Friday, October 28, 2005


Good economic news is often bad news for the stock market and vice versa. Many things are "up-side down" when it comes to news. For example, peak oil stock earnings right now suggest that earnings can only get worse in future years. Peak refinery profits will lead a competitor to build a new refinery and suddenly profit margins will decline. Yesterday, Trinidad announced the start of of a large methanol refinery. Methanol is used mostly in solvents and paints. The important point is that natural gas in Trinidad is now being exported to the USA as methanol, thus reducing the demand for natural gas in the USA.

The economic statistics gathered by the conference board include leading, coincidental and lagging economic indicators. The "bad" economic news is that these indicators are going down. The leading year over year change in the leading indicators is approaching zero fast. Coincidental indicators are headed down to the 2% area which implies the GNP is slowing to a 2% growth rate. Even lagging indicators have turned down.

These weak or "bad" indicators for the economy are potentially great news for the stock market. The indicators suggest that the FOMC will stop raising short term interest rates soon. Companies generally have an easier time making profits when interest rates are low.

Today, the "good news" was that real GNP grew at a 3.8% annual rate this past quarter. This is a strong number. It was boosted by a low GNP deflator number. According to the government figures inflation even in the face of rising energy prices was relatively low. Indeed, the largest component of inflation, labor costs, were up at an annual rate of 2.2%. Those who argue that energy costs show that inflation is out the roof must recalculate; crude has dropped 15% and inflation is therefore negative in the past month.

The favorite inflation indicator used by Chairman Greenspan is the core PCE deflator which indeed was negative last month. One of may favorite inflation indicators is to divide the CRB Futures Contract by the 10-Year Treasury Futures Contract. By this measure, inflation is projected at 2.9%. However, there are a number of indications that CRB Futures are topping out and ready to head down at a rapid pace.

NOW I'M TALKING GOOD NEWS FOR STOCKS AND BONDS! If indeed CRB Futures trade down, the markets could see a significant bond market rally and an even more powerful stock market rally. The 10-Year bond is currently at a high rate relative to its average of the past two years. It is at a low real rate if you, as many folks do, use the CPI as a deflator. If you use Greenspan's favorite, the PCED, real bond rates are extremely high.

Folks the world is not black and white. There are opinions on all sides of the inflation question. Barry Ritholtz has made it his quest in recent weeks to prove that the government numbers are flawed and that inflation is much worse than what is reported by the government and what is indicated by the market.

Investors who are seeking alpha, above market performance, are in effect attempting to be smarter than the market. I and other make that attempt often. It can be a humbling experience because there is always important information that the market knows that any one individual investor does not know. I do not believe in the Efficient Market Hypothesis but I do believe that if you can't see why the market believes something then you don't have all the information you need to attempt to achieve alpha.

Blogger's are selective about which data they present. Barry has been able to pull out much data to show inflation is worse than the 10 year treasury and the 10 year TIPS suggest. I think folks misunderstand the deflator concept. Perhaps I misunderstand as well. The way I see it is that if a person stops taking the daily news paper because he now reads so much of his news on the internet the deflator is effected. The person might have been paying for broad band internet, a newspaper and long distance telephone charges. After a time, if he stops taking the newspaper and switches his phone to VoIP with unlimited long distance free of charge, then this fellow just sent the deflator down. If his newspaper cost him $180 per year and his long distance bill cost him $240 a year, his "personal--personal consumption deflator " has just seen a $420 drop in consumption. If his personal consumption was $30,000 annually prior to the decline, his personal-PCED declined at 1.4% annual rate.

Most folks think of inflation as being the price of something going up or down. The big decline is when you stop consuming an item because you have substituted something else. The law of substitution is powerful and pervasive. I always remember an old timer who contracted for a new house but then raised Cain when plastic plumbing pipes were being installed. He wanted the "real thing". He wanted copper pipes. One key point here is that new products are often not only cheaper to purchase but they are often better and much cheaper to install. It takes skill and tools to sweat a copper pipe joint. It takes a little glue to connect pvc joints.

Folks the ultimate good news for stock investors is the negativity of others. The time to "go all in" in the market is when the majority of folks are upset about something. Tell me who is not upset this week; Democrat, Republican, Conservative, Liberal, Iraq supporter, Iraq non-supporter, Bush fan, Bush critique, stock holder, worker, etc. The reality is that the economy is growing, wealth is being created, crime is down, education and welfare spending is up and baby boomers are in their peak earnings, saving and spending age bracket.

As one old timer used to say, "Times is GOOD!"

As a political aside, let me suggest to you that Bush is again managing expectations. All the "bad news" just happens to be hitting one year before and one year after the elections. Mark my words, a year from now, oil prices will be down, stock prices will be up, seniors will be receiving drugs at subsidized prices, the supreme court nominee will be working, inflation will be tame, the budget deficit will be improving, the dollar will be strong and Bush will be on the campaign trail. Please check the history on this one, but I believe Bush has the very real chance of being the only president to ever gain congressional seats in two off year elections!

With a few more seats, Bush could be in the position of rationalizing the social security system! With a few more minority votes, Bush will have broken the back of the welfare dependency status of the Jesse Jackson crowd. Opportunity and freedom exist for all in this great country. NOW I"M TALKING ABOUT REALLY GOOD NEWS!