Stock Headers
Inflation May Not Be Kind to the Stock Market
http://www.taipanpublishinggroup.com/taipan-daily-042610.html
Investors seem to see inflation as no big deal, or maybe even a good thing. But they forget how inflation killed the stock market in the 1970s… and just how easily those conditions could return.
Federal Reserve Chairman Ben S. Bernanke is now seen as the stock market’s best friend. He is the second coming of “Easy Al” Greenspan… the bearded Goldilocks… the patron saint of easy money.
In years past, euphoric investors talked about the “Greenspan Put,” in reference to the idea that Greenspan would never let stocks go down.
Now there is talk of a “Bernanke Put”… though a phrase like “Bernanke tide” might be more accurate. The Federal Reserve has unleashed a torrential flood of liquidity on the market, enabling banks to profit at will from the steep yield curve.
In the recent earnings reports of the major investment banks, for example, the vast majority of profits came from fixed-income trading and other yield-curve-related activities. A wonderful gift from Uncle Ben.
What’s more, to investors’ great delight, there is no seeming cost (for now) to this liquidity bonanza. Under more normal circumstances, one would expect negative consequences from pumping trillions of dollars into the system. But not this time.
“Wholesale prices rose more than expected last month,” the AP reports, “as food prices surged by the most in 26 years. But excluding food and energy, prices were flat.”
Food and energy – who cares about those, right? It’s the earnings reports that matter, and earnings have been stellar. America is well on the road to recovery, and all is bright. To infinity and beyond!
Inflation Cometh
As with most fairy tales, though, this one has a few problems in terms of real world translation. Take all those trillions pumped into the system by the Federal Reserve, for example.
So far, the Federal Reserve’s trillions have not created a rampant inflation problem (as far as “official” stats are concerned) because monetary velocity has been weak. Velocity has been weak because the U.S. economy has been weak. When business is slow, money moves like molasses. It does not get lent or spent at a rapid pace.
But now we seem to be hearing data point after data point arguing that money IS, in fact, being lent and spent. (For example: According to Edmunds.com, zero finance auto purchases hit a record in March 2010.) This means that velocity is picking up. And that means serious inflation is coming. (Unless, of course, the recovery is a pure stimulus-driven illusion… in which case investors have yet another serious problem on their hands.)
But why should investors care about the return of inflation anyway? Wouldn’t that just be a sign of healthy recovery?
The Death of Equities
To understand the concern, harken back to the infamous BusinessWeek “Death of Equities” cover published in August 1979.
Everyone remembers the “Death of Equities” part. But few recall the subhead: “How inflation is destroying the stock market.”
Consider this excerpt from the original 1979 story:
Until now, the flight of institutional money from the financial markets has been merely a trickle. But if could turn into a torrent if this year’s 60% increase in oil prices touches off a deep recession while pushing inflation sky-high. As it is, the nation’s financial markets and its capital flows have been grossly distorted by 13 years of inflation…
Now, with the image of the inflation-ravaged ‘70s kept firmly in mind, consider the below excerpt from a piece that came out just last week in The Wall Street Journal, “The High Cost of Raw Materials:
An unrelenting rise in the cost of raw materials – largely driven by mounting demand from Asia – is cutting corporate profits, hitting stocks and, in some cases, pushing up consumer prices.
One glaring example is the sky-rocketing cost of rubber, a major tire component, which has climbed nearly 74% this year after rising 92% in 2009…
A similar concern faces firms that buy other rapidly rising raw materials. Palladium, which goes into car exhaust systems, is up nearly 39%..
Lumber, a major cost for home builders, is up nearly 59%…
Iron-ore prices also are rising, while oil and copper prices have tacked on to last year’s huge gains…
Noticing a trend there? As Yogi Berra might say, It’s “déjà vu all over again.” And according to the “official” government statistics, inflation hasn’t even kicked in yet!
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When Goldilocks Turns Vicious
Thus far, the Federal Reserve has created what appears to be a “goldilocks” environment for U.S. equity markets. The flood of cheap money has been enough to keep corporate profits buoyant, without causing the weak economy to heat up too much, allowing investors to celebrate.
But what is given freely cannot so easily be taken back. Investors can ignore the real world costs of rising food and energy prices, focusing on earnings alone as they drive stock prices higher, but they can only do this for so long. Here is why:
* As inflation takes hold, the rising cost of raw materials could soon cut sharply into corporate profits. (As the WSJ points out, this process has already begun.)
* A continued rise in food and energy costs will cut deep into depleted consumer budgets. (And the consumer spending resurgence has notably NOT come from new or rising income.
* As inflation concerns rise, the desire to hold long-term U.S. Treasuries will fall – as inflation would ravage such instruments – leading to higher interest rates.
* If China revalues its currency (as the U.S. is pushing it so hard to do), that will only make China MORE competitive as a buyer and hoarder of raw materials on the world stage.
The upshot of all this is that there are no free lunches when it comes to monetary policy. The Federal Reserve can create the illusion of a cost-free economic boost by pumping trillions into the market, but those costs have not been avoided. They have only been temporarily deferred.
The trouble with a little bit of inflation – seen by investors as a good thing – is that the conditions are in place for a little bit too soon become a lot.
Like his predecessor, Alan Greenspan, Ben Bernanke has concocted a punchbowl recipe that will allow investors’ to party hearty for a time… and then drive themselves right over a cliff, as the stimulative policies enacted in response to the last crisis merely set the stage for the next one.
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About the Author
Kent Lucas is the Editor of Taipan’s Safe Haven Investor. Kent’s experience includes seven years as a research analyst and portfolio manager for a leading investment management firm. He has also actively managed $1 billion worth of equity assets, with particular attention to multi-industrial companies along with auto, construction and farm equipment-related companies.
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