Catching Up on the Week
Friday before a long weekend is probably the worst time in the world to publish a blog article, but other obligations having consumed me this week, Friday afternoon is all I am left with. Herewith, then, a few thoughts on the week's events.
Follow the Bouncing Market
In case there was any doubt about how fervently the dip-buyers feel about how cheap the market is, and how badly they feel about the possibility of missing the only dip that the equity market will ever have, those doubts were dispelled this week when Monday's sharp fall in stock prices was substantially reversed by Tuesday and new all-time highs reached on Wednesday. Neither selloff nor rally was precipitated by real data; Friday's weak jobs data might plausibly have resulted in a rally (and it did, on Friday) on the theory that the Fed's taper might be downshifted slightly, but there was no other data; on Tuesday, December Retail Sales was modestly stronger than expected but hardly worth a huge rally; on Wednesday, Empire Manufacturing was strong - but who considers that an important report to move billions of dollars around on? There were some memorable Fed quotes, chief among them of course Dallas Fed President Fisher's observation that the Fed's adding of liquidity has done what adding liquidity in other contexts often does, and so investors are looking at assets with "beer goggles." It's not a punch bowl reference, but the same basic idea. But certainly, not a reason for a sharp reversal of the Monday selloff!
The lows of Monday almost reached the highs of the first half of December, before the late-month, near volume-less updraft. Put another way, anyone who missed the second half of December and lightened up on risk before going on vacation missed the big up-move. I would guess that some of these folks were seizing on a chance to get back involved. To a manager who hasn't seen a 5% correction since June of last year, a 1.5% correction probably feels like a huge opportunity. Unfortunately, this is characteristic of bubble markets. That doesn't necessarily imply that today's equity market is a bubble market that will end as all bubble markets eventually do; but it means it has at least one more characteristic of such markets: drawdowns get progressively smaller until they vanish altogether in a final melt-up that proceeds the melt-down. The table below shows the last 5 drawdowns from the highs (measuring close to close) - the ones you can see by eyeballing a chart, by the date the drawdown ended.
I mentioned last week that in equities I'd like to sell weakness. We now have some specificity to that desire: a break of this week's lows would seem to me to be weakness sufficient to sell because it would indicate a deeper drawdown than the ones we have had, possibly breaking the pattern.
There is nothing about this week's price action, in short, that is remotely soothing to me.
A Couple of Further Thoughts on Thursday's CPI Data
I have written previously about why it is that you want to look at some measure of the central tendency of inflation right now other than core CPI. In a nutshell, there is one significant drag on core inflation - the deceleration in medical care CPI - which is pulling down the averages and creating the illusion of disinflation. On Thursday, the Cleveland Fed reported that Median CPI rose to 2.1%, the first 0.1% rise since February (see chart, source Bloomberg).
Moreover, as I have long been predicting, Rents are following home prices higher with (slightly longer than) the usual lag. The chart below (source Bloomberg ) shows Owners' Equivalent Rent, which jumped from 2.37% y/y to 2.49% y/y this month. The re-acceleration, which represents the single biggest near-term threat to the continued low CPI readings, is unmistakeable.
Sorry folks, but this is just exactly what is supposed to happen. An updated reminder (source: Enduring Investments) is below. Our model had the December 2013 level for y/y OER at 2.52%...in June 2012. Okay, so the accuracy is mere luck, but the direction should not be surprising.
For the record, the same model has OER at 3.3% by December 2014, 3.4% for OER plus Primary Rents. That means if every other price in the country remains unchanged, core inflation would be at 1.4% or so at year-end just based on the weight that rents have in core inflation (of course, median inflation would then be at zero). If every other price in the country goes up at, say, 2%, then core inflation would be at 2.6%. (Our own core inflation forecast is actually slightly higher than that, because we see other upward risks to prices). And the tails, as I often say, are almost entirely to the upside.
Famous Last Words?
So, Dr. Bernanke is riding off into the sunset. In an interview at the Brookings Institution, the "Buddha of Banking," as someone (probably himself) has dubbed the soon-to-be-former Chairman spoke with great confidence about how well everything, really, has gone so far and how he has no doubt this will continue in the future.
"The problem with Q.E.," he said, with more than a hint of a smile, "is that it works in practice, but it doesn't work in theory." "I don't think that's a concern and those who've been saying for the last five years that we're just on the brink of hyperinflation I would point them to this morning's C.P.I. number." ("Reflections by America's Buddha of Banking", NY Times)
Smug superiority and trashing of straw men aside, no one rational ever said we were on the "brink of hyperinflation," and in fact a fair number of economists these days say we're on the brink of deflation - certainly, far more than say that we're about to experience hyperinflation.
"He noted the Labor Department's report Thursday that overall consumer prices in December were up just 1.5% from a year earlier and core prices, which strip out volatile food and energy costs, were up 1.7%. The Fed aims for an annual inflation rate of 2%.
"Such readings, he said, 'suggest that inflation is just not really a significant risk of this policy.'" ("Bernanke Turns Focus to Financial Bubbles, Instability", Wall Street Journal )
And that's simply idiotic. It's simply ignorant to claim that the policy was a complete success when you haven't completed the round-trip on policy yet by unwinding what you have done. It's almost as stupid as saying you're "100 percent" confident that anything that is being done for the first time in history will work as you believe it will. And, of course, he said that once.
I will also note that if QE doesn't have anything to do with inflation, then why would it be deployed to stop deflation...which was one of the important purposes of QE, as discussed by Bernanke before he ever became Chairman ("Deflation: Making Sure "It" Doesn't Happen Here", 11/21/2002)? Does he know that we have an Internet and can find this stuff? And if QE is being deployed to stop deflation, doesn't that mean you think it causes inflation?
On inflation, Bernanke said, "I think we have plenty of tools to manage interest rates and tighten monetary policy even if (the Fed's) balance sheet stays where it is or gets bigger." ("Bernanke downplays cost of economic stimulus", USA Today)
No one has ever doubted that the Fed has plenty of tools, even though the efficacy of some of the historically-useful tools is in doubt because of the large balance of sterile excess reserves that stand between Fed action and the part of the money supply that matters. No, what is in question is whether they have the will to use those tools. The Fed deserves some small positive marks from beginning the taper under Bernanke's watch, although it has wussied out by saying it wasn't tightening (which, of course, it is). But the real question will not be answered for a while, and that is whether the FOMC has the stones to yank hard on the money supply chain when inflation and money velocity start heading higher.
It's not hard, politically, to ease. For every one person complaining about the long-run costs, there are ten who are basking in the short-run benefits. But tightening is the opposite. This is why the punch bowl analogy of William McChesney Martin (Fed Chairman from 1951 to 1970, and remembered fondly partly because he preceded Arthur Burns and Bill Miller, who both apparently really liked punch) is so apropos. It's no fun going the other way, and I don't think that a wide-open Fed that discourses in public, gives frequent interviews, and stands for magazine covers has any chance of standing firm against what will become raging public opinion in short order once they begin tightening. And then it will become very apparent why it was so much better when no one knew anything about the Fed.
The question of why the Fed would withdraw QE, if there was no inflationary side effect, was answered by Bernanke - which is good, because otherwise you'd really wonder why they want to retreat from a policy that only has salutatory effects.
"Bernanke said the only genuine risk of the Fed's bond-buying is the danger of asset bubbles as low interest rates drive investments to riskier holdings, such as stocks, real estate or junk bonds.But he added that he thinks stocks and other markets 'seem to be within historical ranges.'" (Ibid.)
I suppose this is technically true. If you include prior bubble periods, then today's equity market valuation is "within the historical range." However, if you exclude the 1999 equity market bubble, it is much harder to make that argument with a straight face, at least using traditional valuation metrics. I won't re-prosecute that case here.
So, this is perhaps Bernanke's last public appearance, we are told. I suspect that is only true until he begins the unseemly victory lap lecture circuit as Greenspan did, or signs on with a big asset management firm, as Greenspan also did. I am afraid that this, in fact, will not be the last we hear from the Buddha of Banking. We can only hope that he takes his new moniker to heart and takes a Buddhist vow of silence.
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