Trends Reversing and Implications Thereof

The content on Jesse's Cafe Americain has been informative lately. Not surprisingly, the personal income chart mirrors another one also from www.contraryinvestor.com, on retail sales.

These long downtrends will be in force until they are not. One would at the least expect a snapback, given the extreme nature of the recent declines.

This expected snapback is to a large extent priced into retail stock prices, which now sell with low dividend yields and generally high price to book and price to earnings ratios. Not that the stocks will not rise; I have no idea about Mr. Market's mood or the short or long-term "fundamentals".

Looking back to the left hand side of these charts, one sees that as the years went by, a rising trend of personal income had sharp setbacks. The dominant fear throughout much of that time was literally of a return to the deflationary depression years of the 1930s. A quarter of a century after the worst of the 1932-33 stock and economic cycle is now known to have passed, Benjamin Graham, who mentored Warren Buffett at Columbia and was one of the truly great investors of the 20th century, was able to find numerous NYSE stocks selling for less than cash on hand. This at a time when a multi-year bull market had been in force! It is much easier in hindsight now to have "bought" those dips in income than at the time.

Based on today's data on capacity utilization and industrial production, it would appear that these have hit bottom for the nonce. Paradoxically, the greatest investment opportunity from a risk and reward perspective could be in the major asset class that has performed the worst this year and that one might think suffers from the bottoming of the production cycle: longer term Treasury bonds.

They are both despised and "under-owned" by the public. Even bears such as Robert Prechter advise people to sell stocks and buy ultra-liquid very short-term debt instruments (T-bills), not bonds. Yet a cyclical industrial recovery and an upturn in personal income (or at least a cessation of the decline) means less contra-cyclical government spending, and thus a (relative!) shortage of bonds to a market that has been absorbing unprecedented supply.

Historically, T-bond yields bottom well after a recession/depression ends. The post-Great D low in bond yields was in 1940 or after. The prior 21st Century T-bond low came over a year-and-a-half after the shallow recession ended in 2001. Not that the 30-year T-bond makes sense anywhere the 2.5% it hit last December, but the 10-year is different. It would not be prudent to put all one's money in such a debt instrument given the inflation risks, but consider the following analogy. The great bridge player Marty Bergen says that the bridge point system in which an ace rates 4 points, a king 3 points, a queen two points, etc. underrates the value of the ace.

Similarly, even the fine economists such as David Rosenberg who recommend corporate bonds based on their spread over Treasuries miss the point in their public analysis. U. S. Treasuries are, like it or not, special. All the other bonds must be judged on their absolute yield and riskiness and not on the yield difference over Treasuries.

From a technical basis, the long decline in corporate bond yields has ended. The bull market for Treasury debt remains intact. The CPI is reported to have dropped 2% y-o-y as of July, the sharpest drop since 1950. Thus the instantaneous "real" yield on a 10-year Treasury is 5.5%.

Markets exist in part to surprise the greatest number of people. Can Treasuries (TLT on the NYSE and zero-coupon bonds OTC) truly be vehicles for capital gains as well as safe income?

Time will tell.

Copyright (C) Long Lake LLC 2009

Comments on June CPI and General Price Inflation

The Bureau of Labor Statistics has released the June Consumer Price Index Summary.
One has to wonder about the reliability of these numbers, viz.:

 The index for all items less food and energy rose 0.2 percent in June
following a 0.1 percent increase in May.  Most components of all items
less food and energy posted increases; the indexes for shelter and medical
care rose slightly, while the indexes for new vehicles, used cars and
trucks, recreation, and apparel all increased at least 0.5 percent.  The
index for airline fares did decline in June, falling 0.6 percent.

Whether in Macy's, Nordstrom's, or specialty shops, there are significant sales everywhere. The sales are widespread enough that it would be surprising if a large percentage of final dollar sales were not being made at major price reductions. These are generally "real" sales, I believe, in that they are discounts off of ordinary prices. It is thus at best counter-intuitive for BLS to claim that apparel prices rose in June. Similarly, how plausible is it that total cost to buy a new car rose, after rebates and/or low/no interest rates on new car loans?

Yours truly recently bought some "stuff" at CVS. With payment came a $5 off slip on a purchase of $25 or more, plus a $2.50 further discount. Upon responding to this incentive to purchase more "stuff" that was going to be purchased a month or two hence anyway, the wife and I also found various sales and store brands which lowered purchase costs and from which the above discounts were further subtracted.

These questions ignore the topic of how to measure housing costs. The BLS says that the cost of housing is essentially unchanged year on year.

There are price pressures everywhere, modified by frenetic Chinese buying, the future of which is unpredictable. Sustained, major and rising inflation in the U. S. last began in the mid-1960's with LBJ's guns and butter policy. The economy can probably handle Obama butter without big-time inflation. If Afghanistan heats up substantially or another significant war appears, though, watch out.

Copyright (C) Long Lake LLC 2009

Why the CPI Chronically Understates Housing Deflation After a Boom

The Consumer Price Index is out today and is reported to show prices down 1.3% yr on yr, the largest drop since 1950. However, this index understates the drop in prices. Here is a link to the Bureau of Labor Statistics description of how it estimates housing costs in the CPI: http://www.bls.gov/cpi/cpifacnewrent.pdf.

This total is 30.4% of all costs. There is one fundamental flaw, which is conceptual. 24.4% of the entire CPI is supposedly from what a homeowner would pay to rent the home he/she lives in. The problem is that this cost is theoretical, imaginary and unvalidatable. What is validatable is what the house is worth as an asset, what the mortgage would be on the house, what the taxes and other expenses of maintaining the home are, etc.: in other words, what the cost of OWNING is. The idea that an owner would in effect rent to himself and that that guesstimated cost is part of the cost of living is strange.

The practical problem stemming from this technique is that the owner is asked what his house is worth as a rental unit. Well, most people are going to overestimate the value, and in truth most people who own their own home live in communities without well-developed home rental markets, and often the rental homes are not as well-maintained as the owned homes, so who knows what the rent would be? Further, if all owners rented their homes out, there would be more supply, and rents would then drop.

The beancounters at BLS insist that rents are rising and that "owner-equivalent rent" (that 24.4% of the CPI) has risen over the past year and rose last month.

In other words, the CPI probably understated housing inflation somewhat during the housing boom, but because of the technique of owner-equivalent rent, most homeowners were probably generous in their estimate of OER increases. However, most homeowners are loathe to acknowledge that their home is declining in price, and so they are understating the OER decline. Numerous studies show that people will agree that the housing market is in a decline locally, but believe that their individual house price is resisting that tide. That's human nature, apparently.

Thus, 24.4% of the CPI is, most importantly, an inappropriate measure of inflation, but we can't change that.

What we can do is realize that within the confines of using owner's-equivalent rent as a measure of price changes to live in a home, there is likely a systematic bias for the CPI to keep up with price increases in a housing boom but to lag price decreases in a housing bust.

Copyright (C) Long Lake LLC 2009

Lies, Damned Lies, and Government Statistics

Once in a while, Government statistics, which are now deliberately presented to prevent people from easily even seeing year-on-year comparisons in favor of almost meaningless month-to-month variations, end up hiding not the bad news but the good news.

Today, for example, the consumer price index was released. Allegedly, clothing and automobile costs led the price increase.

Anyone who believes that automobile prices went up last month is living in another planet. The same is true for clothing prices.

For example, all-cotton Dockers pants are on sale at Macy's for $33, down from $48, but in a post-St. Patrick's day, pre-Passover sale, they are being further discounted to $28. This price has to be a price seen many years ago. In addition, there may actually be some quality improvement, such as permanent crease and something called "micro-sanding for softness". Plus, in tune with the obesity epidemic:

"Your favorite khakis now have an invisible extra inch in the waistband that expands when you need it."

Unfortunately, the Fed keeps insisting that even modest deflation, such as a 1-2% price decline over the next year or two, is so horrible that it needs to continue its hysterical, hyperkinetic activities. Earth to Fed: get on the side of the people rather than the banksters, for a change. Raises are hard to come by. Secure financial assets yield nothing, or next to nothing. Formerly reliable dividend stocks such as GE and BofA have slashed their dividends, and everyone knows that absent the bailout, BofA might well be bankrupt, as might GE Capital. So, the Fed needs to cut the ---- about deflation expectations suddenly becoming ingrained. The truth is that inflation expectations have risen along with the massive Federal deficits and Federal Reserve actions.

Back to railing against Gov't statistics.

They even mislead us about Gross Domestic Product.

The government, for unclear reasons, assumes that even though a home is correctly counted as economic activity when it is built, a homeowner pays him/her-self rent monthly and thus contributes to GDP. This is under the theory that because rents are part of GDP, it is unfair that a house or condo, sitting innocently wherever it sits, cannot be treated like a washing machine or television that gets used regularly but does not add to measured GDP except when it is produced and sold. This "owner's equivalent rent" adds a good deal to announced GDP. Why this logic is not applied to automobiles, which also add to GDP when rented, is not clear. As with the steroids epidemic that keeps the sports records coming, owner's-equivalent rent is economic statistics on steroids- pumped up to keep the public happy.

In any case, the point here is to ignore what the Government tells you about the economy where your eyes and eyes can provide better information, and to be skeptical about all the headlines where you cannot comment (such as trade deficits).

The Establishment/Fed/Feds pound the public through every way possible with the message that the Great Depression was deflationary, and thus the only solution for any economic problem is inflation. This flies in the face of all common sense. If farmers figure out a way to safely double the yield of a crop at the same cost per acre, then they can lower the price, sell more of that crop, and make more money. That's called "good" deflation. If the crop fails, that's bad no matter what happens to the price.

What is going on now in the economy is that there are not enough savings anymore in the U. S. This is analogous to the rural family that in past years saved grain and salted meat to get through the winter, but the rats got into the grain and the meat spoiled anyway. Thus there is currently little buffer for the hard times that have arrived. Now that this year's economic crop is failing, the fact as of today is that prices of almost all freely tradeable goods, absent the governmentally-approved cartel called OPEC, are falling. This is "bad" deflation, as it comes from crisis, but it is, nonetheless, deflation.

In addition, if and when production increases, prices may fall further for a while, as costs per unit of production drop as the increased production is spread over more units with low marginal cost per extra widget produced.

From an investing standpoint, the problem with the current deflation is that there are few to no clearly attractive financial asset classes in which to invest. This is the polar opposite of the situation in the early 1980's, when almost all financial assets, from cash to bonds to stocks appeared attractive.

Re stocks, this blog was started in December 2008 with the Dow around 8500. From the start, the advice was that the stock market was suited only for gamblers. The Dow is now around 7300. The advice remains unchanged. The best investments in companies may be in private entities that have not gone public at inflated cash-out prices.

Capital preservation remains the watchword around these parts.


Copyright (C) Long Lake LLC 2009

CPI Understates Deflation; or, Requiem for a Heavyweight?

The Bureau of Labor Statistics has released the CPI data today.

The annualized rate of prices for the last three months is a negative 12.7%. This is Great Depression-level deflation.

This report understates current deflation because of the following:

"Continuing decreases in the indexes for lodging away from home, airline fare, and new and used motor vehicles, along with downturns in the indexes for apparel and recreation, offset increases in other indexes including rent and owners' equivalent rent, medical care, and education." (emphasis added)

Housing is NOT making a positive contribution to the cost of living. It is making an important negative contribution. Even if we understand and agree that the Government goes out of its way to make matters look less inflationary than they really are, I think that we can agree that currently there is no price increase almost anywhere that can "stick" except whatever is imposed by law or regulation.

The markets "get it" and are taking stock prices down, especially the financials, the latest rally of which has vanished. I suspect that a lot of Governmental and Fed officials have been talking to the Swedes about their nationalization of their banking system in the early 1990s following a real estate bubble. We appear to remain in the teeth of the economic storm.

While what is happening in economics and finance is disastrous, the continuity vibes coming out of the incoming Administration do not encourage me. In my opinion, Mr. Obama needs to bring into his Administration and amongst his advisers those who foresaw that the TARP bailout was hastily and wrongly designed. The complaints about its implementation ring hollow when the complaints come from those who crafted and fought for the legislation. Mr. Obama and his people need to come out hard in favor of equity and not debt. This is not an issue du jour but rather the key to long-term economic recovery. If he does not embrace this issue, the Republicans might do so and unexpectedly gain the edge in what could the most important economic theme of the next supercycle (though it takes time to build such a movement). The productive capacity of the U.S. is unimpaired; the cost of imported goods is plummeting; the people are eager to work; there are no major state enemies; Al Qaeda is on the run and its financial backers are going broke.

Therefore these can be the best of times, and soon. However if the new Administration persists on the failed long-term path of a debt-based economy rather than a true ownership society, not the Bush version that was based on debt (we know Obama will fight for a "fair" society as well), Econblog Review predicts that the best it is going to do is patch the aging fighter up to survive to fight another round or two.

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