In the last month over 70% of all purchasing managers in this country are reporting price increases for everything they buy. They mean everything from aluminum, coal, corrugated containers, oil and natural gas, to fabricated steel. Natural gas prices, as shown in the chart below, have risen for over 20 months. May could become the 21st month. In addition to natural gas prices, the price of oil has hit a two-decade high with prices over $40 a barrel. The cost of fuel has risen so much that companies are now adding surcharges on a regular basis. Continental Airlines is increasing its fuel surcharge on cargo for the second time this year. Prices on freight have jumped from $.15 to $.20 per kilogram internationally or roughly $.07 to $.09 cents per pound. Both American Airlines and Northwest have matched Continental’s price increase. International carriers from Singapore Airlines, British Airways and Qantas are now adding ticket surcharges to already rising ticket prices.
In Jefferson, Virginia the 105-year-old Schweiger Furniture Company will finally close its door. In the early 70’s the furniture maker employed more than 1,000 workers. Today it has only 130 workers who will all get their pink slips this month. Rising energy, raw material, healthcare and labor costs make it difficult to compete with low-priced imports from China. Schweiger isn’t the only furniture company to go out of business. According to recent U.S. Labor Bureau stats, more than 15% of the nation's upholstered-furniture manufacturing jobs have been lost over the last four years. Rising raw material costs are causing companies to cut costs, which usually means reducing payrolls. If companies can’t raise prices to fully cover raw material and labor costs, they opt for reducing their workforce or move production overseas.
Rising raw material costs and inflationary pressures are making their way to Main Street with everyone from the shoeshine boy to the grocery store bagger keenly aware of inflation. In Seattle, Domino’s Pizza driver, Zivel Tsvi, complains that the cost of gasoline will end up costing him more than the 0 he paid for the Subaru he bought to make deliveries. Zivel complains that his gas costs keep rising, but tips from customers don’t.[1] The difference between flat tips and rising gas costs are cutting into Tvsi’s take-home pay.
Rising energy costs are working their way through the whole economy from trucking, shipping and airfares to cab drivers. Dennis Roberts, a Yellow Cab driver in Seattle, has had to pay more for weekly fuel. The price increase came in just one month. While the city of Seattle has authorized a 60-cent surcharge for fuel for drivers like Roberts, the surcharge falls short in covering rising fuel costs.[2] Like Zivel, the difference comes out of his take-home pay.
On Main Street everyone is keenly aware of inflation. You see it everyday when you open your monthly billing statements or shop at the grocery store. On Wednesday this week, the U.S. Labor Department reported a sharp rise in wholesale prices last month. They jumped by 0.7% in April. Wholesale price inflation is now running at an annual rate of over 8%. The core rate, which excludes essential costs such as food and energy, rose 0.2 percent, which was 1.5% higher than April of last year. The wholesale inflation numbers were much higher than forecast by economists, but the numbers were dismissed because of their food and energy component. The core rate of 0.2% was considered "acceptable," so economists aren’t worried that inflation is getting out of control just yet. I’m not sure Zivel Tsvi and Dennis Roberts would agree. To them the jump of 0.7% is a real cost of doing business. When the core rate rises, it reduces their income.
Pick up a newspaper, go to the grocery store, fill your tank with gasoline, look at your property tax bill, visit your doctor, or try to purchase a new home and you are faced with the grim reality of inflation. From cab fares to airfares, from department and grocery stores to filling stations, or a night at the movies, rising costs are all around us. Last weekend, while doing my grocery shopping, the grocery bagger, a high school sophomore, complained to me of the high costs of movies. He was making a little over an hour and the price of a movie ticket just jumped to .50. Popcorn, a small drink and candy cost him another . If he takes his girlfriend, it becomes a date. That’s a lot of money for someone who only makes an hour. He told me that unless it is a blockbuster movie, he now waits until the movie is released on DVD. If it's a blockbuster, such as this week’s release of “Troy,” he’ll go to a Saturday afternoon matinee, which costs .50, the price of a movie ticket three years ago.
The financial press seems surprised at the recent jump in inflation. Outside the usual stories and complaints over rising gas costs, no one seems to have noticed that we have been living with inflation for more than a century. The benign inflation rates of the 80’s and 90’s were only benign, if you looked at raw material costs. Inflation was evident elsewhere if you looked at financial assets and real estate. In Southern California the median cost of a middle class home has risen from a little over 0,000 to today’s middle 0,000. From an investor's point of view or most homeowners, this is seen as a bull market—not what it actually is which is inflation. One of the main reasons so many middle class families are struggling today is because of the high cost of taxes, housing and education. Life in the suburbs is expensive and so are taxes for two-income families. The social security tax base rises every single year, subjecting more of the average wage earner's salary to more taxes. Rising taxes are never factored into inflation costs. Most people just grin and bare it.
Yet the “cradle-to-grave” security blanket, which most voters demand, costs money. Politicians promise more security without any costs. However, they must take money away from producers in order to give more to those who only consume. Most citizens want to be able to consume more than they produce, so they keep voting into office politicians who promise more goodies at the expense of others. What these politicians can’t raise through taxes, they get through inflation. It hasn’t dawned on the non-producers and those wishing more benefits that inflation "taxes" them even more.
The poor and the middle class actually suffer more than the wealthy, because they are the least able to cope with inflation. If your food and gas bill just went up over 22%, you can’t walk into your boss' office and demand a 22% raise. So the poor and middle class get squeezed and adjust their lifestyles lower or take on more debt in order to live. The high cost of food is driving more shoppers away from traditional grocery stores over to discounters such as Costco and Sam’s Club. Shoppers are also opting for more store brands than name brands, which is not good news for brand franchises.
We're Paying for the Last Two Decades
Inflation is altering the way the economy and the investment markets work. As rapidly expanding bank reserves and the money supply rose under the Greenspan Fed and the dollar’s exchange value fell, it became more profitable to invest abroad and speculate than it did to invest in new plants and equipment. Businesses in the 80’s expanded by borrowing money and buying the competition. Acquisitions were financed with debt and companies were dismantled and stripped of assets to pay off acquisition costs. Real interest rates remained high because U.S. savings were inadequate to finance government, corporate and consumer debt. Consumption continued to climb, but increasingly it went to overseas producers. This gave us our large trade deficits, which forced foreign producers to recycle those dollars back into U.S. investments.
In the 90’s this process continued with the securities market playing a bigger role in the issuance of credit. We now had Wall Street firms packaging debt into securitized assets, which were then sold to yield-starved investors from pension funds to pensioners. Under a fiat system and the dollar standard, the U.S. was able to increase its consumption through international credit welfare. We bought more goods than we were able to produce through little effort. Fiat money gave us the ability to buy goods on credit from foreign producers in exchange for dollars. As long as foreigners are willing to extend credit, we are able to live a lifestyle that is beyond our means. As Americans, we buy their goods. They, in turn, buy up all of our assets. Essentially, we are now selling all of our seed corn in exchange for trinkets. It is similar to what went on in Manhattan more than 400 years ago.
The Transformation of Our Financial System
Debt to Deficit
At first as government deficits rose throughout the 80’s, governments and central bankers tried to rein in inflation by raising interest rates to restrain bank borrowing. A modest attempt was made to reduce government deficits and those deficits were increasingly financed through bonds sold to domestic and foreign investors. Using debt instead of monetizing assets transferred inflation to the securities markets. It transformed the global financial system away from traditional banking towards the capital markets. This transformation of the financial system enabled consumers, corporations, and governments to live well beyond their means. The U.S. economy and financial markets now ran on debt instead of savings and investment. Debt replaced savings and speculation replaced investment. The U.S. was able to get away with this only because it was willing to tolerate huge deficits in foreign trade. The increase in money and credit, which led to higher rates of consumption, never produced the higher rates of inflation that once plagued the economy and markets. This was due to the rise of our trade deficits. In a nutshell, our rising trade deficits replaced higher rates of domestic inflation. The large increase in worldwide manufacturing capacity—made possible through the export of dollars—gave us an abundance of foreign-made goods. Again, the catch to this whole process is the willingness of foreign producers to extend us credit and accept our paper dollars.
Reflating Our Way Out
The only problem to this whole scheme is that the huge debt burden that now weighs over the economy and financial markets could create a deflationary debt crisis that must be inflated away. Its only antidote is coordinated reflation by central banks of the world’s large developed economies. This is what we are now seeing. While Wall Street analysts point to the slowdown in the money supply, the proliferation of domestic credit channels outside the traditional monetary system creates even larger amounts of credit. The traditional linkage between credit expansion and money supply has been severed. Credit now runs rabid throughout the securities markets globally and especially here in the U.S. There hasn’t been a single year in which the money supply has contracted in the last half century. The belief that inflation is moderate and has been reduced through the efforts of central bankers is a fateful illusion. Inflation has simply gone through a metamorphosis from traditional standards of measure. Inflation is now firmly embedded into asset prices, institutions, businesses, and personal financial decisions. It shows up in the form of rental increases, labor contracts, leases, adjustable loans, and inflation-protected bonds.
Our Credit Neutron Bomb
This transformation of money and credit and the lack of understanding of what constitutes inflation (an increase in the supply of money and credit in relation to the supply of goods and services) have created a credit Frankenstein. The credit bubble has become so large that the only policy option now is a depression or hyperinflation. These two options are the only recourse to getting rid of too much debt. Hyperinflation makes the debt worthless, while a depression causes its liquidation. Given the horror in which governments and central bankers view deflation, hyperinflation is the more probable outcome. Alan Greenspan must lay awake each night ever fearful of his worst nightmare taking place, a derivative mishap, which is daisychain-linked between money center banks, brokerage firms, financial intermediaries, GSEs, and hedge funds. Derivatives, which are closely linked to all credit instruments, are the 0 trillion dollar neutron bomb that hovers over the world’s financial system. What will cause the bomb to detonate is anyone’s guess. It could be widening credit spreads, a large bond default, an unhedged position, a geopolitical event, or something as simple as a bad trade that turns illiquid through a liquidity trap. No one really has the answer to this one. However, the financial markets have become one large minefield. The more that it is traversed, the more likely a mine will be detonated.
Refusing to Cross Over
Investors Slow to Adapt
While consumers have been quick to recognize the inflation that now pervades their daily lives, as investors they have been slow to adapt to the new inflationary environment. Money still pours into bond funds, stock index funds, cash and other paper assets—albeit at a slower rate. Until recently selling pressure has been absent in the markets nor have rising energy prices translated into energy stocks becoming super bid. Despite gushing profits and oil, energy stocks remain grossly undervalued. Investors willingly pay 129 times earnings for Yahoo! and 68 times earnings to own NASDAQ stocks. They are unwilling to invest in energy at 10 times earnings with dividend yields of 3% or more. The market cap of the NASDAQ is .3 trillion.
Financial Institutions Slow to Adapt
Institutions have been no different. Devoid of any original thinking outside the box fund, managers relentlessly pursue tech stocks regardless of whether they are making money. Most funds have become closet index funds with fund managers holding the top 10 stocks in the S&P 500. That is why companies such as Microsoft, GE, Intel, IBM and Cisco carry such high multiples. Index funds must own and buy them. Fund managers pursue them in an effort to index the returns of their fund, while momentum investors continuously trade in and out of them. The table below shows most of the top S&P 500 companies trading at high multiples. It doesn’t matter whether you look at P/E multiples, price-to-book or price-to-sales or even market caps. With the exception of Exxon Mobil, they all remain dangerously overpriced.
All of this leads to the point of my essay: Investors have failed to cross over and adjust the asset allocation of their portfolios.
In an inflationary environment with oil and .50 natural gas, which of the above stocks would make the most money? Investors and fund managers haven’t connected the pieces of the inflationary puzzle together. In an imaginary poll, how would the typical fund manager or investor respond to an inflationary environment where the true rate of inflation is running between 8-10% given the following choices?
A. Money Market or Bond Fund
B. Certificate of Deposit paying 2%
C. S&P 500 Index Fund
D. Gold, Silver, Oil or other Commodities
E. Cisco
Most fund managers would buy Cisco, while the average investor would invest in an S&P 500 Index Fund, a bond fund, or certificate of deposit depending on age and risk tolerance. In fact, as already mentioned, most funds have become closet index funds. The last place you would find fund managers buying would be in the precious metals or commodity sector. Given the crash in the metals stocks recently, it has been shown that most mutual fund and hedge fund managers have been big sellers of precious metals or precious metal stocks. This explains a good deal of the rapid fall in the XAU and HUI as the funds unloaded their positions. Following the sector, I have noticed not only an increase in short selling, but also heavy selling by most mutual fund companies.
Like lemmings following the pigs to the slaughter, they have joined each other into the fray of selling. While they have unloaded their commodity-related stocks, the mutual fund companies have loaded up on big cap and small speculative stocks taking down their cash positions to near zero.
Fund managers want to believe in the recovery and that we are going back to the good old days. Their internal biases have blinded them from any objective analysis of the present inflationary environment. You still find funds loaded up on tech, financials, and cyclical stocks with sector weightings as high as 15-20%. It would be rare if you ever found a fund with 15-20% sector weightings in energy, precious metals, base metals, food, or other commodity-related companies. Everyone wants to believe in the illusion of the 90’s. Wall Street trumpets the increase in sales and earnings in the tech sector. Yet as High-Tech Strategist, Fred Hickey, points out in his May letter, most of IBM’s revenue growth didn't come from unit volume growth, but from currency gains from a lower dollar. Hickey further highlights the fact that in the technology world there is just too much capacity and supply. Hickey sums it up succinctly. “The bulls all believe they’re in a bull market, yet they’ve lost money in 2000, 2001, 2002 and 2004 to date. Something is very wrong and they haven’t figured it out yet. When they do, panic will ensue and the bear market will complete its unfinished work.“[3] Hickey expects the dollar to go lower, so he is buying more Newmont Mining and Pan American Silver. He also owns the short-term government bonds of Australia, New Zealand, and Canada.
The Gold Wars
At a time when the PPI and CPI are all heading higher, a time when gasoline prices are going up every week, when food prices are going up at an annual rate of 22%, oil is at .08 a barrel, soybeans are selling at 2.50, cocoa at 43, copper at 7.90, and wheat at 9.25, investors should begin to adjust their portfolios.
Allocating a portion of their investment portfolio to foreign commodity country bonds, energy, food, base metals and/or precious metals would be in order. Instead, investors have bought into the mindless drivel coming from Wall Street and the financial press that tells them inflation is benign and as long as the Fed raises rates slowly stocks will continue to do well. Numerous articles have appeared recently calling for the death of gold as an investment. According to the latest thinking among the herd, rising interest rates are bad for precious metals. I refer the reader to last week's chart of interest rates and gold prices from the 1970s. As those charts show, as interest rates rose, so did the price of gold. In fact the price of gold and silver rose in spectacular fashion. [See]
Instead of focusing on rapidly rising energy and other commodity prices, the financial press flippantly dismisses rising PPI and CPI reports by routinely stripping away and playing down the food and energy component. Don't you think analysts, anchors, reporters and fund managers have to drive to work, eat food, live in a home, and pay taxes? Let's assume they inhabit the same earth that you and I do. They should have noticed by now that the “macro environment is not characterized by low inflation or that independent-inflation targeting central banks are the norm or that financial risk is negligible.” Inflation is all around them in the form of asset bubbles in stocks, bonds, mortgages, real estate, and in rising commodity prices, especially energy. The financial environment is strung with risks. What else would you call 0 trillion in derivatives worldwide and a bond carry trade with the average participant leveraged 20:1? This isn’t just risk. It is financial insanity.
It's Time to Connect the Dots
Gold and silver represent money—the only money that isn’t another person’s liability. It has served as money for longer periods of time than any of today’s wallowing fiat currencies. To suggest that the inflationary environment is benign is explicitly illustrative of the financial press' ignorance when it comes to inflation. They simply aren’t connecting the dots between the price of things they have to buy in order to live and an expanding and runaway credit system. Nor are they helped in any fashion by the originators of today’s inflation, which springs from the expansion of credit from the financial system—whether through central banks and the affiliated banking system—through the financial markets. Our financial elites constantly throw out such mindless statistics that show inflation rates of l.7% year-over-year. Yet debt in this country has expanded by over trillion in the last six years! Investors can put it together when it comes to rising real estate prices, but they haven’t been able to connect the dots when it comes to precious metals or energy. They have made no connection to inflation, rising energy and metals prices and how that translates into rising profits for commodity producers. Instead, they buy Cisco.
The financial press, from the Financial Times to the New York Times and Money Magazine feature stories of how to invest during periods of rising interest rates. The word "inflation" hardly comes up since a rise in the inflation rate is considered to be temporary. What do they think the asset bubbles of the 80’s and 90’s were?
What I Expect to See
For the average investor, the true realization of inflation will have to be experienced first hand through deflating bubbles in the stock and bond markets and in real estate. What I expect to happen is that the Fed will try to raise interest rates, but I don’t believe they will get very far before the stock market and economy begin to roll over as the stock market is now doing. Then the real panic will begin to set in and we will see the central banks reverse course and begin to reinflate. More importantly, like Federal Reserve policy during the 70’s under then Fed chairman Arthur Burns, the Fed is targeting interest rates rather than the money supply. The markets will simply adapt, if they don’t blow up first. A 2% Federal Funds Rate does nothing to stop inflation. Curbing money and credit—by raising bank reserves and raising interest rates high enough where it becomes no longer profitable to borrow money to speculate—would curb financial credit and asset bubbles. The only problem with this kind of policy response is that the economy and the financial markets are far more geared than when Paul Volcker applied the breaks to credit and money in the late 70’s and early 80’s. The financial markets could not handle the stress on account of its leverage.
That is why history shows inflating one's way out of a credit bubble has been the preferred policy of choice from Roman emperors to Prime Ministers and American Presidents.
With debt levels this high, the only policy option is to inflate or die. The other alternative is a debt-cleansing depression. Instead of a benign macro environment as the financial press would suggest, I see a malignant tumor. All of its symptoms are listed below taken from my March 1st Market Observation “Collision Course.”
Seven Headwinds of Inflation
- Lax monetary policy
- Expanding government budgets
- Rapidly rising government deficits, 5% of GDP and growing
- A falling currency
- War and an expanding military budget
- Soaring oil and commodity prices (This time it's structural.)
- Protectionism
To the seven headwinds of inflation, I would add the structural fundamentals for gold and silver. [See Super Bull and Silver Catalyst]
Gold and Silver’s Bright Fundamentals
- Producer hedge book reductions and decline in central bank gold sales
- Reflation
- A declining U.S. dollar
- Increased investment demand and decreasing supply
- Low negative Interest rates
- Volatile geopolitical storms
- Resource scarcity
Ask Yourself...
As to the constant mantra echoed so often in the financial press that "gold is dead" or that "the macro environment is healthy" and that "central banks have inflation in check," I would ask the reader to take some time and think about it. What have you read or heard versus what you are experiencing firsthand? Do you find that you spend more money today for food and gas or utilities than you did a year ago? If you bought a home recently, has its price risen double-digits over the last few years? Are you paying more in social security, property taxes, and sales taxes this year? Are your healthcare premiums going up or down or by only 4.5% as the government now reports? Have your dentist, family physician, chiropractor, or psychiatrist raised the cost of an office visit? Did your investments keep pace with inflation in 2000, 2001, 2002, 2003, and 2004?
If you are experiencing inflation firsthand in the form of rising gas and utility bills, rising food bills, rising service costs, then why don’t you own gold, silver, oil or natural gas, foreign currencies or commodity-related investments? Taking this a step further, if you have owned them, do you still own them? If you sold, why did you sell? Was it because of price? Do you believe what you hear and read in the financial and mainstream media that inflation is low or benign?
A Financial Force 10?
In summary, I would like to end with a story from one my life's passions, which is sailing. On August 11, 1979 303 sailboats embarked on a 600-mile race from the Isle of Wight off the southwest coast of England to Fastnet Rock off the Irish coast and back. The race began with fine weather with weathermen forecasting ideal racing conditions. Those "ideal" racing conditions changed abruptly into a Force 10 storm with sixty to seventy knot winds and forty-foot seas. The storm sprang up so fast that it slammed into the sailing fleet with epic furry scarcely giving crews time to prepare. For almost an entire day forty-foot seas pummeled 2,500 sailors as they desperately tried to survive. By the time the storm was over, five sailboats had sunk and twenty-four crews had abandoned ship, resulting in the deaths of fifteen sailors. Rescue helicopters and lifeboats struggled to save all. They managed to rescue 136 sailors, but were too late for the unfortunate fifteen who didn’t make it. Of the 303 boats that started the race, only 85 crossed the finish line.
When an inquiry was made as to why so many sailors died, the results were surprising. Many boats did not have a barometer on board. The sailors responded that they relied strictly on weather forecasts. [Sounds like today’s investor listening to the financial media.] The Ocean Racing and Yachting Association making the inquiry came to the conclusion that this storm was something special. [Storms usually are special.] Most crews had sailed long distance races before, but very few had ever experienced a severe storm. [Today’s derivative models, which are not designed for Force 10 storms.]
Several crews, who abandoned their sailboats—believing that the risk of staying on board was much greater than getting into a much smaller lifeboat—made another fatal mistake. [Today’s investor dumping their gold and silver and putting their money in paper assets that deflate and sink.] The conclusion of the race committee was as follows, “In the 1979 race the sea showed that it can be a deadly enemy and that those who go to sea for pleasure must do so in full knowledge that they may encounter dangers of the highest order.”[4]
Storms at sea are no different than financial storms. Few investors have the experience to navigate them safely. Like the boats without barometers that relied strictly on weather forecasts, so too are today’s investors who listen to the constant sunshine forecasts coming out of Wall Street. Few have any life jackets and much less a lifeboat. Those who have had a lifeboat and abandoned their boat [gold and silver] will find themselves in a similar situation as those sailors who abandoned their sailboats. They will drift perilously in a sea of rising volatility without speed or directional control.
Like this 1979 storm, fair and sunny weather in the financial markets can quickly turn into a Force 10 storm. The financial barometer keeps dropping, but nobody is noticing. Volatility levels in the VIX and the VXN are near record levels indicating widespread investor complacency. Valuation metrics like P/E multiples, dividend yields, price-to-sales and price-to-book ratios are all at bubble-like levels, yet they are discarded. Credit and debt levels keep rising along with bubble prices in paper assets.
It is time to take precautionary measures. Today’s leveraged economy and financial markets, along with investor complacency, are just the type of conditions where storms suddenly appear. Make sure your safety harness is on, your lifeboat is nearby or you’re close to shore. The barometer keeps dropping, but investors are blindly unaware. The weather forecasts call for extended good weather. I say, "Man the lifeboats."
Chart Courtesy:
StockCharts.com, Grandfather Economic Report, Economagic, Yahoo!, and Alan Newman
References:
[1] Seattle Times, “How soaring gas prices affect everyday life.” May 12th, staff reporter
[2] Ibid.
[3] The High-Tech Strategist, May 2004, p.3.
[4] Rousmaniere, John, Fastnet Force 10: The Deadliest Storm in the History of Modern Sailing, W.W. Norton & Co., 2000, p. 263.
