Weekly Wrap-up: Don't Poo-Poo the Inversion
The following article was first published at The Agile Trader on Sunday, February 18, 2007.
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This coming week the weightiest economic report that prints will be the Consumer Price Index on Wednesday at 8:30 am EST.
While many argue that this is a flawed indicator (some claim it understates inflation and others claim it overstates inflation), it does generate heated debate and can act as a catalyst for stock-market activity. In the context of Fed Chairman Bernanke's relatively dovish comments before both houses of Congress last week, a surprise on the CPI data could easily spur market volatility this coming week.
Currently the consensus estimate is for a +0.1% M/M on the CPI, which is below trend, and would be bullish for stocks. The most recent Y/Y reading stands at +2.61%...
...as does the latest Core CPI number.
For those who are skeptical of the veracity of the CPI series and would rather rely on some of the newer research on the subject, such as the Cleveland Fed's Median CPI and the Trimmed Mean CPI, Here's a chart going back to 1990 that plots CPI, Core CPI, and the two newer versions against one another.
What can we say about each of these series? Well, the CPI (red) is awfully spiky and erratic. But this we know. That's why the Fed looks at the Core CPI (royal blue).
The Core CPI and the Trimmed Mean CPI (light blue) appear to track one another quite closely.
And the Median CPI (black) seems to be off on its own trip at times, bulging higher and floating above the others now and again when it does not look like a good forecaster of the future trend.
As a measure of the relative lack of forecasting prowess held by the Median CPI, let's do a little thought experiment. The last time the black line bulged higher above the other 3, in 2001, do we think that the Fed should have tightened rates?
If the Fed has listened to the inflation signals from the black line at that point they would held rates steady or else raised them, and a severe recession (or depression) would have ensued. The black line would have been both a) a poor forecasting tool and b) a terrible policy guide.
The aggregation of the other 3 lines on the chart at or below +2.6% looks to be a much better measure of where the trend in inflation is at present. Moreover the PCE Deflator (most recently at +2.3% Y/Y--not shown), the Core PCE Deflator (+2.2% Y/Y -- also not shown), and theDallas Fed's Trimmed Mean PCE inflation rate (+2.5% Y/Y -- also not shown), further confirm the rate of the trend, with 6-month annualized Trimmed PCE inflation at +2.1% and the 3-month annualized rate at +2.0%.
Still further, the Treasury Inflation Protected Securities (TIPS) market appears to be essentially in agreement with the lion's share of these other inflation metrics.
In terms of inflation expectations over the coming 5 years, the TIPS market is pricing in a Breakeven Inflation Rate (blue line below) of +2.32%, compared to +2.4% at the beginning of the month and +2.64% last August. (If we use the Cleveland Fed's method of adjustments for liquidity and other factors, the figure may be below +2.2%)
Meanwhile that same TIPS market is generating a Real Yield (something very close to expected Real GDP) of +2.36%, down from +2.63% last October.
So, while inflation expectations, which had been creeping up in the latter half of January, have more recently begun to drop down again, so too have expectations for economic growth, as recent economic data has suggested that the strong GDP data from 4Q06 (+3.4% annualized real growth) will be revised downward, perhaps as much as by -1%.
Lower inflation? Good for stocks. Slower economic growth...not so much.
In line with deteriorating expectations for economic growth has been the consensus estimate for Forward 52- Week Earnings per Share (F52W EPS) on the SPX (blue line below).
Over the past 4 weeks the blue line has fallen by more than $1 from $96.54 to $95.49, which drops the consensus for Forward Earnings growth relative to Trailing Earnings to a trend-like +7.8%, down from 11.2% last October.
The good news for the economy continues to be that the deceleration in earnings seems to be largely predicated on diminishing profits in the Energy sector.
Since the end of September almost $5 has been lopped off the consensus for F52W EPS in the Energy patch while the trend has remained above the waterline for all other 9 sectors in the SPX.
While the consensus for forward earnings growth is decelerating for the SPX in aggregate, (black dotted line below), only Energy (yellow) is below 0%.
We continue to see some wobbliness in forecasts for earnings growth in Information Technology as well as in Industrials, Utilities, and Consumer Discretionaries, but despite the most recent volatility in expectations the overall growth picture for Telecom Services, Info Tech, and Health Care look especially positive.
If there's a recent development that's cause for concern in my mind it's the steepening of the inversion of the yield curve. That is, bond investors have bid up prices again, dropping the 10-Yr Treasury Yield (TNX) down to 4.69%. Meanwhile the Effective Fed Funds Rate is at 5.29%. So, the yield curve is -0.60%.
Bond investors are willing to settle for paltry yields, which suggests that the prospects for nominal GDP growth have fallen back again.
Remember, my bullish forecast for 2007 is built on long-term bond yields tending to rise throughout the year as investors discount accelerating nominal GDP growth. So, if the yield curve continues to steepen its inversion, then we may have to back away from some of our bullishness and begin discounting a rockier (rather than soft) landing.
I suspect that in the context of an inverted yield curve (and especially of a steepening inversion) the market's PE is unlikely to continue to expand as it has since last summer. Note that since '03 there has been a strong correlation between the sinking market PE and the flattening (and then inverting) yield curve. At present PE is rising as the trend in the yield curve resists doing likewise. I continue to suspect that that divergence is unsustainable.
Unless the bond market starts discounting accelerating economic growth I suspect that the "cap" on PE will be not too far above where it is now.
Earnings estimates are falling. The market is discounting higher valuation on what is likely to be a decelerating revenue stream. Low inflation helps by lowering the rate at which future earnings are discounted. But low inflation can only help so much. At some point decelerating growth will be interpreted negatively rather than as just a function of diminshing inflation.
The temptation exists to poo-poo the inversion of the Yield Curve as "different this time." But at some point in the not-too-distant future bond and stock investors are probably going to have to come to some sort of closer agreement about what the prospects indeed are for the economy. A condition in which the bond market is discounting +2.36% real GDP and in which the stock market is discounting earnings growth that's a 3.3 times greater...well, that's very likely unsustainable.
The time is right for the market to "take stock" of these factors.
Best regards and good trading!