Inflation Education

Greetings –

Anyone catch Letterman the other night, where he does one of those great moments in presidential speeches bit, oh man, are we going to have fun with G.W. Bush for years on this sketch. Well he goes on to show Bush saying “the right hand now knows what the left hand was doing” – of course the president was trying to be clever and refer to party – but it still just sounds funny. Alright – to business….

When your used to spending a five spot on lunch and all of sudden now your almost out two five spots for the same meal, you notice it. Even if your mega-rich, and “the rich have been bitching.”

This phenomena is called inflation. Now the simple example above we can all relate to, but lets dive into why inflation is bad….

inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency

WOW – that was a mouthful!

Could there be a chance inflation is good after all that being said???

I read that “inflation eases the national debt burden”, that’s positive. If you owe lots of money and are locked in to a fixed payment, perhaps it’s not so bad for you the payer, because you pay the lender back in depreciating dollars, but hey why would someone want to lend if they knew that was going to happen.

Let me know if you see any positives from inflation….

Wait I got it, more expensive food will solve the country’s obesity problem by forcing people to eat less and higher quality to maximize the use of such food.

Anything else……hmmm – ahh yes, higher energy prices force conservation, and incentivize exploration for more efficient fuels, now we’re rolling.

Anymore? Is it gonna be the tough love to kick people in the rear and get them going on the right track?

No that just doesn’t sound right, inflation is bad.

The relative price stability of the past 15 years is giving way to worsening inflation

Inflation is caused by more money chasing the same amount of goods, and there has been a lot of more money being run off the printing presses here in I.O.U.S.A. (I still have to check that movie out!).

Who can protect us from the beast? I know, productivity is a foe because getting more out of the same input works to drive inflation down. Let me get that straight, producing more for the same pay helps?? Yessir! Ok, can anybody else help? High interest rates seem to help because then people spend less in search of better returns – right. Does the list end there? Tighten the money supply!!! Thereby making each dollar more valuable which will drive down prices as people compete for the fewer bucks floating around. Oh jee wiz – this is not going well.

Think about this, while the world only gets more and more crowded, we need to have more money floating around for everyone to survive – that’s just a given. So I now turn to a quote:

Ludwig von Mises states as follows: “Finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them.”

Ok, that was a little scary, but lets pay attention to the part that says inflation is a deliberate policy. That sounds about right, when paper money is not backed by gold anymore which would restrain the printing press. I want to think about it some more and come back to it…..

So where does inflation leave us?

Results of inflation are a tightening of our belts and acceptance of lower living standards and higher prices plus a weaker economy, resulting in fewer jobs. Well we have been living the high life the past decade or so, and here in the states, we do not spend as much of our discretionary income on necessities as the more impoverished places, we’ll get back to that in a second….

Some quotes:

Dallas Federal Reserve President Richard Fisher and Richmond Fed President Jeffrey Lacker said on Tuesday 8.19 that the Fed should be prepared to hike rates at a moment’s notice if it becomes evident that inflation is out of control.

Fisher said he worried that the economy may have already come down with a case of inflation “fever” from the surge in oil prices.

Ask yourself – do you think value meals at McyD’s are going to get cheaper? Did you hear the dollar menu is under fire? I would say inflation fever is definitely with us to stay….

Companies are already planning to pass higher input costs on to consumers, Fisher said.

Fisher said the cost of manufacturing goods in China is increasing due to rising labor costs and enforcement of new work rules.

Hey that is interesting. So does that mean as other countries get on a firmer footing of parity with the U.S. that we will move out of what we have been used to in terms of prices? We have been living in a dream world! Back to the serious quotes:

Lacker said credit stress should not “tie our hands” to hike rates. “The type of credit market stress… is going to be just as stressful with a little higher funds rate or a little lower funds rate,” he said.

Markets are great – especially where there is such a split in opinion – we just need to be careful its not a reflexive process – which is driven by a misunderstanding or misconception and is exploited over and over again. (Kind of like how the young mathematicians all saluted themselves for their financial product genius, which was based on equilibrium theory and rational expectations, etc, but turned out to be dead wrong when they did not imagine the dislocations that could form from unreasoned despair – alright that’s another blog). Here is the other side:

Dennis Lockhart President of the Federal Reserve Bank of Atlanta says the worst of inflation will soon be behind us and has argued that inflationary pressures should ease in coming months. He is on Bernanke’s side (for now). If he turns out to be wrong, Lockhard vowed that he will quickly join the chorus calling for higher interest rates.

I would say that recent price increases are more likely to be transitory than persistent,” Dennis Lockhart said in a speech at Georgia State University’s business school. “I expect that CPI inflation will peak near the July level of 5.6%.”

Hey how about that – we don’t have much to worry about according to Lockhart. Are things going good in the ATL???

Ahh….but Fisher says “everybody at the table is concerned about inflation,” and “if there is a sense that slower growth is not squeezing this inflation out of the system, I don’t doubt for a second that the committee won’t do what is required” to bring price pressures back in line.

Can I get a Lil John – WHAT! They won’t do what is necessary – aren’t these guys your friends Fisher??? That’s right they will not raise rates to fight inflation until they absolutely must….which is in the distant future I suspect – but hey maybe a curve will come with a 25 bp hike just to keep markets off guard…one never knows.

In terms of the Fed offering further assistance to financial markets, Fisher said “we have done a lot, and I would be hesitant to do much more.” Fisher has been a consistent hawk, squarely focusing on the threat inflation poses to the broader economic outlook.

“The real concern I have as a central banker is whether or not (inflation) begins to affect the mentality of spending patterns by consumers (and) pricing patterns by producers,” Fisher said – it’s sort of 50/50″ whether the inflation gains will prove a “one off event,” or something more persistent, Fisher said. He fears the latter scenario may be more likely: “I have been most concerned” that expectations of further price increases will become embedded in the economy.

And it’s still unclear whether the recent retreat in energy prices will lower price pressures

You said it – I am riding with that. The mentality has shifted – lets take a survey on that.

Now what do these guys look at when they make their call on inflation, lets list tem out:

The Beige book which is there anecdotal testaments in their respective districts, exports which measure how competitive we are with other countries products (this has been going good which tells you our dollar is not so hot), exchange rates of currencies (again the dollar chart tells you something), CPI which refers to the consumer price index (just hit a 17 year high ladies and gents), PPI (the producer or whole sale price index which outdid CPI and hit a 27 year high in July), the TIPS spread Treasury Inflation Protection Securities (buy these and you don’t have to worry about inflation, just the prospect of deflation), the PCE (personal consumption expenditure) index, personal incomes and spending patterns, and in general inflation expectations, which on the positive has decline eight tenths of a percent to 6.7% for the year.

I gotta go – but hopefully this illuminated the landscape somewhat…..

Dollar Strength

Surely you must have noticed the low of the dollar around July 12th hanging at the 71 handle, and in recent days the dollar strength has taken us above the 76 handle.  What a move in a short period of time and Forex traders are either sipping boat drinks or trying to raise new capital.

Some high level explanations, slowing demand for oil which works inversely with the greenback, since it is priced in our currency – actually the causality is working the other way in my opinion – as the dollar strengthens, oil weakens, but if you heard commentary last week stating more supply is coming online and maybe we have not hit peak oil yet, you would be inclined to think the former is driving it.

Other explanations include the knock down of the premium in the Euro when Trichet did not raise rates to combat inflation which is the ECB’s sole mandate.  Same deal with the pound from inaction by the BOE.

Did you see last Friday 8/8 that productivity is up – although hours worked is down – so that helps inflation temporarily but growth suffers, and unemployment will continue to rise as result – it figures, you have to get more for less or out of less people – right.

Could FED rhetoric and Paulson’s jaw boning for a stronger dollar have finally caught on in the populace’s mainframe? Don’t put too much into that, although self fulfilling prophecies are wonderful to watch.

The trade deficit declined in June, as reported today, which is a positive for the dollar, but exports suffer as a natural consequence over time when exchange rates move in favor of the greenback.

So you may have heard, central bank intervention is responsible for the dollar rally with good evidence by James Turk (this guy’s pretty smart).

I wouldn’t rule out some help from the PPT as well (wink wink).  Is Paulson involved with that ??

Another, well the obvious, reason for dollar strength is that the global outlook is worsening – other economies are slowing – so alternate currency holders are now happy to hold dollars instead – I mean, its a safe currency when times are bad (since the dollar symbol is understood everywhere), save when times are bad for the currency itself – also the US has already gone through a lot of pain, but we are not done yet (banks are telling us that), plus the FED must save the banking system with whatever tools they can, inflation and growth trade places as the second and third priority – HA!

Wow – Bil Gross was right on time with his call to buy dollars last month – I keep telling everyone those PIMCO guys have front row seats – wonder if they have popcorn and butter while they watch?

Alas this is just market sentiment at the moment – friends, its in style to buy dollars once again.  But the fundamentals have not changed for the US – can’t wait to see I.O.U.S.A on 8/21 – so this dollar rally could go on for a while, maybe through the end of the week for option expiration, maybe thru the election, maybe til next year – who knows – but at some point the dollar will circle in the whirl pool again – so in this scenario I am happy to state I am a buyer of gold….

Take a Second…and Just Think

At the risk of being labeled a malcontent or a dramatic similar to Rep Ron Paul (TX), I shall begin….

Lets wonder, while capitalism has thrived it undoubtedly creates classes at the extremes (max and min) and a group somewhere in between – it has spread and continues to, but what happens when the gaps get too wide, and the group in the middle gets pushed more toward either extremes?  Social uprising perhaps…well as we then shift toward socialism for a period, the move may then lead back to communism or the one ruler dividing everything equal for all – and as we know this disincentivizes progress of any kind – so what happens next is a new beginning for democratic capitalism – which is nothing more than starting the game of class segmenting all over again, and those aware of how to play will do well and those oblivious to the game will be at the bottom….okay enough about that – but just a thought – does it make sense?

On to some real issues – James Turk’s recent commentary points us to the following link:  http://research.stlouisfed.org/fred2/series/BORROW This my friends should be alarming, and its not even a matter of adjusting for inflation as the chart begins back in the 1920’s.  Mr Turk does a good job of elaborating on the charts implications….

Did anyone hear that a 30 Year bond is to be sold on Aug 7 to raise $10B for the US govmt (I thought those were a thing of the past – wow).  $17B will be sold in 10 year bonds on Aug 6 – why? well to deal with soaring budget deficits…..double wow!

I saw Sen. Konrad (ND) the other night speaking about fiscal irresponsibility, and with the Olympics approaching, he suggested awarding President Bush the Gold, Silver and Bronze for record deficits, Gold for 2008, Silver for 2004 and Bronze for 2007.  He also had a nice chart that illustrated that President Bush as one president tallied $1.61T vs the combined amount of his predecessors of $1.01T  – I am not sure exactly if it was debt or spending but you get the picture….and its not good

FED extends emergency loan program to Wall St., until end of Jan 2009, it was supposed to end in September next month, this is bad news people, the discount window is a fancy name for running the government printing press for our currency – and the more currency out there, the less valuable it becomes – right – yeah I changed from poly-sci after frosh year to econ in my sophmore year – but you don’t need ECN 101 to get that!  I was in the barber shop and a fellow citizen refused to believe the govmt would allow reckless money creation that would devalue the dollar, but its happening – go back to the chart in the link to see it….

The IMF and Bill Gross of PIMCO have said there is no end in sight to the crises at hand – even with the passing of the Housing and Economic Recovery Act of 2008 last Saturday – rallies in nominal stock markets are bear traps – don’t get caught in one!!!

Fellow New Yorkers will have seen Gov. Patterson’s declaration of a recession here in the state and the putting up of bridges and the like for sale to handle budget short falls – but this is not new – over a year ago the 3^rd Ave bridge was put up for sale for the low cost of $1, but the catch is that it needs at least $1M per year to maintain which the owner has to pay – so not such a hot deal unless you can set up a toll both and collect to make it profitable….are we headed in that direction?

Ahhh, but maybe this is all a bad dream and I am missing something and we shouldn’t run to our deep bunker bomb shelters rifle in hand just yet.  When your outside and see the populace going about daily routines, one wonders how can a total collapse happen?  It would lead to great strife everywhere, it can’t happen - or can it – and more importantly – will it?

The OMB has criticized congress for not even finishing the appropriations bill for 2009, gambling they will get a better deal from the next President – but they still got paid a full year’s salary although they have not done a full year’s work and guess what – recess is coming for them – oh that ‘s just great (sarcasm).

And many have said before me, which I concur with, the problems with debt and deficits is really bad – and it will make both Obama and McCain unable to fulfill all their campaign promises when one of them is President – yes I am bleak but how should I feel?  Giddy and dancing in the streets – no I think not – take a second and just think…..

Energy Dominating All Circles

On 7 23 2008 Rep Gingrey (GA), Rep Hall (TX) and Rep Wamp (NC) all outlined the case to drill on the coastal shelf of Anwar Alaska, which does not affect the refuge or wilderness areas. They specifically displayed that the coastal shelf was zoned in 1980 by President Carter as a source for US oil, to be used at some point in the future – well lets hope Congress acts and brings this new bill to the floor for a vote.

Investment tax credits are set to expire or are expiring on renewable energy initiatives – if Congress extends those credits, massive investment will flow into renewables. That sounds like good energy policy.

The Beige Book, released 7 23 2008, on page 11 mentions “Kansas City [Fed District] cited rising interest in tapping shale oil deposits.” A WSJ article on 7 18 states that “estimates are US oil shale reserves could yield 800 billion barrels of oil, triple the current proven reserves in Saudi Arabia.” Oil shale rest in CO, UT and WY. An industrial process would first protect surrounding ground water, then over two years heat the oil shale rock into oil which could then be extracted by conventional methods – sounds easy right, perhaps not yet economical and more likely faces conservation groups sensitive to the impact on environment.

One issue: market forces are driven by earning profits not on social needs – so the right need of governmental policies – aka tax breaks – are needed to get things moving, but pilot programs are underway by Chevron and Shell.

Also, chemists know how to put coal into gas tanks thru an industrial process called Fischer – Tropsch liquefaction.

So why are we scared of “peak oil”? Fossil fuels should last through the century, before a shift to solar and nuclear is needed on an even larger scale.

A few weeks ago an IL Rep promoted coal mining in the state, which would produce American jobs for mining coal, building a refinery, operating a refinery, building a pipe line and more. Lets go!

Maybe the high gas prices are shaking Americans out of the comfortable mediocrity that has been becoming more pervasive this decade. It is the dawn of the energy revolution.

While much is still uncertain and it does not take a lot to throw the train off the tracks, at least the prospects for the future should help America stay great – but there will definitely be more pain in the short term to make sure the issues stay at the forefront.
I felt like thinking out loud today, and want to close with this: Knowledge works most powerfully when widely shared – spread the word.

Citibank’s Shareholders’ Equity vs. Market Cap

My friend Sam from Northeastern asked me:

Is there any relation between shareholder equity and market cap? Say for example Citi’s ’07 SE was at something like 113 B whereas the market cap now is 88 B is that a sign of being undervalued or are those two things completely unrelated?

This is a great question. Shareholders’ equity is a firm’s total assets minus total liabilities and can be found on a company’s balance sheet. Citibank’s 1Q 2008 balance sheet notes that their total assets were $2,199,848 million and total liabilities were $2,071,629 million; so their shareholder’s equity was $128,219 million ($2,199,848 million – $2,071,629 million).

The snapshot below from Citi’s last two quarters shows another way to calculate shareholders’ equity. You’ll see that shareholder’s equity is made up of capital a firm receives from selling stock + retained earnings – treasury stock. Nota Bene: Treasury stock is how much a company spent buying back shares, which is IMO an interesting value to follow.

In regards to the second part of your question, “is that a sign of being undervalued (shareholder’s equity greater than market cap) or are those two things completely unrelated?” The two numbers are definitely related, but there is more to it than simply juxtaposing them.

Citibank's 2008 1Q & 2007 4Q Shareholder's Equity

With all of Citi’s 2008 losses from the subprime crisis, their return on average equity for 1Q was -18.73%. So even though C’s shareholders’ equity is bulging at the pockets, they haven’t been doing a very good job of profiting from their assets.

Overall, shareholders’ equity is undoubtedly a number worth weighing when considering buying a stock, but in addition to earnings growth, Buffet’s profit moats, management bonus structure, etc.