Summer Rally?

July 28, 2000

In Sugar Maybe, But Not In Stocks!

As you know, when the markets tried to rally earlier this month after the hammering they took in the preceding months, most analysts and gurus immediately declared that the summer rally had begun. As you may also know, I steadfastly declared that no such phenomenon had occurred. Why did I believe this? I assure you it had nothing to do with a stubborn adherence to my previous declaration of bearishness. I am first and foremost a pragmatist. I am not stubborn except when I know that I am correct. This comes from having observed for many years the accuracy of the model, particularly when it is so close to ‘critical mass’ readings. It has always correctly indicated extreme danger, and also when it is very unlikely that a rally can turn into anything significant. That is the case right now and so I am not in the least surprised that the ‘rally’ has fizzled.

There are many factors, of course, that have contributed to this negative environment. I have tried to outline some of them over the last several months and I will continue that process here. One of the chief reasons that the environment has changed is the effect of rising interest rates. Short-term interest rates in particular have risen substantially. This is of great importance to the investment environment because, among other things, high short-term interest rates are real competition for stocks as investments. High short-term rates also put tremendous pressure on the balance sheets of both financial and non-financial institutions. Particularly affected are banks and other financial enterprises as they are forced to pay ever-higher rates to attract new depositors while their income is predominantly based upon relatively low long-term rates. This is exactly why a sharp yield curve inversion is so dangerous. Look at the chart below to get a feel for just how much short-term rates have risen over just the last 1-½ years.

Inflation Is Gaining a Foothold

One of the reasons that short and long term interest rates have been rising, of course, is because there clearly are inflationary pressures building. As investors demand more protection against the erosion of paper money assets caused by inflation, interest rates must rise. Now, we are not quite at the point where the model would generate an inflation related signal, not only indicating that stocks are unsafe but that it would be time to buy inflation hedges. However, there has been enough inflationary pressure to insure that interest rates, at least at the short end of the curve, will continue to rise. But what has caused this systemic inflation to emerge? There are a number of factors but really the groundwork was laid over the last couple of years in particular.

If you recall, when the Asian, Russian and Hedge fund crises were emerging in 1998, world governments went on a currency-printing binge. Chief among these was our own Federal Reserve. They pumped up the money supply tremendously to protect against a meltdown of the financial markets, but the downside was that all that activity guaranteed that inflationary pressures would be rekindled. So, as is usually the case, after a lag time of a year or so noticeable signs of inflation began to appear. Further exacerbating the situation was the fact that U.S. consumers (whose net worth’s were dramatically increasing due to the sharp appreciation of financial assets caused by this wash of liquidity) continued to set record after record of overindulgence. This led to a continual string of record-breaking trade deficits and contributed to the overall problem of inflation. Furthermore, as many of the nations affected by the preceding slowdown began to recover thanks to the inflow of liquidity, they began demanding more for their goods. Particularly affected was the price of oil.

Now I realize that many ignore the oil component of inflation data but I think this approach is ridiculous. For unless it is only a short lived crisis that has caused high oil prices, the effects of rising energy costs are all pervasive. There is not a single good or service in this country whose price is not affected in some way by higher oil prices. Therefore, the cumulative effect of higher energy costs affects the rate of inflation, which ultimately leads to even higher interest rates. It is truly a vicious circle and will only be resolved in this cycle when the stock market collapses and the excesses are wrung out of the system. The chart below demonstrates just how dramatic the rise in oil has been and the importance it is to our current investment environment.

As you can see, oil prices have skyrocketed from $12.00 per barrel in January of 1999 to over $30.00. That is a dramatic increase and cannot be ignored. Very soon the reporters and pitchmen will have to pay attention to the fact that something that is involved in everything we do in this country has tripled in just over a year, and the trend continues. So, the next time you hear a report that says ‘minus food and energy, inflation was only up such and such an amount,’ remember this is only spin talk.

Has inflation touched other areas of the economy yet? I believe that it clearly has. Look at the Employment Cost Index released yesterday. While the data showed an ‘as expected’ 1% gain in the second quarter over the first, the reality is that the index rose 4.4% on a year-over-year basis from the second quarter of 1999. That is much more significant. Really, unless you are living is some remote part of the country, I am sure you have also observed the price pressures of a tight labor market.

In the area where I spent some time over the Fourth of July holiday, I noticed very clear evidence of this supply/demand imbalance. Much to my surprise, one of the local fast food restaurants was advertising for help to start working for $11.00 per hour. That is to start! Can you imagine: making nearly twice the minimum wage for flipping burgers. No doubt about it, wage inflation is a reality and will continue to exert its insidious pressure on overall prices.

All in all, the die is cast and all of the necessary ingredients are in place for a calamitous decline in stock prices. When the model gets to critical mass (and it is making substantial headway in that direction right now) we will soon experience what I believe will be the most dramatic collapse of stock prices in history. Then, depending upon how the Federal Reserve handles the situation, it will either turn into a deflationary black hole, or blast off into an inflationary spiral. Whichever direction is taken, the model will predict exactly which assets to be invested in and when to take profits. Believe me, the slight delay we have experienced in getting to critical mass after the initial sell signal will seem meaningless once the stock market begins its meltdown. Meanwhile, we have outperformed almost everyone else with a safe and sane strategy that will eclipse others once the selling really starts. I believe this year will be the most important we will ever see. There is just too much evidence available to reach any other conclusion. Take care.


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This page last edited
March 13, 2001