The market has rallied hard after a third foray to or below the 200 day moving average. It definitely looks and feels bullish at first glance. I must admit to being surprised that the annual tax windfall rally has come back to life here in mid-May. That’s more a factor of my own bearishness than it is of history, however. The annual tax windfall rally typically persists until mid or late May, even in bear markets. In that respect, this rally is not at all unusual.
Here’s why you should not get too excited about possibly chasing this rally. Rule Number One, the first commandment of investing, has not been repealed. “You shall not fight the Fed” still rules, and the Fed is very much on course to continue tightening.
Even by the deeply flawed and misleading measure, the CPI, inflation is at the Fed’s target. By other measures that more accurately portray inflation, it is well above target. The Fed will not be deterred from continuing to tighten, that is to remove money from the system, just because of the silliness that CPI missed expectations. It’s still at least 2%, and it’s heating up.
Furthermore, as the Fed raises the Fed Funds rate target, it will only stimulate more inflation. The Fed will be behind the curve, because the Fed is always back there pushing it ahead. Every time it raises the Fed Funds target rate, the Fed signals the decision makers in the US economy that it expects more inflation. Consumers and businesses behave accordingly. I showed you the history of that a couple of weeks ago.
And the fact is that we really have more inflation than they’re telling us.
This is a deliberate obfuscation, and today I’m going to show you exactly what they leave out (and what that means for you).
The Fed Conveniently Ignores Housing In Its Official Numbers…
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In classical economics textbooks inflation is defined as the “general level of prices.” The CPI and the Fed’s favorite measure, the PCE, are hardly measures of the “general level of prices.” In fact they measure only a tiny portion of all the things on this earth that have a price.
For example, do houses have prices? Why, yes. Yes they do. Are house prices included in CPI or PCE? No. No they are not! Why? Because they are assets, not consumption goods, say the high priests of Economism.
Economists and government statisticians measure inflation today by focusing only on a narrowly defined basket of consumption goods. The funny thing is that that basket changes over time, usually to exclude or underweight the goods and services that are rising fastest in price. The goal of these measures is to suppress official reported inflation. In this long running tragedy, they come to bury inflation, not to praise it.
Once upon time, even in the adult lifetimes of most of us who are reading these pages, as well as the guy writing this one, the government and economists actually did recognize that house prices should be counted in the popular measures of inflation. But that became a huge problem by the late 1970s as house prices inflated at breakneck speed year after year. Because housing was so heavily weighted in the CPI, that became a huge, HUGE, problem for the politicians and their corporate oligarch cronies.
In those days, you may recall, there were these organizations called labor unions, who represented many, many workers in many industries. And those unions drove hard bargains to get the best wages and benefits for their members. The US had a vast blue collar middle class that thrived at that time. Generally it became customary in labor/management contract negotiations to index wage rates to the “cost of living.” These were known as cost of living adjustments or COLAs.
And that, in fact, was the purpose of the CPI. It was the measure used by the Federal Government to calculate COLAs for social security recipients and government workers. CPI was also used to adjust government contracts. And for many years, it was the basis for labor contracts in private industry.
As a result, as housing prices surged in the late 1970s, CPI soared toward double digits. The captains of industry made it clear to the Federal Government that something had to be done.
The BLS undertook a study of how to change CPI so that it would not show so much inflation. They came up with a clever solution. In 1982 they replaced the housing component of CPI, which used actual home prices, with something today known as owner’s equivalent rent (OER).
The BLS took housing out of the CPI because it was costing the Federal Government and big business too much. Ronald Reagan’s big business sponsors had his ear. They were not happy with the pay packages that the unions were getting and they let the Gipper know.
In 1982, housing was out of the CPI, and Paul Volcker raised interest rates so high, they began to crush the US economy, along with housing prices and consumer inflation. It took rates of 16-18% to finally do that, by the way. Think about the implications of that.
The BLS publishes a history of the CPI through the years that details the whole story of how the change in measuring housing inflation, and subsequent changes in the CPI came about. Now, I had to read between the lines of that report to flesh out the story. But my friend and former colleague David Stockman was the White House Budget Director under Ronald Reagan, and he confirmed that my reading of that history was on the money.
In the past few years, house prices have been inflating consistently in the 6-7% range. But that is NOT INCLUDED in CPI! Not even is it not counted in the official measures of “inflation,” real estate industry shills, Wall Street, and the high priests of Economism have managed to brainwash the whole world into forgetting that house prices are constantly inflating. After all, housing prices don’t inflate, they “appreciate” or “grow.” I challenge you to find a news report anywhere that refers to rising house prices as what they actually are – inflation. You just won’t find it. The word is never used.
So since 1982 the BLS has used this measure called Owner’s Equivalent Rent to account for housing inflation. It asks homeowners what they think their homes should rent for. That is adjusted based on a quarterly survey of tenants’ contract rents. Then the BLS interpolates the quarterly numbers into a monthly series.
Since residential leases typically have minimal annual escalators, OER began to even lag behind market rents. And market rents have only risen at about half the rate of home prices. As contract rents and worker incomes began to lag and stagnate, OER fell farther and farther behind soaring house price inflation. In April, OER rose by 3.4% year to year. Compare that with house prices inflating by 5.8% reported by the NAR, or 7% reported by Corelogic.
The housing component of CPI is weighted at roughly 40% of Core CPI (Excluding food and energy.) Simple math tells us that if housing were included in CPI then total core CPI would be 40% of the difference between the OER measure at 3.4% and the actual housing inflation rate of between 5.8% and 7%. For the sake of simplicity, let’s call it 6.4%, making the difference between actual housing inflation and OER a nice round 3%. Therefore using OER instead of actual housing inflation reduces core CPI by 1.2%. Had housing inflation been included, then core CPI should have been 3.3%, not the reported 2.1%. On this basis, it’s pretty clear that the Fed is behind the curve.
That calculation isn’t the only measure showing that inflation is way above the Fed’s “target” of 2%. If that’s the target, the Fed is looking in the rear view mirror.
…And General Retail Prices Are Also Somehow “Forgotten”
The most suppressed of all rates is the Fed’s favorite, the core PCE. It’s the most suppressed of all the official inflation measures because it reduces the weighting of items rising faster in price and overweights those rising more slowly. Obviously, if you want to measure general price levels accurately and consistently, you would measure the same basket of goods and services all the time. That’s not how economists do it. They throw out the stuff that’s inflating and keep the stuff that isn’t inflating. So we constantly get the fake news that inflation is too low.
Let’s compare the popular top line measures to a more consistent measure, and let’s forget about housing altogether. We know what it’s doing and how excluding it suppresses CPI. But what about general retail prices? Perhaps the best measure is the Producer Price Index (PPI) of core finished consumer goods. It’s what retailers pay for the stuff we buy in Walmart and at Amazon.com a couple of times a week.
That index is now rising at 2.6%. In fact, this measure of retail goods at the wholesale level hasn’t been below 2% since 2013. By this measure, inflation has been above the Fed’s target since 2014. Had housing prices been included in core CPI, it never was below 2%. It would have been in a range of 2.5% to 4.5% over the past 5 years.
Now that the Fed is raising rates, the signaling effect that this has to economic actors will drive the headline numbers to start to catch up with this reality. And the more the Fed raises the Fed Funds target, the greater the signaling effects will be. It will only encourage the Fed to continue pulling money out of the market under its bloodletting program. And it will be a long time before rates get to the level where, like in 1982, they were punitive enough to stop inflation in its tracks.
So we face a lot of monetary tightening ahead.
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Hiding Inflation is A Losing Battle – And Reality Is About to Bite
Right now traders are using up the last of the tax windfall cash that the Treasury used to pay down $133 billion in debt in mid to late April. In addition, we can imagine that they’ve been extending leverage that is using margin to buy stocks.
And in fact, they are.
This won’t end well. Here’s why. The Fed’s bloodletting plan is working. And the traders who are borrowing margin to buy stocks are violating Rule Number One. They’re fighting the Fed.
We know that the Fed’s draining operations are working because we can see it in bank investment portfolios.
Bank investment accounts, excluding Treasuries and MBS include a wide range of other fixed income securities, both investment grade and lower, and even a few equities. These securities are carried at original cost. They are not marked to market. There are no price effects in the graph below. It’s all about quantity.
These accounts broke a 6-year uptrend in January. Since then, their selling has accelerated. That’s consistent with the Fed pulling money out of the banking system. The banks have less cash to invest.
And this is only the beginning. The Fed is only a little more than $100 billion into the bloodletting, or as they call it, “normalization.” To get to a “normalized,” tight reserve position they still have a couple of trillion to go. As the size of the Fed’s draining operations ratchets up from $30 billion per month now, to $40 billion per month in July, and $50 billion per month in October, the banks will be forced to shed even more assets.
The selling will depress bond prices and raise yields. That will spill over into stocks as investors rotate out of stocks into higher yielding, “safer” securities. Eventually, leveraged traders will face margin calls. The up and down, rangebound sprinting in stock prices will gradually evolve into a trend of lower highs and lower lows. Periods of intense liquidation are likely to be interspersed.
But what about the short run? This chart from the Wall Street Examiner Pro Trader market update suggests that the market will make a run at 2755-2780 where it should face resistance.
Cycle projections point to targets of 2740 in the short run, and then possibly 2780 by early June, although I suspect that the rally can’t be sustained that long.
In any case, it’s another gift selling opportunity if you haven’t raised enough cash in your portfolio to reach a very high percentage of cash. Only you can decide what level is appropriate for you. I like the idea of taking all your cash home and letting it hug you when the market finally sags in a big way.
In the meantime, I’ll be looking for an opportunity to short the SPY and pick up a few puts when the short term cycle oscillators on this chart begin to roll over again. That should happen within the next couple of weeks.