Ignore the Noise

Last Update: 23-May-11 09:23 ET

Investors are consistently subjected to a nonstop cacophony of ramblings about the latest release or market trend. Most reflect over-analysis or the need to fill air time. Herewith are some thoughts on the most recent waste of time propagated on investors by the chattering classes, with particular regard to inflation and Fed policy.

Recent Noise: Lower Commodity Prices are Bad for the Stock Market

This is absurd.

Let's review. A month ago it was well known, and repeated every 30 minutes on TV, that higher commodity prices are bad for the economy because they reduce the consumer's disposable income and create a higher cost basis for the production of goods and services that consumers desire.

This makes sense. Higher gas prices drain consumer income away from the purchase of other goods and services. Companies other than gas companies, such as retail outlets, are harmed. Higher commodity prices also create higher input costs for companies that utilize commodities in their products. Profit margins are lowered for companies that don't directly benefit from higher commodity prices (such as gold producers or Caterpillar).

The past couple of weeks, however, the conventional wisdom has been that lower commodity prices are also bad for the stock market. The logic here is supposedly that oil traders have some magic, divining rod that provides them with foreknowledge of the economic outlook well ahead of anyone else in the world. Apparently, a dip of even 1% (after a runup of 10% or more) in oil prices is the single overriding factor reflecting global economic demand across all sectors, including toothpaste and hamburgers.

The fact that the swing in oil (and other commodity) prices might be due to the price having run up excessively on speculation related to turmoil in the Middle East or other factors is considered irrelevant. After all, oil prices were down, stock prices were down; therefore, the logic must be true.

Ignore the noise. Lower commodity prices are good for the economy, particularly the type of modest drop seen the past few weeks. Commodity prices did not suddenly become some magical forecast of the economy simply because it no longer appears as if the assumed $140 a barrel oil by mid-summer is not going to materialize.

Continuing Noise: The Fed Has to Tighten because Inflation Has Picked Up.

Wrong.

Inflation has indeed picked up, but it is largely due to the commodity price pressures noted above. Bears on inflation are fond of saying -- "hey, food and energy prices count too!" That is certainly true, but there is an important reason for looking at these price pressures differently than the core rate of inflation.

Core inflation (excluding food and energy) reflects the underlying demand side of inflationary pressures. When there is excess demand in the economy, prices of core goods and services will start to rise. Hotel prices, apparel prices, entertainment prices, rental rates, and so forth, are heavily influenced by demand. The economy is far too weak at this time to create significant pressures on prices due to demand. A corollary to this is that when there is excess capacity in the economy, inflationary pressures are weak. At present, there is considerable excess capacity in industry and in the labor market.

Demand-side inflationary pressures are weak, and it makes no sense for the Fed to tighten policy on this basis.

Tightening policy because commodity prices have risen also makes no sense. Higher commodity prices are the result of rising global demand and, in the case of oil, political tension in the Middle East as well. It is illogical for the Fed to tighten U.S. monetary policy because of these factors, which are outside of its control.

Should the U.S. really pull back on its economic growth (put more people out of work) because demand for commodities is rising in China? Foreign governments would have to laugh at that and thank the U.S. for lowering commodity prices on their behalf, while the U.S. absorbs the pain of trying to undermine global commodity prices.

The Fed will only use monetary policy to impact that which it can control -- U.S. economic demand. The Fed will not tighten policy to combat inflation if it is due to something outside its control. That would be a policy mistake of the worst magnitude.

Noise Contrary to the Facts: The Fed is Printing a Massive Excess of Money

That leads to another greatly misunderstood inflationary consideration which is indeed within the Fed's control -- money supply growth through quantitative easing.

The endless sputtering about the Fed overloading the world with dollars is seemingly interminable. The worst part is -- very rarely is the actual data ever mentioned. Here are the facts.

There is no question that the Fed is "printing money" through quantitative easing -- the purchase of government debt by the Federal Reserve credits credit/money supply.

Yet, the facts show that this impact on overall monetary growth has been to simply grow money supply at a rate consistent with moderate economic growth and moderate inflation.

To leap from the fact that the Fed is printing money to the fact that runaway inflation is inevitable is, to say the least, squishy logic.

The reality is that the monetary data are released weekly by the Fed via the H.6 report.

Over the past 12 months, M2 is up 4.9%.

Even to advocates of strict monetarism (of which your current author is certainly not an adherent), that is not a problem. Such growth is consistent with nominal GDP growth of 4.9% -- say 2.5% to 3% real GDP growth and 2% to 2.5% inflation.

Some may argue that inflation at that range is excessive. Fair enough. But real GDP may also pick up, and inflation might moderate.

In any case, it is simply not true that the Fed is fueling massive monetary growth through quantitative easing. Rather, the Fed is making up for slack monetary creation from the private sector. That occurs through bank lending. As lending picks up and creates money supply growth, the Fed can back off quantitative easing and keep overall money supply growth at a reasonable level.

The monetary data belie the fears of runaway inflation caused by massive currency devaluation. It is just more noise.

The Real Trends

The key underlying trends in the financial markets over the past six months have not changed.

Economic growth is decent, but subpar. Consumer spending is rising and payrolls are increasing. The housing market remains severely depressed and is likely to remain so for a while. Government spending is weak.

Inflation is modest at the core level, although it may be rising marginally. Commodity prices are problematic but the outlook is as uncertain as those "for sure" forecasts of $140 a barrel oil that were prevalent just weeks ago.

Corporate earnings are rising at a solid, albeit slowing, pace. Multinationals have better earnings prospects than companies based solely in the U.S.

Interest rates are likely to remain low for a considerable period of time, due in part to constrained inflation and due in part to the Fed wanting to push economic growth above the long-term trend (and that will take some time).

Perhaps most importantly, but rarely discussed, conditions in the credit markets and banking system are improving. Demand for loans, as evidenced in the weekly H.8 report, is slowly picking up. Commercial and Industrial (C&I) loans outstanding bottomed in late summer 2010, and have now risen six straight months, and at a moderately accelerating pace. Real estate and consumer lending overall remain weak, but the improvement in C&I loans is a start.

The budget imbalances of the U.S. and European governments remain a legitimate concern.

What It All Means

The factors which support the argument for relative value in stocks remain intact. Frankly, not a lot has changed since our February 28, 2011, article on this issue.

Of course, the pundits need to fill every day with analysis. If the Dow is up even 20 points, there must be a reason -- whether it is that day's minor economic release or a single earnings report. If it is down, the reason must be whatever else happened that day. Perhaps commodity prices were lower. Causality and correlation get conflated in an effort to explain.

It is important for investors to learn to ignore this constant noise and to focus on the long-term trends. Right now, those long-term trends are reasonably favorable.

There will be periods this summer when the market drifts lower. The summer is a traditionally weak period for the markets and this year is not likely to be an exception.

When that occurs, the talking heads will explain that it was due to whatever factor the traders were focused on that day. Perhaps it was higher commodity prices. Or perhaps it was lower commodity prices.

In any case, there will be a reason given, and it will seem plausible, even logical. After all, the market moved, X or Y happened, so that must be the reason. Everyone says so. Financial market analysts can be highly intelligent and persuasive. Who are you to disagree?

Most of the time however, the smart move simply will be -- Ignore the Noise.

--Dick Green, Briefing.com

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