Goldilocks or Stagflation!

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.