A One Day Drop In Stocks And Gold Does Not Mean That Inflation Is Dead

by: Right Blend Investing, LLC

Stocks, commodities and precious metals all fell sharply on Monday, a day when diversification did not work as expected. My moderate risk model portfolio felt the pain with losses in nearly every asset class. The only positions that rose on Monday were bonds and the Arbitrage Fund, ARBFX (perhaps because there were $52 billion of mergers announced on Monday).

Days like yesterday remind me why I still own some Treasuries. I don't like the long-term outlook, but when every other asset class goes up in flames, you can still count on a flight to safety.

So I hold my nose and buy TIPS and Treasuries (not a lot, but enough for volatility management). Monday shows that this still works, even though gold makes more sense as a long-term hedge.

Moderate Risk Model Portfolio, Ranked by Daily Performance on 4/15/13

Fund Symbol Last price % Change
Barclays ETN S&P VEQTOR ETN VQT $133.89 -2.1%
WisdomTree Emerging Markets Eqty Incm Fd DEM $53.10 -1.4%
iShares Gold Trust ETF IAU $13.19 -1.3%
Schwab U.S. Broad Market ETF SCHB $37.43 -1.0%
JPMorgan Alerian MLP ETN AMJ $44.69 -0.9%
Schwab Emerging Markets Equity ETF SCHE $24.63 -0.7%
Schwab U.S. REIT ETF SCHH $33.61 -0.7%
iShares iBoxx $ High Yid Corp Bond HYG $94.15 -0.6%
Schwab U.S. Dividend Equity ETF SCHD $31.65 -0.6%
Schwab International Equity ETF SCHF $27.75 -0.5%
Arbitrage Fund Class R ARBFX $12.45 0.0%
iShares IBoxx $ Invest Grade Corp Bd Fd LQD $121.47 0.0%
Schwab U.S. TIPS ETF SCHP $58.56 0.1%
Schwab U.S. Aggregate Bond ETF SCHZ $52.59 0.1%

Signal or Noise?

The convergence of correlations on Monday and a spike in the VIX is usually a sign of a financial or economic crisis. The news on Monday was certainly tragic (Boston's bombing), but not economically disastrous (China's slowdown). The steep decline probably reflects the market's complacency in spite of weak fundamentals. This complacency is aided and abetted by quant easing, which makes it easy to overlook bearish data about Europe, corporate profits, employment, etc. (Speaking of employment, a labor force participation rate of 63% is a disgrace, and nearly four years after a "recovery" it's a catastrophe.)

But the litany of bad news at home and abroad is not new, and bad news did not cause the sell-off on Monday. It's not clear what did: Perhaps forced selling at a few large hedge funds, or perhaps the market was simply extended. QE is not an anti-gravity machine; it's more like a hot-air balloon.

Inflation Is Not Dead

In a few stories I've read, the simultaneous drop in stocks, commodities and precious metals is being treated like a warning bell, ringing loud and clear that inflation is dead and deflation is the new enemy. This interpretation is helped by the assumption that commodities are a proxy for global economic growth.

But it is too early to tell if Monday's move signals the death of gold, global recession, or the onset of deflation. Granted, this is what the price signals indicate. But I do not assume that price signals are correct or predictive of underlying economic growth.

Quant Easing Still Drives Markets

There is a fallacy in using asset prices to predict economic fundamentals. Global capital markets have been massively distorted by quantitative easing, so asset prices have been sending distorted signals. The distortion has been most obvious in the U.S. bond market, with 10-year Treasuries offering negative real yields. But QE's fingerprints have also been evident in the stock market, and in the disconnect between stocks and corporate profits over the last six months. There is also evidence that QE is also affecting U.S. residential real estate, since near-zero rates have led to a massive influx of institutional money.

With all of this money chasing assets, it's a safe bet that QE is also affecting commodities and precious metals. The fact that QE is not driving commodity prices higher right now is probably a sign of short-term rotation into other asset classes. This short-term rotation is being exaggerated by the amounts of money at work, and by leverage. QE makes leveraged bets by hedge funds much less expensive, and leveraged bets wreak havoc when they are unwound suddenly. With gold prices breaking through key support levels, this is probably what's at work today. Moreover, margin calls and forced selling tend to cascade across asset classes, causing selling across the board. This happened in the fall of 2008, when hedge funds had to unwind positions that had no direct link to Lehman, to mortgages, or to the economic slowdown. That's why they call it contagion.

So for now, the price moves and the convergence of correlations look to me like rotation among asset classes, exaggerated by QE and leverage. I do not read these moves as an inflection point in the economy or inflation. Not yet, anyway.

Confusing Cause and Effect

It can be a mistake to use price movements explain the news. Journalists often do this under deadline pressure, and financial journalists are notorious for assuming that the market is always right. "If prices are moving, there must be a reason." That's true, of course, and I pay attention. But there doesn't have to be a fundamental reason. And a dramatic plunge in gold strikes me like a signal about the gold market, and not a signal about economic growth or inflation expectations.

The U.S. still wrestles with a mountain of debt, and the country is kicking the can down the road with QE and zero-bound interest rates. The U.S. also has massively underfunded public pensions, and partisan gridlock that renders us unable to address Medicare and Social Security. It is all a recipe for inflation, a political cure-all for weak leadership and unrealistic promises. Consequently, I believe that America's monetary and fiscal policies will eventually lead to inflation. (A deflationary outcome is even worse, since a shrinking economy and falling government revenues would make our deficits larger. In that case, we get stagflation, and lots of it.)

Since the monetary and fiscal outlook for the U.S. has not suddenly improved over the last day, week, or month, I believe it is a mistake to conclude that lower gold prices mean lower inflation. The drop in gold may signal lower growth - that remains to be seen. But I sincerely doubt that lower gold prices have ended the threat of inflation.

Guilty of Optimization in the First Degree

Monday's broad sell-off across asset classes is a good time to highlight the fatal flaw in static optimization models: Correlations change. The past is not always prologue. Days like Monday are a reminder of the weaknesses in automated tools that "help" investors plan for retirement. In the worst form, these mindless models treat diversification as a simple matter of blending asset classes and strategies, and financial planning for a 30-year retirement is no harder than making a smoothie.

Paul Kaplan once said, "Historical statistics should not be blindly fed into an optimizer." Yet that is exactly what most investors do for their retirement planning, after they encounter one of the optimizers that are so popular on the web. When the assumptions fail and the projections fall short, the hapless investor is left holding the bag.

As for me, I am guilty as charged of optimizing portfolios, and I live with the messy results. What are the differences between what I do and "blind optimization?"

  1. I'm candid with clients about what models can achieve.
  2. I use models as a means, not an ends. I'm responsible for the results, not a model.

Those are the differences in my practices. I also differ from most optimizers in my beliefs:

  1. There are no perfect hedges - any asset that acts as a hedge eventually loses this characteristic after it becomes a liquid, marketable security.
  2. Hedging, diversification, and risk management are all inherently fluid, tactical, and specific to each client's goals.
  3. Active management is still the best form of risk management.
  4. There is no perfect model, mix, or method. There is only process, execution, and accountability.

Disclosure: I am long VQT, DEM, IAU, SCHB, AMJ, SCHE, SCHH, HYG, SCHD, SCHF, LQD, SCHP, SCHZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. LONG ARBFXAll written content is for information purposes only. Opinions expressed herein are solely those of Right Blend Investing and our editorial staff. Material presented is believed to be from reliable sources, however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. The presence of this article shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services to any residents of any State other than the State of New Jersey or where otherwise legally permitted. This is not a complete discussion of the information needed to make a decision to open an account with Right Blend Investing, LLC. There are always risks in making investments, including the investment strategies described.