you one simple long-term picture and accompany this with one simple long term question.  Below is the year over year rate of change in the headline CPI over the last 35 years.  If this chart were a stock, would you buy it or sell it?
      

Again, although it’s a bit of a spike up experience, we need to at least entertain the idea that we’re looking at a longer-term break out.  Ultimate magnitude?  That will be answered in the tomorrow’s of our lives, now won’t it?

Whichever Way Your Pleasure Tends, If You Plant Ice You’re Gonna Harvest Wind...All right, let’s get straight to the topics we believe are deserving of reflection.  Again, as you are most likely aware, although the headline CPI number spiked up 1.2% in September, the “core” rate of inflation (ex food and energy) rose a very modest 0.1%.  Virtually a rounding error.  For now, the year over year rate of change in the core rate is lower than it was six months ago.  Part of the reason for the almost non-existent growth in the core was a weak owners equivalent rent number.  So what else is new?  The Fed must be breathing a sigh of relief, right?  Not so fast.  The year over year rate of change dichotomy between the headline CPI number and the core rate is nothing short of glaring at the moment.  Have a quick peek at experience for the headline and core rates of CPI change over the last 15 years.
       

There’s nothing like what we now see.  In fact, at this point, there’s really nothing like the current rate of change dichotomy experience seen stretching all the way back to the initial oil shock of the early 1970’s a good three decades ago.  In the following chart we’re plotting the percentage difference between the year over year rate of change in the headline CPI number and the core number over the last three and one half decades.  See what we mean about this being a bit of a rarity?
      

And, as you’d guess, back in the early 1970’s circumstances were quite similar to what we are now experiencing.  Energy prices were taking off like a rocket and the rate of change in core numbers were not yet following along.  Of course what would have been the key characterization at that time was the word “yet”.  We all know that energy prices influence economic activity with a lag.  The full impact of a dramatic rise in energy prices usually is felt one to two years after the acceleration has been in play.  Interestingly, historic spikes up in this ratio have either been right in front of or during meaningful recessions (early 1970's and early 1980's).  As we look at the above chart, what it says to us is that the big dichotomy in the rate of change between headline and “core” CPI in the early 1970’s was the precursor clue or giveaway that broader inflation was to pick up in a big way.  And, as you know, accelerating inflationary pressure simply characterized the 1970’s post the initial oil shock.  Are the numbers now telling us that we’re living through our own true oil shock of the moment?  Well, if that’s not the message, then we just don’t know what is.

As you are probably well aware, we have already seen a good number of companies come right out and tell us they will be raising prices dead ahead.  Clorox, who recently announced an earnings miss, accompanied that little piece of news with announced price increases.  And they produce non-discretionary consumer products.  The influence of higher energy prices is absolutely making its way into the system more broadly than has been the case over the past few years.  So, how much longer until the Clorox’s of the world begin to influence the “core” rate of US inflation?  History is telling us that we better start addressing this question in a serious manner.  The pundits can rant and rave all they want about the CPI being driven by energy prices and that the core is telling us everything is really A-OK.  But lessons of history are suggesting to us that the heat of CPI acceleration is about to move from the outside in.  Straight to the core.  Just remember to think how pervasive hydrocarbons have become in our everyday lives.  Is this current set of circumstances also at least in part a result of the “liquidity” the US Fed and their central banking buddies across the globe have unleashed over the past five years in an effort to keep the US consumption driven global economic game going?  Of course.  They are in the process of harvesting right now.  Harvesting wind as a result of their prior actions of planting the ultimately icy cold seeds of excess liquidity.  Without sounding melodramatic, we strongly suggest you think about what the chart above is telling us.  To ourselves, it’s saying that the fuse has been lit in terms of the potential for core inflationary pressures to now move higher as energy related input costs pressure corporate profit margins.  At this point, as we see it, it’s either continued corporate profit growth or higher core inflation.  Just which one do you think corporate CEO’s and their shareholders will vote for?  We suggest that our upcoming new Fed Chair Bernanke ask Santa nicely for a pair of new running shoes.  After all, history seems to be telling us that he's about to be in a footrace with accelerating core inflationary pressures.

Take Your Life.  Chart It Out In Black And White…There are a few last issues involving the spike up in the headline CPI that we believe deserve ongoing attention.  Although we have intuitively known this might happen for some time now, what the spike in the headline CPI does do is make plain for all to see that real wages are under tremendous pressure here.  Now there's simply no denying it or explaining it away, as has been the modus operandi on the Street for some time now.  Can we really expect corporations facing meaningfully rising input cost pressures to simply be benevolent enough to start voluntarily raising the wages of US workers given what is clear for all to see below?  Not a chance.
      

As we look into 2006, without question we suggest a major issue facing the real economy and financial markets will be "the consumer squeeze".  Rising interest rates are a reality.  How they affect the ability of households to service variable rate debt remains to be seen.  Declining real wages are a reality.  How this ultimately influences retail sales trends also remains to be seen.

A second issue we believe is very important in light of increasing headline CPI involves foreign funding of the US trade and fiscal deficits via the ongoing purchase of US financial assets by the foreign community.  Although we could have asked this question a thousand times over the last three to four years and essentially have had it meant nothing up to this point, we believe it's important now perhaps more than at any time over the past decade.  For how much longer will the foreign community be willing to finance the US economy?  Just why is this question important now?  Clearly the US is digging a deeper fiscal budget hole by the day.  We know the headline numbers have looked a bit better over the recent past, but we need to always keep in mind just how many US forward liabilities/promises are "off balance sheet".  We also need to remember what lies dead ahead in terms of funding the ongoing Iraqi operation that will not stop anytime soon and that the clean up in the South in the aftermath of the current hurricane season hasn't even yet started.  Although we won’t drag you through a series of chart and tables, there has been very important change in the global collection of US Treasury buyers over the last 12 months.  Looking back over calendar 2003 and 2004, the Asian community collectively purchased roughly $200 billion of UST’s annually.  From mid-2002 through 2004, Asia was buying US Treasuries as a part of both recycling trade dollars and going through the motions of practicing mercantilist economics in earnest.  The drive of mercantilism clearly outweighed real investment return considerations.  But over the last 10 months, Asia has definitively moved to the sidelines.  In the past ten months, Asia has purchased all of $30 billion in UST’s.  A shadow of 2003-2004 annual experience.

Who has picked up the slack in foreign buying of US Treasuries is the UK.  The UK position in UST’s has virtually doubled  in the last 10 months – up $80 billion.  In our minds, these are petrodollars making a brief stopover in London prior to finding their way to US Treasury land.  In light of current inflationary (CPI) readings, you know that the real Fed Funds rate is once again in negative territory.  To the foreign community this is really nothing new as this has been the case since late 2002, with the brief exception of a few months earlier this year.  But we suggest the very important question that addresses the change in global capital flows over the last ten months is for how long will our newly arrived petrodollar buyers of UST's be willing to accept negative real returns in short dated and longer dated US Treasury paper?  After all, the petrodollar gang has no interest in mercantilist market practices.  We're going to buy their oil no matter what.  Until recently, it appears the answer to that question has been "less and less so" as 2005 has played out.  And we believe that this is because Asia is no longer the dominant Treasury financier at the margin.  But now we’re firmly back in negative real rate of return territory in the world of Fed Funds.
      

In our minds, quite importantly, what is now new in the current period is that 10 year Treasury yield has also recently fallen into negative real return territory as the headline CPI has squirted higher.  As is easily seen below, nowhere in the last ten years have we seen anything like this.  Without sounding melodramatic, this is new and meaningful change from our standpoint.  We again pose the question, for how much longer will foreign buyers of US Treasuries be willing to accept negative real returns at what is now close to being the case across the entire Treasury curve?  With a new cast of incremental Treasury buyers as of late, the answer may be a whole lot different than was the answer while Asia was buying up every Treasury in sight.
     

One last chart to get across just how significant a point this may be in terms of current change and circumstances.  The following is a very long term look at the year over year rate of change in US CPI.  Overlaid on top is the 10 year Treasury yield.  It's been two and one half decades since the 10 year Treasury yield has been below the headline rate of change in CPI.  We have the feeling this has not been lost on the foreign community in the least.
      

As we've stated many a time, we firmly believe that market participants simply take it for granted that the foreign community will continue to finance US economic and credit cycle expansion virtually without limit.  The longer term picture of real rates of return available in US Treasury investments that has clearly changed meaningfully as of late suggests to us that those limits just may be closer than most believe.  Perhaps much closer. 

Compared To What?…We all know that the financial markets have been experiencing a bit of heartburn as of late.  This is now both equities and fixed income.  Not a lot of fun.  Expectations regarding potential inflation have shifted, at least for now.  The recent CPI numbers certainly seem to have caught the consensus off guard.  Moreover, it’s just our gut speaking, but the whole concept of core CPI numbers sure seems to be losing its hallucinatory influence on the investment community, as well as on mom and pop America, in a big way.  Welcome to the real world, right?  Is it time to pull out the old barometer of gold to have a quick peek at what it’s “telling us”?  We believe the answer is definitively and resoundingly yes for both equities and bonds.  We’ll leave you this month with a few final charts and thoughts to contemplate as we move into the end of the year and beyond.  We very strongly suggest that investors everywhere practice probably the most important personal investment skill imaginable right now – listening to the messages of the markets themselves.  Cover your ears at your own peril.

As crazy as it may sound, we think gold is perhaps telling us that the primary trend of the bear in equities has once again awoken from its almost three year slumber and is ready to start tromping around a bit.  Again, and as always, we don’t mean this to be ultra negative by any means, we’re simply trying to honor the tried and true financial market approach of “listening” to what the markets are telling us.   What is clear in the chart below is that during the period of the cyclical equity rally from early 2003 to the present, the S&P on a relative basis has been at best in a trading range against the price of gold.  In other words, in terms of gold, there has been no cyclical US equity rally (as measured by the SPX) since early 2003!  Whether one was in stocks or in gold, it’s been pretty much an even money trade off.  And what is also crystal clear is that with the recent absolute price level correction in stocks, the relationship of the S&P relative to gold is breaking through the lower level of the 2003 to present trading channel to the downside.  Technically, not much lies below this trading channel except the lows in this relationship that date back to the first quarter of 2003.  Remembering that as the S&P has underperformed gold in the past, the absolute S&P itself has been declining, does this recent break of relationship trend to the downside between the S&P and gold foreshadow what may indeed be the resumption of the primary bear trend in equities?  Again, we’re not suggesting this to be ultra bearish, but rather we’re simply trying to listen to market history whisper in our collective ears.  In our own little financial market playbook of life, we’d consider a break of the SPX and gold relationship ahead below the early 2003 low to be a very negative omen for the macro equity market.  We'd consider it "game on" in terms of resumption of the macro bear.  Will we get there?  We'll see.

As you’ve noticed, we've shaded periods of the S&P underperforming gold in red in the chart below.  Of course these also correspond to very weak, or flat at best, periods of absolute S&P price performance.  But, in our minds, what is most important in the chart below are the very well defined long term upward trend lines.  To be honest, these trend lines are virtually picture perfect in terms of having captured very important price bottoms over the last 15 years.  
      

Of course, what stands out like a sore thumb is the fact that the long term relative SPX and gold chart has shown us that it has just broken to the downside this very important rising bottoms trend line.  Yet coincidently the absolute S&P itself is still a good ways above its own nominal price trend line as we speak.  If indeed what happens to the absolute S&P as the S&P under performs gold holds true, based on historical precedent, as we move ahead, continued relative under performance would imply that the S&P itself has a good shot at hitting the absolute price trend line again.  For now, that lies somewhere between 950 and 1000.  Also, it could very well be that what we consider to be the important trend break in the relative SPX and gold chart on the top portion of the above graph is "telling us" that the primary bear trend in equities is about to reassert itself.  The big question is, "is gold a leading indicator or not?"  And is the action of the equity market relative to gold a leading indicator of what's to come in terms of equity prices in the absolute sense?  Although we see virtually no talk about this when gold is the topic of discussion, we suggest listening to what the combination of gold and the equity market is saying.  The message of gold just may be much broader than concerning just inflation.  The message of gold, in our minds, is that the risk premium in financial assets of all kinds is too low.  And, of course, the contraction in risk premiums over the years has been delivered to us on a golden platter by the central banks of the world who've created far too much liquidity.  At this point, they can keep the liquidity.  We'll take the golden platter, if you don't mind.   

Now let’s look at the ten-year Treasury yield relative to gold.  If indeed meaningful real interest rate change is upon us (nominal and real rates moving higher), we suggest what you see below will be a very important chart to watch.  As you can see, we have almost six straight years of downward movement in this chart based on declining tops.  In other words, it has been telling us interest rates were pretty strongly destined to fall, especially in “real terms” (relative to gold).  But you can also see that we have bounced off of what is clearly very strong resistance a good number of times over the last two+ years.  This chart “looks” like it’s ready to break out to the upside.  If so, it will be telling us “real” interest rates are on the rise, and perhaps meaningfully so after having broken a clearly definable downtrend of a half decade.  Although it’s important to keep tabs on nominal yields, we consider what you see below much more important.  
      

Will the relationship between gold and the US equity and bond markets light the way for us ahead in terms of where interest rates and stock prices in absolute terms are headed?  In our minds, gold has decoupled from the dollar as of late.  It’s preaching to a new and broader congregation well outside of the foreign currency community.  It’s preaching to US equity and bond investors.  Are you ready to listen?