Inflation-Deflation Timer Turns Neutral

by: Cam Hui, CFA
The Inflation-Deflation Timer model turned neutral last week after showing an “inflation” signal that has been in place since July 2009.

[click to images enlarge]

The above chart shows the price graph of the Reuters/Jeffries CRB Index and the timing of the most recent signal. The Inflation-Deflation Timer model turned bullish on inflation and commodities in late July and moved to a neutral stance this week, which represents a profit of about 8.5%.

There is a possibility that the model could turn positive on inflation again. The commodity and stock markets appear to be staging an oversold rally, which could create a whipsaw condition and flip the model back to inflation. Such a reversal is likely to be a fake-out. For example, consider the technical position of gold, a leading indicator of inflationary expectations. Gold is facing significant resistance; technical resistance that it faces if it were to rally significantly. Investors are overly eager to be bullish, which is contrarian bearish. Moreover, commodity prices as measured by the CRB have violated the uptrend line shown in the above chart.

A more defensive position?
An investor who strictly follows the Inflation-Deflation Timer model would move from a position of holding a basket of commodities into a 100% equity allocation. However, I would be inclined to be more cautious than to assume the risk of an all-equity portfolio.

There is substantial valuation risk embedded in the stock market. The chart below shows the Tobin Q ratio, or the market value of a company divided by the replacement value of the firm's assets. (A low Q, between 0 and 1, implies undervalue while a high Q, over 1, implies overvalue.) Right now, it indicates that the S&P 500 is substantially overvalued.

In addition, other respected investors believe the stock market to be overvalued. John Hussman believes fair value is between 672 and 810. Jeremy Grantham has a fair value estimate of 860 on the S&P 500.

Technical violations also a negative
As well, stock and commodity prices have violated a number of important technical trendlines. This loss of momentum also indicates that investor sentiment may be turning against the investment thesis of economic recovery.

The combination of a valuation headwind and neutral or negative price momentum makes us highly nervous about a full all-equity commitment. Under these circumstances, I would be inclined to add a greater bond component to a balanced fund portfolio.