Today’s update on consumer price inflation brings good news for the trend in February, and not a moment too soon. CPI was unchanged last month, the Bureau of Labor Statistics reports. That’s a sharp deceleration from recent months.
“On a seasonally adjusted basis, the CPI-U was virtually unchanged in
February, following a 0.4 percent rise in January,” according to the Bureau’s press release. “Each of the three groups–food, energy, and all items less food and energy–contributed to the deceleration.”
Now begins the debate over whether the welcome news marks the end of the recent surge in pricing pressures that have been bubbling for the past year or so. It’s tempting to think that the inflation scare has passed and that it was all just normal CPI volatility within a range. Anything’s possible, of course, but we’re skeptical that it’s safe to ignore inflation risk from here on out. Still, one can’t fully discount the possibility that the pricing fires are cooling, if only temporarily. As always, only time will tell, leaving earthlings with the thankless task of speculating with incomplete information.
Ideally, our speculations are rooted at least partly in a sound reading of the data and a respect for market history. Even so, that leaves plenty of room for error, which is why our default position is always staying diversified, in varying degrees over time, in the primary asset classes.
To the extent that inflation factors into our strategic asset allocation, we remain suspicious that the danger has passed. Our skepticism begins with the old saw that one month a trend does not make. In any one period, the possibility for statistical noise is high–and that’s true for any data series. One can partially minimize the noise by looking at longer measures of change over time. By that standard, it’s hard to ignore CPI’s annual rate of change that, even with February’s flatlining, is still running above 4%. Although that’s down slightly from the recent past, a 4%-plus inflation pace is hardly benign.
Notably, it’s the general trend that offends. As our chart below reminds, the sharp rise in the annual change of CPI of late is at the core of our worries. Plotting the linear trend (as per the chart’s black line) reminds that pricing pressures have been on the rise for some time. Inflation in absolute measures still remains modest by historical standards, but we should remember that small brush fires can turn into something more if left unattended.

But if headline CPI offers compelling evidence to stay wary on inflation’s upside potential, the trend is more favorable if we restrict our analysis to core CPI, which excludes food and energy prices. Why would we do that? For starters, that’s the Fed’s preferred measure of inflation and, to be fair, the preference enjoys some historical rationale. The case for using core inflation as a benchmark for monetary policy boils down to the fact that in the past, core has been a superior predictor of future inflation than headline. That’s because food and energy prices were more volatile than the other components and so by looking at core one saw a clear, less statistically noisy inflation trend. In other words, prices bounced around a lot but over, say, five years they didn’t usually change much. The proof is that in the past, core and headline inflation have generally converged over time.

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There are at least two more reasons to worry and wonder about the future, judging by today’s data updates. Import prices and retail sales provide fresh incentives to stay cautious.
Let’s start with import prices, which are now rising by 13.6% a year as of last month, the U.S. Bureau of Labor Statistics reports. That’s sky high by recent standards, as our chart below shows. Energy imports are, of course, driving the trend, although non-petroleum import prices are also rising at a robust pace of 4.5% over the past year. By comparison, U.S. consumer prices rose by 4.3% for the year through January. Any way you slice it, the United States is importing inflation, adding momentum to the domestic inflationary fires already smoldering.

Meanwhile, retail sales took a hit last month, according to the U.S. Census Bureau, falling 0.6% in February. That’s the steepest monthly decline since last June. More worrisome is the longer-term trend. As our second chart below illustrates, year-over-year retail sales continue slipping, as they have been for the past two years.

From a price stability perspective, lowering interest rates looks irresponsible at this point. With inflationary pressures bubbling, printing more money will only add fuel to the trend. Indeed, the dollar continues to weaken, which is helping pump up import prices. If the Fed continues to cut interest rates, the buck may plumb even lower depths. The U.S. Dollar Index is already at all-time lows, and no one should discount the possibility that more selling awaits.
But what’s irresponsible from the perspective of monetary policy may look necessary from another vantage. The Fed is under growing political pressure to inject more liquidity into the economy and slow the slowdown. It remains to be seen how effective the central bank’s tools are for the task at hand. Meanwhile, the market expects lower rates: the May ’08 Fed funds futures contract is priced in anticipation of a 100-basis-point drop in Fed funds.

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Yesterday’s powerful rise in the stock market offers an easy target for rationalizing that the five-month-old correction in equities is over. Perhaps, but your editor is suspicious.
Yes, there’s no getting around the fact that yesterday’s 3.7% jump in the S&P 500 is one of the better daily gains on record. But the human mind is too easily influenced by the most recent events while minimizing older trends. For our money, the older trends are still in force, which is to say that all the obvious threats to a sunny outlook for stock prices still apply: Higher energy prices, continuing fallout from real estate, the accumulating evidence of an economic slowdown or worse, and so on. All of these items, and more, threaten to weigh on the stock market in the weeks and months ahead. One more Fed decision intent on liquefying the otherwise gummed-up credit market doesn’t materially change much for this writer’s intermediate term outlook.
Yes, the Fed’s accumulating actions will eventually be a contributing factor that turns the strategic sentiment to positive. But the idea that this moment arrived yesterday afternoon looks slightly premature.
That’s only a guess, of course, and so the new bull market may be underway as we write. The S&P 500 was off roughly 15% as of yesterday’s intraday low from the all-time high set last October. That’s hardly trivial. But considering the context of the last several months, one can reason that the selling is driven by the fundamental deterioration in general economic conditions. If so, the central question is whether those deteriorating conditions have ended or are about to end in the near future? On both counts, our forecast is “no.”
Again, we have no way of knowing for sure and so one shouldn’t fully discount the possibility that the stock market’s headed for higher ground. In fact, there’s an inherent danger in assuming that economic cycles and stock market cycles align in real time. In fact, they very definitely do not. That’s an important caveat to keep in mind in the months ahead. The risk of being early or late is forever present in timing the bottom, which convinces us to diversify strategic and tactical bets over time as a tool for grabbing the opportunities that corrections inevitably offer while keeping risk at bay.

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Markets correct, valuations become more attractive and expected returns rise. It’s no short cut to quick riches, but paying attention to valuation offers strategic-minded investors the opportunity to improve risk-adjusted returns compared to simply buying and holding.
Savvy investors have long preached no less. Graham and Dodd’s Security Analysis is the bible for analyzing securities in search of market prices trading at less than intrinsic value. The academic literature has increasingly come around to this perspective over the past 20 years as well. Buying low and selling high, in short, boasts support from both practitioners and academics. What works for individual securities looks no less appealing for broader measures of equities and asset classes too.
The devil, of course, is in the details. While it’s easy to argue that buying low and selling high is the only way to fly, there’s the perennial problem of timing. The mere arrival of higher-than-average dividend yields, or lower-than-average p/e ratios is hardly the investment equivalent of blasting the all-clear signal. Stocks can get cheaper for longer than a sunny optimist assumes. That doesn’t mean we should ignore valuation; rather, we must understand the potential risks as well as rewards that come with shopping for value.
With that in mind, we present a brief history of trailing dividend yields for equity markets in the developed world as of last month’s close. As the chart below shows, valuations look relatively more attractive today compared with the past two years. Europe is particularly alluring compared with the U.S., according to S&P/Citigroup Global Equity Indices.
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Meanwhile, our second graph below shows that forecasts of p/e ratios for the fiscal year ahead also compare favorably these days relative to the recent past. Europe is also out on front on this metric: its forward p/e dropped to 11.4 as of February’s close–the lowest since at least the mid-1990s. (Asia Pacific developed p/e ratios were left out of the second chart because of the absurdly high valuations of a few years back due to Japan. As a result, a graphic comparison between Asia Pacific developed and other regions is difficult. In any case, recent trends in Asia Pacific developed forward p/es reflect falling ratios elsewhere in the world. At the end of last month, Asia Pacific developed’s forward p/e was 14.2, down from the mid- to high-teens of the past 24 months and currently just slightly above the U.S. forward p/e of 13.9.)
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What does it all mean? For starters, equities are becoming relatively more attractive. Of course, they may get even more attractive, which is to say the correction may roll on. We don’t know for sure, and neither does any one else. As such, caveat emptor. That said, rest assured that what was overpriced is, for the moment, moving towards being fairly priced and, perhaps, that will lead to inexpensive pricing. The process is underway as we speak, although where it stops, nobody knows.

There’s more than a week to go before the Fed’s next scheduled FOMC meeting on March 18, but judging by the February employment report released this morning the odds of another rate cut look virtually assured.
Payroll employment slumped by 63,000 last month, the Labor Department reported today. That’s the second monthly decline and the steepest in nearly five years. Perhaps the economy’s capacity for minting new jobs is set to rebound, but it doesn’t look that way. As our chart below suggests, cyclical downturns have been known to run for a while, suggesting that at this moment it’s premature to think that the economy has now purged itself of excess.

Yes, the previous downturn was extraordinary in some ways and so perhaps the recent past isn’t necessarily prologue this time around. The hope is that the current slump will be short and mild, but as always there’s no guarantee. In fact, there are more than a few reasons to think that we may be in store for something more than a brief rough patch. For example, mortgage foreclosures jumped to an all-time high at last year’s close, the Mortgage Bankers Association reported yesterday. Meanwhile, home equity dropped under 50% for the first time since World War II in last year’s fourth quarter, according to the Federal Reserve.

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It’s said that investors learn more from their mistakes than their successes. If so, most of us are a lot wiser today compared with a year ago. If so, much of the progress in controlling cognitive bias relates to understanding risk. Such insight doesn’t come easy, nor does it insure success in the future although we’re confident that ignorance of risk eventually leads to failure.
With that in mind, consider a recently published essay by Malcolm Knight, general manager of the Bank for International Settlements. In a speech late last month, given at the Ninth Annual Risk Management Convention and Exhibition of the Global Association of Risk Professionals, he discussed what he sees as the major surprises and non-surprises that have defined much of market activity since roughly mid-2007. Perspective is no short cut to profits, but a healthy dose of historical context may save us from grief later on.
An excerpt from Malcom Knight’s Feb. 26, 2008 lecture on risk:
Some of these problems could have been foreseen, and indeed some observers had expressed strong warnings well before the turmoil. Which developments should not have come as a surprise? And what has been genuinely surprising? Let me highlight three non-surprises and three surprises.
The first non-surprise was the sharp repricing of risk that began in the middle of last year. The signs of an underpricing of risk had not been hard to discern beforehand. A month before the turmoil, we issued our BIS Annual Report for 2007 and repeated our grave concerns about the build-up of financial imbalances and their potential disorderly unwinding. Admittedly, it was impossible to predict the timing of the repricing. But the likelihood that it would occur was not. Indeed, in one respect the fact that it did occur is actually welcome: had the underpricing continued, the eventual adjustment would have been worse.

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Forex is hot, your editor observes in the March issue of Wealth Manager, and for all the obvious reasons, starting with the fact that the formerly mighty dollar has come under the attack of the bears these past few years. No wonder, then, that a rising number of investment strategists in the U.S. see currencies generally as a separate and distinct asset class. It all looks good on paper, but does treating forex as one more choice in asset allocation plans stand up to reason in practice? Exploring the question is the subject du jour, and you can find a full serving here….

The power of diversifying across asset classes has rarely been more convincing than it was last month. Perhaps even more notable is the fact that the winners and losers of late are beginning to reflect the longer term trend.
Consider the table below, which ranks February’s total return among the major asset classes. Commodities were the top peformer, surging more than 12% last month. In fact, raw materials were in the lead for the past 12 months. At the bottom of the rankings: REITs, the big loser for February and for the past year too.

No one knows when the correction will end, but it’s worth reminding that the division between bull and bear markets across asset classes is nearly evenly divided. Recognizing that momentum doesn’t last forever (because it inevitably gives way to the value factor, and then vice versa) has us thinking about the next big shift in strategic portfolio design and how we might take advantage.
For now, momentum has the upper hand, which is to say the winners keep winning and the losers keep losing. For now….

On the surface, consumer spending appears to be holding up, and surprisingly well, considering the barrage of discouraging economic and financial trends harassing the waking hours of our hero, Joe Sixpack, of late.
This morning’s update on personal income and spending in January reveals that personal consumption expendtires rose 0.4% last month, up slightly from December’s 0.3%. That’s about average if we look at the past two years of monthly PCE spending patterns. If we leave it there, we can say that Joe’s spending habits haven’t changed much, at least in nominal terms. Extending the thought, perhaps worries of recession are excessive. Consumer spending, after all, represents 70% or so of GDP; if Joe’s still pulling out his wallet as always, the odds of a deep and/or lasting economic stumble may be overbaked.
But as regular readers of this site are all too aware, we’re never willing to “leave it there.” Obsessed with the idea that there may be a more granular truth lurking in the numbers, we push on, wondering if we’ve missed something in the 30,000-foot survey.
On that note, let’s dive a bit deeper into today’s spending update by noting that the 0.4% rise in PCE last month all but evaporates when we adjust for inflation. Real PCE spending was unchanged (based on rounding to one decimal point) in January. In fact, that’s the second month running that real PCE was flat, and it was the third instance in the last four months. Stepping back and looking at the broader trend in real personal consumption spending only reaffirms the message in the last few months, namely, a slowdown in Joe’s willingness and/or ability to spend after stripping out inflation, as our chart below illustrates.

If the trend raises questions about the future, breaking out real spending by the major categories provides even more incentive for staying cautious on the question of, What’s next? Durable goods spending last month fell by 1.3% last month from December, measured in real terms at a seasonably adjusted rate–the fourth monthly decline in a row. Nondurable goods spending slipped too, albeit at a comparatively modest -0.2%. Only services-related spending managed to rise in real terms last month, advancing by 0.4%.
The implication: consumer spending, after cutting away the distorting cloud of inflation, is generally falling, and arguably looks set for more of the same in the foreseeable future. The hope is that the Fed and Congress can arrest the trend via rate cuts and fiscal stimulus, respectively. Perhaps, although there’s a cost to everything, starting with the risk of trading a cyclical downturn for higher inflation. In addition, there’s the added worry that even if Washington is able to engineer a bounce in consumer spending, the effect will be temporary and so a “W” recovery may be coming. That is, we’ll see a modest bounce down the road, but it’ll give way to another dip before the real upturn takes root.
This is all speculation, of course, and so this essay may end up being one more hockey puck added the junk yard of discredited analytics. So it goes in attempting the impossible: forecasting tomorrow with yesterday’s data. To which the only antidote is watching, waiting and looking at the new numbers as they come in, which is the worst possible solution except when compared to the alternatives (our apologies to Churchill). Stay tuned.