Tuesday, May 12, 2009

More Headwinds To Worry About

On the way into the office this morning, I was listening to CNBC radio on Sirius Satellite. In that 7 minute drive, I think I heard the word "inflation" about 15 times. With year over year CPI virtually at zero, I am not sure what the worry is all about. This is the reality. Inflation is low.

On the other hand, with world central bankers making the cost of capital almost nil and their willingness to do "whatever it takes" to break the global slump and revive growth, the perception is that inflation is lurking around the next corner. If we can borrow the thinking of stock bulls, maybe we can say that inflation is so low that the only way it can go is up! It's a second derivative kind of thing.

All nonsense of course. But when it comes to the markets, perception always trumps reality.

However, what is worrisome from an equity perspective are the current trends in crude oil, gold, and 10 year Treasury yields. The prices in these assets are rising and gaining momentum, and this is a headwind for equities. So let's look at some data.

Figure 1 is a weekly chart of the S&P500 and the indicator in the lower panel is a composite indicator that assesses the strength of the trends in crude oil, gold, and 10 year Treasury yields. When the indicator is above the upper line (i.e., inflationary pressure line) that means that these trends are strong and inflationary pressures (real or perceived) are rising.

Figure 1. S&P500 v. Inflationary Pressures/ weekly

The question becomes: how do these inflationary pressures affect equities? So let's construct a study where we "short" the S&P500 during the time the indicator is at or above the high inflation line. The position is covered when the indicator drops below this line.

Since 1985, such a strategy has yielded 581 S&P500 points. There were 52 trades and 60% were profitable. The time spent in the market to get these 581 S&P500 points was an incredible 12%. Remember, this is a strategy that shorted the S&P500 through a bull market. Buy and hold S&P500 resulted in 736 S&P500 points. The equity curve for the strategy is shown in figure 2.

Figure 2. Equity Curve

I have tagged the equity curve with some dates, and in this age of asset bubbles, rising inflationary pressures (as measured by strong trends in crude oil, gold, and 10 year Treasury yields) is another headwind for equities. Note the rise in the equity curve since 2004. Whether inflationary pressures truly exist or not is another matter. The perception is that inflation does matter, and a stock market that has been pumped up on steroids (i.e., liquidity) will likely remain vulnerable to this dynamic for the foreseeable future.


dacian said...

I enjoy this post, really!

The curve showing the gains one would have made shorting the equities when the "inflation" indicator is high it's impressive; and it is even more impressive as this was during a bull market!

If the history repeats, there might be an opportunity entering short positions at these levels.

The breath of this rally was weak lately, but the question is: are we going to make new lows or the lows for this year was printed?

Guy M. Lerner said...

New lows for the year? I read some comments by David Rosenberg, recently of Merrill fame, and his feeling was that new lows were unlikely or the pace to those lows (if it were to occur) would be unlikely as the gov't has decided it will do whatever it takes; he basically stated that short selling was risky for such reasons.

dacian said...

Tranding range +/-50% for years is not impossible, as there is no growth for the economy...

How about you, do you believe 666 was the low for this bear?


Guy M. Lerner said...

My style doesn't really lend it to picking a price target; I see where support is etc., but the next good buying opportunity (most likely) will occur when sentiment turns negative.

So do we go below the March lows? I don't know; if I wanted to be a bull, that would be good if that happened but we are far away from that point - probably both in time and price

dacian said...


I don't want to go too much off topic here, but

"...as the gov't has decided it will do whatever it takes; he basically stated that short selling was risky for such reasons."

the question is not what the government will do, but what the government CAN do. Most thing their powers are unlimited, but that is wrong. If they continue on the same path (QE, devaluation, brutal interventions) and don't let the bubble deflate (eventually in an ordered fashion, ie helping here and there and guarantee people's money), bond holders will say STOP by asking much higher interests; this might create a sudden panic among investors and it will just accelerate the deflation and lead us all into depression. The general belief these days is that govt. massive interventions will lead us out of this mess, but actually, if they insist too much, might make things worse.

Guy M. Lerner said...

In my opinion and it is only my opinion is that the government is trying to restore confidence that everything is going to be alright; their methods might be wrong but this is what they would rather have - everyone be happy....don't worry....legislate happiness!

BigB said...

Guy - what is the methodology for calculating your inflation 'indicator' - can us mere mortals replicate it? thanks