Inflation, Bond Yields, And The Market
John Mauldin's Outside the Box

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Introduction

Today's "Outside the Box" will be a combination of 2 different writings. The 1st is an email that I received from Research Affiliates Chairman Rob Arnott in response to my letter last Friday, "Honey, I Created a Bubble." The 2nd is the latest article by the well-known fund manager, John Hussman. Upon reading both commentaries, I was struck by the similarity between the two. It behooves us to pay attention when two very intelligent gentlemen that both actively (and successfully!) manage billions of dollars are marching to the beat of the same drum.

For those of you who are unfamiliar with Rob and John, let me say that both have stellar credentials. Rob is Chairman of Research Affiliates where he manages a multi-billion fund for PIMCO. In addition, he is editor of the Financial Analysts Journal and creator of a new index fund concept. John is the President of Hussman Investment Trust where he manages the Hussman Strategic Total Return Fund - HSTRX and the Hussman Strategic Growth Fund - HSGFX.

In their commentaries below, both Rob and John take a look at what inflation and bond yields mean for the market. I strongly recommend that you read each piece thoroughly and hope that you will find them to be "outside the box."

John Mauldin, Editor

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Inflation, Bond Yields, And The Market

By Rob Arnott and John Hussman

From Rob Arnott comes this email:

John,

Nice report, as usual. When much of the financial community was panicked about 1% inflation heading to 0%, I moved the All Asset Fund to 65% in TIPS and Commodities. Why?! The four best predictors of inflation, in order of effectiveness are:

  • Real Short Rates. Below zero, look for reflation. Above 2%, look for disinflation. It was zero. Then, as inflation started to roll, it reached -1.5% before the Fed abandoned the idiotic fight against deflation.
    • Early 2003: -1.5%. Severe risk of renewed inflation.
    • Late 2006: +2.5%. High odds of disinflation.
  • Slope of the Yield Curve: Steep, look for reflation. Inverted, look for disinflation.
    • Early 2003: +4%. Severe risk of renewed inflation.
    • Late 2006: -0.5%. Likelihood of disinflation.
  • Magnitude of Current Accounts Deficit. Long-term inflation predictor. Larger than average GDP growth (3% of GDP) is not permanently sustainable and hence is inflationary.
    • Early 2003: 4% of GDP. Risk of long-term inflationary pressures.
    • Late 2006: 5% of GDP. Risk of long-term inflationary pressures.
  • Magnitude of Fiscal Deficit. Long-term inflation predictor. Larger than average GDP growth (3% of GDP) is not permanently sustainable and hence is inflationary.
    • Early 2003: 4% of GDP. Risk of long-term inflationary pressures. If vast off-balance-sheet deficit is included, immense inflationary pressures.
    • Late 2006: 3% of GDP. Diminishing risk of long-term inflationary pressures. If vast off-balance-sheet deficit is included, immense inflationary pressures.

So, early 2003, we had four red lights out of four ... all with strong signals. Today we have short-term indicators showing lower inflation and weaker long-term indicators showing higher inflation. The latter can be eliminated with the stroke of a pen, whenever Congress and the Administration share a view that our SS and Medicare promises are unsustainable. That'll happen some day, but probably not until we're in the thick of boomers retiring, in a decade or so. - Rob Arnott


Low Yields
November 13, 2006
By: John P. Hussman, Ph.D.

In a recent segment of National Public Radio's "Car Talk," a guy called in with a Datsun that had over 200,000 miles on it. The base of the floorboard had long rusted away, and the accelerator pedal had detached from the vehicle. Not wanting to pay for a new floor plate to be welded in, the caller fitted a round pad of rubber to push down the accelerator mechanism, and glued it under the ball of his right shoe, which he wore at all times. The problem was that he was developing a limp...

There are times when you stop trying to get the last mile out of a car, squeeze the final bit of toothpaste out of the tube, or speculate for an extra few percent in an overvalued, overbought, overbullish market that has every likelihood of surrendering those gains over the full cycle, even if they materialize.

I don't hesitate to recognize that the quality of market action remains favorable here, which has historically been an indication that investors have no particular aversion to risk, and are in a speculative mood. More often than not, that has been associated with positive stock market returns, even when valuations have been elevated. The difficulty at present is that despite generally favorable market action, stocks are strenuously overbought, and advisory sentiment shows very little bearishness (just 26% bears, according to the latest Investors Intelligence figures). Historically, this has defined what I call a "sub-climate" where stocks have typically underperformed Treasury bills, on average, until the overbought or overbullish condition (generally both) has cleared.

In some cases, a decline that "clears" the overbought condition is also accompanied by enough internal deterioration in the quality of market action to shift the Market Climate to a fully negative condition. So several historical "overvalued, overbought, overbullish" conditions turned out in hindsight to be market tops. But presently, we don't have that evidence. What we have is an overvalued, overbought, overbullish market, with prospects of slower economic growth, narrowing profit margins, and dollar weakness, and yet, also with market action favorable enough to suggest a speculative mood among investors.

In short, there's no rush to take market risk here given the overextended condition of the market, but if the market declines enough to clear this condition without a great deal of internal damage, we will have to allow for a return to new highs. Until the quality of market action deteriorates enough to suggest a fresh "skittishness" on the part of investors, we can't become too eager for the market to complete its cycle by achieving more attractive levels of valuation right away.

For the Strategic Growth Fund, that means that we currently have less than 1% of assets invested in call options, but that we're willing to scale that position to about 2% of assets on a reasonable market correction. Such a position would allow the Fund to participate in as much as 40-50% of the market's fluctuations, but without sacrificing much downside coverage. Our present call position gives us "directional" exposure in the event the recent market advance pushes even further (the low implied volatilities in the options market make this sort of coverage fairly cheap in terms of potential time decay).

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As I've frequently noted, current valuations are already rich enough to conclude that the market has very little "investment" merit. Stocks are currently not priced to deliver satisfactory long-term returns, nor are they likely to achieve further gains that would be retained over the full market cycle. So any market risk we accept here is "speculative." While I do believe that the quality of market action is a useful guide to establishing and removing speculative positions, and that such positions can partially relieve the discomfort of standing aside in richly valued markets that are continuing higher for a while, I don't believe that large speculative exposures are necessary to long-term investment success.

Aside from that 1-2% potential exposure in call option positions to provide speculative exposure, the Strategic Growth Fund remains fully hedged.

Low yields

In reviewing investment conditions this week, I'm struck by the general insufficiency of yields across the investment landscape. In Treasuries, the yield curve is inverted, with 10-year yields below 3-month Treasury yields, which itself has typically been unfavorable for stocks, and much more so when the general level of yields has been depressed.

While it's true that declining yields have generally been favorable for stocks, investors should make a strong distinction between "declining" (an indication of trend) and "low" (an indication of level).

I can't emphasize enough that the most hostile periods for stocks (as well as bonds) have been those where yield levels have started at low levels and have been pressed higher. While it's true that you can squeeze a reasonable capital gain out of a low-yielding market, by pushing yields even lower, that's definitely not where you find sustained gains, or gains that are typically retained over the full market cycle.

Beyond the comments on the "Fed Model" I've made in recent weeks, it also bears repeating that when the overall level of yields has been low, a "buy signal" on the Fed Model (meaning that 10-year Treasury yields are lower than the forward operating earnings yield on the S&P 500) has not been a reliable buy signal for stocks at all, but has often been a great sell signal on bonds.

As for the universally-known fact that slower economic growth means slower inflation, I would submit that it's not a fact at all.

The chart above shows data from 1962 to the present. The inverse relationship between economic growth and inflation (i.e. higher economic growth implies lower inflation) is not just a feature of historical data - it's also perfectly consistent with economic theory (it is an identity that price inflation can be written as %P = %M + %V - %Y, where M is money, V is velocity, and Y is real output). In other words, holding money and velocity constant, inflation and economic growth should have a negative relationship, with a slope of -1. As I've noted before, it can be useful to broaden the definition of "M" to include all government liabilities, whether they are issued by the Fed or the Treasury.

Basically, you get inflation when there is a lot of growth in government liabilities (high %M) and investors are not willing to hold them (high %V - essentially, velocity is high when investors treat government liabilities like a hot potato). We may in fact observe inflationary pressures near the tail of an economic boom, but that's generally because output can't grow fast enough to satisfy demand. Faster output growth alleviates inflationary pressures.

Likewise, you get an easing of inflation when there is restrained growth in government liabilities, or investors are very eager to hold those liabilities. You see that a lot during periods of credit default and bankruptcy, because investors rush for the safety of government bonds and currency. Even during these periods, less availability of goods (low %Y) serves to increase inflationary pressure.

That's why interest rates often lead inflation (rather than simply following it). Higher interest rates are a signal of weak demand for government liabilities generally. Likewise, weakness in the foreign exchange value of the U.S. dollar can also be an indication of weak demand for U.S. government liabilities.

Presently, the inflation picture is mixed, but it's not at all clear that inflation has become a non-issue. On the side of low inflation, intermediate-term interest rates have backed off in recent months, suggesting decent demand for government liabilities. However, T-bill yields are still holding near their highs. The inverted yield curve and the weakness in the U.S. dollar in recent sessions are not favorable toward the low inflation case. The year-over-year rate of core inflation has also been increasing without interruption. Overall, it's difficult to conclude that inflation concerns have become irrelevant.

Suffice it to say that the stock and bond markets currently reflect very depressed yield levels, and that the case for lower yields is not as clear as is widely argued. While we can't rule out the potential for still lower yields, it's increasingly important to remember that the most hostile periods for stocks and bonds have typically been associated with upward pressure on yields from relatively low starting levels.

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Conclusion

Your as data dependent as ever analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.

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Posted 11-13-2006 4:42 PM by John Mauldin