By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements .

The following is an update of a post that I wrote on April 17th, 2007 regarding the probability of a Goldilocks scenario versus Stagflation. I’ll update the data on the last day of each month and repost it. The purpose of this post and subsequent updates is to objectively examine the changes in both economic and inflationary data since the Federal Reserve made the decision to quit raising rates in the Summer of 2006. (Click here to view original post.)

In the month of March, Inflation figures continued to heat up (CPI and PPI) while economic numbers improved slightly. Unfortunately, consumer sentiment continues to slip which is one of the better leading indicators. Action in April did nothing to dampen the threat of stagflation which will continue to make the Fed’s job increasingly difficult.

This morning, the commerce department reported that new home sales came in at an annualized rate of 858,000 - 23.5% below last March’s figure! This decline is partially offset buy an increase in median sales price of 6.4% since last March. (BTW, incentives are not deducted from the sales price, therefore, margins or profitability may not be moving up in line with sales price.)

Personally, I’m a bit thrown off by the growing disparity between new home starts and new home sales. By my quick and dirty calculations, new home starts have outpaced new home sales by over 151,000 in the last three months! (Starts from Jan thru Mar came in at 371K while sales were a dismal 219K). At this rate, homebuilders would add an additional 600,000 homes to the market in this fiscal year – doubling the current inventory. I realize that home sales are seasonal and perhaps builders are getting prepared for the summer months but the disparity seems extreme.

Investors rewarded the homebuilders when the housing starts information was released last week by pushing my mini-homebuilder index up 6%. [My mini-homebuilder index consists of KB Homes (KBH), DR Horton (DHI), Lennar (LEN), Centex Homes (CTX), Hovnanian Enterprises (HOV) and Pulte Homes (PHM).] Apparently, the market thinks it’s a good thing when you build many more homes than you can sell. With home ownership rates at 70%, an all-time high by a wide margin, who is going to buy all these homes?

Icing on the cake – Earlier in the month, the homebuilders confidence index came in at 33 – it’s second lowest reading since 1991. I can understand industries being blinded by their own success and overproducing, but I’m at a loss when an industry knows sales are going to “suck” (I’m quoting here) but yet they still overproduce. Let’s examine a rundown of the industry

Sales - Down
Confidence - Down
Prices - Flat (I’m discounting for their incentives)
Costs - Up (Check out the CRB Index for support on this)
Inventories - UP
Foreclosures - Shooting thru the roof
New Construction - Flat to increasing

Add it all up and I’m afraid it won’t be long before these stocks start testing their cyclical lows from last summer.

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements .

This morning the government reported an increase in the Consumer Price Index or CPI of 0.6% over last month’s reading while Core CPI rose 0.1%. While the Core number seems “contained”, the real CPI is pretty hot. For the year, CPI is up 1.2% which translates to a 4.8% annualized rate (without compounding that is).

The Fed decided to stop raising rates last August with the assumption that their job in curbing inflation was done. Their job as they foresee it was to cool the economy just enough to bring down inflation but not so much to force it into recession. That’s where the term Goldilocks comes from (not too hot but not too cold – pretty clever, eh.) They stated that their future decisions would be “data dependent”. So let’s examine the data since they made their decision to put off any further rate hikes.

I created the following spreadsheet containing various means of measuring inflation and economic growth. I took the average month-over-month figures from last August and September and compared them to the most recent data available which is January and February. (I used two months in hope of smoothing out any spikes. March figures are not included, but I’ll update this and repost it once they all are available.)

INFLATION DATA		Aug – Sep Ave.		Jan – Feb Ave.		Hot or Cold
Core PCE		0.20%			0.30%			Hot
CPI			-0.10%			0.30%			Hot
PPI			-0.35%			0.35%			Hot
Core CPI		0.20%			0.25%			Hot
Energy Prices(1)	-9.65%			3.49%			Warming
CRB Index		-2.74%			2.00%			Red Hot
Wage Inflation		0.40%			0.80%			Red Hot
Unemployment		4.65%			4.55%			Red Hot
	
ECONOMIC DATA		Aug – Sep Ave.		Jan – Feb Ave.		Hot or Cold
ISM Index		53.5			50.8			Cooling
Construction Spending	0.00%			-0.25%			Cold
Consumer Spending	0.10%			0.60%			Hot
New Home Sales		1.048M			0.893M			Cold
Existing Home Sales	6.24M			6.60M			Warm
Median Sales Price	$222.5K			$211.7K			Cold
Durable Goods Orders	3.85%			-2.65%			Cold
Consumer Confidence	102.4			109.2			Hot
Consumer Sentiment	86.7			90.4			Neutral
	
(1)	Energy prices measured by the CRB Energy Sub-Index
All other data gathered from CBS Marketwatch and Bloomberg News.

So far, its looking like the Fed is failing on both counts. Inflation is hotter than it was last summer and several parts of the economy, mainly housing and manufacturing, are cooling dramatically (the exception being good ol’ consumer spending). Over the last several months, The Fed and Wall Street have been predicting a “Goldilocks” scenario, but the data strongly suggests that it is becoming increasingly unlikely. (I’ll grant that this is just 8-9 months worth of data so it doesn’t necessarily establish a formidable trend, but the picture is certainly much bleaker than what is being promoted by the financial media.)

The opposite of Goldilocks is Stagflation – an old friend from the 70’s. While the term Stagflation is just now being uttered in very dark corners of the financial media, the broad market has dismissed any possibility of it occurring. The yield on every type of income investment including Real Estate is making the bold prediction that inflation will subside. The continued ascension of equity prices is clearly making the case for economic strength. I like the quote by John Hussman of Hussman funds who said “The market has its head in the freezer and its feet in the oven and Wall Street is claiming the temperature is just right.”

Unfortunately, I’m not clever or naïve enough to look at the data and reach an optimistic conclusion. To me, the data is shouting STAGFLATION! - yet very few are listening.

Stagflation: Historical Precedence and Secular Trends
The Stagflation theme plays into my macro view of the markets. I believe that we are currently experiencing a secular bear market that could last another 5-10 years. I define a secular bear market as a 10-20 year period where the stock market doesn’t do squat. (Forgive my Texas vernacular but sometimes my upbringing gets the best of me and I just can’t find an eloquent way of putting stuff.)

In the last 80 years, the US stock market has suffered two secular bear markets [The Great Depression (1929 – 1945) and the Inflationary 70’s (1968 – 1980)]. Each of the two previous secular bear markets can be divided into 4 stages which consist of an 1) Initial Correction then a 2) “Dead Cat Bounce” followed by a 3) Secondary Correction and finally 4) Sideways Action for an extended period of time.

Here’s a timeline of the four stages
Stage				Great Depression	Inflationary 70’s	Tech Bubble
Initial Correction		’29 – ‘32		’68 – ’70		2000 - 2002
Dead Cat Bounce			’33 – ’37		’70 – ’72		2003 - ????
Secondary Correction		’37 – ’38		’73 – ’74
Sideways Market			’38 – ’45		’74 – ‘80

What is interesting is that both Secondary Corrections (’37 & ’73) were characterized by high inflation. The majority of bear markets are deflationary in nature but not in these two cases. In ’37, inflation was created by excessive government stimulus in an effort to recover from the Great Depression. In ’73, inflation was created by the combination of a tremendous increase in input prices primarily associated with the spike in oil and government intervention to devalue our currency (removing us from the Gold standard).

Today we have a combination of all three factors.
1) We have governments hell bent on creating excessive stimulus (while the US government is doing its part, Japan is the most egregious offender in creating inflation).
2) The US government is doing everything in it’s power to devalue our currency. (At 82.08, the US$ is less than a couple of points off its all time low of 80.39.
3) Many input costs including oil and its derivative products have increased more than three-fold in the last several years (the exception being some Soft and Agricultural commodity prices but they are on the move).

If History rhymes, then it stands to reason that this Secondary Correction will be inflationary as well. There are several things pointing to this outcome but I’ll just point out the biggies:
- The appointment of a deflation fighter as Federal Reserve Chairman
- The ever-increasing CRB Index
- The continued free-fall of the US$
- Increasing protectionism
- Record-setting Government deficit spending

While the spreadsheet above only covers 9 months worth of the data, these long-term trends strongly suggest that inflation will continue to haunt the US economy. With that being said, making money in the markets over the next several years will require a radically different strategy than Wall Streets traditional approach of allocating accounts into equities and bonds.

Index Investing is a strategy that consists of investing in passively-managed mutual funds and/or ETFs that are designed to mimic a particular index (i.e. S&P 500, NASDAQ 100, Russell 2000). Typically, index fund advisors use one of three fund families which are: Dimensional Fund Advisors (DFA Funds), Vanguard and Fidelity Spartan funds. (If you advisor recommends any other family for index funds, you’re likely paying too much.)

Indexes were originally created by the Dow Jones Corporation around the turn of the 20th Century. They chose a sampling of stocks for the purpose of representing an entire sector of the stock market. The first index Dow Jones created was the Railroad company index, which no longer exists (a little factoid that is rarely discussed). The second was the Dow Jones Industrial index which still exists today but only one of the original stocks in the index is still included.

At the heart of index investing is an academic theory created in the 1950’s by Harry Markowitz called Modern Portfolio Theory (MPT). MPT makes numerous assertions but most notably it says:

There are a large number of American financial advisors who are deeply committed to the idea that MPT is one of the greatest financial innovations in investing since the creation of the equity markets themselves. I refer to these Index fund advisors as MPTer’s. I will argue that while there are better solutions than indexing, it does provide a sound means of allocating capital. Unfortunately, too many American financial advisors charge their clients far too much for this solution.

1. You’ll never do much worst than average (in spite of countless assertions to the contrary by your high school English professor)
2. Since the market has historically gone up 2/3 of the time, you’ll make money more often then you’ll lose it (Odds better than Vegas, baby!)
3. Index investing is completely rational and therefore eliminates emotional errors in investing (I actually would disagree with this on certain levels. Over short periods of time, it eliminates emotional errors but many index fund advisors make large, macro errors which I’ll cover later.)
4. Keeps investing costs to a minimum (Bankrupting those good-for-nothing bums on Wall St)
5. It is a tax-friendly strategy because it defers realized gains (Bankrupting those good-for-nothing bums in Washington)

While I’ll agree that you could do a lot worse than using an index investing approach, I personally believe that it has numerous disadvantages which is why I am not a proponent of index investing. In the next post in this series, I’ll cover the many disadvantages of index investing.

While I believe that index investing has its merits, I do not believe that it is the only means of getting your investment compass to point true north. Advisors who buy into MPT fail to acknowledge the many issues with indexing – so allow me to provide some counterpoints to their argument.

There is a very basic, fundamental flaw with index investing which is that they use backwards tested data in making forward looking projections. They calculate what would have worked best and assume that that strategy will continue to work best. Unfortunately, the markets work in the exact opposite manner resulting in MPTer’s “buying high” and “selling low”. Furthermore, it results in them adding sectors or asset classes long after the “easy” money has been made. (Ironically, Markowitz’s paper ever-so-briefly addresses this issue but it is largely ignored by MPTer’s who see their strategy as flawless.)

MPTer’s don’t include Commodities because the sector was such a lousy performer over the last two full decades. If they included a commodity allocation, their “projected returns” based on the extrapolation of historical returns would be far less appealing. However, in 2000, the best thing you could have done was move your portfolio to commodities. (Did you know, that the Dow Jones Index is actually down when priced in Gold since it started its rally in Oct of ’02. Click here for post .)

In short, the answer is very little. Index investing is basically a commodity and the profit margin on a commodity will eventually be reduced to zero. In order to manage a portfolio of index funds, advisors are required to carry out the following two points of execution:

Despite its simplicity, it has come to my attention that there are advisors charging over 100+bps or 1% for an indexed strategy. The hypocrisy of it all is that American financial advisors who promote index investing do so because of the low cost structure of indexing, yet they charge around 1% for practically no work.

Assuming that your account is worth $500,000 and you’re paying 1% for management, that’s a $5,000 annual fee for approximately 2 hours worth of work. That’s $2,500/hour! What an incredible gig! Hell, I’d get it into if I wasn’t so painfully aware of how poorly domestic equities and bonds will perform over the next 5 years.

Conclusion 1: You could do a lot worse than an index investing approach by buying expensive, actively managed funds that consistently underperform the market.

Conclusion 2: Unfortunately, you’ll still lose money in an index fund approach over the next several years as equities and bonds seek to reach more normal valuations.

Conclusion 3: Index investing is a losing strategy in an inflationary environment. Inflation was uncharacteristically low in the 80’s and 90’s so investors are discounting it.

Conclusion 4: DON’T OVERPAY FOR INDEXING! Do it yourself by following Scott Burn’s strategy, The Couch Potato Portfolio, or find an advisor that will only charge you 10 – 20 bps for 2 – 3 hours of work each year. Better yet, have them charge you an hourly rate instead.

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements .

Dear Clients,

On Friday, The Dow Jones Index closed the quarter in negative territory – the first down quarter for the Dow since 2Q 2005. Despite the market’s recent sideways action, this is still the second longest stretch that the equity markets have been through without a 10% correction. Prior to the 3%+ drop on 2/27/07, it was the longest stretch the market had gone without a 2% intraday correction.

Here is how my performance measured up to the averages for the first quarter of 2007.

Core Portfolio				(0.4)%
Focus Portfolio				(2.3%)
S&P (VFINX)				0.2%
NASDAQ (QQQQ)				0.5%
Benchmark				1.2%

While my strategy continues to lag the major indexes by a small margin, a few very positive events took place over the last quarter that has solidified my faith in the direction I’m taking with your accounts. As you know, I’ve heavily weighted your portfolio towards Gold and Silver with a smaller allocation to other commodity sectors. Three specific trends have emerged that have increased my confidence in Gold and Silver. In this update, I’m going to focus on our Precious Metals positions as they will largely dictate how your account will perform over the next 6-12 months.

Three Bullish Trends for Gold and Silver
1. Fundamentals: Gold/Oil and Gold/CRB Index Ratio
2. Gold/Equity (non)correlation
3. Trend in Silver to Gold Leverage
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