Inflation Up, Stocks Down

We've opened earnings season with a market reaction more erratic than usual. Some stocks got pounded after missing earnings estimates by a hair. Other stocks drifted upward, despite nosebleed valuations and unimpressive earnings.

Banks are making out like bandits...at least on paper. They simply post whatever earnings they feel like reporting, because loans and securities no longer have to be marked to market. So why not mark down bad loans at a glacial pace? Doesn't matter that they might be in non- performing status and aren't producing cash flow. Some banks have even lowered their credit-loss provisions because they feel they've adequately reserved for what will be the biggest credit loss cycle in history. Such banks may surprise to the downside next quarter if they re-accelerate their provisioning.

Outside of the narrow, government-stimulated first-time homebuyers' segment, mortgage and house price fundamentals continue to plague the banks. Since banks are slow to foreclose, many homeowners who bought during the bubble have defaulted and have been living free of rent or mortgage payments. (I've seen credible estimates of a $100-$200 billion annualized bump in US consumer spending from "strategic" mortgage defaulters. This bump is temporary. When folks are finally evicted, they'll have to start paying rent somewhere).

Cash flow will eventually fall short of the levels implied by loan marks on bank balance sheets. "No worries," say the bank stock bulls. "Banks can replace the cash flow from defaulted loans with Treasury securities that carry low minimum regulatory capital requirements."

In other words, even if a bank is undercapitalized, it can buy Treasury bills and notes to create instant revenue. If it wants to roll the dice on interest rate risk, it can generate a whopping 3.7% yield in interest in 10-year Treasury notes, or 4.5% for 30-year bonds.

But this type of activity never ends well. Today's yield curve and lending environment fosters unhealthy carry trades in government and agency securities. If rates rise significantly, those trades will blow up in spectacular fashion. And if yields rise, the Federal Reserve - our giant taxpayer-backed hedge fund - will book huge losses on its bond portfolio. By law, under such a scenario, Congress would have to appropriate money to keep the Fed solvent.

Meanwhile, over in the stock market, risks are on the rise. A negative economic surprise in 2010 is likely to originate in Europe, where weak welfare states seek financial support from relatively stronger ones. Just yesterday, global stock markets tanked on fears that rescuing Greece will be easier said than done...coupled with the realization that Spain and Portugal might soon be looking for handouts. This story ain't over yet.

Meanwhile, a potent new inflation could inflict a negative surprise for the US economy in 2010. Already we're seeing very high producer prices. The Wall Street Journal described this phenomenon in a recent article entitled "The High Cost of Raw Materials":

"Data on producer prices released by the Bureau of Labor Statistics on Thursday shows how rapidly the pressure on corporate America is mounting. The producer-price index showed that crude goods such as iron ore, construction sand and pulp shot up 44.5% year-over-year, the fastest rate since 1974. Including energy and food costs, crude goods prices rose 33.4%."

The ISM's Prices Paid Index is telling a similar story. On Monday, the ISM announced that its Prices Paid Index registered the largest year- over-year increase since the 1970s.

Promoters of the world's crazy, unconventional monetary policies (usually bankers) like to blame rising prices on things like droughts, floods, OPEC, and labor unions. But when they do so, they fail to imagine what might happen to prices if the broad supply of money and credit were relatively fixed. If that were the case, it's likely that rising prices in one sector of the economy would have to be offset by falling prices in another.

Demand typically falls in response to rising prices (depending on the "price elasticity" of demand). But when government deficits, easy money, and easy credit (rather than income and savings) drive demand, we could easily see persistently high consumer prices, even in a weak economy.

For the past few years, I've written that we would see radical pro- inflation policies from central banks in response to the bursting credit bubble. And I've expected these policies to result in higher commodity and energy prices, rather than another credit boom.

We're seeing more evidence that basic materials prices are soaring, which should squeeze margins in many manufacturing businesses.

Even if the strongest-positioned businesses are able to pass through rising raw material costs to customers, the market eventually sniffs out this "inflationary" earnings growth, and lowers P/E ratios. Rising prices creeping into the CPI figures could be one of the many potential catalysts that lower the very high P/E ratios in today's stock market.

Dan Amoss
for The Daily Reckoning Australia

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