Economy Will Recover With Inflation, Not Deflation, Likely to Follow

by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay (published Monday, August 9th):

I read Peter Boockvar’s prose after reading a debate between two top economists. One is in the deflation camp and the other is not. To be sure, I was quite impressed with Peter’s cogent comments against deflation. Indeed, deflation has always been a “bad bet,” except for the 1930s. Currently, however, deflationary concerns are swirling on the “street of dreams;” and, I don’t believe them. I think the present-day policies will actually prove inflationary. While it’s true transfer payments to middle / lower-income recipients are not going to be all that stimulative (or inflationary) given falling housing prices, that still does not spell deflation. In such an environment recipients will probably not spend the transfer payments, but rather save them to offset the negative wealth effect of lower housing prices.

A better strategy would be making “transfer payments” to a program like the WPA of the 1930s. Recall, the Work Progress Administration was crafted in 1935 to employ the unemployed with the objective of putting people back to work by building infrastructure projects. Such operations have a far greater “multiplier effect” (for every $1 spent you get a $2+ impact) in the economy. Accordingly, given the current economic policies, the nascent economic recovery is likely to be slow, but with no double dip. And, that is what’s happening as the recent economic reports have softened, punctuated by last Friday’s ugly employment numbers. Nevertheless, the economy will recover with inflation (not deflation) likely to follow.

Clearly, the stock market believes an economic recovery lies ahead as the S&P 500 has rallied ~83% from its March 2009 “lows” into its April 2010 “highs.” Since then we have experienced a typical correction accompanied by cries that this was merely a rally within an ongoing bear market. Ladies and gentlemen, since the first Dow Theory “sell signal” of September 1999, I have opined the equity markets were likely going to be in a wide-swinging trading range for a very long time that would be characterized by numerous tactical bull and bear markets. I likened it to the 1966 – 1982 affair whereby the DJIA went nowhere for 16 years, but within that trading range there were 13 skeins where the senior index rallied, or declined, by more than 20%. I still think that is the kind of stock market pattern we continue to face.

I also believe the March 2009 lows will not be breached. Again, looking at the 1966 – 1982 sequence, the nominal stock market low of 574 (basis the DJIA) was registered in November of 1974, while the “valuation low” came eight years later during the summer of 1982 with the Dow selling at 7x earnings, below book value and with a yield approaching 7%. The point is that the November of 1974 price-low was never breached! I think that is the case here in that the S&P’s price-low of 666, recorded in March 2009, will not be violated.

Last Friday, however, the negative nabobs again came out of the woodwork emboldened by the egregious employment report. Nevertheless, Friday’s selling was contained, leaving the DJIA down only 21-points for the session after being down 159-points at 11:00 a.m. That price action is consistent with my sense that selling will not gain much traction. Reinforcing that view: the NYSE Advance / Decline Line has traded to a new high, stocks making new 52-week highs are substantially above stocks making new 52-week lows, Lowry’s Buying Power Index remains in an uptrend while Lowry’s Selling Pressure Index tagged a new low reading last week, credit spreads have been narrowing, the Volatility Index is retreating, and the bullish list goes on. Such metrics are inconsistent with the onset of a new bear market. As the Lowry’s service writes, “In Lowry’s 77 year history there has never been an instance, at this early stage of a new bear market, where Buying Power was at a new rally high and Selling Pressure at a new reaction low.” Plainly, I agree.

Accordingly, I think the equity markets should grudgingly work their way higher, even though I remain cautiously positioned. Given that cautionary stance, I favor the strategy of buying high quality, dividend paying stocks combined with special situation income funds like Putnam’s Diversified Income Fund (PDINX/$8.10). And this week we get another special situation income fund from my friends at WisdomTree for your consideration. To wit, on Tuesday WisdomTree Emerging Markets Local Debt Fund (symbol: ELD) is slated to begin trading. It will contain emerging market debt with a duration of between 4 – 5 years and will be denominated in that country’s local currency. As always, terms and details should be vetted before purchase.

Speaking to stocks, I was interested to see a number of the names I have been using make it into a list compiled by Jim Grant of Grant’s Interest Rate Observer. To make said list, a company had to be U.S. domiciled, have a market capitalization of more than $5 billion, a return on equity of greater than 15% (for the latest fiscal or calendar year), a dividend yield greater than 2%, a debt-to-assets ratio of less than 35%, and a price-to-earnings ratio of less than 15. These are the names from Raymond James’ research universe that made the grade: Exxon Mobil (XOM/$61.97/Outperform), Wal-Mart (WMT/$51.79/Strong Buy), Johnson & Johnson (JNJ/$59.96/Outperform), Intel (INTC/$20.65/Outperform), Abbott Labs (ABT/$50.57/Outperform), Aflac (AFL/$50.75/Outperform), Chubb (CB/$53.76/Outperform), Diamond Offshore (DO/$66.43/Market Perform), and Darden (DRI/$41.82/Market Perform).

The call for this week: The earning’s yield (E/P) on the S&P 500 is currently 6.6%, which is the highest in 15 years, while the spread between the earning’s yield and the 30-year Treasury Bond is the widest in 30 years. Accordingly, I favor the strategy of buying high quality, dividend paying stocks combined with special situation income funds like Putnam’s Diversified Income Fund (PDINX/$8.10). Last week the DJIA tested, and held, support. Meanwhile, the Transports are trying to break out to the upside. All of this should lead the equity markets higher.