Resistance is futile

Bloggers are wont to refer to other bloggers. So much so that some of the most popular sites are just reference lists, and the sites they refer to themselves refer back to the previous sites, until they disappear into a tornado of self referential gibber. It’s enough to make your brain spin.

So I’m going to try to avoid too much referential stuff – I’d rather think for myself.

Now I went from full on bullish to more cautious last week – clearly a bit early.

So the big fundamental questions right here are;
a) Is the US recession over?
b) Has the dollar made a major low?
c) Did food prices spike because of hoarding, and will prices unwind once hoarding slows down?
d) Did oil spike for the same reason, and will it fall off as well?

Now, the reason these are important questions is that the coincident spikes in food and oil, against a recessionary background in the US, and of course the credit crunch – all went directly to the 20% fall in the S&P from October through January. If we dial back food prices and if we’ve got through the worst of the recession, equity markets could move up sharply. Back in 73/4 it was precisely the fall off in resources prices after an inflationary scare, coincident with a recovery, which led to the jump in stocks. Not many stocks. Just the Nifty 50.

The reason for this is pretty clear. It’s because inflation drives stock ratings. The chart below shows headline inflation vs S&P ratings. A lot of strategists called for stock reratings during the 2003-7 bullmarket. It never happened. The US market actually rose more slowly than earnings per share. Why? Because headline inflation just kept rising.

Now, if the answers to a, b, c and d above are all positive, then I was wrong to turn cautious. Because a rerating will send the markets straight through the well defined resistance on the S&P. Even if earnings are lacklustre.

And it won’t matter that the VIX has gone back to 19, that complacency has jumped, and the front cover of Barron’s has a bull dipping its toes into the water.

Now the market clearly thinks today that the above answers are all yes; gold and oil are taking a bath, and the market has the horn. A few of my hedges got stopped out today, and my base portfolio is underperforming the rising market, badly. My fund has moved back from 14% ahead at its peak from the mid-Feb start, to 10.5% up now. It’s just as well I decided to reduce my gross, and cut down my trading a couple of weeks ago. It’s been tough enough even with lower risk on the table.

So the thing is this; should we answer yes to all the questions above? No, I don’t think we should.
There are three reasons for arguing that we are neither returning to the halcyon days of the late 1990s, nor even the mad nifty 50 explosion of 1973/4.

The first thing is this; there ain’t no slack. The US hasn’t been under trend long enough to allow for non-inflationary, let alone disinflationary growth. And if you cast around the BRICs – every single one has utilisation rates at multi-year highs.

The second thing is that global rates never got high enough to stop growth directly – through raising the cost of capital above the return on capital in the BRICs. It was the implosion of asset backed securities, of leverage, at relatively low rates that caused the carnage. I still think all engines are firing in the BRICs. And I can’t see the prospect of rates getting dialled back anywhere apart from Europe.

The third thing is global reserves. Global reserves are probably the best measure of how many dollars are finding their way overseas. They are, in short, the prime leading indicator of global reflation. They’re exploding right now – up 25% YoY. And that’s despite the shrinking US current account deficit. It’s global macro's greatest anomaly. This kind of reflation, added to high utilisation, well, it’s the perfect recipe for inflation.

So it looks to me that this brief disinflationary boom we’re in is a countertrend move. A bit like late 2006. Back then I made a nice turn long the French banks. I’m not going to trade French banks now – my job is to try not to lose too much money before we get back on the inflation train.