Is Inflation High and Rising or Low and Falling? A Four-Quadrant Model of Investing Analyzed

I received an interesting email out of the blue yesterday from Archie Kangethe, a Vice President at Morgan Stanley Smith Barney.

Good Morning Mish,

If you have time please check out the chart below from Dr. Kelly at JPMorgan. The data from the US government would lead me to believe we are in the lower left quadrant, but my daily life leads me to believe we are in the upper left. If we are indeed in the upper left and the markets were to perform as it did in the past; commodities and cash could do well.

I would love to read your thoughts.

Archie P. Kangethe
Vice President-Wealth Management
Financial Planning Specialist
Financial Advisor
MorganStanley SmithBarney

2Q 2011 Guide to the Markets

Kangethe forwarded a chart showing "four quadrants of inflation": high and rising, low and rising, high and falling, and low and falling.

I asked to see the context and received a link to 63 page PDF called the 2Q 2011 Guide to the Markets by Dr. David P. Kelly, CFA and four others on the JPMorgan Market Strategy Team.

I did a double-take on this and in case you missed it, Kangethe works for Morgan Stanley, the chart and PDF in question is from JPMorgan.

I found a number of interesting charts in the PDF to comment on and will get to "four quadrants" last. Here are some charts that caught my eye.

In all cases, anecdotes in red or blue on the charts are mine.

Total Private Payroll



In the "Great Recession" 8.8 million jobs were lost. Only 1.8 million have been added. It's worse than it looks because in general, it takes 125,000 jobs a month (1.5 million annually) to keep up with birth rate and immigration. The recession ended June 2009.

In theory (all things equal which they seldom are), unemployment should be rising. The only reason it has fallen from 10.1% to 8.8% is several million people dropped out of the labor force. Millions want a job but stopped looking for work and are therefore not counted as unemployed.

Forward Earnings Estimates



One thing supporting rising earnings is lack of hiring. If you outsource to Asia, and/or get by with fewer workers profits rise. Still, those operating earnings are highly suspect.

A far better valuation case can be made by looking at 10-year normalized "real" earnings as opposed to fluff forward estimates that are frequently wildly off as they were in 2007-2008.

Moreover, most stock market gains and losses do not come from earnings but rather the price investors are willing to pay for those earnings.

GDP - The Great Depression vs. The Great Recession



One of the things that smoothed out GDP is that government spending by definition adds to GDP. Whether anything useful is produced is irrelevant.

When you throw $trillions at a problem one might expect more than the paltry rise in GDP and employment we have seen in this alleged recovery.

However, the question as always is "where to from here?"

US Headwinds

• Expiring unemployment benefits
  
• Cutbacks in state budgets
• Rising taxes in many states
• Congressional focus on cutting the deficit
• Pent-up demand for autos is exhausted
• Renewed housing slump
• Massive housing inventory
• End of QEII
• Gas prices over $4

Global Headwinds

• Rising interest rates in Europe
• Renewed sovereign debt crisis in Europe
• Rising interest rates in China
• Regime change in China in 2012
• Unsustainable growth in China
• Property bubbles in Australia, Canada, China

That is veritable cornucopia of headwinds. I struggle to see many tailwinds other than exceptionally low interest rates. Worse yet, exceptionally low rates fueled what I believe is another stock market bubble, another commodity bubble, and another round of speculative mania in junk bonds.

CPI 1960-2011



The above chart shows the CPI as computed by the BLS. Many would dispute that chart. I dispute it for completely different reasons.

I think actual housing prices belong in the CPI, not Owners' equivalent rent that is the single largest component in the CPI with a 25.2% weighting.

I have talked about this many times before but the most recent chart I have is a year old. Please consider Case-Shiller CPI Now Tracking CPI-U; Real Interest Rates Are Once Again Negative

CS-CPI vs. CPI-U



click on chart for sharper image

Note that at the height of the property bubble CS-CPI was at 8% vs. 4% as reported by CPI-U. The opposite happened in the housing crash. Given the renewed downturn in housing, CPI inflation is overstated now.

Four Quadrants of Inflation



click on chart for sharper image

Archie Kangethe wrote "The data from the US government would lead me to believe we are in the lower left quadrant, but my daily life leads me to believe we are in the upper left."

Is one's daily life a measure of inflation? Can one ignore housing? Is there a representative basket? More importantly, where to from here?

Inflation may be high as measured by commodities, education, and energy but not housing, electronics, or food bought on sale and stored. I do all of our grocery shopping and I think food is a bargain. Sale prices on meat are no higher than they were 10 years ago.

As noted above, I do not think one should ignore housing. Housing prices used to be the CPI at one point until someone got the not-so bright idea to use rent prices instead.

The CPI would certainly be lower today if housing prices were factored in. It would have been way higher in 2006. Greenspan missed huge inflation by failing to incorporate housing prices. Bernanke repeated Greenspan's mistake.

Prices a Poor Measure of Inflation

Regardless of how one feels about the above price commentary, prices are a poor measure of inflation for numerous reasons that I have spelled out at length. One such example is Inflation: What the heck is it written way back in 2006.

I have since changed my definition slightly to include a "mark-to-mark" valuation of credit.

Certainly by my own definition we have been in a period of inflation since March 2009 even though various measures of credit have declined.

Another way of looking at things is by conditions one might expect to see in periods of inflation, deflation, and hyperinflation as described in Humpty Dumpty On Inflation in December of 2008.

At that time, a table of 16 factors signaled deflation. Most are synonymous with inflation now. However, and I keep point this out to many deaf ears, my model has been the US would go in and out of deflation over a long period of time similar to Japan.

We were in deflation then, we are not now, and I expect another credit crunch and another round of deflation to which Bernanke will likely respond again, probably pushing gold up again.

Four Quadrant Inflation as a Method of Investing

Can it Be that it was all so simple then?
Or has time rewritten every line?

No, it's not that simple. In 13 times since 1971 inflation was "low and falling" yielding a return of 12%. In 2008 inflation was low and falling yielding a return of -50% or so depending on what index one wants to measure. Foreign equities did worse because of the rising dollar.

By the way, I need to be fair to JPMorgan. They posted that quadrant chart without comment. They did not say it was a way to invest.

Nonetheless, assume for a moment that Kangethe is correct, and that inflation is high and rising. Look at the upper left quadrant. Does one expect cash to return 7%? With interest rates near zero, I should hope not.

Are commodities even the place to be now? Personally I doubt it as explained in Manufacturing ISM Prices Paid Hits Another High, Up 22nd Consecutive Month; Inflation Hysteria?

Four Quadrants a Poor Investing Model

The four quadrant model of investing has two more serious flaws.

1. It fails to consider in valuation
2. It fails to factor in cycles of PE-expansion and PE-Contraction

Valuations Matter

Valuations are a critical factor in investment decisions.

In case you missed it, please consider Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think

Annualized Rates of Return for Select Years



Click on any table to see a sharper image

Note how much the starting PE valuation matters. Someone who started investing in 1929 received an annualized rate-of-return of 0% for two full decades, even if they religiously reinvested dividends every year.

However, someone investing in 1982 received an excellent annualized rate-of-return for two full decades (12% for the first decade and 9% annualized for 20 years).

Note year 2000. Starting valuations were the highest in history. It should not have been a surprise to discover that 10 years later, the annualized rate-of-return was -2%.

Bear in mind, the Case-Shiller normalized PE for the year ending 2010 is 23. Does that bode well for the next decade?

Cycles of PE Compression and Expansion



Over long periods of time PE ratios tend to compress and expand. Unless "it's different this time", history says that we are in a secular downtrend in PEs. From 1983 until 2000, investors had the tailwinds PE expansion at their back. Since 2000, PEs fluctuated but the stock market never returned to valuations that typically mark a bear market bottom.

Moreover, demographically speaking, the current decade not only starts with very rich valuations, but also comes at a time when peak earnings of boomers have passed. Those boomers are now heading into retirement and will need to draw down savings, not accumulate large houses and more toys.

Of course, the market can of course do anything this year (or the next few years), but history strongly suggests that stock market returns for the next 10 years will be lean years, perhaps negative years.

Commodities Analysis

In regards to Quadrant I investing (high and rising), once again assuming that is where we are (which I doubt), does one really want to plow into silver at $50 up from 5, oil at $110 up from $35, etc?

Someone may, but I don't, especially given the headwinds I noted at the beginning of this post. The time to buy sectors is when they are undervalued and unloved, not when nearly every hedge fund in the world is plowing into commodity futures and leveraged mo-mo bets on equities.

Are there any bears left? On anything other than the dollar and treasuries?

Ironically, cash can do well at zero% if commodities and equities both tank. Given extreme bullish sentiment including a number of prominent bears throwing in the towel, that is a rather likely possibility.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Portugal Negotiates $116 Billion Bailout Loan, Bond Market Yawns

Portuguese Prime Minister Jose Socrates is singing the praises of a $116 bailout on good terms, even though two weeks ago he denied the need for Portugal to take a loan at all. The bond market responded with a big yawn.

Please consider Portugal Says It Has Negotiated a Bailout Loan of $116 Billion

Portugal has reached agreement with the European Union and International Monetary Fund on a three-year bailout loan of 78 billion euros or about $116 billion, the caretaker Prime Minister Jose Socrates said on Tuesday.

Mr. Socrates, who now faces a snap parliamentary election on June 5, hailed the package as a victory, saying it included more lenient terms than those imposed on Greece and Ireland.

“The government has obtained a good deal. This is a deal that defends Portugal,” Mr. Socrates said.

“Some of the parameters look a little softer than expectations such as the higher deficit target and longer time line,” said Vitaly Serebryakov, currency strategist at Wells Fargo in New York.

The deal is expected to be approved at a meeting of euro zone finance ministers in mid-May, in time for the European rescue fund to raise money for Portugal by June 15, when the country needs to meet a bond redemption of 4.9 billion euros.

Good Deal or Impossible Deal?

• Portugal gets a 3-year loan
• Portugal needs to cut this year's budget deficit to 5.9%
• Portugal deficit will shrink to 4.6% in 2012
• Portugal deficit will shrink to 3% in 2013

I have three questions:

1. Does anyone possibly think Portugal can pay back $116 billion in three years?
2. Does anyone in their right mind think Portugal's budget deficit will be 3% in 2013?
3. Given that Portugal is crowing about getting better terms than Ireland or Greece, how long will it take for Ireland and Greece to start bitching?
   

Portuguese 2-Year Government Bond Yield



I have a final bonus question.

If the bond market does not believe the deal, why should I?

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Images of Copenhagen Take II; Key to Quality Images; Photo Equipment Review and Camera Bag Suggestions

The images I posted in Meeting with Saxo Bank Chief Economist; My Speech in Copenhagen; Images of Stockholm and Copenhagen were raw unedited images. Burning and dodging a few select areas in Photoshop can help.

Reader "CH" took one of my images and sent it back with a message "I hope this doesn't offend you".

In a second email "CH" replied

I 'dodged' the boat. I also used a Photoshop plug-in called Topaz Labs Adjust.

Here is a before and after of a kayaker in Copenhagen.

Copenhagen Kayaker and Ships - Raw Image



Copenhagen Kayaker and Ships - Edited Image



The contrast is now a bit too high, but the extra details on the kayaker and water are excellent.

Click on either image to enlarge.

I did not have time to alter any of the images in my original post. Many could have been improved.

Key to Quality Images

• Start with an excellent composition and an exposure in the ballpark, +- 1/2 stop.
  
• I prefer a slightly under-exposed image to an over-exposed one. Once detail is washed out, it cannot be recovered.
• Shoot in the last two hours of the day or first two hours of the day for landscapes
• People and flower closeups generally photograph best on bright overcast days.

I used to carry a boatload of Canon lenses and equipment, all professional.

• 100mm macro
• 70-200mm F2.8 L
• 17-35 mm F2.8 L
• 28-70 mm F2.8L
• 24 mm Tilt-Shift
• 2 Canon Camera Bodies
• Tripod

I would guess that 75-85% of images I have ever taken were in the range 24-100mm range.
In Europe my equipment list looked like this:

• EOS 5D full frame digital camera
• 24-105 L lens

Camera Bags

The above two items fit nicely in a Lowepro Passport Swing Bag but one does have to remove the lens hood.



I used to carry a huge backpack that weighed a ton. Does it make sense to carry all that extra gear for 15-25% of the images?

The above bag will also hold a few filters, extra battery and battery charger, and other small items but it will not hold two lenses as the description of the bag says, unless the second lens is a small one or you do not have many extra items.

The length of the 24-105 lens is about 4.5 inches. Attached to the body, it takes up the entire removable padded center pocket.

For my current needs the above bag is nearly perfect but I wish it had a bit more padding in the side pockets. To carry an extra lens, I would advise putting some padding in the side pocket.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List