commodities and inflation protection

It’s clear from the commodity price increases experienced over the past couple years (see this post) and anecdotal evidence -- but not official government numbers -- that inflation has returned and that price increases will be making their way through the economy. Several consumer staples companies have already raised prices 5-7% (P&G, Kimberly-Clark, and Fruit of the Loom, for example). This is just the beginning.

Often, money moves into commodities as an inflation hedge, but do commodities actually protect one's purchasing power after the onset of rising consumer prices? Based on the last time we saw this in the U.S., the answer is "mostly, no". Commodity prices, not surprisingly, tend to lead increases in actual inflation. But once inflation emerges, their ability to purchasing power protection diminishes. Thus, commodity ‘investors’ (aka speculators) who get in near the end of the pricing uptrend do not tend to fare as well.

The above charts illustrate this phenomenon over the same period I discussed in the last two posts, 1964 through 1988. They show commodity prices (Commodity Research Bureau spot price index) rising prior to a major jump in CPI inflation, with the bulk of the price spike clustered into just a couple of years (up 22.1% in 1972 and 59.8% in 1973), while actual annual inflation was just around 4.0%. From 1964 through 1973, average annual inflation was just 2.5% while commodities rose 8.4% per annum. After 1973 and through year-end 1988, annual inflation averaged 7.1% while commodity prices rose just 1.9%. Today’s commodities investors might be disappointed in their future returns while consumers may similarly be displeased with future price increases.

I do not want to be fatalistic and state unequivocally that inflation is inevitable, but I am not optimistic that it can be avoided at this point. The longer commodity prices remain high, the more they lead to higher structural costs for the economy as a whole. Once companies raise prices, they do not tend to lower them. Likewise with wages.

The final chart illustrates commodity prices versus actual inflation since 2000. To me, this looks similar to the period from 1964 through 1974, when commodity prices rose ahead of actual inflation in the face of inflationary government policies (namely, deficit spending). We see similar policies in place today, coupled with unprecedented monetary intervention that isn’t likely to abate anytime soon, especially in the face of a still-stagnant economy. And our national balance sheet is in worse shape. Are the mistakes that led to stagflation in the 1970s being repeated? Unfortunately, it appears so.

stocks and inflation (part 2 of 2)

(This is an update from yesterday's discussion on inflation's effect on markets.)

To augment the information presented in yesterday's post, I wanted to add additional perspective with respect to earnings. Stock prices can be reduced to two components: (1) earnings and (2) a multiple against those earnings. Yesterday's post dealt with the latter without much discussion of the former. So, I've added the chart below to address this oversight.

Readers will note that earnings (dark blue) more than kept pace with inflation over the twenty-five year period from 1964 through 1988. Certainly, if it were possible to invest in corporate earnings alone during this period, an investor would have fared quite well. This is the crux of the argument made by those who believe stocks will keep pace with inflation -- that corporations will raise prices and earnings will largely keep pace. Unfortunately, it's the 'multiple' component that hurts investors during inflation - if ending valuations are meaningfully lower than beginning, an investor may not fare well even if earnings grow nicely. And over this period, they certainly did -- real earnings were 50% higher in 1988 than in 1964.

stocks: inflation hedge or vedge?

I want to spend a little time thinking about what markets do when inflation hits. Common knowledge seems to believe that when inflation rears its ugly head stocks will rise in line with inflation. I think we have seen the monetary stimulus from the Fed show up in financial asset prices lately and I want to dispel this fundamental misconception of stocks as a hedge for high inflation with some market history. Note that my comments are not valid for hyperinflation. Almost anything is better than paper money during such time periods. During Brazil's high inflation of the late 1980s and early 1990s the stock market roughly held its own with domestic paper money (but looked flat to a foreign investor). If you’re like me and believe we’ll see elevated, but not catastrophic inflation in the near future it makes good sense to look at what periods of elevated (again, not hyper-) inflation have done to the stock market.

I looked back at a period of time where inflation was low, rose to quite elevated levels, and fell back again to low average levels. In other words, a period containing three "regimes": before inflation reared its ugly head, during high inflation, and back again to more stable, predictable levels. I chose the twenty-five year period from 1964 through year-end 1988 because it nicely exhibits these characteristics.

The chart to the left shows inflation (consumer price index) in red, the S&P 500 total return in green and the real return (total return minus inflation) in purple. Each is indexed to 100 at 1/1/1964. Clearly, stocks (green) did not keep up with inflation over this time period while the real return on the market over was negative. That’s a pretty poor showing over a period when inflation boosted the consumer price level to almost 4 times its starting point. If stocks were a good inflation hedge we’d expect the green line to be persistently higher than the red, and meaningfully higher at 12/31/1988 if real returns were positive. However, this does not seem to have been the case.

Why were stocks such a poor inflation hedge over this period? The answer lies in valuation. Using Shiller’s cyclically-adjusted PE ratio, which I’ve cited often, the S&P 500 traded at 21.6 times earnings in 1964. By year-end 1988, they were just 14.7, a P/E decline of 32%. The chart below shows the inverse relationship between inflation (red) and stock valuations (cyclically-adjusted PE, green). Over this time period, the correlation between the two was negative 0.956, representing an almost perfect inverse correlation. High inflation proved to be an enemy when stock valuations started high.

Why is inflation so hostile for stock valuations? It comes down to interest rates; nominal interest rates must include compensation for inflation plus a real return component. Investors ultimately compare this rate against the "coupon" available on stocks - that is, corporate returns on equity (ROE). Since ROE does not tend to fluctuate much over long periods and is more likely to fall than rise during high inflation, the yield available on stocks can only change if their prices move lower (coupon "yield" relative to book value moves higher). Maturities are also compared – bonds have a definite maturity while a stock’s maturity is infinite. I’ll defer to Warren Buffett for further clarification: “Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent return on equity versus, say, 10 percent return on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

Historical stock returns are likely to have looked much different if starting valuations were much lower than the 22 PE we see in the above illustrations. Because of these elevated levels, inflation had a demonstrably large impact on longer-term returns. While starting valuations always matter for subsequent returns, they seem to matter even more during high inflation.

Could this happen again? Well, today the cyclically-adjusted PE ratio is 23.7, so valuations are even higher than where these charts begin (1964). Even if you believe the Fed has everything under control and we won’t see high inflation anytime soon, it’s worthwhile to consider the aforementioned data when allocating your portfolio. The importance of stable prices is most noticeable when they go missing.

market bottom: feliz cumpleanos

Interesting perspective on the two-year bull run we've had since the market bottom.

earnings guidance not as extensive

Since I started investing I've always shaken my head at the quarterly guidance game, which seems to be played extensively. (Who cares if you the mid-point of your own guidance (which analysts home in on as their point estimate) by a penny?) Of course, it's always been concentrated among larger companies and these are disproportionately mentioned on CNBC. Speaking of CNBC, Herb Greenberg has some interesting statistics here that elucidates just how extensive (or not) this practice is.

Buffett on inflation

press reaction to the Buffett letter

Warren Buffett's annual letter came out Saturday and I found it to be one of his better. Amidst a wealth of insight, Buffett discussed the short- and long-term prospects for the U.S. economy. Not surprisingly, overwhelmingly the (mainstream) press reaction has focused on his bullishness about the United States' future prospects and the ingenuity of its people. Close followers know this is nothing new for Buffett.

I've observed this cheer-leading getting more frequent, and it's no surprise. Why? Berkshire is levered more than ever to the future prospects of the U.S. - rail, utilities, manufactured housing, building materials, furniture. In a major economic collapse, Berkshire would be hurt more than ever.

I'm not even implying that a major downturn is likely so Berkshire is a major risk. I am a personal stockholder so my own money is betting on my long-term belief in this company and its prospects.

I just don't think it's possible for Buffett to offer a completely candid view on broad issues like the economy. He will always be "talking his book" to some extent because he can actually influence how people behave. With public figures, as with researching investments, it's important to "read the footnotes."

Buffett letter out today

A few things that immediately struck us from Buffett's annual letter:

On the institutional imperative: "'The other guy is doing it so we must as well' spells trouble in any business, but none more so than insurance."

On housing policy: "Our country's social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford."

On market declines: "As one investor said in 2009: 'This is worse than divorce. I've lost half my net worth - and I still have my wife.'"

On value estimates: "It is appropriate, nevertheless, to including improved [interest] rates in an estimate of 'normal' earning power."

On investment managers: "It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed."

On manager compensation:

"We have arrangements in place for deferrals and carryforwards that will prevent see-saw performance being met by undeserved payments."

"Should we [add one or two investment managers] we will probably have 80% of each manager's performance compensation be dependent on his or her own portfolio and 20% on that of the other manager(s). We want a compensation system that pays off big for individual success but that also fosters cooperation, not competition."

On false precision:

"Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. Charlie and I can’t supply one of those. We believe the true liability of our contracts to be far lower than that calculated by Black-Scholes, but we can’t come up with an exact figure – anymore than we can come up with a precise value for GEICO, BNSF, or for Berkshire Hathaway itself. Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong."

"You can be highly successful as an investor without having the slightest ability to value an option.'

On debt: "...to finish first, you must first finish."

There are more concepts we'll likely discuss at a later date, these were some initial highlights that resonated for one reason or another.

Great letter again this year. We never cease to be amazed at how after all this time, he nonetheless manages to discuss something he's not openly addressed in the past. That doesn't mean they haven't been speculated about and, often, nailed by others. But to read his own words about, for instance, GEICO, is fascinating. Thanks again, Warren.

the 21st century education

Since I was in college, I've been frustrated with the way the modern academic system works. Over time, that dissatisfaction has only grown more severe. As a value investor, my goal is to get the most value for the price paid. Yet formal education is an investment whose value seems to have decreased over time - it provides less and costs more every year. At my alma mater, students today are paying more than double the tuition I did to receive an education that is a commodity. I believe there are much better ways to deliver education that don't involve formal education or degrees, but rather systems that potential employers agree offer a comprehensive assessment of skills. In short, it'd be a, "I don't care how you learned it if you know it" approach. Folks with the wherewithal to learn the requisite skills through self- or small-group study would be encouraged to do so. Others could pursue a more formal path but not by following the pre-determined, formal curriculum that now exists.

One university is taking some concrete steps to shift the model, and it sounds promising. Steve Blank wrote a nice blog entry about it. It's available here.

a couple quotes

A couple recent quotes that speak volumes.

Michael Pettis, in this week’s research note, on the economics of China’s growth :

“Not only do I believe that the combination of very low cost of capital, socialized credit risks, and strong short-term political incentives to fund massive projects always leads to capital misallocation, but I also believe that the explosion in [Non-Performing Loans] a decade ago, and the fact that total [State Owned Enterprise] profits are just a fraction of the interest rate subsidy they receive, is strong evidence that misallocated capital has long been a serious problem in China.”

Jeffrey Gundlach, on high-yield bonds (Barron's):

“The current 300 basis-point, or three percentage-point, spread between yields in the high-yield market and on 20-year (Treasury) bonds is as narrow as it has been at any time in the latest credit cycle.”

friday afternoon filing fun

It's always fun to see what filings roll in around 6 pm eastern on a Friday.

Todays is Wellcare (WCG), which despite making the decisions on bonuses and an increase in base salary on Monday (the 14th), just now got around to filing the paperwork. (emphasis and additions mine)

On February 14, 2011, the Compensation Committee (the “Committee”) of the Board of Directors of WellCare Health Plans, Inc. (the “Company”) determined bonuses under the Company’s annual cash bonus plan for 2010 of $1,015,625 for Alec Cunningham, the Company’s Chief Executive Officer; $546,250 for Thomas L. Tran, the Company’s Senior Vice President and Chief Financial Officer; and $320,000 for Scott D. Law, the Company’s Senior Vice President, Health Care Delivery. These bonuses are expected to be paid on March 4, 2011.

The Committee also approved increases to base salary for Mr. Cunningham from $650,000 to $800,000 (note: +23%) and for Mr. Tran from$475,000 to $500,000, each effective as of February 13, 2011. For 2011, Mr. Cunningham’s short-term and long-term incentive targets will remain as 125% and 300%, respectively, but will be applied to his new annual base salary. Mr. Tran’s short-term and long-term incentive targets will remain as 100% and 150%, respectively, but will be applied to his new annual base salary.

a few words about inflation

The basket of goods and services consumed is different for everyone, so inflation is experienced uniquely by all. The person who lives in a lower-cost area and drives into a high-cost one for work might have above-average transportation expenses but below-average housing costs. The retiree might spend less on housing but much more on medical care. College students spend a lot on education.

Here is the “basket” used to compute the Consumer Price Index (CPI):

I see glaring differences between what I personally spend on many of these categories, and I suspect a lot of the population would, too. The CPI is used “adjust incomes, lease payments, retirement benefits, food stamp and school lunch benefits, alimony, and tax brackets.” But the government is keeping the books. So what’s the incentive here? It goes without saying that they stand to benefit most by keeping it as low as possible.

The current commodity environment is undoubtedly inflationary. The rising prices of base metals, food inputs, cotton prices, among others, don’t just affect electronics, food and apparel costs but ripple into other areas as well. The longer high prices persist the more they have the potential to permanently raise structural costs (including wages). It may be a while before these increases show up in the official statistics, though, as the most recent 1.6% year-over-year print indicates. Nonetheless, these increases can profoundly affect consumers without a commensurate increase in the Consumer Price Index (CPI).

Below are year-over-year prices changes (through yesterday) on several basic commodities. Not a pretty picture if these prices are sustained for a length of time. Even grease is up almost 80%. Grease!

To close I’ll mention one of my favorite statistics the BLS publishes, the Special Index called “Purchasing power of the consumer dollar (1967=$1.00)”. That number -- $0.152. Purchasing power clearly erodes over time, even if it doesn’t show up in the statistics in real time.

complacency built, and building

Yesterday, the NYSE saw 365 new 52-week highs and just 9 new lows.

How much longer can this relentless, low volatility run continue? Since the end of September, we have seen only six days where the market has declined by 1% or more (just two of those this year). And the last time the market declined 2% or more was on August 11th -- and it's happened only twice since the end of June last year! That's a long time to go without substantial downside volatility.

Now, it's one thing to see the market climbing but we must consider its context. To do that we juxtapose this against prevailing valuations. On that front, it’s not encouraging. The S&P 500 stands at 18.5x earnings (over 24 cyclically adjusted) and is discounting decade-ahead per annum returns under 5% (1.8% of which is from dividends). Sure, interest rates are low which means stock *should be* worth more, but I don't buy it because investors can revise their return expectations relatively easily (and quickly).

So volatility is low and valuations are elevated, but the market keeps going up?

"It feels safer."

"There is money to be made."

Low volatility to the investor, to borrow from N.N. Taleb, is like the farmer feeding the soon-to-be-Thanksgiving-dinner turkey. Just as the safety appears greatest (based on backward-looking data), the danger is actually at its highest.

private market froth-iness

While it's not clear there is a bubble yet, some of the private market valuations I've seen are bubble-icious. My evidence is more anecdotal since I'm not an "on the ground" venture capitalist. But here is something from Fred Wilson, offering a good overview from a very credible source that there is a froth in the private markets. Money is sloshing around the bathtub, and I'd argue it's spilling over into all asset classes.

Remember W.B.: "The first rule of investing: Don't lose money. The second rule: Don't forget Rule #1." Remember the downside, grasshopper.

the Fed and housing

Whoops.

BUSTED: Unsealed Docs Show The Fed Was Fully Warned Of A Housing Crisis

commodities running a marathon or sprint?

Commodities have been on a spectacular run since August. The Wall Street Journal’s front page story this morning specifically addresses agricultural commodities, including wheat, soybeans and corn. Along with precious metals, agriculture has led commodities’ price rise and helped incite continued inflows into these markets over the past several years. Traders cite on the ground reasons that prices have gone up so far so fast – including increasing consumption from China, multi-decade low reserves and higher corn ethanol production. Also, backwardation (future prices less than spot prices) in one-third of the GSCI commodities boosts the case for tight supply/demand conditions. But these supply/demand theses are valid regardless of price. (As with all non-income generating “assets,” pricing is an elusive exercise.)

Regardless of the specifically-cited reasons today, what I question is whether this is a modern incarnation of Gresham’s law, bad money driving out good. A hundred years ago, on a bi-metallic standard in countries that accepted other countries’ currencies as legal tender, the most “fine” or pure currency would be hoarded and the less pure (“bad” money) would be spent. Thus, as the debased money was used to buy the stronger currency, its relative price decreased and became even less valuable. The market saw to it that the worse currency was worth the least and the “good” money fell from circulation. Of course, this generally occurred in a system of fixed exchange rates and (mostly) convertible currencies. Today’s free-floating currencies are a relatively new development in monetary history.

Today, it looks like (“good”) physical assets are driving out (“bad”) fiat currency. Stated in terms of the dollar (because that’s how we measure them), commodities are clearly on the rise. Gold, silver, and copper, which as recently as a hundred years ago were used as a medium of exchange, were up 29%, 82% and 30%, respectively. Cotton and coffee gained 92% and 77%. As Standard & Poor’s observes, “2010 year can be broken down into two distinct periods – one extending from January through August and another covering the remainder of the year. The announcement of quantitative easing from the U.S. Federal Reserve has helped provide a bid for most commodities.” On one hand, it looks to me like the market is saying that fiat currencies are less valuable and/or are being debased. Or, we could have a speculative almost-bubble on our hands.

Bolstering the case for the latter is that ten years ago about $6 billion was invested in commodities. Today, it’s nearly $300 billion. Money flows tend to drive prices higher, all things equal, and it appears to be the same today. And where the money is flowing isn’t necessarily in the right direction. This Businessweek article elucidates some good points about commodity exposure. As someone smarter than me said, there is no asset class that enough money can’t spoil.

Whether these price increases are well-founded or not is open to debate, but there is a clear correlation between the announcement of “QE2” and the snapback in financial markets, including equities (correlation of commodities with stocks is near all-time highs). But not all commodities are moving higher – one that has bucked the trend is natural gas, which is abundant and experiencing low demand. Its price fell 40% last year. If the behavior Gresham discussed was occurring, we shouldn't expect its price to languish for long.

Still, we can't ignore the "hot money" going into commodities. For these, Wal-Mart may have said it best: "Watch for falling prices." What the wise man does in the beginning, the fool does in the end.

predicting economic data points

As usual, they got it wrong. According to the Wall Street Journal, economists in Dow Jones Newswires’ survey had forecast payrolls would rise by 150,000 and the jobless rate would fall to 9.5%. The actual numbers came in at 103,000 and 9.4%, respectively, meaning they were off the actual number by nearly one-third. In typical fashion, CNBC spent most of the morning speculating about the release. The repartee between two folks is classic “time filling” television when the number is only an hour or so from release.

This offers a case in point on why it’s best to ignore prognosticators, especially on metrics like jobs. These numbers may move one way or another, but there is no point in trying to trade on such information because we can’t know beforehand. Forecasters tend to be within a tight range of each other, so when there are big numbers they are just as surprised as the markets might be.

Of the 103,000 jobs created (statistically, at a 90% level of confidence) this month, 113,000 of them were private. About half the decline in the rate was due to folks leaving the labor force, the other half was actually increases in payrolls. Service-providing industries were by far the largest area that saw job creation, up 115,000. We can quibble over 10 or 20 basis point down tick in the headline number, but 16.7% is the number on which to focus. This is the so-called U-6, and it represents unemployed but also those who are working part time but want full-time work. Thus, it’s more comprehensive.

To get back to the point: it’s mostly pointless to focus on predictions, which tend to introduce noise into an investment process. Remember this the next time economic data is close to release and the media fills time with speculation.

how much is a trillion dollars?

I found this page through Greg Mankiw. It's a great way to visualize a number that is being tossed around a bit too casually these days.

quick market snapshot, new highs/lows

Yesterday's trading:

NYSE:

New Highs: 375

New Lows: 2

Nasdaq:

New Highs: 296

New Lows: 5

Juxtaposed against prevailing market valuations, it's telling to see new highs outnumbering new lows by such a wide margin.

title for a 2011 year-end entry

Another year has passed, while a new one begins. Each annual turn is often a time of reflection as well as prediction. In keeping with that tradition, today’s entry will comprise some of the former, but mostly the latter, and some of neither.

The S&P 500 ends the year up about 15%, the Nasdaq about 17% and the Dow 11%. From where I stand, that’s a banner year, especially considering that average annual returns are more like 8-9% and long-term expected returns from today’s levels look to be under 6%. (Thus we can say this one year’s returns represent two years' expected.) Commodities and other risky assets also had a great year. Bonds and stocks, both foreign and domestic, performed well. Commodities, in some cases, knocked it out of the park (think cotton, up 90%). Gold rose about 30%, oil 13%. Housing prices did not do so well, however, and the economy limped along.

So 2010 looked good for the markets. Does that have any relation to a 2011? As we have to disclose often, past performance is not necessarily an indicator of future results. Still, the two are often related. Specifically, past performance can be a contrary indicator of future results. As the saying goes, if something can’t continue, it won’t. I am optimistic about the future overall, but I see several areas that appear stretched and where future results may not be as robust as the recent past.

Today we learned that that Groupon accepted about $500 million of a $1 billion funding round. This is a two-year old company is an industry that doesn’t have a lot of barriers to entry. Sure, they were the first, but their margins are artificially high and their labor-intensive strategy depends a lot on street-level salespeople. There is a lot of panache here; Groupon is cool and retailers want to be associated with them - now. But “cool” is ephemeral and in business competition does not lay down just because you're bigger. Especially when the business model is so easily copied and the space nascent. Competitor LivingSocial has received investment from Amazon and it’s not a stretch to believe my favorite online retailer could move into that market. Yet Groupon is raising a billion dollars. To me, it’s unbelievable and is probably a sign of too-heady times in the private markets.

Meanwhile, the commodities rose still has its bloom on the ever-present investment thesis of increasing consumerism in emerging markets. I think there could be several surprises on the “emerging” front in the new year that will surprise a lot of the gung-ho investors in this space. I speak specifically about gold and rare-earth metals here, but I get the feeling that a lot of the agricultural commodities have run up too high (and so have some of the ag-related stocks). A thesis that makes sense at a price does not make sense at any price.

Oil seems fairly priced to me at present.

As for stocks, a previous post pretty well elucidates my thoughts here. Bonds are something I’ve also recently written at length about and my feelings here haven’t changed a whole lot. I think surprises to the downside on bonds and stocks await. Put premiums are low as markets near their recent highs amid high levels of investor bullishness. This tends to be the case near market peaks.

Are there any bubbles (other than in the use of the word “bubble”)? I think there is one in concerns over our fiscal and monetary situation. That is a funny thing to say because I, too, am concerned. It just seems to me that “everyone” is concerned about these two things and so they are probably somewhat overblown. Such things have a way of working themselves out. While it’s often felt that the good folks in Washington live in a different world, I’m not convinced they won’t take care of these problems. A year ago, I wouldn’t have dreamed Obama would break his campaign promises by passing a law that was largely deferential to Republicans. But it doesn’t take much to change Washington’s mind and/or direction these days and our problems will not just get worse in a linear fashion. However, fiscal and monetary issues should lead investors to plan for contingencies, protecting from downside deviation.

The solutions aren’t linear, either. Think protection from phase transitions, or more popularly, tipping points. Securities trading below intrinsic value. Healthy balance sheets. Excess cash. Opportunistic management teams with flexible operating philosophies. Don’t try and time the market, but be ready to pounce when Mr. Market turns manic.

Most of the economic data coming out is noisy. The bottom line is the economy isn't going gangbusters and I'd expect that activity would remain at a similar pace. Of course, that's the easiest expectation. Unemployment just can't come down as fast as we'd all like without some significant retraining and job creation in other sectors. It’s a structural issue which will take years to resolve. At the same time, corporate profit margins are well above their historic highs.

2010 was a fantastic year, personally as well as professionally. Each day is a chance to learn something new and I'd like to think I was able to do so. I hope 2011, despite its being an odd year, holds similar promise. Happy New Year.