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A Case for Stagflation

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May 21, 2009 – Comments (16)

I have not found any stories that really caught my eye this morning, yeah weekly jobless claims stunk, yeah states have no money and they're raising taxes, blah, blah, blah tell me something that I don't know.  Perhaps all of this stuff seems so repetitive to me because I follow the news and current events so closely.

So instead of focusing on any single event, I thought that I would float a fairly high-level, macro theory that I have been tossing around in my head this morning out there.

I strongly feel that as an investor it is very important to keep an open mind and not to lock in on any one particular theory about where the economy is headed.  Here's what I have been thinking about the economy, followed by a new theory that I have been tossing around. 

For some time now I have been of the opinion that deflation, or at least dis-inflation, is more likely in the near term than inflation.  The reason why I believed this is that to me it seems as though the velocity of money is dropping much more rapidly than the government can print and spend it.  The only think that I thought would be able to create near-term inflation would be a precipitous drop in the value of the U.S. dollar, which I don't see happening in the immediate future because the economies of most other countries are in as bad or worse shape as ours is and for the most part the value of currencies is all relative.

That has been my line of thinking for a while, but here's something new that I have been tossing around in my head...that the United States might be headed for a period of stagflation.  Here's why.

I realize that my saying this will bother some people, for the life of me I have not been able to figure out why the stock market has rallied so significantly in the face of such bad economic news.  Yeah, it's forward looking and perfectly, efficient, yada, yada, yada...  I'm not short anything in real life so it's no skin of my back if stocks want to rise, I'm just trying to understand the rally.  Certainly part of the bullish move is a result of the fact that people now believe that the economy is no longer falling off of a cliff and that the end of the world is not near. 

Whatever the reason for the move, one thing that this rally demonstrates is that even after the incredible destruction of wealth that has happened over the past several years there is clearly still A LOT of money out there looking for a home.  As the old saying goes "Follow the money."  For now, optimistic investors who are seeing imaginary green shoots and are looking for a "V" shaped recovery are shoveling money into the markets.  Furthermore, money managers who are afraid of being left in the dust and having to explain to their investors why they didn't hop into what many believe is the greatest investment opportunity of our lifetimes are franticly piling into the market to make themselves look good.

After one filters out the short-term gyrations of the market, stocks ultimately trade at a multiple of their EARNINGS.  In order for stocks to perform well companies have to have solid earning power.  Moreover, for investors to award companies with solid earnings multiples they have to display the ability to grow their earnings in the future.  As someone who strongly believes that we are headed for a period of worse earnings in the near term and slow to no growth over the next several years I believe that the people are jumping into the market at this point will eventually be disappointed with earnings and look for somewhere else to put there money.

The question is...where.  One logical place is oil.  Oil has rallied from the mid-$30/barrel range in December to its current $60/barrel.  Heck, oil has risen 75% since March despite the fact that the fundamentals for the market are still absolutely terrible.  Even though oil inventories fell last week, they're still sitting very close to their 19-year high and demand is very, very weak.

So why has oil rallied so significantly?  Money.  Lots of money is piling into the market.  It is entirely possible that as investors become disenchanted with companies' disappointing earnings later this year and early next year that they will sell their stocks and put there money to work some place else...possibly in commodities again.  Commodities could become the "hot" trade even with terrible fundamentals.  Any dip in the value of the U.S. dollar would magnify the increase in the price of oil.

To summarize my latest theory:

Clearly there's a lot of money out there looking for returns and it has to go some place.  People aren't going to sit in cash forever.  Right now they're shifting their money into the stock market...but without solid earnings and growth they will eventually grow tired of sitting there and put their money some place else.  Oil and other commodities is one possible destination.

A weak economy with little to no growth + more expensive oil = stagflation.

Anyhow, that's what's on my mind this morning.  I certainly am not putting all of my eggs in this basket.  I have positioned my portfolio for both deflation with a decent chunk of high yield bonds and inflation with positions in oil and natural gas and a some conservative, non-discretionary dividend paying stock in the middle.

I'd love to hear others' thoughts on this subject.

Deej

16 Comments – Post Your Own

#1) On May 21, 2009 at 9:58 AM, Deepfryer (27.60) wrote:

Sounds like you've been reading Roubini's blog? He's been talking about the possibility of stagflation for a while now. http://www.rgemonitor.com/blog/roubini/

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#2) On May 21, 2009 at 10:01 AM, XMFSinchiruna (27.46) wrote:

You're getting substantially warmer. :)

Deej, I offer for your thoughts the comments I posted to an inflation article by Anand:

Anand,

may I offer a third scenario?

Bernanke's interventions don't have to be successful to spur inflation.

When you have a contracting economy, but massive spending transitioning into quantitative easing in a failing attempt to counteract de-leveraging, and foreign creditors grow increasingly wary of the entire mess... these are clear ingredients for stagflation.

Eroding value of the USD (looming) vis-a-vis bailouts and quantitative easing can indeed stoke double-digit inflation even as several key asset classes like housing experience falling nominal prices in a contracting overall economy. I prefer the term stagflation because it differentiates from the commonly understood hyperinflationary model which presupposes some measure of economic stabilization to precede the event (thus increasing velocity of money).

I believe the bailouts and fiscal interventions will fail to generate economic recovery in the face of an insurmountable mountain of toxic derivatives (at least $684 trillion). I believe that the recent foray into quantitative easing is just the beginning, which creates a dangerous vicious cycle for the USD, prompting further acceleration of the printing press and sealing the downward trajectory of the USD against the basket of foreign currencies.

This will yield higher USD prices for core commodities like oil, food, metals, etc., forcing the hands of foreign holders of USD reserves to begin unloading in one form or another and making the eventual emergence of a replacement reserve currency system a certainty. Foreseeing this scenario, I believe, China and Russia have held no punches in voicing their level of discomfort with our policies and the continuing role of the USD as the reserve currency of the world.

It seems most folks are watching housing prices, unemployment figures, and other such domestic economic indicators for clues about when we could being to see deflation bottoming and allowing inflation to rear its head. I agree that such a reversal would indeed herald the arrival of inflation, but I consider this scenario far less likely than the stagflationary case.

Instead, I have my focus honed in upon Treasury bond auctions and quantitative easing, the USDX, gold, the growing crisis tally, strategic moves to secure future commodity supplies, and global currency developments with respect to concern over the fiscal health of the greenback, etc. These, I believe, provide the clues we need to follow to predict the onset of inflation.

 

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#3) On May 21, 2009 at 10:04 AM, kaskoosek (70.89) wrote:

Come to the dark side.

 

Al my portfolio is commodities and multinational stocks.

 

Kaching.

People are stupid and will stay stupid. As long as that is the case, I will always make money.

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#4) On May 21, 2009 at 10:13 AM, portefeuille (99.60) wrote:

Have a look at video #3 here (there are 4 videos on that page and the third one is the one that precedes the phrase "Video #4"!).

Hugh Hendry vs. one of those inflation freaks ...

Really entertaining. Really!

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#5) On May 21, 2009 at 10:16 AM, portefeuille (99.60) wrote:

Video #3 - Mar 11: As the Bank of England prepared to launch its asset-buying program Wednesday, Liam Halligan from Prosperity Capital Management and Hugh Hendry from Eclectica locked horns over how quantitative easing will affect the economy. (Hendry starts around the 2:40 mark(!!!!!!!!!))

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#6) On May 21, 2009 at 10:26 AM, mas113m (< 20) wrote:

I've also been considering stagflation as a possibility lately.

At first, I was under the assumption that once we passed the deflationary period, we would head towards inflation. With all the spending, printing of money, deficits, and quant easing, I felt this had to be the case. In the past couple of weeks however, I have begun to realize that one key componet of inflation is missing. The money is not reaching consumers. The government is buying worthless assets with all of this spending, such as GM, AIG, etc. The money is being spent, but not really on anything. Meanwhile, consumers are being taxed more heavily, working less, and earning less. The stimulus bill will do very little to actually stimulate the economy and put money in the hands of consumers.

just my two cents

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#7) On May 21, 2009 at 10:40 AM, JakilaTheHun (99.94) wrote:

I've been predicting stagflation since about October. 

I still say the rally is not hard to understand.  Stocks were undervalued with many companies selling below liquidiation values.  This was particularly true with commodity producers and that's where the biggest gains have been.  Tha'ts why I bought in very heavily into that sector. 

You mention "earnings" but "earnings" are an accounting concept.  P/Es do not effectively measure the value of companies *EXCEPT* in the rare event that a company has steady, consistent, recurring cash flows with a great deal of predictability. 

P/E ratios are useless for commodity producers.  P/E ratios are useless for these banks right now.  P/E ratios are nonsensical for REITs.  P/E ratios are useless for companies losing money and companies with small profits. 

At Dow 6500, the market was extremely undervalued.  At Dow 8500, the market is somewhat undervalued.  Dow 9000 - 9500 would probably be about right given the economic environment right now and realistic valuations. 

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#8) On May 21, 2009 at 10:49 AM, megank12 (< 20) wrote:

Thanks for sharing your thoughts everyone.  Keep 'em coming.

I still am not sold on the imminant demise of the U.S. dollar nor inflation spurred by the government printing money given the problems in other countries and the drop in the velocity of money.

I'm not saying that those things are not possible.  They are, I just don't see them happening in the immediate future.

What I'm talking about here is a massive wave of "hot" money piling into the next trendy sector hunting for returns like a blind rooting around for truffles.

Plus, this is just a theory that I have been tossing around in my head this morning while trying to understand the recent market action and what might happen next.  As I said earlier, I have made some investments that will do better in a deflationary environment and others that will do better in an inflationary one, all the while focusing on yield.

Deej

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#9) On May 21, 2009 at 11:09 AM, TMFDeej (99.41) wrote:

Dude why do I always do that?  The aforementioned login was an account that my wife created that I hijacked and turned into a mega bull portfolio.  I also have created a dollar is doomed portfolio. 

Just some small things to keep me entertained given the fact that my main account is sitting floored at the 200 pick limit.

Deej

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#10) On May 21, 2009 at 11:11 AM, TMFDeej (99.41) wrote:

Jakila, I thought that you like REITs.  I don't particularly think that REITs would thrive in the sort of environment that I described.  Sure real estate would do well if hyperinflation grabbed a hold of everything or if the dollar fall off of a cliff, but not in an environment where the economy is slow and commodity prices explode.

As far as stocks trading below their liquidation values, in theory that's great...in practice not so much.  General Growth's bankruptcy is the exception to the rule.  Most companies exhaust every possible angle to stay out of bankruptcy and destroy the value of their assets in the process.

Take a look at the automakers and banks.  They convert preferred stock to common, they issue new shares, they convert debt to stock, they issue new debt.  Most companies that are on the brink of financial disaster will dilute the he-two-sticks out of investors before they file for bankruptcy.  Sure, right now a stock that is trading at $X per share is worth more than it would cost to liquidate a company, but how much will you get as an investor when the company issues 100 billion new shares.  Not much.

Furthermore, investors in common stock are on the very bottom rung of the capital structure.  Just wait and see how much money the owners of GM common stock will reveive in bankruptcy.  Practically nothing.  They'll do some sort of 100 for 1 reverse split and issue a whole bunch of new shares to the UAW, bondholders, banks, the government, etc... 

In the real world, the common stock of companies that are in really bad shape often ends up being worth significantly less than one thinks it will be.

Deej

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#11) On May 21, 2009 at 11:28 AM, portefeuille (99.60) wrote:

Sure, right now a stock that is trading at $X per share is worth more than it would cost to liquidate a company, ...

? (I think I know what you mean)

100 for 1 reverse split

1 for 100 reverse split

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#12) On May 21, 2009 at 11:40 AM, Evlampius (24.80) wrote:

Good way to keep recommends coming to your account too...

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#13) On May 21, 2009 at 12:13 PM, JakilaTheHun (99.94) wrote:

Deej,

Automakers and the banks have liquidation values near $0.  GGP had a liquidation value near $0.  Any firm levered to the tilt will normally have a liquidation value near $0. 

For these very reasons, I think preferreds are not a particularly great investment.  There's no additional "safety" in owning preferreds except in the event that the company could actually liquidate and still pay off all the bondholders.  And since most companies in danger of filing bankruptcy have Liability/Capital ratios of 90%+ or have properties that have seen significant declines in value, there's no reason to believe in most cases that preferred holders will get a dime in the event of BK.

I'd rather play common stock and take advantage of the more beaten down prices.  You're paying extra for safety on the preferreds, but your not really getting it in most cases.  Though, I don't really disagree with buying high-yielding bonds with the market finally rising.  You do get a degree of safety with bonds.

 

I do like a lot of REITs right now.  See my entire series on them:

http://seekingalpha.com/article/138942-brandywine-realty-a-reit-bargain-even-with-impending-carnage#comment-512879

(Sorry, everyone needs to schill for themselves occasionally ;))

 

Not all of them are good bets.  I keep a mile away from the overlevered ones.  But there's a fine line between being overlevered and being fairly safe in REIT-land.  Certainly, if you see a REIT with a Liability/Value ratio of 90%+ that is in a lot of bubble markets, keep away with a fifty-foot pole. 

On the other hand, when you find a REIT that is mostly in middle America (i.e. not heavily concentrated the big city bubble markets), has a Liability/value ratio under 70%, and didn't buy all of its properties during the bubble, there's a significant chance it's priced for bankruptcy despite the fact that it's very unlikely that it will become bankrupt. 

I'm probably not going to convince you to go on a REIT common share buying spree, but I would suggest it might be wise to look into the corporate bonds of quality REITs if you'd really like safety.  Many of them are safer than you might think and they probably have good yields right now (I don't follow the bond market much so I wouldn't know for sure).  Brandywine (BDN), Winthrop (FUR), and Lexington (LXP) all look relatively safe to me on the bond front.  I'm long on the common stock for all three, but the reason I'm long is because I think they are fairly safe while the market does not. 

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#14) On May 21, 2009 at 12:15 PM, JakilaTheHun (99.94) wrote:

Urggghhh ... sorry, accidentally linked to a comment rather than my article:

http://seekingalpha.com/article/138942-brandywine-realty-a-reit-bargain-even-with-impending-carnage

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#15) On May 21, 2009 at 8:25 PM, XMFSinchiruna (27.46) wrote:

portefeuille

The video you linked to in comment #5 above is indeed enormously entertaining. I will have to keep an eye out for Liam Halligan's stuff, as he clearly understands the fundamental precursors of stagflation, while the guy insulting him is somewhere out in left field. The only statement of his that I might agree with is the idea thay by now perhaps inflationists are no longer a minority. The inflation IS a crowded trade, but I believe that's because it's backed by the fundamentals. For that reason, the crowded nature of the trade will affect the dynamics, but not the direction of the trend. This is one reason why I've been suggesting that we'll see increasing volatility on the commodities and currency trades coming up... perhaps even mind-blowing volatility... but the direction of the dollar is the one thing I feel I can forecast with tremendous and objective confidence.

There is only one asset class that I know of that is positioned to gain substantially, whether we see stagflation (as I believe we will) or whether the interventions trigger a money-rush that spawns fiercer inflation, and that is gold. People hemmed and hawed when gold initiated its correction in March 2008 about the impending deflation and how that would destroy the bull market for gold. I reminded Fools then as I'll remind them now, that this is first and foremost a currency event, and only secondarily an economic event. Because the administrations have (and had) signalled there is no limit to the reflation efforts that would await continued deflation, gold is/was even positioned to withstand deflation.

Precious metals will of course be impacted by how the future plays out with respect to inflation, but even still the direction of gold will not be so determined. Gold will rise whether inflation hits sooner or later, or whether it approaches by stagflationary quantitative easing or some sort of kick-start from the trillions (again... I am extremely doubtful that this could occur). The reason ... the road for the dollar has been paved no matter what happens from here-forth. It's all about the dollar, and it's all about China. Stay tuned.

 

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#16) On May 23, 2009 at 7:55 AM, intangibles (73.61) wrote:

The deflation/inflation debate is still alive and well.  I do not claim to know for sure which one will ultimately triumph, but it seems evident that the government will do anything it takes to stop the housing market from plummeting.  If all the steps that they are taking eventually leads to inflation and higher interest rates then won't this add more downward pressure on the housing market as affordability goes down?  When you combine this with the fact that there is a ton of "shadow" housing inventory as people wait in vain for the market to get better (especially baby boomers who want to downsize), I thank god that I didn't listen to my elders and lever up and buy at the top of the market in 2005. 

In terms of Russia and China getting weary of the greenback, to me this is mostly rhetoric.  For China to give up on our currency would be detrimental for their economy not only because their current holdings would plummet, but because American consumers are crucial to their economy as seen buy the insane amount of factories that have shut down since the recession hit and the 20 million or so newly unemployed.

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