Inflation may not be an overt threat at the moment, but it’s too early to stop worrying.
Today’s release of the consumer price index for April reminds that the pendulum is precariously balanced and may swing one way or the other in the months ahead. Correctly deciding which way it swings has become the all-important variable that will determine profit and loss for the foreseeable future among the more speculatively inclined players in the capital markets.
CPI’s 0.6% rise last month isn’t the highest we’ve seen in recent years, but neither is it the lowest. In fact, April’s advance, when put in context with recent history, exhibits many of the qualities that one associates with persistence. Stubborn upward persistence, we might add, noting that prices seem inclined to rise rather than play dead.
The trend is obvious when one looks at a chart of monthly 12-month CPI percentage change over time. Indeed, consumer prices are pushing higher over time. The trend unfolds in fits and starts, but it’s a trend nonetheless.

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Ron Surz of PPCA Inc. says he’s built a better mousetrap of indices used for benchmarking and analyzing money managers. In fact, he’s just following the advice of a Nobel Laureate.
Professor William Sharpe, who shared a Nobel Prize in 1990 for his work on developing the Capital Asset Pricing Model, laid out the foundation for returns-based style analysis in a 1992 paper. The strategy is one of analyzing, say, a mutual fund’s returns by regressing performance against various indexes to determine what’s driving the performance. In essence, it’s a quick and fairly reliable way of x-raying a portfolio to see what’s going on behind the scenes.
For example, by running a returns-based style analysis on an actively managed large-cap U.S. stock fund, one might learn that the benchmark-beating results came primarily from loading up in small-cap companies. There’s nothing wrong with that, of course. But if you’re telling the world that your benchmark is large-cap stocks, you’ll have some confused (or angry) investors if they learn that you’re buying small-cap equities. Perhaps, then, a small-cap index is the better benchmark for the fund, in which case maybe the large-cap manager’s performance doesn’t look so impressive after all.
So it goes in the world of analyzing managers. Trying to make apples-to-apples comparisons is the bane of analysts who are forever attempting to separate alpha’s wheat from beta’s chaff. No easy task in the best of times. Talent, after all, isn’t easily defined, and less-than-obvious when looking only at numbers. Indeed, surveying past performance offers no foolproof way for deciding that manager A has the right stuff and manager B is a pretender to the throne. That’s not to say that reviewing the past is worthless. But there are limits to studying history as a short-cut to seeing the future.
That said, some argue that an effective search for talent requires going through a portfolio’s holdings with a fine tooth comb, and comparing changes over time. But a holdings-based analysis isn’t practical because managers’ reports are infrequent, and quite often out of date. In the case of some hedge funds, you might not ever learn what it’s in the portfolio. So much for timely analysis.

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Sometimes a picture really is worth a thousand words. Whether it’s also a window into the future is an open debate. With that in mind, we’ll simply post a chart of last week’s returns for various asset classes. Take note that the high-flying returns that risk has so generously dispensed of late has reversed course. Risk does indeed pay off handsomely at times, particularly over the long haul. But there can be a price to pay for touching the sky in the short term. The question is, how big a price?

Indices/Funds: MSCI EM ($), Russell 2000, MSCI EAFE ($), DJ REIT, S&P 500, DJ-AIG Commodity, ML HY Master II, Pimco EM Bond Fund ($), Lehman Bros. Aggregate, Pimco Foreign Bond ($)

It’s yellow, it’s malleable and its price is soaring.
An ounce of Gold yesterday moved above $725. That’s up about 40% so far this year, and double the price from about three years ago. The precious metal, in short, is enjoying its greatest bull market in a quarter century.
The general assumption for the ascent is that inflation fears are stoking demand for the metal. Gold, after all, has a long history of proving itself as an inflation hedge, and a few thousand years of pricing aren’t easily dismissed. But one fiercely independent gold bug says there are other forces pushing the price of gold upward. In particular, gold’s price has taken wing because of the unwinding of the so-called gold cartel, which rigged the price of gold over the past ten years. This according to Bill Murphy, a former commodities trader who’s now chairman of the Gold Anti-Trust Action Committee (GATA).
Murphy and GATA have been called extremists, even by other gold bugs. Indeed, GATA spins a heavy tale of a government and Wall Street conspiracy, charging that the Federal Reserve and powerful banks have been manipulating gold for years, keeping its price lower than it otherwise would be. This is strong stuff, and even some card-carrying gold bugs are inclined to distance themselves from the theory. Euro Pacific’s Peter Schiff, for instance, yesterday told The Wall Street Journal (subscription required) that GATA is “a little conspiratorial, for me even. I don’t know if there was any real orchestrated event.”
Nonetheless, the fact that the Journal is writing about GATA and its theories suggests the world is coming around to taking Murphy’s conspiracy talk seriously. Or so says GATA’s chairman in the following interview. Another example he cites of the rising respect for GATA’s message: a gold report published in January by European bank Cheuvreux that references GATA’s research.
The Capital Spectator talked with Murphy yesterday by phone to learn more. With gold prices soaring, the time is ripe for a chat with a gold bug’s gold bug. Indeed, Murphy thinks a run in the metal to as much as $3,000 or more isn’t beyond the pale.
In any case, we can’t confirm or deny Murphy’s assertions, but given the strength in gold prices of late we’re not ruling anything out at this point.
WHAT’S DRIVING THE GOLD BULL MARKET THESE DAYS?
There’s a short squeeze of epic proportions going on.
HOW SO?
The gold cartel–the United States government, some other central banks and the bullion banks like Goldman Sachs and J.P. Morgan Chase–rigged the price of gold in the mid-1990s. It started with [former Treasury Secretary] Robert Rubin and the strong dollar policy. To help rig the price, in clandestine fashion, [several large banks] borrowed gold from the central bank and leased it into the marketplace without telling anybody–this was the gold cartel.
What happened was that the bullion banks could borrow gold at, say, 3/4% to 1% from a central bank, and then they would sell it. And that sold [shorted] supply would keep the price down. They would invest the proceeds [elsewhere], and for years they were trading in a rigged market, which allowed them to make money [at the expense] of the speculators who were unaware of what was going on.

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If the Federal Reserve’s announcement yesterday on interest rates was intended to keep the market guessing, the central bank scored a home run.
The bond market went exactly nowhere yesterday, although at various points the fixed-income set was alternatively bullish and bearish. But when the dust cleared, the 10-year yield was unchanged at 5.125% at Wednesday’s close.
In fact, shrugging one’s shoulders is an eminently reasonable reaction to yesterday’s Fed advisory. The rhetorical smoking gun from the FOMC is this line: “The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.”
That’s a slight change from the previous statement in March, which said that “some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.”
Translated: a pause in rate hikes is all but assured when the FOMC meets next in late June. That implies that Fed funds rate is at or near the typically elusive state of monetary affairs known as neutrality. In Goldilocks fashion, a neutral Fed funds is neither too hot nor too cold, or so we’re told. Occupying this never-never land is said to neither promote growth nor retard it. Bernanke and company seem to be saying that we’ve now reached this state, and so further rate hikes are unnecessary, and perhaps even detrimental.
But there are no free lunches, even in the land of neutrality, which is fostering a bit more indecision than usual about what comes next, according to Ken Kim. An economist who watches the central bank for Stone & McCarthy Research Associates, Kim tells CS that decisions are getting trickier for the central bank:

Now that the Fed’s closer to the perceived neutral rate, unfortunately there is more uncertainty as to where the stopping point is [for rate hikes]. Even though they have models and forecasts, it’s hard to specify within a quarter percent of where you should be. I think we are at neutral. My personal opinion is that come late June, at the next FOMC meeting, they’re going to pause and leave the Fed funds rate at 5.0%.

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The Federal Reserve’s FOMC meets today, and it’s widely expected that interest rates will again rise by 25 basis points, bringing Fed funds to 5.0%. That’s a prediction hardly worth the name, as the Fed’s been dispensing 25-basis-point hikes methodically since June 2004. Indeed, the Fed funds futures contract for May is priced for 5.0%, and hardly anybody expects a surprise.
What’s different this time around is that Fed Chairman Bernanke has recently suggested that a pause in rate hikes may be coming. But given the ensuing debate that Bernanke’s advisory triggered on the matter of his inflation-fighting credentials, some wonder if perhaps Ben may rethink his inclination to put tightening on a hiatus, temporary or otherwise.
A bit of uncertainty, in short, hangs over the policy outlook for the Fed for the first time in recent memory. Perhaps it’s unavoidable, given the ample dose of conflicting signals coming from the economy and the capital markets on the all-important question of whether GDP is or isn’t slowing more than a little. But no matter the cause, transparency has dropped down a notch or two for the Fed. For the moment, the central-bank transparency that Bernanke has long espoused as an academic looks to be on the defensive now that he’s running the money machine in Washington. That may change in the future, but in the here and now there’s a bull market in guessing where monetary policy’s headed, and that’s probably not what the Fed wants.
Or is it? Bernanke himself confessed in March that “the implications for monetary policy of the recent behavior of long-term yields are not at all clear-cut.” No one can accuse him of exaggerating, considering the current state of puzzlement over the future of Fed policy.

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The Saudis are optimistic. Really optimistic. Ali al-Naimi, minister of petroleum and mineral resources for Saudi Arabia, said last week that “there are at least 14 trillion barrels of reserves in the world,” according to a transcript of a conference hosted by the Center for Strategic & International Studies in Washington. How much is 14 trillion barrels of reserves? Three-and-a-half times more than the highest estimate noted in an historical survey of such guesses by other, as published by 2000 study the Energy Information Administration.
Meanwhile, a new article published by the Reason Foundation references an estimate from the industry journal World Oil, which cites proven oil reserves—defined as oil that is recoverable presently given current economic and business conditions—is 1.1 trillion barrels. BP puts the number at 1.2 trillion, and the Oil and Gas Journal says 1.3 trillion. Last year, the Reason article continues, the IHS Energy consultancy “estimated that the world’s remaining recoverable reserves, excluding unconventional sources such as heavy oil or tar sands, are between 1.3 trillion and 2.4 trillion barrels.”
If there’s one thing that unites the otherwise disparate conjectures about how much oil’s left, it’s the fact that all are lower than Minister Ali al-Naimi’s estimate. Perhaps there’s some play in the difference when it comes to comparing estimates of “recoverable” reserves vs. total remaining reserves otherwise uneconomical. But the minister’s optimism suggests that something close to his belief in the 14-trillion-barrel number is approachable, courtesy of technology. “With advance[s] in technology, I believe our ability to recover more of the 14 trillion is there,” he said at the CSIS conference.
The stakes, of course, are high when it comes to the debate about how much oil is left. The center of the universe for this debate is Saudi Arabia itself, which is the globe’s leading producer of oil and home to the biggest reserves in any one country. Matthew Simmons, chairman and CEO of Simmons & Co., launched a fierce discussion over Saudi reserves last year with his 2005 book Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, which questioned the outlook for raising Saudi Arabia’s future oil production.
But the Kingdom remains optimistic on that front too. “We [in Saudi Arabia] are undertaking a massive investment program to increase our production capacity to 12.5 million barrels per day by 2009 with the potential for more later if market conditions warrant,” the minister promised at the CSIS confab. “This expansion will make a significant contribution to meeting the world’s increasing needs for energy.” If it comes, it would represent a roughly 14% increase over current Saudi production as of March, according to EIA.
Greed and fear may rule in the pricing of oil, but when it comes to official Saudi estimates of black gold, the coin of the realm is optimism. The question is whether that optimism is on steroids.

It was the best of times, it was the worst of times, Dickens wrote in A Tale of Two Cities. One might say the same after surveying the outlook for the economy and the implications for investing.
There are numerous straws about that threaten to break the proverbial camel’s back. At the same time, there are a number of counter forces at work that may bushwhack the best- laid expectations of the pessimists for a time. Watching this back and forth, and trying to figure out when and where a tipping point will occur represents one of the more worthwhile areas of scrutiny for the intrepid investor.
On the aisle of optimism is the bullish prediction flowing from the most famous discounting mechanism, otherwise known as the stock market. Equity traders, bless their little hearts, just can’t help bursting with bullishness these days. Friday’s session was particularly exuberant, with the S&P 500 surging upward to its highest since early 2001. Indeed, the 1% climb on May 5 was anything but tentative. The stock market is hardly infallible. But if the steady climb in equity prices that’s prevailed for much of the past two years is misguided, it’s one of the more consistent and lengthy instances of imprudence on record.

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The train kept a-rollin’, all night long,
With a heave, and a ho,
Well I just couldn’t let her go.
–The Yardbirds
Risk, we’re so often told, reaps reward. If there are exceptions to this rule from time to time (and there are) it’s less than crystal these days.
As the chart below reveals, risk across the board has paid off handsomely in the recent past. As a snapshot of the past, this is a reason to celebrate, at least for those who’ve been long in certain asset classes. But the chart also represents a challenge, namely, where to deploy money now? Does this chart draw the profile of bull markets still in their prime? Or does the layout of the returns give you pause?
Emerging markets stocks, the riskiest of the asset classes in our survey, is the clear leader so far this year and for the past three years as well. In fact, equities generally, and a broad mix of commodities, occupy the top half of the performance roster, while the lagging returns are populated exclusively by bonds of various kinds, the so-called safer investment species. The pattern is true for both year-to-date and trailing 36-month returns through May 2.

Indices/Funds: MSCI EM ($), Russell 2000, MSCI EAFE ($), MSCI REIT, S&P 500, DJ-AIG Commodity, ML HY Master II, 3-mo T-bill, Pimco EM Bond Fund ($), Lehman Bros. Aggregate, Pimco Foreign Bond ($), Vanguard Infl Prot Sec
The dollar-based advance in emerging markets stocks is especially hot. The MSCI Emerging Markets equity benchmark has soared by annualized 42% a year after translating the gains back into greenbacks. By any standard for asset classes, American investors have been treated to a level of profits rarely witnessed in so short a period. Even the red-hot commodities sector overall hasn’t kept pace with the stocks of emerging markets from a dollar-based perspective.

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There’s a growing chorus of predictions that the economy’s due to slow later this year. But recent economic reports don’t yet jibe with that view. Could the forecasters be wrong? Or just early?
Either way, yesterday’s stronger-than-expected reports on factory orders and the service sector are the latest in a string of items that raise questions about what comes next.
Nonetheless, the Federal Reserve expects the economy will cool, if only slightly. Thus, Fed Chairman Ben Bernanke’s announcement last week that the central bank is considering a pause in the current round of interest-rate hikes.
The Fed wants to avoid a recession. But does pausing with monetary tightening come at the price of letting inflation gain a stronger foothold in the economy?
For some thoughts on that and related questions, we called Paul Kasriel, director of economic research at Northern Trust. In a telephone conversation yesterday, Kasriel expounded on why he too thinks the economy will moderate.
WHAT’S YOUR TAKE ON FED POLICY THESE DAYS?
The Fed’s following a restrictive monetary policy. Not necessarily a recessionary restrictive monetary policy. But I think the Fed has already put in place a monetary restriction so that we’ll see a lower trend in economic growth. The year-over-year growth in the first quarter was 3.5%, and I think we’ll trend lower than that as we go through the year.
WHAT EVIDENCE DO YOU SEE IN SUPPORT OF YOUR OUTLOOK?
There’s a lot of evidence in the leading indicators.
FOR EXAMPLE?
I guess I’m one of the last people to still pay attention to the money supply, and we’ve seen a significant slowdown in the price-adjusted or real M2 money supply.
And although we’ve seen some widening in the spread between the 10-year Treasury and the Fed funds rate, that spread on a longer-term basis has come down quite dramatically.
Meanwhile, housing has been a leading sector of the economy as a whole. If you look at things on a year-over-year basis, we’ve seen a definite slowdown in housing activity. Both new and existing home sales have slowed. And [house] prices are softening.
Then there are automobile sales, although I haven’t tested them as a leading indicator. But we’ve seen three consecutive months of flat sales. That is, February, March and April were all around 16.5 million units [for car sales]. That’s another indicator of slowdown in the economy.

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