Inflation vs. Strategic Vision

As expected, inflation is now retreating in the face of financial turmoil and economic contraction.

Consumer prices were flat last month, following a 0.1% decline in August, the Labor Department reports. Of the eight major components of the consumer price index, three posted declines (housing, apparel and transportation prices) last month. Among those that posted increases, food and beverage prices led the way with a 0.6% rise. Core CPI (which excludes food and energy prices) rose 0.1%.

The data doesn't yet confirm that inflation has faded from the economic landscape, but that future's coming. CPI's 12-month change dropped to 4.9% last month, down from 5.4% in August. It's likely that the annual pace of consumer inflation will show further drops in the months to come, courtesy of the slowing economy that's probably headed for contraction if it isn't already shrinking.

Looking for lower inflation is hardly a dangerous forecast these days. Commodity prices have continued falling in October, with crude oil prices falling under $75 a barrel yesterday in New York futures trading for the first time in more than a year. A number of other key commodities are under selling pressure as well.

The big unwinding of the last five years is underway and it'll roll on for a bit. It's an across-the-board correction and it's driven by fundamentals and fear. The U-turn doesn't surprise us since there was a bull market in virtually everything for several years running. If one trend's possible, so is the other. Cycles are as old as civilization, although it's the degree of the rotation that's so shocking this time, although the shock is directly related to our capacity for focusing primarily on the recent past and thinking that's true perspective.

For strategic-minded investors, the reversal of fortunes offers opportunity -- eventually. For those who missed the commodity bull run, for instance, the chance to climb on board at greatly reduced prices now and perhaps in the coming months and quarters reveals itself once more. Emotion, however, will argue against the idea, as always. The crowd-pleasing elixir of going with the flow will prevent many from partaking in contrarianism until the all-safe sign has been flashing in earnest for a few years.

No doubt there's a strong case for remaining cautious on all the asset classes save cash these days. Nothing wrong with that. Being a little late jumping on the eventual rebound bus is no great tragedy. The same can be said for being a bit early. It'd be nice to call bottoms exactly, but that's not an option for mere mortals.

Keep in mind that it's easy to delay one's opportunistic buying until the next wave of selling, and repeating the decision again and again. Bear and bull markets promote self-reinforcing behavior and so one must be careful of letting inertia in one's decision making become a habit that no longer reflects strategic thinking.

Far better, then, to have a plan -- a long-term strategic plan. Making a commitment to x number of asset classes with an eye on making multiple purchases over time, based on where absolute and relative value are highest, is a good start. Almost anything is better than sitting dazed and confused for months, which can turn into years if you're not careful. Inaction has a tendency to turn into a long-term strategy if you're not paying attention. That and 50 cents gets you a cup of coffee, although free advice is sometimes good advice.

There are no easy answers in managing risk portfolios. The threat of loss is always lurking, although the magnitude of the threat is forever in flux, in part because prices aren't static either. That's good news, even if it's not obvious when you're reviewing your 401(k) statement of late.

Comments

[JasonC]

People think that risk has increased because the market is off a lot. Which is pavlov and conditioning, but utterly irrational. The market was extremely risky this time last year. It is dramatically less risky now, because prices are lower.

The PEs available on likely future earnings range from 1.5-2 for the crushed financials, to 4-5 for other unloveds, to 6-10 for high quality companies that haven't done a thing wrong. That hundreds of millions of men think those are "risky" testifies to the power of recent pain to destroy the human mind.

All the talk of early is also irrational, a piece of the illusion that one can own everything when the sign of its recent changes is positive and nothing when that sign is negative. As though anything that just happened must continue to to infinity or zero. Enough, trend following is not thought, it is a dumb mechanical destabilizing force of nature.

Profit from it. The master game starts with "buy low".

[winslow]

you could be right...or you could be wrong. It the trillions in hidden derivatives blows-up, the DOW could descend to 2000.

[SWRichmond]

When Dow and physical (real) gold are at 1:1, the most of the risk will have been wrung out of these markets. Wait for it.

Jason, so risk is lower now that the following is our situation:
1. EU wants another Bretton Woods conference because the currency exchange system doesn't work anymore
2. The Federal Reserve has lent out its entire balance sheet of Treasuries
3. All major US banks have just been nationalized
4. An unknown and inexperienced messianic socialist is about to be elected president of the US
5. 1,000 point chop in daily DOW has become routine
6. Credit markets are seized up
7. National bankruptcies have begun
8. Dow is off 40% from it's highs
9. Money stock is growing at an annual rate of 114%
10. Paulson is desperate, Bernanke is MIA, and Bush looks like he hasn't slept in a month
11. We get a new plan to save the economy every Sunday night
12. Every Monday morning the markets tell the central banks what they think of the "plan"
13. People have stopped trusting certain currencies; how long until they stop trusting all of them?
14. There's about a 4 day food supply in the distribution system at any given moment.
15. The Dow didn't regain its 1929 high until 1954.
16. The Nikkei is now at -80% of its all time high from 18 years ago.
17. Paulson's idea of "transparency&quo... is to try to enable the ongoing hiding of insolvency

So, what are you buying?

[pitaking]

The commodity trade will come back, just not in the near future. Once the liquidity that the fed is injecting has some time to boost bank balance sheets, we will see a serious spike in inflation and commodities along with it but not until 09. SWRichmond, Obama's election will be the start to a year end rally, regardless of what his policies might be, Mccain means DOW 6,000.
Disclosure DZZ, EEV

[aarc]

Stock market shareholders almost always get the raw deal.

Instead of the govt protecting stockholders, the treasury gave them a kick on the chin with BS, Fredie and Fan, and AIG. No wonder shareholders decided to get out of this anti-investor anarchic environment.

Joe six pack knows nothing of bonds and preferred shares and the mechanics of the stock market while he is being encouraged to invest hard earned cash while saying at the same time no guarantee at all he can make money and may actually lose everything in case of company bankrupcy. Also they dont have the ability to know when to get in and when to get out, thus the ordinary investors got crushed most of the time. Mutual Funds and Hedge Funds are no better than ordinary investors with many of them now on shaky grounds. ETF was another flavor with the same main ingredient which is stocks. Like softdrinks with main ingredient being water.

Banks tried the SIV (Structured Investment Vehicle) with guarantee of capital to investors but no guarantee of profit. Their biggest mistake is that they re-invested those cash in a no-guarantee stock markets. Now the banks are in big trouble.

Govt has to protect common shareholders from companies going bankrupt. That is the minimum. To prevent total collapse of the stock market in this extremely volatile environment; govt has to guarantee in part or in full stock share purchases in the next 3 months for 3 years with minimum 1 year holding period. Mechanisms should be installed to prevent stock prices running 10%, 20% or even 200% in 1 day. Govt may also charge some insurance fees from those stock purchases to recoup loses from companies going under.

[Chris B]

Jason C is right. Equities were riskier this time last year than they are today.

SWRichmond, volatility is a sign of bottoms and tops. If capitalism and democracy didn't collapse in the S&L crisis or the tech bubble, why would it collapse because mortgage backed securities experience 2% defaults instead of the expected 1%? You have to ask yourself: "what would it look like if I bought low?" Of course, pessimism would be at its peak. The overall cost from this debacle, although high, will be less than the Iraq war disaster ($3T+, 5k+ dead, 15k+ disabled, and counting). It is measurable and hopefully just as managable for a country like the US. The bottom will be scary, and the scared will sell at just the wrong time.

[phdinsuntanning]

the currency exchange system is working very well,
but favoring a strong dollar, good for EU exports...

[Socialism cannot compete!]

"No doubt there's a strong case for remaining cautious on all the asset classes save cash these days."

Cash is the riskiest of all!! Look for some big inflation in the coming months. I wouldn't want to be stuck in cash then.

[sheople]

aarc, I seriously doubt that the "government" is going to guarantee anything about the stock market. Right now they are putting trillions into the market just to intice investors into it. This will fail as the maket will continue it's fall. The feds/treasurer/congres... should not be guaranteeing anything. The only thing they are doing is delaying the invevitable. The people will just be in more debt because of their actions. The crash is coming. Too bad, but then we, the people should not have let them move our factories offshore. It won't matter who is elected. The central banks want Obama. As they control the media, we will get Obama.

[JasonC]

I'm buying all sorts of stuff. Financials, materials, retailers, a few unloved techs, preferreds, distressed financial corporates, long dated corporates at 7-8% spreads.

The best times to buy in history were - 1933 with FDR taking office and the banks closed and unemployment at 30%; 1942 with Germany nearly winning WW II, 1974-5 with the dollar forced off gold and the presidency destroyed, Saigon falling, 1982 with interest rates 15-20%, inflation still high in the rear view mirror, and a deep recession sending corporate profits negative overall.

The master game isn't "chase a headline". That is for losers.

[Whidbey]

calling a bottom, or near? I think not yet. My E-Wave analysis suggests more to go. It must be the calendar and history that drives the emotions. Today was just a 400 point setup for OpEx.

[JasonC]

I'm calling a level. Whether every single quote between now and doomsday is above the present one doesn't matter a darn. Prices are going to be a lot higher than this 10 years from now, or 25 years from now, and I'll still be collecting dividends then, not selling. The return I get from the buys I make today are going to be way above the average I'll get over my whole investing life, and I know that with certainty, regardless of where indexes squiggle to in the next 3-6 months.