Wednesday, April 30, 2014

"Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair." --Sam Ewing

INFLATION IS THE LEAST APPRECIATED PHENOMENON TODAY (April 30, 2014): If you were to poll ten thousand investors about what is most likely to occur in the worldwide economy during the upcoming twelve to fifteen months, then rising inflationary expectations would probably be among the least popular responses. However, evidence demonstrates that there has already been the kind of behavior which typifies a period of global reflation. Commodities from coffee to corn to limes to palladium to soybeans have been surging in recent months, while gasoline (petrol) prices recently climbed to 13-month highs. Each of these so far has been attributed to a separate localized reason rather than the unifying theme of rising prices, but eventually these will be recognized as part of a related theme. Rents have been steadily rising in the U.S. and around the world, while wages have been increasing at their fastest pace since before the last recession as unemployment especially among skilled workers has declined to a sufficiently low point where there is a shortage of qualified candidates in many fields and particularly in certain specialties.

The U.S. Federal Reserve appears to be obsessed with the risk of deflation, while being unconcerned about the possibility of rising prices. Because the Fed wants higher U.S. housing prices, the usually inflation-wary Fed is likely to continue to be especially accommodative toward allowing inflation to move higher especially if this helps to keep unemployment low. The Fed giving the green light to rising prices is especially dangerous, since history has demonstrated that once inflation appears it will become quite challenging to suppress. The shares of companies which benefit from rising inflationary expectations, including most emerging-market equities and commodity producers, had mostly bottomed at five-year lows at various points from June 2013 through March 2014 and have begun what could become dramatic uptrends as they revisit their respective peak levels from 2013, 2012, and 2011, in that order.

General U.S. equity indices have likely terminated their uptrends which mostly began in early March 2009. Whenever we are transitioning from a U.S. equity bull market to a bear market, inflation historically is most likely to emerge. This is partly because companies and employees are reluctant to raise prices or to ask for higher wages when memories of the previous recession remain fresh. As time passes and four or five years have passed since the last economic downturn, companies and individuals become bolder in asking for more money to buy their goods or to compensate them for their services. Thus, inflation becomes artificially depressed in the early years following any recession, and later accelerates dramatically in order to catch up to reality.

As a result, we have a situation in which the Fed is concerned with deflation and nearly all investors aren't worried about inflation, while historically we are maximally likely to experience rising prices for goods and services. This will lead to what appears to be a "sudden, unexpected" inflationary surge which will of course be completely predictable, just as we had previously experienced in 2007-2008, 1972-1973, 1936-1937, and during similar periods near the beginning of important U.S. equity bear markets. In 2008, the prices of many energy and agricultural products surged to their highest levels in decades. Everyone in July 2008 was worried about how much higher gasoline prices would become. A half year later, no one was concerned about gasoline while everyone feared that they would lose their jobs. We are likely to experience a similar economic sequence during the next two to three years, where we first have concerns about rising prices--and then, less than a year later, everyone has shifted their focus to the serious problems facing a contracting global economy.

During this kind of transition, the shares of mining companies and emerging-market equities are often among the top performers during the first year following the end of a U.S. equity bull market, with long-dated U.S. Treasuries generally being the biggest winners during the second and sometimes the third year. Investors will progressively realize that they can no longer make money by remaining in their favorite securities, and will eagerly seek out whichever alternatives appear to have established the strongest uptrends. Now is the ideal time to own many of the funds listed in the following paragraph; during the first half of 2015, it will likely become timely to gradually shift out of these and into pure U.S. Treasury funds including TLT and ZROZ. Especially since so few investors recognize or appreciate patterns which have occurred repeatedly in past decades, very few people have positioned themselves to profit from global reflation. Therefore, if you take action sooner rather than later, you will be among the first to embrace this concept. As Warren Buffett has sagely said, what one wise investor does in the beginning many fools do in the end.

Disclosure: In August-September 2013, and again during the first four months of 2014, I was aggressively buying the shares of emerging-market country funds whenever they appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares and related assets especially following their most extended pullbacks. Starting in December 2013 I have been buying HDGE whenever it has traded below 13 dollars per share with the idea of selling it in 2016-2017 as we are completing the next U.S. equity bear-market bottoming pattern; HDGE is an actively managed fund which sells short various U.S. equities. From my largest to my smallest position, I currently own GDXJ, KOL, XME, GDX, SIL, COPX, SCIF, REMX, EWZ, RSX, IDX, GXG, GLDX, VGPMX, HDGE, ECH, BGEIX, VNM, URA, ZJG (Toronto), PLTM, EPU, TUR, SLX, SOIL, EPHE, and THD. I have reduced my total cash position since June 2013 to approximately one sixth of my total liquid net worth in order to increase my holdings in the above assets. I sold almost 90% of my SLX near 49 dollars per share in November-December 2013 because steel insiders were doing likewise. I plan to buy more HDGE each time it drops below 13 dollars per share, because I expect the S&P 500 to eventually lose more than half of its current value--with most of that decline beginning during the second quarter of 2015 and extending into 2016 or 2017. The Russell 2000 Index failed to achieve a new all-time top in April 2014 while the S&P 500 did so several times, in a classic negative divergence which previously occurred during October 2007.