May 13, 2011

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

1. “It’s Not Me, It’s You.” Sometimes I’m so busy I forget to drink very much water and begin to get dehydrated. When a headache flares, there is the temptation to solve the problem expediently. Reaching for an ibuprofen or other such pain reliever is an easy solution. Of course, knowing what is causing the headache may be of greater benefit in the short and long run, rather than merely treating the symptoms with a pill. After all, making the pain go away will not necessarily keep it from coming back. Only getting to root causes will do that. The Fed might be reminded of this simple reflection.

Price stability, the Fed’s first mandate, is vital not only to the creators of money at our central bank, but those that empower them as well. When prices rise aggressively, the man in the street feels it. Fed credibility and political predictability can be shattered.

Politicians have a great deal to lose when people are angry with their lot in life, frustrated over challenging job prospects, or confounded by the disconnect between stated inflation rates and the world they encounter day by day. So a rise in the price of commodities – a bull market, if you will – takes on a very different character than that of a bull market in stocks, bonds, real estate, or those asset classes most commonly offered by Wall Street (which all tend to raise spirits versus raze them).

A bull in the commodities arena can be targeted for control, and you’ll find attempts to undermine it quite common (price controls, subsidies to the poor, regulation of imports and exports, state controlled distribution, just to name a few) given its destabilizing effects. But treating the symptoms of inflation without looking to the causes won’t solve anything in the long run.

As we witness commodity prices inching higher, the price movements are viewed as pernicious by politicians (pernicious and politician instinctively seem related). Who is the malfeasant responsible for pushing prices higher? They say “the speculator.” They say a negative consequence of capitalism is this profiteering at the expense of others by owning a commodity. You win and society loses if by owning it money is made and someone else bears the brunt of higher prices. Weimar bankers solved this by creating more money so that people could afford what was rising in price, failing to objectively see that they were the problem, not the solution.

The argument then follows quickly on the heals of this scapegoatish indictment: regulation, limitation, control, and a stronger governmental apparatus surely is the only means of protecting the innocents from the buzzard-like opportunism of speculators.

In the opinion of our esteemed Senators and Congressmen, it is clearly the speculators that set the market for oil – not OPEC. Clearly, speculators are driving up the cost of basic foodstuffs – not supply-related, one-off events or money creation. With inflation being non-existent according the official government numbers, the only possible explanation for rising commodity prices – be it oil, silver, gold, wheat, corn, or rice – is the speculator (and we don’t much like him).

Clearly, if there is something causing my head to ache (I’m hydrated today, I’m OK) – it is the idea that root causes are nary a consideration for our legislators and regulators. The underlying factor is the inordinate credit creation causing the price of real things to rise. Sure, there is a contingent of investors that understands the impact of monetary inflation on price inflation – feel free to call them speculators. These people are not the cause of the trend, they are simply following it. Like flying a kite, you cannot be blamed for the wind, and it’s foolishness to take credit for it – you are simply holding onto the string.

To our current cohort of legislators and Fed bubble-blowers, we would simply respond – “It’s not me, its you.”

2. Market Schizophrenia. The market had a hard time getting its bearings this week. Questions about the continuity of “QE” in the bond market, mixed with a drop in commodity prices, had markets guessing and flat by the close today. However, in taking a deeper look at the structure of trading, stock investors have turned defensive by selling bank and technology stocks in exchange for consumer staples and health care.

In the “flight to quantity” department, bonds were hard pressed to rally, with yields dropping less than a basis point for the week, perhaps due to lower announced POMOs ($93B vs. customary $97B to $112B) by the Fed or due to mounting credit concerns in sovereign debt both here and in the EU. Metals stabilized and for now seem to be caught in a trading range, while energy was clobbered in the wake of rising inventory data in both oil and gas. Falling oil is usually bullish for stocks; however, the markets were perplexed by the conflict in the news between economic weakness and central bank “intentions” to become hawkish on inflation later this year. Cries of stagflation also resurfaced.

April U.S. retail sales disappointed, after strong talk of consumers “weathering” price increases. Sales rose 0.5% vs. expectations of 0.6%. Removing gasoline from the data, sales rose only 0.2%. Service Station sales increased 2.7%, food and beverage store sales increased 1.2%, while furniture sales declined 1.1% and electronic store sales declined 2.2%.

Inflation was found in wholesale prices, as well. The PPI rose 0.8% vs. expectations of 0.6%. Rising prices were seen in tires, civilian aircraft, and food (egg prices rose 57% YOY!). The PPI is now up 6.8% YOY, more than double the hedonically adjusted CPI data, which showed a more meager rise of 3.2% YOY. Initial jobless claims showed the first improvement since February. Claims were 434K for the week ending May 7 vs. 478K the week before. That still may not be enough to convince anyone that the job market is improving, as readings above 400 are still well into bearish territory.

Confidence indicators were mixed, with small business sentiment declining and consumer sentiment (University of Michigan Confidence index) increasing marginally. It’s often the case that business sentiment is influenced by wholesale prices, and consumer sentiment by the progress in stocks – which have rebounded to levels 10% higher than seen prior to the 2008 crisis.

Overseas, the debt concerns previously thought to be “contained” continued to escalate. S&P lowered its ratings on Greek debt to B from BB-. S&P’s projections suggest that principal reductions of 50% or more could eventually be required to restore Greece’s debt burden to a sustainable level. The EU is also going so far as to propose a lower interest rate for bailout loans made to both Greece and Ireland.

Finland cast a strong nay on the vote for continued aid to Portugal – a vote that must be unanimous among all 17 EU members. The Finns are requesting that the capital not be used to cover losses to investors but for something more economically productive – perhaps government thrift? We can only hope.

German April inflation accelerated more than first estimated. The rate jumped to 2.7% from 2.3% in March. Also, the U.K. Bank of England lifted its inflation outlook, and may raise rates later this year. China also raised its margin requirements for a fifth time and postponed a rate increase for the near term. Oddly enough, this inflation news had a negative impact on the metals this week, where in the ’70s it would have had the opposite effect.

We’ve said before that the metals may have some transitional difficulty regarding a shift in monetary policy – whether fictitious or real – in the short run. Speculators who use leverage to purchase commodities are subject to prospective rate changes more than anyone. If there is a perceived hike in the cost of the carry trade, trades will be trimmed (margin increases reap the same effect essentially).

However, higher rates are part of an inflationary environment that has historically proved taboo for anything productive, but a boon for tangibles such as gold. Taking speculators out of the picture periodically over time may not be as unhealthy as some might think. Taking leverage out of the market increases the equity within, and builds stability and confidence for the next move forward.

Have a great weekend!

David McAlvany
President and CEO

David Burgess
VP Investment Management