A Lost & New Decade, Part I

January 29, 2010

 

The Price Index Score (PIS) Is Flashing Red

PIS measures the rate of change (ROC) of the price of stuff consumed, produced, commodities traded and government price indexes. The PIS score as of Dec. 31, 2009 was 1.53 (Figure 6), and the reading was 32.4 percent (Figure 7). PIS is warning investors that they are in an extreme risk climate, one in which existing trends can end abruptly.

It is time to overweight portfolios to high-quality bonds/stocks and to hedge positions in long-only commodity investments. High quality mostly means strong balance sheets, high free cash flow and consistent earnings growth. PIS is advising a 30 percent allocation to low-quality assets like high-yield bonds, and high beta stocks that rise and decline more than the S&P 500. It is prudent to hold the remaining 70 percent in high-quality securities excluding Treasury bonds with more than a two-year maturity.

 

A Lost New Decade Part I Fig6

PIS is not confirming the S&P 100 price volatility index’s (VXO) recent decline below 20. Past divergences were evident when the Federal Reserve Bank and the shadow bankers (Wall Street) were pumping excessive liquidity into the financial system in 2005 and 2006 (Figure 7). The shadow bankers are dead, but Chairman Bernanke is alive and kicking! A tame VXO while the Commodity Research Bureau’s (CRB) Raw Industrial Index’s 12-month ROC is sharply increasing is absurd. The ROC for consumer and producer price components have also been accelerating.

Of major concern is that the PIS had its highest reading since August 1980, which was a wild time for asset prices, currencies and inflation (Figure 8). During the 1980-1982 period, volatility was king, but there was no VXO to wear the crown. It looks like VXO wants to be king again.  

Most of the gains for real assets in Figure 7 came after October 2003, which is when PIS climbed above its poly-trend line (green). A very high PIS is associated with extreme currency devaluations, which amplify commodity and asset price volatility. Inflation (CPI) destabilizes when PIS is high.

 

A Lost New Decade Part I Fig7


(To see a larger version of Figure 7, click on the image above.)

 

 

 

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