A Case for Stagflation
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.