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Excerpt from fund manager John Hussman’s weekly essay on the US market:

Is Inflation Really Falling?

Two months ago, the year-over-year inflation rate in the CPI hit 4.3%. Seems like a lot has changed since then. In the two most recent monthly CPI reports, consumer prices have increased by 0.7% overall, which represents an annualized rate of... well... 4.3%. How exactly have we arrived at the notion that inflation pressures have measurably subsided?

Well, it's because of core inflation, of course. Two months ago, stripping out food and energy, the year-over-year rate of “core” CPI inflation was running at 2.7%. In the past two months, however, the annualized rate of core inflation has been 2.7%.

Somehow, the data seem underwhelming.

“Core” inflation is an interesting animal. The notion of “stripping out volatile components” isn't too objectionable, provided that deviations in those volatile components average out to zero over modest periods of time. But over the past 4 years, for example, the annualized inflation rate in the CPI has been 3.07%, while “core” inflation has averaged just 2.00%. The "core" figure is clearly doing more than just reducing volatility – it's leaving out components that have been in clear uptrends, and is therefore understating an index that's probably already understated due to factors like “hedonic” adjustments, “rental equivalent” housing costs, and the like...

That said, credit spreads have popped wider in the past 2 weeks as measured by the spread between Moody's BAA yields and 10-year Treasuries, by 6-month commercial paper yields versus 6-month T-bills, and other spreads. That sort of behavior is typical of pre-recession market action, and though we're still not yet at the point where a recession appears inevitable, the risks continue to mount. Wider credit spreads, as I've noted before, suggest early concerns about default risk. If those concerns become more severe, the resulting flight to government liabilities (cash and Treasuries) as safe-havens could suppress inflation pressures. For now, though, we probably haven't seen enough widening in credit spreads to accomplish that...

Likewise, my impression is that U.S. gross domestic investment is likely to stagnate in the coming years. Foreign capital inflows have financed all of the growth in U.S. domestic investment since 1998, and it is becoming increasingly difficult to expand an already massive current account deficit. Our current investment position isn't driven by that thesis, but again, a contraction in foreign capital inflows will certainly make things worse. The surprisingly steep drop in net foreign purchases of U.S. securities last month shouldn't go unnoticed...

Until we observe a reasonable (10% or deeper) market decline, the stock selection aspect of our investment approach will probably have a more reliable potential to drive Fund returns than a speculative exposure to market fluctuations could. So while we can't rule out the possibility of lifting a portion of our hedges if the quality of market action improves, I expect our returns to be driven primarily by the difference in performance between the stocks we hold and the indices we use to hedge (primarily the S&P 500).

Source: John Hussman: Stocks Need to Shed 10% Before Initiating Speculative Positions