The Many Faces Of Inflation - June 2008 Contrary Investor

[slipslidingaway]

Charts and full article at link.

http://www.contraryinvestor.com/mo.htm

"The Many Faces Of Inflation...As we've mentioned more than a number of times in the past, one of the key debates among investors at the moment is that of greater macro inflation versus deflationary forces. Go ahead and check out investment message boards/forums focusing on gold, commodities in general, housing, etc., and the debate is hot and furious. We see the same thing in the divergently opposing outlooks of many headline financial market commentators. For most, it's simply a black or white choice, with about zero potential for any gray to enter the picture. Personally, we're believers in coexistence. Really going back to the beginning of this decade, our macro investment credo has been that both proactive sector and asset class selection, as well as equally important selective and proactive sector avoidance, is key to successful investment outcomes in the current environment. As we stand here today, we see absolutely no reason to alter this philosophical outlook. And to us, that means in both sector and broader asset class characterizations, we can indeed experience both inflation and deflationary nominal pricing pressures, dependent, of course, on the individual sector or asset class being analyzed. So, although we want to hopefully provide some perspective on headline inflationary trends and how those trends directly relate to our investment activities in the here and now, in no way will this be a debate over definitive macro inflationary or deflationary pricing outcomes. Why? Because we expect both to occur simultaneously, as we have been directly experiencing over the last few years...


Having said all of this, let us cut right to the chase and get to the issue we believe to be most important, and hopefully most helpful in our here and now investment activities as far as headline inflation is concerned. Point blank, periods of rising headline inflationary pressures have been associated with periods of contracting equity valuations. Important point being, if we are to look for a better tone to the equity market any time ahead, a key structural support to that better tone would be inflationary pressures that are declining on a rate of change basis. To be honest, history is very supportive of this idea. Below we've created one of our infamous combo charts that tracks both the year over year rate of change in headline CPI set against the longer term S&P 500 P/E multiple...


Very briefly in terms of explanation, this phenomenon is pretty much common sense. In rising inflationary periods, rising corporate revenues and earnings are more reflecting price inflation as opposed to organic revenue and earnings growth, all else being equal. Here's a relatively dramatic example for you, but it completely proves the point as to why equity investors should not "pay up" for corporate earnings that are driven in large part by general price inflation, and why macro equity valuations should indeed contract when the general level of inflation is rising. In inflation adjusted terms, S&P 500 earnings in early 1968 and again in 1982 were equivalent Over this same period of time, reported S&P 500 nominal earnings were up 140%. Also over this same space of time, the S&P in price only terms was up less than 5% point to point. If you ask us, over this period of clearly accelerating inflationary pressures, the equity market was indeed very efficient. It looked right through inflating corporate revenues and earnings by imposing almost perfect continuity of contracting P/E valuation multiples across the entire period. A dramatic longer cycle example? You bet it is. But, again, as we eyeball the chart above, this same valuation contraction phenomenon is seen again and again as headline CPI rose meaningfully on an annual rate of change basis...


Lastly, as we listen to Street pundits far and wide pontificate about inflationary trends ahead (again, remember as per the consensus thinking regarding inflation that is nominal dollar prices), we hear again and again that inflation is not about to become a real problem in the absence of wage inflation. And as we all know, current wage inflation is occurring at a rate even below that of the headline CPI numbers. History does indeed tell us that, as an example, significant inflationary pressures seen in periods such as the 1970's were indeed accompanied by meaningful wage inflation, ultimately reinforcing the primary trend in higher nominal prices system wide. But these pundits tell us that since there is no real nominal domestic wage inflation at the moment, the risk of higher macro inflationary pressures continuing is small. Or as the Fed and friends would tell us, "inflation is contained". Again, in our minds, this is narrow thinking. You're darn right, wage pressures domestically are indeed subdued. And this is exactly why US consumers are being squeezed at the gas pump and at the grocery store. But again, we simply implore folks to think more broadly. It's globalization, globalization and globalization...and little else in terms of analytical framework. Although wages are not growing domestically, what about the global wage frontier? Decade to date in the US, payroll employment is up 5.7%. It's the lowest decade to date US percentage payroll employment growth number on record over the last half century at least. Global corporations are drawing on a global employment base. Although wages are not growing domestically at a rate exceeding even the heavily massaged CPI, that's not the case at all in foreign markets..."