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August 11, 2007

Inflationary Bear Markets
by Matt McCracken

PART I: INTRODUCTION TO INFLATIONARY BEAR MARKETS (IBMs)
PART II: WHY ARE IBMs SO DANGEROUS?
PART III: WHAT CAUSES IBMs?
PART IV: SIMILARITIES BETWEEN NOW AND THEN
PART V: COULD IT REALLY HAPPEN AGAIN?
PART VI: CONCLUSION

PART I: INTRODUCTION TO INFLATIONARY BEAR MARKETS (IBMs)

When the market is fluctuating near its highs, it can be easy to forget that markets move in cycles rather than lines over time. It's similarly easy to forget how effective corrections and bear markets are in eliminating most or all of late-stage bull market gains. - John Hussman, Ph. D., 6/18/2007

About every 30 to 40 years, the US stock markets experience a rare but significant type of correction that catches Wall Street completely off-guard - an event I call an Inflationary Bear Market (IBM). This type of bear market only occurred three times throughout the 20th century ('07, '37 & '73). Personally, I believe that we are due for another one of these events. In this article, I'll explain why and what you can do to protect yourself and your hard earned savings.

But first, I'd like to differentiate between an "Inflationary Bear Market" (IBM) and a "Deflationary Bear Market" (DBM) because they are very different animals. A DBM occurs when there is more stuff than there is cash to buy it, so the price of stuff goes down (i.e. deflation). An IBM occurs when there is more cash than stuff, so the price of stuff goes up (i.e. inflation).

DBMs are much more common than IBMs. DBM's are caused by a cyclical slowdown in the economy. During these economic down cycles, income-producing securities such as bonds, Real Estate (REITs) and defensive equity sectors (i.e. Utilities) outperform and may even make you a little money. Securities that generate cash do well because there is a shortage of cash. Companies that make stuff (growth companies) but don't necessarily generate cash (high P/E's) get slammed. Commodities tend to perform poorly during DBMs as a slowing economy reduces demand for the stuff that makes stuff.

IBMs are unnatural events caused by the overheating of the economy, typically as a result from government interference of free markets. Preceding an IBM, governments seek to stimulate the economy by creating excessive amounts of money which in turn debases their currency leading to price manipulation which eventually results in severe price imbalances. These price imbalances create inflationary pressures that continue to persist even in the face of a cyclical economic slowdown. These imbalances lead to severe price movements in all asset classes which results in big gains and big losses!

The opposite takes place in an IBM as a DBM. Securities that generate cash get slammed because cash is of little value because there is so much of it. Companies that make stuff, commodity companies in particular, do well because there is a shortage of stuff. But even better than buying the companies who make stuff, is buying stuff directly - or at least derivative instruments whose price is directly linked to stuff.

The next market cycle is shaping up to be an Inflationary Bear Market (IBM) that will provide a once-in-a-lifetime profit opportunity for those who know how to invest in this type of market environment. Unfortunately, the ensuing IBM will lead to significant losses for the majority of individuals who have implemented a traditional asset allocation of stocks, bonds and REITs.

PART II: WHY ARE IBMS SO DANGEROUS?

1. Wall Street is oblivious IBMs because quite frankly most of the folks who were around for the last one are retired, dead or were too young to remember it. They have no point-of-reference when it comes to investing in an IBM. They are oblivious to the events that proceed it and therefore are completely ill-prepared to protect their clients assets during one.
2. IBMs destroy "Safehaven" investments that investors use to protect their clients in a bear market. "Safehavens" are cash generating investments that are genuinely considered safe or defensive. Securities such as US Treasury and AAA bonds, REITs, and dividend paying stocks (i.e. utilities, financials, ect.) Since cash loses value because of its mass production by central banks, securities that generate cash lose value.
3. Governments and their Central banks respond to the problem the same way they always respond to a problem - by providing additional stimulus to the economy which creates more inflation - which caused the problem in the first place - making the problem even worse.

The result is a bear market that is far more devastating then ordinary bear markets. Historically, IBMs have seen losses that are more severe and happen faster than DBMs. Here is a rundown of the last three IBMs.

(I used figures from the Dow Jones Industrial Index for the first two and the S&P 500 for the third.)

It took 2.5 years for the S&P to lose almost 50% in the early part of this decade. Imagine those same losses in 13, 18 or 21 months. That's what happened the last two times our government let inflation get out of hand.

And this only addresses the potential for equity losses. Remember that bonds and other income producing investments will lose as well. In 2000, if you maintained a solid balance of 50% equities and 50% bonds, the appreciation in bonds offset a good portion of your equity losses, but this was not the case in '37 or '73 (I couldn't find Bond data going back to 1907).

I estimate that AAA bonds depreciated a half a percent in '37 - but this was coming off the worst deflationary accident our country has ever experienced. From January, 1973 through December, 1974, US Treasuries loss 4.3%. A balanced portfolio of equities and bonds would have depreciated 23% from 1/1/73 through 12/31/74.

In order to protect your portfolio from losses, it is paramount that you avoid the sectors that will suffer the most damage. Ironically, these sectors are the ones that most financial advisors steer their clients into as the economy slows down.

PART III: WHAT CAUSES IBMS?

IBMs occur when there is a confluence of a slowing or stagnating economy coupled with continuing price inflation in commodities and finished goods. A British fellow name Iain McCleod coined the term Stagflation back in the 1960's to describe such a set of circumstances. While stagflation was coined to describe the state of the economy, I refer to the corresponding market correction as an Inflationary Bear Market.

As I stated earlier, Bear Markets are typically deflationary. Equity price's depreciate as the economy slows down reducing the demand and prices of commodities and finished goods. This was the case in 2000, 1987, 1968 and 1929. But occasionally (every 30 - 40 years), the government gets so carried away with stimulating the economy; they create a scenario where inflation pressures persist even when the economy slows down.

Personally, I do not believe it is an accident that these events are spread out as they are. It takes a generation to wipe out the old guard and bring in fresh, new politicians - new politicians who have no recollection of how destructive inflation can be. These new politicians see an economic slowdown, such as the one in 2000 and respond by stimulating the economy. It's not their fault; it's a Pavlovian response for politicians to mess with free markets. The first mistake they make is to over stimulate the economy. The second mistake is to do it all over again when the economy slows again. It works fine the first time but backfires the second.

Historically, IBMs come as an aftershock from a severe deflationary event. In 1929 and 1968, equity markets suffered substantial losses from significant economic slowdowns ('29 being much more severe). In response to these losses, the federal government created both physical and fiscal stimulus to aid in the recovery of the prior economic depression or recession. Rather than let market forces do their job, the government seeks to buy votes by bailing out the economy. And it works for a while - but then it doesn't. By 1937, the "New Deal" had stimulated the economy to the point that price inflation was inevitable - regardless of economic conditions. In the 70's, there were multiple factors contributing to the inflationary picture. The three most significant were:

• The War effort in Vietnam. Wars aren't cheap and they always lead to inflation.
• The devaluation of the US$ by President Nixon when he reversed the Bretton Woods international monetary system effectively taking us off the Gold Standard.
• The massive spike in Oil Prices resulting from the OPEC oil embargo, the peaking of US Oil field production and the Nixon administration's price controls on Oil in 1971.

PART IV: SIMILARITIES BETWEEN NOW AND THEN

History seldom repeats itself, but if often rhymes. - Mark Twain

Looking back over the canvas of our country's economic history, it is hard to ignore the shocking similarities of today's economy and the early 70's. Let's take a candid look at the following themes and see how today's economy rhymes with the early 70's:

• Rising Commodity prices
• A slumping housing market
• Rising Interest Rates
• Engaged in an pre-emptive, polarizing war
• Government actively debasing our currency

Rising Commodity Prices

For the purpose of measuring commodity price inflation, I'll use the CRB index. Since the CRB Index was created in 1956, there have been two periods of significant commodity inflation - the 1970's and today. Here's a table that compares the history of commodity inflation:

Four Rate of Change of the CRB Index:

Here's what I found truly amazing. If you measure Commodity inflation from the inception of the CRB index (1956) throughout the end of the Century (1999), but eliminated the decade of the 1970's, commodity prices actually fell over 31%!!! (Source: Commodity Research Bureau)

I have to qualify this statement by saying that there is some substitution bias. For example, Regular Gasoline has been replaced by Unleaded Gasoline. Lead doesn't play such a vital role in our economy anymore; therefore it makes up a smaller percentage of the index today than it did in the 70's. However, when the good people at Reuters change the weightings of the index and make substitutes, they attempt to do it in an equitable fashion so the impact is minimal. In its 50+ year history, the index has only been changed or adjusted nine times.

Regardless of the substitution bias, we're only talking about a few percent. The key point is that over the last 50 years, commodity inflation has been all but nil with the exception of the 70's and the current economic cycle. I think that provides the necessary evidence to compare the impact of inflation on equities and bonds from these two periods.

A slumping housing market

I'm attempting to establish that inflation can coexist with a recession resulting in Stagflation. Since housing is one of the biggest components of our economy and it is especially vulnerable right now, I chose to focus on it. There have only been four periods since 1960 where Housing Permits fell by more than 30% in less than 12 months, which were 1973, 1980, 1990 and 2006. All four episodes ended in recession.

I could write a dissertation about the issues surrounding the current housing slump but I'm far too lazy for that sort of thing so I'll just copy a bunch of quotes I've kept from recent articles from the financial media.

Homebuilder's confidence Plunges Again in July

With interest rates moving higher, a glut of homes sitting unsold, and the problems in the subprime mortgage market worsening, U.S. home builders' confidence in the housing market plunged further in July...The NAHB/Wells Fargo housing market index dropped four points to 24 in July, the lowest since the 20 recorded in January of 1991 and the third lowest reading in the 22-year history of the survey. - CBS marketwatch - 7/17/2007

Sales of existing homes Drop to Slowest Pace in 4 Years

Reflecting further housing troubles, sales of existing homes fell in may to the lowest level in four years while the median home price dropped for a record 10th consecutive month. - Associate Press - 6/25/2007

Housing Construction Falls in May

Construction of new homes fell in May as the nation's homebuilders continued to struggle with a steep housing slump that has been exacerbated by rising problems with mortgage defaults. The Commerce Department reported Tuesday that construction of new homes and apartments dropped by 2.1% last month, the poorest performance since a huge 13.9% plunge in January. - Associated Press - 6/19/2007

Rising Interest Rates

Leading up to and through the 1973 IBM, bond prices fell causing interest rates to rise in order to properly discount the inflationary pressures in the economy. Here's a side-by-side comparison.

Engaged in an pre-emptive, polarizing war.

I'll try not to get political, but it's tough to address the issues of government intervention in the markets without talking about government. I'll stay away from any potentially sore subjects and stick to points that can't be argued - at least by rational people.

• Wars are expensive.
• Vietnam and The War in Iraq have had a polarizing impact on our country.
• All the messing around we've done in the Middle East hasn't made us too many friends over there. It's undeniable that we've exhausted a sizable amount of goodwill.

Why is this important and how does it play into the stock market and inflation? There are two main reasons why the War on Iraq will impact the markets. First, as I stated above, Wars are expensive. The Congressional Budget Office delivered a report to lawmakers in July that estimated that the total bill for the War in Iraq will be at least $1T. The most liberal estimates at the beginning of the War were at $200B - 20% of the current estimate. We've already spent $500B.

We've gone deep in debt financing this War. We can argue all day long about whether the war is worthwhile or not, but we cannot argue that we've accumulated massive amounts of debt paying for it and eventually the debt will need to be paid.

The second reason is that the War in Iraq gives the Middle East justification for using the "Oil Weapon". The following is an excerpt from Jim Roger's book Hot Commodities regarding the Oil Embargo of 1973:

What most people have forgotten (or never knew) was that the OPEC oil embargo had little to do with high prices. In the early 1970's, long before the war, oil supplies were already tighter than they had been for decades. The huge US oil fields had already begun to decline. Oil producers no longer had the capacity to produce a surplus, while demand for oil was increasing. To stall inflation, the Nixon administration had put price controls on oil in 1971, discouraging investment in oil production or exploration and encouraging Americans to consume more oil...The Cartel's most prolific producer, Saudi Arabia, had resisted "the oil weapon" but, before the war, in September of 1973 the Saudies finally agreed at an OPEC meeting in Vienna to summon the world's major oil companies to confer about a price hike the following month in Vienna.

A month before the War broke out, OPEC had already decided to raise prices. All the war did was give OPEC justification for the embargo - which they conveniently used. Something they could point to and say "Look, you did this to yourselves, you foolish Americans."

The inconvenient truth is that the "Elephant Fields" in the Middle East are losing production. They have pulled every trick in the book to keep pumping at an unsustainable rate and when the inevitable decline in production takes place, the War in Iraq will allow them to project the blame onto the American's. The next spike in oil prices will be supply driven - not demand driven - they just need a reason to allow it to happen. The following is just some of the evidence of the issues surrounding Middle Eastern Oil production:

• Saudi Arabia has not allowed a full audit of their largest oil field, Ghawar, since 1975. They haven't permitted any sort of audit of their oil fields since the 90's.
• OPEC does not police or audit their member countries. OPEC members are allowed to report their accounting numbers as whatever they see as reasonable. This allows OPEC members to engage in one-upping each other by claiming to have more reserves then the others.
• Many oil market prognosticators including Matt Simmons and T. Boone Pickens are calling for a significant reduction in the capacity of OPEC's largest oil fields. Oil fields tend to lose 4-5% of their productivity each year. By their calculations, the "elephant" oil fields belonging to OPEC members should start seeing a significant decrease in production if they aren't already. Currently, Oil imports have decreased by double digits year-over-year.

We will not run out of oil in any of our great-great-grandchildren's lifetimes. Canada has more oil than Saudi Arabia. There is tons of oil off our coasts and in Alaska. The problem is that the "easy" oil is running out. Getting usable oil out of the ground in Canada and other places is expensive and difficult - but it is there when we need it. I don't foresee Oil going to $200/bbl or anything ridiculous, but it could get considerably more expensive in the short-term - which will provide the proper incentive to ramp up drilling efforts aimed at more difficult oil.

Government actively debasing our currency:

Treasury Department Data going back to 1978 show that every administration except [George W.] Bush's entered the foreign exchange market to buy dollars in an attempt to support the currency. - Bloomberg, July 23, 2007

In August of 1971, President Nixon suspended the convertibility of the US currency into Gold, thus effectively ending the Gold Standard in the US and worldwide. In one fell swoop of his Presidential Pen, he did more to devalue our currency than any other President ever would or could do.

During the 90's, the federal government maintained a "strong dollar policy" resulting in the US$ appreciating substantially. The trade weighted US$ index increased approximately 50% from 1993 through 2002.

But since the beginning of 2002, the US$ has fallen by almost 1/3 and just broke through its all-time low. Despite rhetoric out of Washington, it is well-known that the US government is seeking to devalue its currency through various means. Paul Samuelson, the 1970 recipient of the Nobel Prize in Economics says, "The early line of the George Bush administration was that we want a strong dollar, [but over time] they began to want a depreciated dollar." (Source, Bloomberg 7/23/07)

There is a strong consensus among top investors (Warren Buffett, Marc Faber, Jim Rogers, ect) that the US$ will continue to depreciate and erode its global purchasing power. I'm not wishing to make a statement on the merits of currency debasement. Lots of people feel very strongly one way or the other. I don't. There are plusses and minuses to debasing a nation's currency. Here is what I do know.

• Our government is seeking to debase our currency - as it did in the 70's.
• A debased currency is inflationary.

I'm not interested in making political statements. I'm solely trying to draw comparisons to today and the stagflation that our economy experienced in the 70's.

Part IV Wrap-up:

Obviously, there are dissimilarities between today and the 70's. To paraphrase Twain, "History simply rhymes, it doesn't repeat itself." There are a whole host of issues that I could point to that would differentiate what happened in the 70's versus what is happening today. For starters, the bear market in '68 wasn't nearly as bad as the one in 2000 (however, valuations weren't nearly as high in '68 as 2000). We are not enduring a Cold War that could end in Nuclear Holocaust. Oil prices are not likely to go up 500% in just a few months as they did in '73.

I'm simply trying to draw comparisons and the closest economic situation to today's, is the 70's. And for that reason, I think it is wise to play the odds and invest in a strategy that would have delivered superior performance during that period.

PART V: COULD IT REALLY HAPPEN AGAIN?

Investors and ordinary citizens have good reason to worry about a perfect economic storm: [1] A deepening loss of confidence in the dollar leading to higher interest rates, [2] the higher rates bringing a crashing end to a hedge-fund, private equity, and merger binge that has depended heavily on cheap borrowed money; [3] the boom in bait-and-switch mortgages ending in a morning-after of rising defaults and sinking housing values; [4] inflationary pressures in food, oil, and other commodities leading to still higher interest rates - all unsettling stock and credit markets and putting a new squeeze on consumers borrowed to the hilt. - Robert Kuttner - Boston Globe, 7/30/07

While I'm not quite as pessimistic as Mr. Kuttner, I believe a steep sell-off in equities coupled with continuing price inflation is a strong possibility. In fact, I believe that without some sort of seismic shift in the economic landscape, an IBM is inevitable for the following reasons:

1. The Necessity of Inflation
2. Bond and Equity Fundamentals
3. Leverage
4. Ben Bernanke - Deflation Fighter

The Necessity of Inflation

Why must our government inflate the heck out of the world's economy? Simply because of our twin deficits - Trade and Budget. It's really quite simple. When our economy was booming, we bought a ridiculous amount of oil and gas from the Middle East and a bunch of other crap from Japan, China and other Asian Tigers. In return, they invested in our government's debt instruments (i.e. treasury bonds). Granted, they would have liked to buy other stuff, like ports and energy companies, but we wouldn't let them, so they just kept pouring their imported US$'s into Treasuries. With interest rates already at historic lows, the inflow of US$'s just pushed prices higher and rates lower.

How ingenious of us! We stuck those suckers with bonds yielding 3-4% knowing full well we could just inflate the world's economy, rates would rise and then we could invest our money in Eurobonds and other foreign Treasuries yielding 6-7%, pay off the 4% notes and keep the rest. Brilliant!

Market Fundamentals

Here are just a few of the fundamental issues with Equities, Bonds and Real Estate:

• The market's valuation is well above its historical average of 14.5 while earnings growth has peaked and set to decline.
• The market is currently experiencing its fourth longest bull market rally and its second longest stretch without a 10% correction.
• Yields on every type of income-generating security are at all-time lows (with the exception of some points on the Treasury curve). Utility stocks currently provide their lowest yield since 1930. REITs are 50% below their average historical yield. AAA bond yields are at a 40+ year low. The risk premium on Junk bonds is at its lowest level ever (recently started to correct). As these yields improve and return to more normal levels, investors will exchange over-valued equities for higher-yielding securities.
• A slowing housing market coupled with the oldest baby boomers now exiting their peak spending years will likely result in a precipitous decline in US consumer spending, which accounts for 70% of the nation's economy.
• There are long-term fundamental issues with our nation's currency. Weakness in our currency will likely lead to a broad-based sell-off of US assets by foreign investors.

Leverage

There is an unprecedented amount of leverage in the market. When this leverage is unwound, very bad things will happen! Steve Baily of the Boston Globe says that "Leverage is a wonder on the way up, and frightening on the way down."

We have seen begun to see the first signs of the impact of leverage. Practically every day there is news of another hedge fund collapse. The root cause for the demise of these funds was leverage. When a fund is levered up 10:1, as many are, a 10% loss in the underlying assets turns into a 100% loss for the fund. That's how a fund filled with mortgage backed securities that own a claim on real property that has real value can go to ZERO in less than 6 months.

The implosion of the Bear Sterns' funds and others will not be an isolated or "contained" event. More of these will come and as investors liquidate their Hedge Fund shares, the velocity of money coming out of the market will be "unprecedented". Back in 2001, if an investor liquidated $1 from a Mutual Fund, the Mutual Fund had to liquidate 97 cents of equity exposure. When investors liquidate Hedge Fund shares, the fund will have to unwind on average $5-$10 worth of equity exposure to redeem $1 worth of fund shares.

Ben Bernanke - Deflation Fighter

The man who is charged with navigating our economy, Fed Chairman Bernanke, is ultimately ill-suited to deal with stagflation. The Fed chairman earned the nickname "Helicopter" Ben for a speech where he claimed that we could defeat any sort of deflationary threat by figuratively dropping money from a Helicopter to increase spending. Bernanke did his Ph. D. dissertation on The Great Depression and how it could have been prevented through various means of stimulus. Please forgive the sports analogy, but we have an offensive coordinator coaching the defense. His entire adult life has been spent focusing on defeating deflation - not inflation. Bernanke has had it easy thus far but he'll start "waffling" on the topic of inflation as the economy begins to weaken.

PART VI: CONCLUSION

IBMs lead to sharp price movements as years of growing imbalances become unwound. The sharper the price movements, the greater the opportunity for profit - and loss. Unfortunately, the strategy implemented by the vast majority of Wall Street minions will be on the losing side.

My goal is not to make sensation claims to generate fear in the marketplace, rather I seek to provide an objective and realistic view of anticipated market movements based on historical precedence. I am not looking forward to the events that will likely take place during the next cyclical correction - but I do anticipate them. I am not a doom and gloom type person. I have been very bullish and fully invested in equities for 3 ½ of the last 4 years. While many financial advisors were taking a cautious approach in 2003, I had my clients fully invested starting in April after being in cash for all of 2002. It wasn't until last year that I "let my foot off the gas."

I don't want to see our economy go through a period of stagflation and the corresponding market correction - but I don't want to see world hunger, corrupt politicians, adulterous Evangelists or another damn episode of American Idol either - but we live in a broken world where sometimes things go wrong. It's naïve to think that occasionally the market won't lose a little bit here or there. Sometimes, those losses are more than just a little bit and the next market cycle is one of those times. I hope I'm wrong for the sake of the millions of boomers who are getting ready to retire - but I'm not willing to bet on it and I don't believe you should either.

Matt McCracken
McKinney Avenue Capital

Matt McCracken is the founder of McKinney Avenue Capital (The MAC). The MAC is a financial advisor based in Dallas, TX offering asset management to individuals and corporations.

Copyright © 2007-2008 Matt McCracken

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