You can put them in the same bottle, but you have to shake ’em up to mix ’em.
In response to my brother’s question about how the expected QE will affect equities, I offer the following observations:
In regards to the “inflation vs deflation” debate, I’ve been inclined to see this question as something like being on the “horns of a dilemma”. All of the debate focuses on it being an either/or proposition, and I’m not sure that’s ever been realistic or appropriate.
First, both phenomena are, in my opinion, a mixture of both monetary and psychological factors. Too much or too little money in the system will tend to propagate, both functional and perceptual responses. (And, yes, I’m sure you know all of this, but consider it as foundation for the premise.)
a) For inflation, too many dollars chasing too few goods and, at some point in the process, the belief that the diminishing buying power of the dollar makes today’s “stuff” more valuable than the money. Get it now, for tomorrow it will require more dollars. That’s how it gets in the midst of any “bubble”. Better buy a house now, because you won’t be able to afford it tomorrow.b) Deflation works the same way; a diminishing stock of money will coincide with and/or result in the perception that money is more valuable than “stuff”. Don’t trade it, because you don’t know how hard it’s going to be to get more and, besides, prices are stable or dropping. There’s likely to be a better deal out there tomorrow, so it’s best to wait.
In addition, both phenomena don’t have to be (and generally aren’t) completely pervasive, unless or until they really go into “high gear”, where virtually every buyer and seller of almost anything is responding to it.
Rather, we’ve been fooled into ignoring many decades of inflation/deflation booms & busts, simply because of what can be described as a “pooling” effect. This, I believe, is largely a function of institutional money flows in the system. The big question is always going to be, “where’s the money going to go and how is it going to get there?”
We’ve had inflation all along, it’s just shown up as bubble phenomenon in one sector or another. And, for the most part, we’ve had some deflation whenever each bubble finally bursts. Neither necessarily result in a pervasive flow of too much or too little money throughout the whole of the economy, unless it’s somewhat more widespread, like in the housing market where it was, in fact, ‘bleeding out” into other parts of the economy to the extent that it was providing a real boost to consumer spending via HELOCs.
It’s also worth noting that, so long as it’s not generally pervasive, the feds are able to more effectively “hide” the effect within the computations of the CPI or other indices. I’ve probably sent you this link, but it’s worth checking now and again – http://www.shadowstats.com/
Macro Structure Issues
As a final consideration, there are pretty significant implications related to the structure of the economy, including foreign trade and currency exchange. I have to believe that these “structural” issues matter a great deal. You may recall that I’ve suggested that the dollar was already in crisis mode in mid-2008 and that the subprime crash effectively “saved us” (or deferred) the inflationary effects that were poised for a serious rampage.
Not only were we seeing domestic inflation in housing and related spending, but oil was going “parabolic” This was not (as generally explained) simply “speculative greed” or “oil companies gouging consumers” with record profits, etc. Naturally, there’s always going to be someone who benefits from the latest bubble trend…..owners of land suitable for housing development, for instance, or owners of oil wells and drilling equipment when that particular sector explodes. Neither was it simply the forces of “supply and demand”, even if China’s demand was becoming a more significant factor.
No, what was driving the spike in oil was always the crashing dollar. The more we spent on imported oil, the less the dollar was worth and the higher each successive barrel was going to cost. That’s a classic foreign exchange-based currency death spiral right there, a problem that’s only temporarily been superseded by “higher priority” allocations, notably the “flight to safety” that strengthened the dollar and, for consumers, savings rather than filling their gas tanks. The bottom line is that you don’t have to weaken the dollar at the printing press. All you really have to do is buy more than you sell long enough. Of course, that habit tends to lead to or coincide with excess printing.
So, even aside from any deliberate attempts to devalue, there are still very real structural foundations for the weakening dollar. Our fiscal problem is still nearly as serious as (and, perhaps, only a year or two behind) the one in Greece and the other PIIGS.
Depending on how do the math, it may be even more serious. Quite a bit more of our money and debt is floating around out there in the world, for one thing. And, I’m not so sure that our accounting practices are any better than the Greeks. Regardless, that problem hasn’t gone away just because we’ve been looking somewhere else.
And, nothing will worsen it more quickly than a flight from treasuries. We could easily see (and I truly expect) all of our short-term debt instruments to explode into a much bigger piece of the deficit as they begin to be rolled over at higher rates.
Be that as it may, we are now fully engaged in a currency war, where almost every country in the world is playing with QE gasoline and FX matches. Aside from simply adding destabilizing volatility to the FX markets, it’s a very dangerous game of chicken when viewed from the vantage point of those “outside” of the game, like, say, OPEC and, ostensibly, China who never floated.
The Fed, the ECB, the BOJ, and all the others who want to play “currency chicken” can (and are) battling it out in the “race to the bottom”, all the while forgetting that those that sell us our oil or any other strategic resource are largely standing on the sidelines, but still getting pummeled along with the participants. And, since nobody’s going to win the devaluation game, it will (and already has) led to the next phase: trade wars.
None of this is good, but it really gives me pause to remember, as I noted last night, most of the major wars on the planet have begun in this fashion. Real damage is being done already, and it’s escalating very quickly now.
Flight to Safety Redefined
One very reasonable expectation here is that, amidst all the currency volatility, money is flowing to the handful of monetary “constants” available: gold, silver, oil, etc. I don’t know yet how it will play out in oil, but I’m inclined to believe that OPEC will trump the supply/demand part of the equation if needed. The real point is that money is not safe in bonds when valued in a currency that is actively and intentionally being debased.
I agree that we might yet see a decline in treasury rates for the near-term. But, let’s face it, the Fed is now openly monetizing some portion of the debt load. (And, by the way, the Fed is now the second largest holder of treasuries….) This has been going on sub rosa for a while; the fact that it’s being done openly now is a pretty serious indicator of just how close to the end game we are. Add deliberate devaluation and you’ve got a serious problem for foreign bond holders and/or buyers. They’ve simply got to move somewhere else.
So, that sets the stage to actually answer your question about equities and the S&P. (Whewwwww.)
I understand that forward-looking earnings are now being estimated at $95 for the S&P? Well, personally, I didn’t see that coming, really, and it’s a wonder to me that it’s been possible. Still, that clearly is reflecting some combination of increased efficiency and the positive effect of refinancing at ever lower interest rates. I suspect that there’s also a bit of M&A benefit in the mix.
Still, there’s no indication that there’s been all that much (if any) real top-line revenue growth behind it and, frankly, most macro indicators are still pretty flat. So earnings are up, but growth remains questionable, especially when adding consideration of taxes, health care, etc.
Considered in isolation from what an appropriate yield ought to be, the slow growth scenario should still produce a relatively low P/E on historical measures. We’re now at 12 and change, which is equivalent to an 8% yield and quite near the long-term average. But, that might be considered to be pretty high when compared to bonds at the moment. That doesn’t tell us, however, what it “ought to be”, let alone what it will “probably be”.
Reversion to the Mean
I’ve suggested that we should expect a “reversion to the mean”, which should mean some longish period of time below 12, just to balance out all that time we spent so high above the mean. That we’ve not yet seen and we should expect it at some point. The market “must” seek “positive real returns” and, in my opinion its just not getting them at the moment. Mostly that has to do with imperfect information and associated pricing signals. At it’s root, it’s all about the manipulated bond market, whose day of reckoning is fast approaching. In the absence of “positive real returns”, by the way, the market will settle for “neutral real returns”, meaning simple preservation.
I’ll keep this simple: Adjustment to yields in the bond market will, almost certainly, correspond to adjustment in yields in the stock market. These are, after all, indirectly related to one another. Traditionally, equity yields should be higher than those for bonds, as they are right now. So, just imagine ratcheting the whole scale up the ladder. How high? Who knows. But, we are have already increased the monetary base by more than 100% since the crisis began, have continued over the past year to add at a rates near 10%, and by all acounts , may be headed for territory north of 25% or 30% next year. That should give us a clue.
Why hasn’t that resulted in more dramatic pricing growth, which is clearly the Fed’s goal? A) Much of the market simply doesn’t believe that inflation is likely in the face of so much destruction, and b) this perception is understandable since, so far at least, the flows of that money have been pretty narrow. That’s the Fed’s dilemma right now and, based on Bernanke’s recent comments, you might imagine they’re wanting to scare us into the belief that inflation is heading our way. After all that gasoline, however, I’d be worried about the “Whump” of ignition.
All of this speculation is really intended to hazard a guess at future monetary flows. Out stocks and into bonds, followed by out of bonds and into what? At the moment, equities have been drawing some back, even as the Fed takes up more and more of the slack in bonds. Not so smart in my opinion. Its true that some companies can keep pace in an inflationary environment. So, certainly, there are short-term gains to be made there, but, as I noted above, at some point the yield target is going to change, and very quickly I’d imagine.
As it happens, the huge volume increase into precious metals gives us a clue to what’s really happening, and it’s pretty much as I’ve expected. Quite simply, when all currencies become suspect, you put your money into hard assets. Typically this is a classic “inflation play”, as hard assets are a better store of wealth than devaluing currencies. Is that what we’re looking at? Inflation? Oh, yes, I think so.
So, Inflation vs. Deflation or Inflation & Deflation
How do you reconcile that with all the talk about deflation? Easy, really. Just follow the money flows and see where it pools or where it doesn’t. We can have deflation in a range of sectors all the while having inflation in others. We can have domestic deflation and imported inflation. We can have a deflating household sector and an inflating financial sector.
There are very real functional reasons why neither inflation or deflation would be so pervasive (at least for a time) that it over-rules one for the other. In effect, we can have “stagflation on steroids” or what has also been called a “hyperinflationary depression”.
This is a perfect storm of sorts, whereby, no matter how much money is printed, it doesn’t “kick-start” real growth. We’ve confused inflation and growth for so long that it tends to surprise us. After all, the (now openly admitted) fed mandate to create inflation is a good indicator of how well we’ve institutionalized this viewpoint. But, it’s not the same and never was. In fact, it’s hidden real declines in production.
And, for what it’s worth, we’re seriously deranged if we believe the positive GDP figures being reported today. Imagine borrowing 12% of your annual spending and calling it “income”. That’s what we’re doing, isn’t it? Take that 12% out of the GDP and you’ll find out what our real income is….and it’s still negative year over year.
Now, imagine printing, stealing, or simply declaring that you’ll never, ever pay that 12% back and you’ve got a more complete picture of where we stand. We’ll never grow our way to paying for it honestly. Never happen. (And, I haven’t even mentioned all of those $130 trillion in unfunded liabilities we’re still facing.)
So, we’ve already got an active mix of inflation and deflation occurring. We’ve got persistently high unemployment, declining spending and, in some sectors like housing, declining asset values, deleveraging, and money shrinkage. In other sectors, we’ve got massive pooling, notably bonds (for the moment), maybe an uptick in equities (for the moment), and into fungible and/or strategic hard assets, like gold, agriculture, rare earths, oil.
Some prices (along with demand) are going down…..some technology, some durable goods, some leveraged real estate. In other sectors, prices are going up, like food, gold, and maybe, gasoline. We’ve got currency wars and trade wars gearing up and we’ve got active devaluation, rising fiscal deficits, active fed monetization of the debt. I don’t know how else to describe it other than the first glimmer of “stagflation”, if not a full-blown hyperinflationary depression.
Wish I could change my view, but I’m still in the mode of: buy food, buy gold, pay off debt where you can, figure out how to make a living in a tough environment, get out of the city, pray for protection.
Unfortunately, I really don’t see any way out of the problem. We’re still waiting for China, for Brazil, for OPEC, and others to set the pace. All we have done is give them the excuse and we’re still mailing out invitations.
We’re not alone. I caught the rumor yesterday of the BOJ intending to buy equities. I don’t know how that might work, but, I mean, the insanity is pretty widespread. Can you imagine the Fed doing that too? Are they already? Would we know if they were?
I told you what Prechter is thinking….DOW 1000. Probably wrong, but, I wonder, just how wrong? Another big crash, a big spike in interest rates, continued and expanding QE, trade wars looming, and a possible jump in oil prices….any one of these is a deal killer right now and we may get all of them at once.
I say keep your powder dry and your options open.