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The Bull That Will Not Die


Ross M. Miller
Miller Risk Advisors
April 12, 2004

The world's economy is like the philosopher's ever-changing river. Every time is different—models that once worked, stopped working long ago. And not only does the game change, so does the method for keeping score. Government numbers, from GDP growth to the unemployment rates to consumer and producer inflation—all rough approximations to begin with—are continually being "tweaked." Still, despite the complexities and conundrums of our post-modern economy, there are occasionally moments of clarity. One such moment is now at hand.

After having been lost and presumed dead, inflation in the United States is coming back in a big way, bigger than the U.S. Labor Department numbers would have it appear. Although I am not one to attribute impure motives to anyone, it could be more than coincidence that about the time that the U.S. Treasury started to issue bonds indexed to the Labor Department's published CPI (Consumer Price Index) numbers, the Department made fundamental changes in the way its numbers were computed. After historically understating the rate of inflation by a full percentage point or more, current CPI numbers appear to underestimate of the actual rate of inflation by a significant margin. Furthermore, they contain so many "adjustments" that they may not only get the total amount of inflation wrong, but also how it changes from month to month. And the PPI (Producer Price Index) is not doing any better. Indeed, it is undergoing such a major overhaul that its timely publication has been suspended indefinitely.

It doesn't take a government economist to tell you that inflation is turning the corner from a creep to a gallop. Regardless of what is responsible for that shift—monetary laxity, fiscal irresponsibility, OPEC, you name it—it is reaching the point where it can no longer be ignored.

We are beginning to see inflationary psychology reappear.

The perception of inflation by humans influences their behavior in a very simple way—it shifts purchases from the future to the present. With borrowing costs at historic lows and credit plentiful, why wait to buy something if the price is going up. Many producers have already figured this out and that is why inventories are swelling. Savvy consumers have caught on, too.

So, what happens as inflationary psychology takes hold? One word—boom. Just in time for the presidential election as luck would have it. A self-sustaining, self-fulfilling boom so powerful that virtually no one or nothing can stop it. At least not this year and probably not until well into next year. Such a boom would carry many stocks with it, especially growth companies involved in emerging technologies. It would also carry interest rates higher—back to their historical averages and possibly beyond.

The conventional wisdom says that it is no big deal that inflation is coming back. Once Alan Greenspan and his trusty band of Fed governors get even the faintest whiff of inflation, they will smite it with not just one rate hike, but an entire series of them. Not only will that nip inflation in the bud, it will send the stock market for a mighty tumble. And, of course, Chairman Greenspan is a good Republican and he would not want to do anything to spook the financial markets until after the November election. Indeed, virtually everyone that I have surveyed believes that "the fix is in" until the election. The stock market may indeed plummet after the election, but then it will no longer matter with the next election four years away. Of course, if "everyone knows" the jig is up on November 3, everyone will bail out before then. Another October crash, perhaps? That is the last thing the current administration wants.

Fortunately, there does not have to be a crash. If economic growth is sufficiently strong, as it would be in the case of an inflation-driven boom, both the stock market and the economy can absorb several rate hikes with minimal damage. With Alan Greenspan in the habit of telegraphing his moves in advance, these hikes will be even easier for the markets to swallow. Historically, increases in interest rates from the extremely low levels that currently prevail in the market tend not to hurt stocks the way they would. The tendency for higher interest rates to hurt the stock market only clicks in when rates are already on the high side.

How fast would the Fed have to move to spoil the party? Without boring you with the math, for the Fed to get back to a "neutral" monetary policy would require a fed funds rate of at least five and probably six percent, especially when one considers that the current CPI of two percent corresponds to what in the past would have been easily three percent inflation. Even the most rabid economist on the Street only has the rate getting to three percent by the end of 2004.

The bottom line is that the present situation is very bullish for stocks, especially those that are relatively insensitive to interest rates and short-term rates in particular. This is not to say that the anticipation of increases in rate hikes will not provide speed bumps for the market, they will initially. Even the stock market will require time to adjust to the new mindset. Still, it will be hard for the Street to ignore the surge in corporate earnings that will vastly exceed all expectations through a combination of a relative increase in prices (technology prices will not fall as fast and other prices will rise faster) and an absolute increase in output. Both geopolitics and presidential politics may provide the stock market with additional turbulence along the way, but once inflationary psychology takes hold, it is almost impossible to shake.

Is an inflationary boom a certainty? Of course not. Nothing is. Even a minor rumbling that the Fed is considering another rate cut is a sure sign that something is terribly wrong. Likewise, any consistent failure of the stock market to respond positively to good news, especially news concerning corporate earnings, should be taken as a major warning sign.

Confirmation that the inflationary boom is underway should manifest itself in several forms. Announcements of price increases by manufacturers should become a common event. New car incentives should begin to disappear on many models. Business inventories should continue to rise. Retail sales should barrel along. Newspaper stories about inflation should start broadening from gasoline and commodity prices to prices of consumer goods.

Of course, inflation is only a positive for the stock market up to a point. Indeed, the risk going forward is not that the Fed will apply the breaks too fast or too hard, but that inflation ultimately degenerates into stagflation.

Once Time or Newsweek runs a cover story on inflation, you know it is time to look for your coat and start saying your goodbyes. When the Wall Street Journal and CNBC start to use the words "overheating" and "bottleneck," the host will be locking up the liquor cabinet. By the time "credit crunch" appears, your key should be in the ignition.

And what comes after the party is over? Just about anything. It may be some time before the signs are as clear as they are now.

Copyright 2004 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to No representations or warranties are made as to the accuracy or completeness of any information contained in this report. The economic opinions contained on this site are not to be construed as recommendations to buy or sell specific securities or as other financial, accounting, or legal advice. You should consult with a professional where appropriate. And if this is not enough to scare you, the author has a Ph.D. in economics from Harvard.