Thursday, April 16, 2009

Be a Zenful Investor

The single most important issue in positioning investments for future growth is to be correct on the question of inflation, more specifically unexpected inflation. Markets are discounting mechanisms based on infinite expectations. The trick is properly predicting the future. As Yogi Berra, the Yankee’s hall of fame catcher, so brilliantly declared many years ago, “it’s tough to make predictions, especially about the future.”

Right now there is a battle royal going on between the forces of deflation and inflation and today deflation is winning. Despite our personal inflation rate which tends to focus on the price increases, not the price decreases, deflation has the upper hand at the moment. But predicting the present does not provide much profit so we need to look further into the future.

The federal government doesn’t help much in clearing the fog of prediction with statistics that seem to distort the past , the present, and the future. Whereas last year a benign Consumer Price Index seemed very much at odds with soaring food and energy prices and personal experience, we now see the reverse happening.
The most important component in the CPI calculation is what is called Owners Equivalent Rent. The OER is the governments estimate of what it would cost if owners were to rent the homes they own. It ignored housing prices for years and produced hugely understated inflation. Now, ignoring the fall in housing prices, the CPI is overstating inflation substantially. If we substitute the Case-Shiller housing index which more accurately tracks housing prices the CPI would show a negative 5.0% change in the index versus the government CPI of +0.2% . The government data show the housing component (approximately 25%) of the CPI rising 2.1% while more accurate housing data have prices falling 19.5%. Who is right?

With such a muddle of numbers which should be guiding us what can an investor do to avoid paralysis of analysis while bludgeoned with contradictory headlines daily? Be zenful and take the middle road. Let the market be your guide. In periods of trendless market action I often take small but opposite positions to act as canaries in the coal mine which I monitor closely until one keels over and the other sings.
Currently I am opening new positions in both long and short treasury bonds. In the past month the long treasury bond position is lower by slightly more than one percent and the short position is lower by about the same. However, in the past week the results are reversed. In other words, clients are hedged until we have clarity and can invest longer term with a clear bias. For now, the deflationary bias still has the edge despite the $trillions of stimulus flooding the market. I believe, in time as the economy begins to regain its footing the Fed will need to remove much of the newly printed money from the system. Historically it takes the better part of a year before the economy begins to feel the effect. But if history is a guide it likely won’t be pretty and investors should be placing their canaries before placing bigger bets.

John Barnyak