August 27, 2010

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Understanding Hedonics: I was a bachelor for two days this week. I made my way to the grocery store for several boxes of my favorite cereal. What I met with was surprising, though it shouldn’t have been.

My first problem was in finding the box. I was looking for a certain box, and it was not there. As I continued to browse, I discovered that the manufacturer had done an extreme makeover on the box. The packaging, including the branding and colors, had changed from the last time I made a purchase.

My second problem was finding the new box slimmer than the last. Of course, if we were talking about computer gadgets or cell phones, that might have been an improvement (smaller is better), and might have been attractive to me regardless of the increased cost. In such a case, our statisticians at the BLS would consider the improved product and the increased price a wash in terms of an inflation indicator. With manufactured goods, improvements in a product justify higher pricing – they’re labeled as “hedonic adjustments,” and are not considered inflationary. But I digress. This is neither an electronic device nor a case of the aforementioned adjustment, and frankly, I like this cereal at almost any price.

So, what was my real issue with the new cereal box? Twelve ounces of cereal is not the same as ten ounces. That’s my issue. The price for the box is the same, but for 20 percent less product. This may seem an insignificant discussion, but the issue is more than skin-deep (or packaging-deep, as it were). An overnight rise in the price of cereal by 20% is a big rise – even if it doesn’t break the bank. What I find curiously coincidental is that the BLS and the food industry are being faced with the same problem. With inflation either occurring (food inflation is globally on the rise) or impending (central bankers are swallowing hard as they look ahead at policy options), the primary goal is not to address core issues, but to manage perceptions and market responses.

Let’s go back to the box of cereal. I mentioned the color scheme had changed. The colors of the box went from dark blue to light tan (ladies, you know that dark colors are slimming and light colors … well, often they’re not). With a 20% reduction in weight, the manufacturer chose to increase the perception of size by shifting to a lighter color palate. At best, we have an act of perception management. Some might suggest a mildly deceptive agenda, using the design change to disguise the reduced size of the product.

Be that as it may, our issue is a fascinating one. The world marches on toward inflation, with the powers that be obscuring the impact and managing perceptions so reality can be ignored. Though the box is attractive (tan is the new black) this can hardly be termed a hedonic adjustment, and is just a spoonful of evidence that inflation (price and monetary) is nigh.

2. Digging in Deeper at Jackson Hole: In remarks this morning, Bernanke indicated that the Fed has everything under control, that no significant changes to policy are in store, and that if inflation or deflation were to rear its ugly head, they would know precisely what to do – they’re ready to “act,” if need be. And as for the state of the Union, we are basking in the luxury of price stability and improved financial conditions that will help to expand the economy. Pesky little problems such as unemployment, tight lending, and stagnant consumer spending were mentioned, but quickly dismissed as temporary problems that would eventually go away.

The real issue – in our view – is that the economy is sputtering after history’s largest governmental stimulus package on record. Normally an economy would show some form of life that would last for at least three years, but in this case the economy is contracting again after only a year and a half – and noticeably (as we have pointed out in previous commentaries).

The probable cause? Money printing eventually leads to greater price gains in vital commodities than in productive assets – slowly choking the economy. Over time, one can see this difference in the performance of oil (the lifeblood of all economies) against the general stock market. Since the beginning of 2000, just before the first crisis in the NASDAQ was about to erupt and the Fed embark on its multi-year war against “deflation,” oil has increased by 208.40% vs. the Dow’s paltry gain of 16.05%. More recently, in March of 2009, when stimulus took hold in the markets, oil again outpaced the Dow by 76.4% to 54.08% – illustrating a no-win scenario for the Fed.

Whether the Fed realizes what’s happening or not may be irrelevant. Any kind of tightening of the money supply to stem this condition would be devastating to the $54 trillion in outstanding debts this country holds – in terms of cost and likely trading losses to the financial sector. It would also send the economy into a forced and deliberate tailspin, pegging the Fed as the culprit and imposing voluntary political suicide. Instead, in our opinion, the Fed will be late to react to these pressures, letting inflation do the dirty work it doesn’t want to do itself.

In today’s comments, Bernanke conveniently warned us about rapidly increasing inflation as a natural consequence of being accommodative for too long. By that, we would guess that the Fed is setting the stage to exonerate itself by being able to say “we told you so.”

Have a wonderful weekend.

David Burgess
VP Investment Management

David McAlvany
President and CEO


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