The Message of the Fed Cleveland Median CPI

By: Henry To | Thu, Apr 27, 2006
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Dear Subscribers,

Please note that our discount period for first-time subscriptions ends on April 30th. If you think any of your friends or associates could benefit from our commentaries, please feel free to forward this latest commentary to them and ask them to subscribe. The first six months of our subscription period have been very smooth indeed (from an operational standpoint, not necessarily from a market standpoint!) and both Rex and I appreciate all the helpful suggestions and contributions to the MarketThoughts "family" thus far. Please keep up the great feedback and posts in our discussion forum!

Note that a press release from us went out on Friday stating our position on the U.S. long bond.

Speaking of feedback and suggestions, I want to clarify what I had written in our mid-week commentary regarding our request for readers to send in their "picks and pans." Readers who are interested should send in a pick complete with a "big picture" analysis of why a particular stock or industry is a good (or bad) pick. Please also disclose any positions that you may have in the stock or industry. I would like to see both a "bull's argument" and a "bear's argument" about the stock. Detailed financial analysis is not required but I would definitely like to see some demonstrated knowledge that you have at least read the latest 10-K and the 10-Q. Picks can be based on valuation (and the belief that the firm's profits can be sustained going forward) or growth - but please, no momentum plays or penny/bulletin board stocks. Going forward, I will attempt to publish a subscriber's pick (or pan) at least once a month - complete with my own analysis and feedback. This way, we can learn more from each other - which is essential since we have many readers working across many industries (and countries). As they say, "no one has a complete monopoly" on knowledge - and ultimately, forcing yourself to put down your thoughts in writing is the best way to learn.

Ever since we began seriously authoring this website in August 2004, we have had to deal with a lot of opposing views. Early on in our commentaries, many of the disagreements had occurred while we were bullish. And prior to our transition to a subscription model, we would literally receive flame mails (usually telling us how dumb we were to be bullish since the markets were about to crash) right at turning points. Today, this is no longer the case, as generally our subscribers tend to be a much more sophisticated bunch. Moreover, over the last few months, one could definitely have detected a sizable shift in sentiment - as many folks have since turned long-term bullish and no longer believe in the thesis of a secular bear market. Historically, the markets tend to correct in a huge way once the Fed is done with its series of rate hikes. The lone exception is the 1994 to 1995 rate hike scenario - when the market really took off after the Fed was done with hiking rates. But even during that relatively "bullish rate hike campaign," the markets experienced many significant corrections during that period - and retail investor sentiment were pitch black during most of 1994 (as opposed to the bullish sentiment we are currently experiencing). Therefore, history tells us that we will experience a significant correction in the market sooner or later - most probably once the Fed is done with its serious of rate hikes.

We switched from a 25% short position to a neutral position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,347.45), this position is 474.45 points in the red. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 - giving us a gain of 89 points. We subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. We had been trying to get rid of this latest 25% short position over the last couple of weeks. We had opted to wait for a more oversold condition before covering it - but it was not to be, as the Dow Industrials rallied a whopping 194.99 points last Tuesday (partly because of the March 28th Fed minutes released in the early afternoon). Again, we are now 75% short in our DJIA Timing System.

As of this point, we do not anticipate changing our positions in our DJIA Timing System anytime soon. In last weekend's commentary, we mentioned that many of our "ultra short-term technical indicators" were getting significantly oversold. Since then, they have become overbought once again. However, there are no potential triggers for a reversal in the near-time horizon - even as liquidity continues to decline and even as commodity prices are blowing off to the stratosphere. Should the market make a new cycle high right before the May 10th Fed meeting, there is a strong likelihood that the market will sell off right after the Fed meeting. Again, we will let our readers know on a real-time basis once we have decided to make changes to our positions in our DJIA Timing System. We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: "A Change in our DJIA Timing System").

So much for all the recent GM bashing - I bet many of our subscribers are getting sick of it now. So readers may find this a bit refreshing: For the year end 2005, the GM pension plan actually managed a return of approximately 13%, compared to a total (capital appreciation plus dividend yield) return of 4.9% in the S&P 500. According to Fortune Magazine, this translates to a return of $10.9 billion - or approximately the amount of money that the company lost last year in their operations. Starting in 2003, the company's pension plan became significantly more aggressive - by first borrowing $14 billion for the pension fund and then radically changing their investment policy by investing a "big chunk of new money [in] hedge funds and other alpha-chasing vehicles, such as emerging-market securities, private-equity firms, junk-bond portfolios, and derivatives." Multiply this same strategy around the country's pension funds and individual 401(k) accounts and you get a world where international and emerging market inflows are at record highs and where commodity prices are blowing off. Okay, readers should now know that I am always a worrier at heart - so what happens once these markets top? Answer: There is no way a pension fund as big as GM's can get out in time.

Let's now backtrack and discuss a little bit on what we discussed in our mid-week commentary. In that commentary, I stated: "Let's now get back to the March 28th Fed minutes and discuss the potential implications. By far the three sentences that most of Wall Street focused on were the following: "Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy. However, members also recognized that in current circumstances, checking upside risks to inflation was important to sustaining good economic performance. The need for further policy firming would be determined by the implications of incoming information for future activity and inflation." Right after the release of the Fed minutes on Tuesday, the odds (as determined by the Fed Funds futures traders) of a further June rate hike to 5.25% immediately dropped from 54% to as low as 30%. The market immediately began to build on its morning rally, with the Dow Industrials closing up 194.99 points for the day. A Fed friendly environment will obviously lend a hand to "cash flow negative" assets such as commodities, and surely, the metals did not disappoint - with gold, silver, copper, and aluminum closing at their highs for the day and mostly building on those highs on Wednesday."

I also stated that while the metals are not as important as crude oil or natural gas when it comes to gauging potential inflationary pressures, they are definitely a reflection of the speculation that is currently occuring in the commodity markets. By far the most important commodities to watch, however, are (in this order) crude oil prices, natural gas prices, and steel prices. Readers should note that many steel companies will be reporting quarterly earnings this week, and you can bet that not only Wall Street analysts will be watching their projections, but that the Federal Reserve governors will be watching as well. Also, as the Fed had pointed out, there is a significant amount of anecdotal information suggesting that rising commodity prices are finally being passed on consumers, such as airlines hiking ticket prices because of high gasoline prices (effectively for the first time since 9/11), rising rental costs, and so forth. Given that the labor market remains very tight - and combined with decreasing productivity, the chances of a further rate hike beyond May 10th still remains high, in this author's opinion.

As I have mentioned before, it is this author's opinion that the Fed won't stop hiking (in the absence of an adverse aggregate supply shock) until 1) commodity prices decline substantially; 2) the Dow Industrials and the S&P 500 decline 10% to 15% from current levels, or 3) the current account deficit of the U.S. shrinks substantially.

So far, we have had none of this - but eventually, monetary policy will work - and both the stock and commodity markets will need to endure a substantial correction. Sure, the easy monetary policy of the Bank of Japan has clouded the situation a little bit - but even the Bank of Japan is now taking off their foot off the accelerator for the first time in a long time. Monetary policy has always worked - albeit with a 12 to 18-month lag. Remember how many commentators were remarking that the Fed was "pushing on a string" in 2002? Well, both the stock and commodity markets have never looked back since. Again, folks who are currently long the energies or the metals are now fighting against the Fed - and while the Fed was prepared to halt its series of rate hikes (as they had indicated in the March 28th minutes), it is difficult to imagine that the same Fed governors could even dare to stop the Fed's rate hike campaign today, given the huge outperformance of the energies and the metals subsequent to that meeting, as shown in the following daily chart:

Performance of Selected Metal Prices Since Last Fed Meeting (March 28, 2006 Base = 100)

Even natural gas - the laggard among the metals and energies - is up nearly 7% since the close on March 28th. Crude oil is up over 11%, and copper, zinc, and silver have just gone through the roof. More importantly, there are no good low-priced substitutes for any of these commodities. Sure, one can use plastic pipes in place of copper pipes, but given that crude oil and natural gas prices are still rising, it is difficult to see how the price of plastics cannot go up as well. Unless the U.S. can ramp up her nuclear power plant construction or commercialize the production of carbon nanotubes in the next couple of months, this author believes that the chance of more Fed rate hikes beyond the May 10th meeting is high.

Please note that many of the "anecdotal inflation pass-through" are now being captured by the CPI data as well - as the latest CPI-U data for March from the Bureau of Labor Statistics surprised on the upside (mostly due to "shelter" and "transportation"). More importantly, the latest "median CPI" data released by the Federal Reserve Bank of Cleveland also surprised on the upside, as the annualized latest month-to-month change in the Cleveland Median CPI hit 5.0% - the highest in over 11 years.

So Henry, what is the Cleveland Median CPI? And why is it important?

Let's first try to answer that first question. As the title suggests, the Cleveland Median CPI is an inflation indicator which attempts to measure the price change of the middle observation of the goods and services that are contained in the CPI-U basket. Quoting from the Cleveland Fed: "In effect, the median consumer price change is the CPI less everything but the price change that lies in the middle of the continuum. Since only the order, not the values, of the various price changes is used in its calculation, the median is a central tendency statistic that is largely independent of the data's distribution. The median also has the intuitively appealing property of lying close to the majority of price changes than does any alternative measure."

The Cleveland Fed claims measurements such as the Consumer Price Index measures "only" the "average price of an array of goods and services purchased by households, but because it is constructed as a weighted mean of all consumer prices, it does not discriminate between relative price changes and inflation. Indeed, the CPI may rise when the price of just one commodity increases." The Cleveland Fed claims that the traditional CPI may not be a good measurement tool of inflation, as "an increase in one price relative to others is the signal that directs resources and rations consumption [in other words, this does not take into account the "substitution effect" by consumers that can ultimately depress prices of the good that has gone up]." Meanwhile, inflation is "a monetary phenomenon that determines the underlying level of all price changes; it has virtually nothing to do with the transmission of market information. Indeed, one fundamental problem with inflation is that it can be confused with relative price movements, obscuring the transmission of market information and reducing market efficiency."

That is, the Cleveland Fed claims that certain non-monetary events can "at least temporarily, distort reported inflation statistics … during periods of bad weather, for example, food prices may rise to reflect decreased supply, producing transitory increases in the CPI. But since these prices do not constitute monetary inflation, monetary policymakers may want to avoid including them in their decision-making." In his book, "Inflation Targeting," current Fed Chairman Ben Bernanke outlines precisely such a scenario (one that will involve the Fed stopping or even easing as opposed to hiking). I will repeat the relevant quote from our last commentary: "In general, there is no conflict between output and inflation stabilization when the precipitating shock is an unexpected change in aggregate spending; using monetary policy to offset an aggregate demand shock is nearly always the correct response. However, an aggregate supply shock, such as a sharp increase in oil prices, may cause a conflict between stablizing output and employment in the short run and stablizing inflation in the long run. Targeting a price index that excludes the first-round effects of common supply shocks can, as we have seen, ameliorate this conflict to some degree. But a supply shock that is great enough, or that arises from some unanticipated source, may justify missing or changing a previously announced inflation target." The Cleveland Fed claims that such an evaluation can be done more precisely by using the median CPI, as opposed to the currently-popular method of the "core CPI" - which is basically the CPI excluding food and energy (together, they constitute more than 25% of the CPI). Says the Cleveland Fed: "One commonly used technique for measuring underlying or core inflation is to exclude certain prices in the computation of the index, based on the assumption that these prices are the ones with "high-noise" components. This is the rationale behind the commonly reported CPI excluding food and energy data. However, economists Michael Bryan and Stephen Cecchetti have found a measure that forecasts inflation better than either the CPI excluding food and energy or the all items CPI: a weighted median of the CPI."

Put more simply, the Cleveland Fed claims that Bernanke can do a better job of evaluating such "supply shocks" by looking at the readings of the Cleveland Median CPI than solely relying on anecdotal information. Now that we have settled this issue, what is the Cleveland Median CPI saying now? In brief, the latest month-to-month change reading does not look good - as the annualized monthly increase in the Cleveland CPI hit an 11-year high of 5%. Following is a monthly chart showing the month-to-month changes in the Cleveland Median CPI (annualized) vs. the effective Fed Funds rate from January 1990 to March 2006:

The Cleveland Fed Median CPI vs. Effective Fed Funds Rate (January 1990 to March 2006) - 1) Persistently high inflation during 1990 - but the country was already mired in a recession at the point - not to mention that the oil spike in 1990 could have only been viewed as temporary. In retrospect, the Fed made the right policy move in cutting the Fed Funds rate. 2) The Fed started cutting rates in January 2001 - even as the median CPI remained relatively high. At the point, however, the bursting of the tech bubble was already well underway, and the country was sliding slowly into recession... 3) Will history repeat itself? That is, will the Fed stop hiking even though the Cleveland Median CPI just made an 11-year high? It is difficult to think Bernanke will do so - unless the Housing Bubble pops in a big way.

On inspecting the above chart, one can certainly make the claim that the Fed had already paused and even started easing the last time the Cleveland Median CPI hit multi-month highs (such as during January 1991 or during 2001). However, readers should note that the spikes during 1990/1991 and 2000/2001 all occurred while the economy were slowing down and drifting into recession (which were associated with both a declining stock market and a declining commodity market). Today, the economy is still going strong - with the latest ECRI Weekly Leading Index readings (the annual rate-of-change is now at 3.0%) turning up and with both the Dow Industrials and the commodity markets hitting multi-month (and even multi-year) highs. Moreover, the new Bernanke Fed has come out and stated their position on focusing on an "inflation target" as opposed to the Greenspan Fed - who focused on both maintaining strong economic growth and maintaining a reasonable inflation number. Certainly the Fed cannot merely stop with another quarter-point rate hike by May 10th - unless the stock and commodity markets crash between now and the June 28th meeting (the next Fed meeting after the May 10th meeting).

The wild card, of course, is U.S. housing, and while there are already signs of a housing market slowdown in parts of the country (combined with a slowdown in refinancings and mortgage equity withdrawals), we haven't seen an across-the-board slowdown at this point - even as the yield of 30-year Treasuries has risen substantially in the last six months. The lack of an across-the-board slowdown thus far is being reflected in the lack of a significant correction in our MarketThoughts U.S. HomeBuilders' Index - which is essentially an equal-weighted index comprising of the five largest homebuilders in the U.S. (KBH, PHM, LEN, CTX, and DHI):

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Henry To

Author: Henry To

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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