With Inflation Up and Housing Down, Diversification's Still Your Only Friend

by: James Picerno

As economic reports go, this morning's updates don't easily lend themselves to positive spins.

On the inflation front, today the government advised that pricing pressures are again bubbling. As a result, consumer prices rose at an annual pace of 2.8% through September. That equals the previous annual peak (set back in March of this year), and is the highest since August 2006.

Meanwhile, the Census Department reported (pdf) that new housing starts continued tumbling last month. The annualized total of starts in September dropped more than 10% from August. Measured over the past year, the annualized level of September's housing starts was down nearly 31%. The bottom line: September's tally of new housing starts is the lowest in absolute terms since the early 1990s.

Today's vision of more housing weakness while inflation appears to be picking up a head of steam should encourage no one. The spin meisters, it seems, have their work cut out for them. Then again, as we've all learned anew in recent weeks, it's best not to jump to conclusions. The data are subject to revisions, and so today's truth could be tomorrow's statistical casualty.

Although perhaps it's still hard to overlook the latest set of numbers, and think that all's well. Anything's possible, but the prospect of future data revisions won't save the deteriorating state of the housing market. Indeed, September's darkness is just another extension in a long line of housing ills.

Even a rock-ribbed optimist must admit that the residential real estate market shows little, if any, signs of stabilizing. In fact, based on today's numbers, one can persuasively make the argument, that the market is still getting worse in both absolute, and relative terms. The same can be said for the trend in building permits, which is a forward-looking gauge for real estate. Alas, the latest profile on this front continues to look troubling: Building permits for privately owned housing units in September were 7.3% below the revised August rate and nearly 26% under the revised September estimate.

As for inflation, there's more wiggle room for debating what comes next. That leaves the opportunity for arguing that there's nothing to worry about. Headline CPI inflation advanced only 2.8% for the year through September. That's a step up from the pace of recent months, but still quite middling based on the experience in recent years.

Then again, with oil prices setting new record highs in recent days, any confidence that inflation's a dead issue is subject to revisions, and not necessarily in favor of the optimists. Indeed, consider the price trends already in force that are most likely to weigh heavily on the American consumer. As our chart below shows, prices for those goods and services that are essential for the average household are rising at a pace well above inflation generally. The one major exception is housing costs which are looking tame. But, the underlying reasons aren't likely to inspire, as noted above.

The good news for investors who take diversification to heart is that a portfolio designed to hedge against the major economics risks will likely fare better relative to portfolios that make heavy bets that the best of times will continue indefinitely. For instance, asset allocation that incorporates commodities and non-dollar factors into the strategic plan are pulling their weight.

In the long run, diversification's still your only friend. Excepting, of course, for those who truly know what's coming.