Inflation (or a close-enough facsimile) Just Ahead?

Earnings season is finally in full swing, and giving us a clear picture of a global economy that is most emphatically on the mend. Monday’s S&P-induced swoon notwithstanding (I had the good fortune to be blissfully disconnected among the pelicans and redfish when that little bomb went off), it’s been a tough time to be of the bearish persuasion. Particularly amusing was yet another collective humiliation of the 47 or so estimate-posting analysts who purport to follow Intel. For about the sixth time in the past seven quarters, INTC blew away the consensus estimates of sales and earnings. Had I not been engaged in this game as long as I have, I would find it unbelievable how so many supposedly smart, driven professionals can be so consistently off the mark. It’s getting to be like a tired, old joke. In a sense, it is not unbelievable at all. It is probably a case of a malady that afflicts every analyst from time to time, and I”m not talking about those strong hints that seem to emanate from the banking side of that proverbial “Chinese wall” or from the prop trading desk. It is the all too human tendency to fall in love with an idea. Not “idea” in the sense of the stock recommendation itself, but the construct that makes a stock attractive or unattractive in the first place. In this instance, it is the notion that the new “must be seen with” toy that goes by the name of tablet is ushering in the demise of the incumbent forms of personal computing. One suspects that the ability of these analysts to assess the value proposition of these accessories is not unlike a journalist of a few years back, a long time resident of the Upper East Side, who famously couldn’t imagine that the Republicans might win an upcoming election, because none of the people she knew voted Republican. As Intel’s results have once again demonstrated, the global roll-out of Web 2.0 is alive, powerful and beyond the ken of the cosseted know-it-all’s who seem unwilling or unable to apply independent thought to the commercial reality of the enterprise that is Intel.

As gratifying as it has been to see the preponderance of earning releases confirm our bullish stance, I am increasingly ill at ease with what perhaps I am only imagining to be a jarring speed bump just ahead. That would be the likelihood that what looks for all the world to be inflation heating up is going to unsettle investors. In the months ahead, continued global recovery is going to take much of what’s left of slack out of industrial capacity and expose at least a few more pinch points. The slow motion erosion of $US versus other currencies continues, as does the tail-wagging-dog phenomenon of the speculative interests driving the price of commodities (the day-to-day fluctuations, abetted and explained away by a thoroughly corrupted media, make it so obvious.)
The only missing ingredient, the one that made the 1970s so dreadful, has been pricing power on the part of labor (excepting, of course in that what we have all gotten used to considering the world’s sweatshop that is China). As such, the vicious cycle of true inflation is not quite in place, but a reasonable facsimile, one that could suffice to get the panic mongers started, could very well make an appearance sometime soon.

It doesn’t have to be this way. This run-up in the price of oil has an all too familiar, seen-this-movie-before, quality to it. It’s more than a little tempting to go with the conspiracy theorists here. Indeed, if I wanted to script a plot for “How to Jazz the Price of Petroleum Without Really Trying”, it wouldn’t require imagination much beyond what we’ve seen play out in the last few months. The belated spread of the Bush Doctrine coursed its way around the south shore of Mediterranean until it found a particularly benighted venue that happened to be the world’s 17th largest oil producer. This place had been run for the past 40 years by a thug whose murderous exploits, at home and abroad, were such that if there were a once in a decade election for “dictator most deserving to be terminated with extreme prejudice”, he might have been a repeat winner. An opposition, largely centered around tribal animosities, laps up the kool-aid spilling over from Tunisia and Egypt and decides that enough is enough. Demonstrations beget crackdowns which beget an armed response, and a civil war is underway.

Here is where the temptation to suppose a cabal at work kicks in. Rather than adroit and determined effort to run off, eliminate or otherwise strong arm His Exalted Strong Contender for Global Public Enemy Number One, we get the most feeble and dilatory of responses. The “no fly” zone and accompanying (but not so well executed) close air support was not forthcoming until after interminable dithering and the near collapse of the rebel forces. This has been followed by weeks of inconclusive skirmishing, as if unorganized, untrained rebels were going to somehow gain control of country that is nearly three times the size of Texas (but without the highway systems). It is only in the last few days that we hear about advisors being sent in, but they are from Italy and France of all places, so how helpful can that be? All this ineffectual posturing simply begs the question, “Is the western world serious about seeing this conflict come to a favorable resolution, i.e., winning?” The answer is that no we are not, but someone, some powers that be, seem quite serious about perpetuating a protracted irresolution, the sort of low boil mess that keeps everybody on edge for as long as possible. The unserious way that the putative “free world” (as we once had the confidence to call it) is the main reason that the price of oil has tacked on an extra couple dozen $/bbl. above production costs.

So is this a rant against the evils of Big Oil? Not really. They certainly benefit from the premium price, and without a doubt have lobbied and contributed in ways have have bent energy policies in ways that have benefitted them. But who else might join into such a cabal? Those venture capitalists who thought that the crazed sex poodle who used to be Vice President was going to use his influence to bail out their alternative energy investments come to mind. They need us paying a whole lot more for energy if they are ever going to get whole. It also stands to reason that practically anyone well heeled enough to own an interest in a hedge fund, which certainly includes the most of policy makers in the Western World and all of the leadership immediately east of Europe, would be a likely suspect. This is not overheated conspiracy mongering by any stretch. It is a mere variation on what H.L. Mencken famously observed about 100 years ago,

“The whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety) by menacing it with an endless series of hobgoblins, all of them imaginary.”

As such, The Libyan conflict is a phony conflict, one that would not be dragging on the way it is if “grown ups” looking out for the best interests of their constituents were calling the shots. Instead we have a massive premium in the price of oil that is getting passed along into the price of practically everything else. This insidious “tax” is slowing an economic recovery that needs all the help it can get. Not so much that the economy can’t keep growing, but at some point no one is clever enough to predict the drag induced by this massive “tax” just might overcome whatever has thus far propelled the economic recovery. At some point none of us can see from here, the specter of “stagflation” just might cross a plausibility threshold. Of course, this will be an opportunity and not a problem for the too-influential pools of speculative capital who always seem to be a half step or so ahead of the hobgoblins. Expect the crowd to get spooked out of its wits sometime during the hot months just ahead.

A Good Time to be Un-Greedy

The Market continues to show its tenacious upward bent. You would think that with all the uncertainty that the world threw at it during the just completed Q1, on the heels of that headlong sprint that was the last four months of 2010, that even a flicker of an uptick in geopolitical tension would have knocked it into a funk. We had regime change in places we almost never think about evoking the metaphorical specter of falling dominos. This gave rise to another fearsome metaphor, that power vacuum waiting to be filled by extreme Islamists who been waiting in the wings for the incumbent thugs to exit. It also added a substantial “fear factor” to the price of petroleum, which amounts to a de facto tax hike on the millions of households whose discretionary spending constitute the major swing factor in the rise and fall of GDP. We had one of the biggest earthquakes ever trigger a tsunami that devastated a region and caused an electrical power deficit in the world’s third largest economy that will not be resolved any time soon. And all the while, various of the European Community’s fiscal reprobates were seen lurching toward that brink we heard so much about a few months back. But instead of the sort of swoon we got when last year’s troubles (Greece, volcano, etc.) started piling up, we got “the best Q1 in twelve years”, a 6.7% advance in DJIA and similarly spirited advances from the other indices. This Bull is one healthy beast.

It gets better. In case you missed it, there was a bona fide correction over the four week period ended March 15. By my reckoning, the DJIA, SP500 and NDQ retreated 6.5%, 7.1% and 8.2%, respectively, during this interlude. This sort of pullback is consistent with past Markets, such as the 1990s, when we went a very long time without a classic -10% “correction”. With the “filter” set instead at +/-5%, numerous pullbacks, lulls typically on the order of down 6-7%, register in the data. The Market has just done that, which does not mean that it is necessarily going higher, but to the degree the months ahead are passably “normal”, a Market thus “corrected” is more likely to trend upward. Fear has been shown to have an increasingly difficult time gaining a foothold, except for that fear that is “how are we going to live in retirement on these crummy bond/CD rates?” (a problem that a 100 basis point bump in rates won’t ameliorate). But even with what feels to me like another year at least in the life expectancy of this Bull, the old adage of “sell in May and go away” seems more compelling than ever. Give me a few more weeks like the last two, and the “tactical trim”, that squirreling away of a little more fire power against the next time it feels like March 15, will be the order of the day.

The situation in Libya has thrown us an interesting curve since I commented on it a month ago. Almost as soon as I opined on the high likelihood of a rather swift resolution, I started noticing reasons why it could drag on for a bit. The first clue was the rebels blowing off attempts to provide them with a semblance of training and rushing off across the desert to liberate Tripoli. You knew that, like the Children’s Crusade of 1212, this wasn’t going to go well. Unfortunately, what we have here is akin to the proverbial “battle of wits between two unarmed opponents.” The Libyan Army might be a joke up against a military organization fielded by the likes of Israel or even the U.K., but they are well equipped and have at least trained at the sort of basic tactical proficiency that is lost on anyone who has not had basic military training (remember that even when the rebels were rifle savvy American colonists and the government troops slogged about on foot wearing red jackets, it took years to get to where most of the battles did not end badly for the insurgency.) So this could drag on, like a boxing match between two octogenarians, one morbidly obese, the other not sure which glove goes on which hand. The balance will likely tip as a function of defections from the regime, of which we have already seen a few. The innermost circle probably expects about as much mercy as they have shown over the past forty years, an ethic not unlike what we read in the Bible about the earliest kings of Israel, who routinely slaughtered every member of a vanquished rival’s family and even their own siblings. It will end with a turn of lethal treachery, or perhaps a negotiated safe haven in some palatial hell hole like Dubai, but it will end soon as history books reckon. Concerns about who takes control in these squalid satrapies will remain, but I would not get too worked up about this being a heyday for the likes of Al Qaeda. In all but the most Stone Age of settings, like the remote mountain valleys where the Taliban can skulk about unhindered by any other authority, the moment has passed for that sort of lethal thuggishness to easily take root. Based on the track record of the past 10+ years, sharia is a much tougher sale than it once was (except perhaps in those parts of Europe where the basic tenets of Western civilization are so taken for granted that they are not likely to be noticed until they are gone). Too many of those who make up the so-called “Arab street” have been wised up to what that looks like once it takes root, and they won’t take it lying down.

We can also expect Japan, or least Japan, Inc., to find its feet and be back in the game as the weeks go by, shifting production of those critical raw materials and components to other locations in their “Co-prosperity Sphere”. The nuclear accident has more than anything demonstrated how capable we are of measuring and detecting even the tiniest variations in radioactivity. (How surprising should this be, given the imperative that developed around the tracking of submarines during the Cold War, that fractions of micro-sieverts bouncing around in the ocean can be picked up and monitored?) We learned a few things about how not to design a power plant, as in the siting of back-up generators, and the inadvisability of overloading spent fuel storage, but safety of basic reactor design has been solidly validated. The crisis lingers on in the form of radioactive water having leaked into the ocean, but entropy working as it does to distribute however many tons of “hot” water throughout the 622MM cubic kilometers that is the Pacific Ocean will make short work of that problem. Already arguably the safest form of electrical power we have (as measured by the number of workers killed or maimed per GW year generated) it will be safer still based on the lessons learned by this recent accident.

So the news probably gets better in the weeks ahead, but “sell in May and go away” is looking like the way to go. How is that? First of all, it is only a tactical suggestion, a little pruning of marginal holdings and trimming around the edges of positions that have already worked out far better than expected back when they were accumulated during the dark days of two years ago. It is way too early to be thinking about short selling or other forms of aggressive hedging. But there will be another stretch at least as turbulent as Feb 18-March 15 out there, and probably before the end of summer, and with the bargain basement pretty badly picked over, making sure one has buying power for the next time things get marked down is a worthy priority.

My sense is that we will in the months ahead get something that walks and talks an awful lot like inflation, that enough of the slack in the global economy wrought by 2007-09 will have been taken out to allow capacity shortfalls to become more apparent. What the CEO of Wal-Mart recently said about higher costs just ahead I have been sensing for some time now. We are already getting it in energy and transportation, where cronyism dressed up as energy policy over the past 60+ years impose dreadful inefficiencies that get paid for by every household that consumes anything that got at least part way there on a truck. The recent lip service given to the need to “reduce out dependence on foreign oil” was less than not encouraging at all. Households dependent on savings, like those well-to-do retirees who a decade ago might have had the means and inclination to help their grown offspring out when the need developed, will be particularly hard hit.

The economy is looking a whole lot better than we were tempted to think even less than a year ago (remember last summer’s resurgence of double dip anxiety?), but it is still has a ton of “issues” to work out. I will feel better about it when it becomes apparent that GDP growth is being driven by things we are particularly good at as opposed the that which merely “creates jobs”. For example, energy exploration and production, which provides high paying jobs across a broad spectrum of skills and educational backgrounds. GDP growth that is about more pet sitters, fingernail polishers, baristas and community organizers is not tantamount to that which arises from exportable goods and services derived from our still considerable comparative advantages (not to suggest that at least three of these occupations do not provide utility and otherwise make our lives richer, its just a matter of calibrating how meaningful a measure like GDP actually is.) So yes, there is a basis for optimism, for at least partial resolution, over the next decade or so, of some of the seemingly intractable issues that have transfixed the perma-Bears, but an awful lot of what might not come to pass has already been priced in. Greed is still in ascendency, but risk/reward having evolved as it has, deference to the ages old maxim as to how “pigs get slaughtered” is likely to enhance one’s heart-burn adjusted ROI in the months just ahead.