What Is Not Seen

The hottest topic of today is definitely inflation. The effects from inflation can be seen everywhere. Recently we saw oil prices, surge to over $134 per barrel.

Leaving fundamental factors aside, inflation has contributed to massive gains in commodity prices during the last year. Even deflated government figures like CPI and PPI have begun to show big increases, as monetary inflation has filtered through the economy, pushing over all prices higher.

The Austrian definition of inflation regards monetary inflation. Simply, If the money supply grows, there is inflation. One result from monetary inflation is price inflation, or increasing nominal prices on goods. The price inflation we see today is therefore the result from monetary inflation that happened in the past. Today, we experience the accumulated effect from monetary inflation, that occurred many years ago.

An interesting question is whether we should expect this historical inflationary buildup to continue to push prices higher, as we speak today? Or, as some people argue, that we should expect prices, or price inflation to moderate as the economy slows.

The problems involved with trying to measure statistically, the effect from monetary inflation on for example PPI, is evident. First, there is no “rule” determining how long time it takes for monetary inflation to show up in prices. Second, the effects from monetary infllation on prices is asymmetrical. Third, monetary inflation tends to accumulate over time, making the effects larger when they finally hit the economy. And fourth, not all monetary inflation show up in statistical measures like CPI and PPI.

With these problems in mind, I have tried to create a rough estimate for future price inflation, given the current monetary inflation we can observe. I have looked at the percentage yearly change in money supply, here measured by MZM (Money with zero maturity), and the percentage yearly change in PPI: All commodities, trying to map the changes in MZM to the apropriate effects in the PPI. The red line signifies PPI and the blue line MZM. Number 1 is intended to map on A, and 2 on B, and so on.

Even if this approach is very basic, I belive it can serve as a rough guide for what lies ahead.

Looking at 8 and H, we see something interesting. When the rate of monetary inflation slowed after the tech-boom crash in 2001, PPI didn’t slow at all. Historically a decrease in MZM has followed by a similar decrease in PPI, as we can see for example with 3 and C.

Ever since late 2001, price inflation has grown significantly faster than than it did, any time since the 80’s. This has happened in an environment where MZM has been decreasing. One explanation for this buildup in PPI, is precisely the historical increases of the money supply, that has been building up, and not until recently starting to puch up prices on goods.

This is supported by what happened when MZM once again picked up. After MZM had bottomed in 9, PPI quickly increase from I to new record levels.

Looking ahead, we hypothesize that the bottom I for PPI coincides with the bottom 9 for MZM, and construct a likely scenario for the development of future PPI and price inflation. The time elapsed between 9 and I is 16 months, between June 2005 and October 2006. This means that the last 16 months change in MZM does not yet show up in the PPI numbers.

According to the chart, money supply, MZM has been growing exponentially ever since 8, and currently by 16 % per year. Even if the rate of change in MZM would slow some time soon, we should still expect prices continue to increase. And even if we would see a temporary decline, the trend in PPI is clear. We are entering a period with on average higher prices, both producer prices and consumer prices.

Yesterday, real gross domestic product came in positive with an increase of 0.6 % since Q4 2007. This number was regarded as great news, and even by some economist, a proof that the U.S. economy will escape a recession. From Larry Kudlow’s blog there is an amusing post called: Recession? What Recession? with a comment by economist James Pethokoukis, who gives the following analogy, that the American economy is

[...] like the Terminator. Not the Schwarzenegger one—the other one, the Terminator from the second film. You could empty a shotgun—or in this case, an imploding housing market, credit crunch, and high oil prices—into that morphing metal dude, and before you know it, the thing’s all healed and chasing you again.

Even if I love the movie, I don’t think his analogy is the least accurate. If we instead look behind the positive headline number, the Q1 GDP report instead looks quite ugly.

Of personal consumption expenditures (PCE), both durable goods and nondurable goods shows steep declines. While spending on durable goods are in free fall with a negative change of 6.1%, nondurables are also declining, but more modestly by 1.3%. These low readings is a reflection of the deteriorating conditions for the American consumer, commented on earlier, here and here.

But more worrying is the overall decline in gross private domestic investment, that shows negative numbers for all fixed investments, both residential and non residential. Residential investments recorded a change of -26.7 %, which is the highest negative change since the housing bust started to deflate in 2005. A negative reading in non residential investments also indicate that the economic slump is no longer contained to certain sectors of the economy, like housing and construction.

Looking at inventories, compared to Q4 when private inventories subtracted 1.79 % from GDP, inventories acctually added 0.81 % in Q1. This means business increased the amount of inventory from last year. As inventory buildups in a crunching economy, often is a sign of slowing sales, this last change in private inventories are rather an indication of the ongoing liquidation process, from earlier malinvestments. This large inventory buildup in Q1 is also likely going to have a negative affect on production in Q2. Last time we saw a bigger decline in real final sales (GDP less inventories) was in Q3 2001, when we was experienced the tech-boom crises.

What is then positive in the GDP report? Still, spending on services have held up nicely, recording a 3.4% gain in Q1. One contributing factor here was spending on electricity and gas, that increase 14.2% in household operations . The reason for this increase is higher energy prices.

Another positive factor was exports, that increased 5.5 %, compared to imports that only grew 1.4% in Q1. Exports will likely continue to be supportive in the Q2 report.

Finally, even if the often cited: two consecutive quarter with negative growth rule, does not yet indicate a formal recession, we know that all four indicators (inflation adjusted personal income less transfer payments, industrial production, non-farm payrolls, and inflation adjusted factory, wholesale, and retail sales) used by NBER (National Bureau of Economic Research) are set on recession mode.

And, even if the terminator has a tendency of “coming back”, the latest GDP report seem to beg the differ, as it provides a rather gloomy outlook for the U.S. economy.

U.K house prices fell by 1.1% during April, the first year-on-year decline since 1996. Compared to the long term trend, real U.K. house prices is currently 25 % higher.

The last time U.K. house prices peaked was in Q2 1989. Back then, prices reached a level of 33% above the historical trend. Even if current levels are not as high relative to the long term trend as they where in the early 90’s, economic conditions are arguably worse this time.

Like U.S., the U.K. economy are now only starting to experience the effects of historical credit expansion, that has been fueling the housing sector since the late 90’s. This is primarily the result from lax monetary policy in the past, that has created economic dislocations, especially in the financial and manufactoring sector.

Housing cycles are often long lasting. After prices had peaked in 1989 it took 13 years until prices had reached the same level again. If we take into account that prices tend to overshoot the trend, we should prepare for quite a long lasting slowdown, this time.

The second estimate of forth quarter GDP was unchanged for the euro area on +0.4%. A closer look at the numbers show a slightly stronger net export than in the first estimate, with an upward revision for exports of 0.6 % from 0.5% and a downward revision for imports of -0.3 from -0.4.

Even if fourth quarter export growth has slowed compared to the third quarter growth of 2.2%, euro zone exports have held up good, despite the strong euro. This is confirmed by german export numbers published today, that show exports have risen in February by €0.4 billion since January this year.

What is to expect? Surely, it takes time for a move in exchange rates to affect trade volumes, especially if business hedge against the surge in currency. As forward contracts eventually will reset, profit margins will contract in the short term. This will likely result in higher prices as business tries to maintain their margins, which in turn will have a negative effect on overall exports in the euro area. Goods that are sensitive to price changes will naturally experience a significant slow in exports as foreign demand will lessen. For countries, like Germany and Finland, exports may be sticky. With a large amount of non-euro exports consisting of capital goods, both countries could benefit from strong Asian demand.

With euro zone inflation at an all time high of 3.5%(p), many companies have already experienced higher costs, as inflation has affected transportations and overall energy prices, resulting in an increase of input prices. According to the CPI euro annual report for February, transports had increased 5,4 % and energy 10,4% since last year. For the exporting sector of many countries this will surely have a double negative effect, also resulting in slower GDP growth.

The goal for most investors is to stay ahead of the curve. Regardless of what ever asset class in mind, fixed income, equity, commodities or currencies the ultimate goal is to be well positioned, and in line with the market. This can be a tedious task especially when market movements go the opposite direction from economic indicators and the overall economy. I can’t remember how many times I have seen magazines, cover stories, etc. proclaiming, either the “The end of equities”, as did News Weak 1982 or “The end of the oil age”, as did The Economist 2003, just to see markets take off in the opposite direction almost the exact same date.

There is no doubt that markets tune in to fundamentals over the long turn. Just like a rock getting thrown up in the air under the act of gravity, markets that rise without fundamental support will eventually return to the ground or for equities to the historical average growth rate. Take a look at total return for GDP and S&P 500 since 1960. During this period, growth rates have varied, but total return is not surprisingly the same. During negative years for stocks, GDP sometimes had a positive return. This is one example when a belief in following the underlying economy can get you side stepped.

The search for economic indicators able to warn investors of such diverging tendencies made me think about the Bullish Percent Indicator. This indicator is a contrarian indicator constructed for the sole purpose of gauging the likelihood of a shift in market behavior. The Bullish Percent is based on the number of buy signals given from Point & Figure charts. The most interesting one is the NYSE Bullish Percent Indicator that shows the number of stock on the New York Stock Exchange currently in a buy signal. The logic behind this goes back to supply and demand, and the fact that changes in these dictates market movements. On Stockcharts.com you can find the index by the ticker name $BPNYA.

A low reading, below 30, indicates that less than 30% of the total 2500 stocks in the index are experiencing buying pressure. This situation is synonymous with one where most investors that don’t have an interest in stocks at the moment is outside the market. The lower this index drops the smaller amount of demand is needed to have a positive affect on market prices, making it a good time to get in the market.

Had you only looked at the underlying economy for guidance or the currant negative trend of historical equity prices, the likelihood is high that you would have missed a potential shift. Historically Bullish Percent has been a good contrarian indicator as it warned us prior to both the crisis around 9/11, and last year of the subprime crises that got to Wall Street in august.

As we have seen stock markets and fundamentals tend to diverge from time to time, making it even harder to get a good read of where the market is heading than usual. Bullish Percent is one of many contrarian indicators, grounded in economic theory that can assist investors in foreseeing possible bottoms and tops in asset prices.

Finally, I would like to clear up one misunderstanding with regards to the Bullish Percent. Most investors have herd the expression that “the trend is your friend”, even Point and Figure analysis is centered on this concept. This idea implies that a stock experiencing upwards- or downwards pressure is likely to continue in the same direction. The obvious question whit regards to Bullish Percent is: What if every stock – let say in the broad NYSE index – had signaled buying opportunities, would not that contradict the logic of Bullish Percent and trending prices? Absolutely not!

If one stock rises, it doesn’t say anything of the overall market demand. Market demand may be slowing, but some stocks always go the opposite direction. Let’s say for the sake of argument that every stock is signaling buying opportunities. This has almost certainly resulted in surging prices as every available demand has entered into the market. With every one willing to participate in buying stocks already owning stocks, there is extremely little demand left to continue acting as upward pressure on prices. This is a situation where a marginal increase of supply will have a significantly large impact on market prices when there is no longer any counteracting force holding prices up.

An extremely weak employment report from Bureau of Labour Statistics show further deterioration of the US economy. Nonfarm payroll of -80 000 is in a historical perspective a very weak number. The last time nonfarm payroll plunged with more than 80 000 was in mars 2003, when payroll decreased with -212 000. Further economic weakness is clear by looking at the revision of February numbers of -76 000.

Economically, employment is a lagging indicator and does not necessary portray an accurate picture of where we are going in the future. The fact is that the index held up until January 2008, while the financial crises hit the markets as early as august 2007.

With the latest manufacturing report in memory, a closer look at the establishment survey shows a job loss of 48 00 in the manufacturing sector. This can be viewed in contrast to the resent growth in employment according to the ISM manufacturing index earlier in the weak. The apparent mismatch is a result of different ways of estimation methods. Despite the positive read in ISM, the Establishment report accurately show how economic slowdown now has started to show up in the labour markets.

According to economic theory, the pattern discerned in the report is interesting. The present economic bust, following the prior multiyear boom is both results of the same thing, namely credit expansion and monetary inflation. In a period of credit expansion and lower interest rates, capital is allocated to sectors further away from consumption, such as manufacturing, goods production and mining, where the amount of capital is relatively high. These, so called malinvestments increase the amount of leverage, pushing prices higher (look at prices in the ISM report +8%), resulting in massive increase of supply. With a deficient amount of demand for manufacturing goods, the inevitable profit squeeze and liquidation is a fact.

If we look at the establishment report, goods-producing industries: construction and manufacturing both experienced a total loss of -93 000 jobs, compared to the service sector that actually gained 13 000 jobs in mars. This scenario conforms to what we would have expected from economic theory.

This stagflationary scenario is similar to what we have seen in earlier recessions, with falling producer prices and rising consumer prices. So far in to the present economic down turn, history seems to remind us of this chain of events.

The latest manufacturing report came in stronger than expected according to the financial media. With a reading of 48.6% the ISM manufacturing PMI increased with 0.3% since February. On this news, markets reacted strongly with a broad surge in prices.

The ISM PMI index consists of 4 different sub indices; New Orders 20%, Production 20%, Employment 20% and Supplier Deliveries 20%. A reading above 50 has historically meant that the over all economy is growing. A reading below 50 on the other hand has historically meant that the economy is slowing. Today’s reading of 48.6% does clearly signify that the US economy is in a decline.

That the US economy is experiencing severe problems is nothing new. But why markets and the media believe the manufacturing report was god news is a bit harder to reconcile.
A closer look at the report show additional weakness:

Both New Orders and Production recorded lower readings of -2.6% and 2.0% for Mars. A production figure of 48,7% is significantly lower than the 49,9% which is consistent with higher readings of Federal Reserve Board’s Industrial Production. The 8% increase in prices paid is especially troublesome, showing additional distress and downward pressure on profit margins for companies in the manufacturing sector. This reading is also in line with the over all inflation picture where last CPI recorded above 4% yoy.

The mars surge in prices is the 15th consecutive month of higher prices. This is a direct effect from earlier credit expansion. What we now se is squeezing profit margins for many companies. Hadn’t it been for the FED recent attempts to devalue the dollar against other currencies, many more companies would now have felt the effects of higher costs of production with falling demand.

The ISM report is not just a good indicator for the manufacturing sector but also for the over all economy. I don’t think anyone has missed the popular commentary by journalist and economist a like that US is a consumer based economy. And according to GDP it is, as GDP consists of a total 70 % consumer spending. Because GDP only measures what happens in the final stage of production that is in consumer related production, a whole lot is ignored especially what goes on in the manufacturing sector.

By looking at the broader statistic provided by the Bureau of Economic Analysis, Gross-Output, total spending in the US economy is approximately $24 trillion. With GDP of $13 trillion, industrial spending including spending on manufacturing can be estimated roughly to $14,9 trillion. This would imply that consumer spending constitute only 38 % of total economic spending not 70 % according to the GDP. The other 62% can be subscribed to spending in earlier stages of the production process, in particular manufacturing.

The low reading of last ISM number, althogh it is only a survey, it is an important indicator of the over all helath of the american economy. Also together with three indicators other than ISM, a reading below 50 has historically and significantly predicted recession. The other three indicators are: credit spreads (Paper-Spread), return in the S&P 500 and the yield curve.