Inflation expectations still overblown

All of the articles about currency wars,QE2, and more calling for China to revalue its currency seem to be producing a mania of sorts against the US dollar.  It seems incredible that for the first time, US TIPS (Treasury Inflation Protected Securities) was sold at a negative 0.55% yield!  Investors are paying the government for inflation protection!  In my opinion TIPS are a poor method of inflation protection because the CPI calculated by the US understates actual inflation – and you are still taxed on the “capital gains” from an upward adjustment in principal on these treasuries, but that is beside the point.  The negative stance on the US dollar has also been pushing up the risk trade in commodities and the stock market, but this can’t be expected to last. 

Remember Bob Farrell’s rule #9:  “When all the experts and forecasts agree, something else is going to happen.”

It often pays to be a contrarian.  A lot of money tends to ebb and flow between asset classes to the favored ones.  When most of it is accumulated, it can be expected to snap back at some point, so being a contrarian is a way to aim at buying low and selling high.  Keep in mind though that this contrarian stance tends to work better for overall asset classes rather than individual stocks – because there are a million reasons why an out-of-favor stock really is damaged goods.  It also pays to look at the economic data and judge for yourself where the risks really lie.

The LEI (Leading Economic Indicator) is a good source, but as Rosenberg mentions it is often better to look only at the “real economy” components.  This means stripping out both the yield curve factor (because yield curve says nothing about economic health in a zero interest rate environment) and the stock market component (when trying to predict the stock market over the next few months, how much does it really help to know it recently went up?  This merely adds noise).  This measure has fallen in the past 4 months.  Also, the coincident-to-lagging indicator ratio fell 0.4% in September and this tends to be a decent leading indicator.

In yesterday’s newsletter (10/25), Dave Rosenberg also offered a great synopsis of the views in the federal reserve, including: 

“The economic recovery is proceeding at a very slow pace and has lost momentum since the spring.”

 “…we project…inflation to be around 1 pct in 2011 and 2012.”

“This low level of inflation, combined with the sluggish GDP forecast and large amount of slack in the economy, suggests that further disinflation is possible.”

“Japan’s experience beginning in the early 1990s underscores the risk of getting into a long period if sustained disinflation. Japan fell into deflation in the mid-1990s and has yet to recover.”

There has been a significant expectation for QE2 priced in right now, but the details on a new monetary expansion are certainly not resolved.  The Dallas Fed’s regional president Richard Fischer, among others, are questioning whether it will even work.  Bernanke is not stupid, and I do believe he understands the risks and some of the arguments (though his position is a bit politicized and thus prone to some bad decisions). 

If you think about it though, how will dropping the long-term yield by 50 or 100 basis points help when the big corporations already have money but are reluctant to invest it because of questionable regulations, taxes, and demand?  And how will gas prices rising over $3/gallon on a sinking dollar really help the US consumer pick up demand?  Right now, companies are already feeling the squeeze of higher commodity prices combined with little to no pricing power in many segments, as consumers readily delay purchases and trade down to cheaper substitutes.  Higher commodities costs are likely to only make this worse; the money printed up hasn’t been reaching the US consumer as seen by high unemployment, claims stuck in the 450-500k range, and declining private sector wages.  The effects of QE2 pushing more cost increases on the consumer seems more likely to further contract the economic activity, these risks are well known to the economists at the reserve banks, and it seems more likely that the program will run toward the conservative side on this one. 

I’m still holding off on gold, waiting it out a few months for the market to once again reflect more of the real deflationary risks, but I still believe it’s in a secular bull market and will go up in the long-term.  I’ve got plenty of unallocated cash waiting for this.

However, I did find some excitement in the bond market today, with the yields back up to 2.64 for the 10-year and 4.00 for the 30-year.  I took advantage by extending the bond portfolio in my Roth further to include some DFY and PLP, with yields at 7-7.5% and BBB ratings.  I’ve found to be a great place to find lists of exchange-traded debt and other income generating securities (and its free).  Keep in mind that the companies with exchange-traded debt obviously have access to the markets and will therefore benefit from lower yields, but its definately worth doing a quick check.

I like to check for significant positive earnings in the underlying company and a balance sheet that doesn’t look too scary.  I also like to see that the company has common stock with regular dividends, showing that there is someone to cut off before you in case of trouble (this is especially important with preferred stocks).  You could try to find interest coverage ratios, liabilities hidden in the footnotes, significant contractual lease obligations and such, but this is more for big investors – when investing $1000 into each of a bunch of these, due-diligence has to be quick because the potential gains will not pay for your time.

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
This entry was posted in Market Thoughts. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s