From the Buffaloes to the Bulls

With apologies to Buffalo Springfield...

There's something happening here
And what it is ain't exactly clear.
There's a man with some bonds over there
Telling me I've got to beware.

I think it's time we stop, traders, look around.
Is deflation coming 'round?

There are battle lines being drawn.
Gold's not right if the yield curve is wrong.
P/Es are speaking their minds
Leaving so many values far behind.

One drawback to being an aging baby boomer is the unpleasant memory of inflation. This scourge ignited during the mid-1960s, when President Lyndon Johnson tried to fight a war with ill-defined objectives and simultaneously to engage in massive government spending without raising taxes. So, how did this Texan in the White House finance all of this? He prevailed upon then-Fed Chairman William McChesney Martin to maintain an accommodative monetary stance.

We're so lucky that no parallels exist today.

We're so unlucky, however, that textbook relationships among monetary policy, price levels and financial markets have entered a new and dangerous phase. Let's untangle the mess and see the investing implications. You'll be surprised and pleased; it's my first remotely bullish analysis of 2001.

Can Monetary Ease Accompany Deflation?

Last week's stunning drop in the producer price index , the largest on record, helped to revive discussion of whether we are in an epoch of systemic deflation, or falling prices. Readers who want to learn more on this subject should check out A. Gary Shilling's outstanding 1998 book Deflation, which may have been written three years too early.

Those who say deflation cannot persist in the face of expansionist monetary policies have to prove their case. We need only to cite the ongoing Japanese debacle or, for that matter, the U.S. during the 1930s to counter that argument. Money needs to be translated into credit to ignite inflation, and it's hard to expand credit in the face of (correctly) risk-averse bank lending policies, excess production capacity and a continued flight away from lower-grade corporate bonds in favor of Treasuries .

Let's look at the monetary base, the total amount of money in circulation plus reserve deposits at central banks. As monetarist theory would suggest, an increase in the monetary base should lead to an increase in nominal price levels at some point down the road. Over the 1981-99 period, the lead time between year-over-year increases in the monetary base and year-over-year changes in the PPI was 21 months.

Does Monetary Base Set the Pace? If So, There's Deflation Ahead

Source: Federal Reserve

But, we have an incredible pattern reversal going on right now. Twenty-one months ago, the monetary base was expanding at double-digit rates as the tech boom was at its height and the Fed was printing money in anticipation of Y2K problems. Today, the PPI is falling like a rock. Moreover, the period of maximum monetary creation was followed by a period of rapid decline in the base's growth rate. This suggests that we'll be under some pressure on the price front for a while.

If the Fed is trying to inflate the stock market, which it'll deny, it may have some short-lived success. In another interesting leading relationship, changes in the monetary base's year-over-year growth have affected the year-over-year rate of change in the S&P 500 nine months later. In other words, an early burst of money flows into financial assets before it flows into real assets, but it's an illusory effect. The resulting pattern is an inverse relationship between money and equities with this lead time.

Monetary Base and Subsequent Changes in S&P 500

Source: Bloomberg

Don't Break the Thermometer

The Treasury's recent decision to abandon the long bond and inflation-protected securities based on it was bad fiscal policy. It's bad for market analysts, too, as it will eliminate a good source of information on inflation inferences from the yield curve and from the yield spread between the bond and its TIPS (Treasury Inflation-Protected Security). The inflationary spread between the 10-year note and its TIPS, which surged between January and May on the belief that this money would be translated into credit by banks, has continued to erode.

However, this inflation premium has not eroded as quickly as the yield on the 10-year note itself, which suggests a divergence. Either nominal yields have fallen too low in our present flight to quality, or the bond market is in a state of disbelief on the strength of deflationary pressures. Given the breakdown in the monetary base-to-PPI relationship noted above, I'll go with the latter, which means that Treasuries may still be attractive even with the present positively sloped yield curve and government stimulus festival.

Is the Inflation Premium Still Too High?

Source: Bloomberg

Rational Overvaluation?

A lot has been rightfully made of the post-Sept. 11 rally. Are we simply reinflating the bubble? If we take the consensus forward-looking earnings estimate for the S&P 500 of $47.06 a share, we get a forward-looking price-to-earnings ratio of 23.8. This translates to a bond-equivalent earnings-to-price ratio of 4.2. The 10-year note yield is now 4.301%. As stocks pay dividends, the present yield on the S&P 500 is 1.39%, and unlike fixed-income instruments, stocks' earnings can grow over time. It's not a big stretch to say that stocks are fairly valued at present levels.

If we take a standard dividend growth model and plug in the above numbers, we get a dividend payout of $15.57 a share on the S&P 500, a dividend yield of 1.39% on an S&P 500 index value of 1120, as of Nov. 9. Using a complex mathematical formula to find the dividend growth rate, I arrived at an earnings growth rate of 8.45% over the next 10 years. Over the past five years, actual earnings growth for the S&P 500, including our present unhappiness and a raft of global crises, has been 8.4%. This is doable.

Given the favorable inflation and interest-rate outlooks, only a collapse in expected earnings and a more-severe-than-expected economic downturn should deter anyone from resuming an appropriate exposure to equities.