Inflation May Be the Solution

Includes: DIA, SPY
by: Ricard

I've been rather vocal about being bearish going into Q4, and so far, it seems I've been either much too early or completely mistaken in acting on my instincts - I began my hedges at the beginning of August, and as of now have completed them and even dipped a little into the short side. Furthermore, there seems to be a fresh bevy of evidence suggesting that the green shoots are indeed real, and have somehow grown roots in what I thought was toxic soil:

Tim Iacono analyzes the state of the housing market, with positive Case Schiller data to back it up.

China sees growth in industrial production, signaling that, despite concerns of their own asset bubble, they may be assuming that the worst is already behind us.

Bloomberg sees an earnings boom due to layoffs and productivity increases resulting from them. In my opinion, this is a net positive, as it shows a willingness on the part of corporations to adjust to a 'new normal'. My original concern was that the economic effects of high unemployment would erode corporate profits - but if profits are still healthy throughout this mess, that means that the first and most important consideration for corporations to begin rehiring is already in place - scaleabe, profitable operations. If they are able to hang onto productivity improvements from this recession, then these operations may scale quite well as demand eventually works its way back into the system - even if it takes years for it to do so. In the meantime, we will have to see if bottom lines are actually buoyed by these 'productivity improvements'.

The government has begun to implement the beginning stages of an exit to QE. Of course, the government can easily reverse course and re-start even more emergency measures, but the fact that they're winding down these kind of operations is suggesting that they think the fire in the theater has burnt out. Now, reconstruction can begin.

Don't get me wrong, there are still enormous hurdles to overcome:

From the Fed: Consumer credit decreased at an annual rate of 10-1/2 percent in July 2009.

Retail has dropped accordingly. Even Wal-Mart (NYSE:WMT) is feeling the effects of decreased consumption.

As always, John Lounsbury is able to make a most compelling case, this time that banking is still a basket-case.

So, at this juncture, with the winter ahead of us, I wanted to see if there were any factors I may have missed a couple months ago that would lead to a benign environment for stocks in general, short and long term. Even after dismissing the somewhat contradictory signals above as being a wash, I still cannot quite dispel the specter of inflation.

Not being a professional economist myself, I will do the best I can to outline an inflationary scenario that may end up culling the bears from the market. I would appreciate any feedback in adjusting base assumptions or in any logical flaws that may arise from my approximations. My concern is that it is quite possible that inflation could become such a dominating force as to not only nominally raise the price of living in the US, but at the same time destroy the main foundation of any bearish argument on the economy - debt overhang and the corresponding consumer retrenchment.

The Fed has seemingly dedicated itself to fighting the beast that is deflation. As a result, policy has been incredibly accomodating towards stimulating economic activity in any shape and form. So far, it seems that what has been stimulated more than anything else is a mini-asset-bubble, as evidenced by oil's resurgence and the S&P's 6 month rally. Gold has also rallied nearly 40% from last winter's lows.

Combine this with Bloomberg's point about productivity improvements. The idea here is that corporations would somehow be able to deliver higher profits even in a slowing spending environment. This would be one sign that besides adjusting to a new normal, higher commodity prices would have been passed to the consumer - the first indication of inflation filtering throughout the economy. The consumer, cognizant of higher corporate profits, may end up demanding higher wages to keep up with the pace of commodity inflation. Once this happens, then it is easy to see that concerns about nominal consumer spending dropping and debt overhangs may become mitigated by the rising tide - the consumer may end up with less overall (the 'new normal'), but they will end up with even less debt.

What this may translate to is that the current rally may be justified as already pricing in future inflation and wage growth.

Signs to look for would be inflation in commodities (check), and a rise in corporate profits (pending). Once profits rise, wage level increases (or at least a fuller employment picture) would follow (pending). Then, the coup de grace would be whether or not the Fed decides to reign in inflationary forces by not only mopping up the QE liquidity, but also by raising rates to counter inflationary forces. I don't think I've relayed anything new here - this (outside of the initial commodity inflation) is a textbook definition of a recovery.

What I think will happen this time around (and is quite possibly already priced into markets), is that the Fed will not act forcefully to reign in inflation. Unlike the 70s, the Fed simply has no reason to - in fact, it has every reason to let the genie out of the bottle and wish our debt away into a distant memory. To put this into my trampoline-speak from earlier this year, instead of getting off the trampoline and doing a proper inspection of the device, the Fed will opt for us to jump as high as we possibly can, hoping that this air-time will be enough to fix any problems they may find in the integrity of the trampoline, and also hoping that such a leap will not itself permanently damage the trampoline. Not too reassuring, but it is not like the public would care that much - all they want is for the party to begin anew, and to feel that rush from the upward surge into the air (just don't look down).

The result is that people like myself, looking at the depressing, horrifying spectacle of the grasshopper struggling in the winter, may be over-reacting in the marketplace. It's quite possible that shorts in this environment may get their rear ends handed to them as they correctly predict a 'new normal', except that nominally speaking, this 'new normal' may be accompanied by wage and asset inflation masking the effects. Winners in such a scenario would be holders of base commodities and non-dollar denominated assets (as the dollar gets decimated in the international currency markets due to this permissive debasement scenario from the Fed), and anyone who was mildly to strongly bullish on the US economy (nominally speaking). Losers would be anyone nominally shorting the market, as I have done recently to a small degree.

I'm not sure if I am simply relating common sense, or something more contrarian to common knowlegde, or if I am completely mistaken in my logic and reasoning. I had the urge to at least attempt to solidify a possible scenario that is contrary to the bearish views that I have come to accept, one reason being that the markets are indeed brushing away all bad news for seemingly no good reason. It could be that the nominal rises are simply that - inflation may end up making the waters rise for everyone.