If I Could Turn Back Time

So is this A-B-C or 1-2-3?   Inquiring minds want to know.  While the recent SPX rally provided quite a bit of overlap with waypoints from the downdraft, suggesting that recent weakness was indeed corrective, other indices have not.   The jury, therefore, is still out, as yesterday's price action indicated.

The slightly-below-expectation CPI print was presumably enough to raise the hackles of at least a few deflationistas, but really, in the grand scheme of things, it's merely trading water in the range of the past couple of years.

In fact, Macro Man was rather interested to observe that in the latest edition of the Financial Crisis Observatory's quarterly Cockpit publication, they identified several negative bubbles in commodity markets, as well as signs of a strong USD bubble.  Signs that the deflation scare is approaching "tabloid" status, perhaps?

Unsurprisingly, they also identified more signs of government bond bubbles than six months previously- and bear in mind that the document was released on the 1st of this month, before 10y Treasuries ripped 35 bps in one morning!  Intriguingly, the analysis found less risk in equity markets than they had at the beginning of April.   One can only presume that the bubble risks in stocks have receded further.

Source: http://www.er.ethz.ch/fco/FCO_Cockpit_October1st_2014.pdf


None of this is to be taken as gospel of course; nevertheless, it is still interesting to observe what the maths say in terms of the sustainability of price action.

Switching gears slightly, the other day while cycling Macro Man had the grave misfortune of having that wretched Cher song "If I Could Turn Back Time" stuck in his head.   How it got there, he has no idea (Cher isn't exactly in the rotation on the MM family Sonos system), and it was only by climbing a few arduous hills that he was able to extricate himself from its grip.

However, the experience got him thinking.  As many readers are no doubt aware, prior to the formation of the Federal Reserve there were more than a few instances of low inflation/outright deflation in the US economy.   This was naturally a function of the metallic monetary standards that were prevalent for much of that time, as well as the periodic financial shocks that hit the economy.  (The last of these, the Panic of 1907, was one of the raisons d'etre for the Fed's creation.)

In any event, Macro Man thought it would be fun to look at stock and bond performance during the pre-Fed era to see if there was any linkage to inflation/deflation.  He sourced data from the excellent Irrational Exuberance website, which purports to have scrubbed data going back to 1871.

He divided the data into 10 deciles sorted by annual CPI inflation, and calculated the mean equity market annual total return for each decile, as well as the standard deviations of those total returns.  He also calculated the average 10 year government bond yield, again using data provided by Professor Shiller.  The results are set out in the table below.

As you can see, deflation was much more prevalent pre-Fed than since the birth of the central bank.  Indeed, in the 43 years preceding the birth of the Fed, the average annual inflation rate was slightly negative- note that the first 5 deciles are all in negative territory.  Put another way, in the 43 years prior to the foundation of the Fed, there were 243 months of negative annual CPI inflation; in the 100 years since, there have been only 166.  There are a number of factors which explain this, not all of which are maleficent. Indeed, one could argue that transatlantic cables and the invention of the telephone and radio were the equivalents during this time frame to the latter day internet and globalization.

Regardless, the moral of the story from the table above is that equities really only showed a sensitivity to inflation at the extremes, performing poorly in times of sharply negative deflation and performing best when inflation was at its highest.   This is clearly not an experience that has been replicated in its entirety during the Federal Reserve era, when peak inflation coincided with execrable stock market performance. (The only properly nasty deflationary episode of the Fed era did, however, coincide with wretched stock performance.)

One wonders, meanwhile, whether bond investors before the Fed were primarily from Wales or New Zealand- the historical record certainly suggests that they were sheep, with yields displaying zero long-term sensitivity to the level of inflation.   Some of this may of course be a data quality issue, but man- it must have been nice to get 4% on a bond investment with inflation of -10%!

What does all of this mean for today's investor?   Quite possibly nothing.   Much as some might wish it were not so, the continued existence of the Fed is indeed a fact of life, and it is very hard indeed to see the modern financial system returning to a framework as rigid as a metallic currency standard.

Moreover, the explosion of debt across vast swathes of the world economy over the past several decades has made deflation a less savory outcome than perhaps it once was, particularly given the predilection for "zombiefication" instead of Schumpeterian creative destruction.

In any event, basing high-frequency investment decisions in the 21st century based on financial pricing in the 19th will almost certainly end in tears.  Nevertheless, it is comforting to know that a dose of disinflation, particularly one that stems from global capacity issues, does not automatically consign risk assets to a watery grave.

That still leaves the tactical issues of how to navigate the end of QE and the possible onset of rate hikes.   Old Diamond Jim Brady, Jay Cooke, and Cornelius Vanderbilt never had to deal with these sorts of issues.    If only we could turn back time....