Everywhere you turn these days, you hear about the wonderful miracle of the world’s central banks creating trillions of dollars in new liquidity with no inflationary consequences. It’s modern alchemy, in reverse: gold turning to lead. Last Wednesday and Thursday, for instance, we learned that inflation in America doesn’t exist. Both of our major inflation indexes were under water, with prices contracting at 5% to 8% annual rates, despite five years of unprecedented monetary expansion at the Federal Reserve.
Key short-term interest rates are now at or near zero in four of the world’s most dominant currencies – the U.S. dollar, Japanese yen, British pound, and euro. In the first half of May, six central banks cut their rates by 25 basis points – India, Australia, Poland, Korea, Israel, and the euro. According to Kopin Tan, writing in last week’s Barron’s, there have been over 510 acts of “easing” by central banks since mid-2007.
Central banks around the world are printing money with no apparent inflationary outcome. As Spence Jakab wrote last week in The Wall Street Journal (“Inflation Continues to Make Itself Scarce”), “Consumer prices are expanding at their slowest pace since summer 2010, when the Federal Reserve launched ‘QE2,’ its second round of bond buying. It isn’t just the U.S. seeing disinflation. Consumer prices in the euro-zone rose by just 1.73% year on year in March, the slowest since August 2010. Japan’s renewed monetary exertions of recent months haven’t yet reversed its outright deflation. Even Chinese inflation has dropped.”
The miracle of inflation-free monetary expansion has rendered the laws of economics obsolete...right?
Wrong! The New Wave of Inflation is “Hidden in Plain Sight”
Late last week, we learned that April’s Producer Price Index (PPI) fell 0.7% and April’s Consumer Price Index (CPI) fell 0.4% due largely to a drop in gasoline prices. On the retail (consumer) level, there was a 4.3% drop in energy prices, led by an 8.1% drop in gasoline prices. Energy prices are dropping because the U.S. is finding massive new supplies. The Energy Information Agency (EIA) says that the U.S. will become energy self-sufficient in the 2020s and may even pass Saudi Arabia as the #1 energy producer.
On the same day those inflation figures were reported, Christie’s held an art auction in New York City, Wednesday evening, May 15. According to the next day’s New York Times, a Jackson Pollock abstract called “Number 19, 1948” went for “an unimaginable $58.63 million,” exceeding the highest estimate of its value by 50%, “an extraordinary occurrence at these stratospheric heights. When offered 20 years ago at Christie’s, the Pollock sold for $2.4 million.” (That’s over 17% per year in compounded price gains.)
At Christie’s last week, Roy Lichtenstein’s “Woman with Flowered Hat” sold for $56.12 million. The Times said “the price is doubly astonishing. The picture is a spoof of Picasso’s late portraits that break up and distort the human face in a style derived from the Cubism of his youth…. Usually, interpretations of another artist’s work are not easy to sell. The furious competition that sent Lichtenstein’s climbing so high underlines the abyss that separates the buyers of contemporary art from traditional collectors.”
Another piece of art from the 1960s sold for $25.88 million, “nearly doubling expectations. The price is the more extraordinary because the paint is applied in thick, seemingly disconnected impastos….’”
Less than two months ago, Picasso’s “La Reve” sold for $155 million on March 26, 2013. That’s the second highest price ever paid for a work of art, so items on the high end of the spending spectrum are enjoying massive price inflation. Last week, an anonymous donor bid $610,000 for an hour with Apple CEO Tim Cook, even though the charity estimated the hour would probably bring no more than $50,000.
People with money are spending freely. Due to the widening wealth gap, those with more money are obviously free to spend more recklessly than those who are hurting from years of fruitless job hunting, but when the world’s central banks create about $10 trillion dollars in new liquidity within five years (2008 to 2013), that money does not evaporate into thin air. It has to go somewhere. Some of it is going to high-end works of art, but the vast majority of it is going into bonds, the stock market, and real estate.
The S&P 500 is now up over 150% in the last 50 months. It is up 30% in the last 12 months, from 1295 on May 18, 2012 to a new record high above 1680 yesterday. In addition, investors have poured a net $1.1 trillion into bond funds since March 2009 according to the Investment Company Institute.
Real estate prices are up 11.8% in the last 12 months according to the National Association of Realtors. The 20-city S&P/Case-Shiller housing index is up 9.3% in the last 12 months, and we learned yesterday that the volume of existing home sales rose 9.7% in April, year-over-year, to 4.97 million units, while the median price is up 11%. Put those numbers together and the dollar value of transactions is up nearly 22%.
Inflation Requires Two Components – “Too Much Money” and “Two Few Goods”
The word “inflation” originally referred to an increase in money supply, not prices. We have come to associate “inflation” with prices, but we have defined those prices too narrowly, as prices for consumer goods and services. We see the prices for electronics declining and other prices staying flat, so we say there is no inflation, but the money always goes somewhere. This time, it is going into financial assets.
The classic definition of price inflation is “too much money chasing too few goods,” so too much money is only half the story. The second half of the equation is equally important. Since there are too many “things” around us (like cheap clothing, electronics, energy, generic foods), their prices are not rising.
In general, prices are rising for those goods which are in short or limited supply – like rare works of art, desirable real estate, luxury items, stocks, bonds, and Tim Cook’s time. Since stocks are in surprisingly short supply, there is a shortage of shares available for purchase, so the price of stocks continue to rise.
Investing is a matter of supply and demand, like any other market. There are now fewer shares available than at any time in years. There are only 3,573 companies in the Wilshire 5000, down from 6,639 issues during the dot-com boom 15 years ago. Mergers, acquisitions, and buybacks have been gobbling up share supplies. Several big companies say they plan to go private or merge, thereby leaving the Big Board.
Due to shrinking share volume, P/E multiples have not soared. The S&P 500’s P/E is now only 14.4, not far from the historical norm (since 1978) of 13.7, but today’s super-low interest rates justify a higher-than-normal P/E. Economist Ed Yardeni cites a “Rule of 20” valuation model, which says that the P/E of the S&P can fairly trade at around 20 minus the CPI inflation rate or 10-year Treasury rate, currently under 2%, so the S&P could sustain a P/E of 18. Considering the latest S&P forward earnings estimates of $115.51, we could see the S&P at 2100 within a year, up another 25% from its recent all-time highs.
To summarize, today’s inflation skeptics need to quit looking at gas prices alone. New money always goes somewhere. In the 1920s, the Fed’s monetary expansion went into the stock market, pushing the Dow to a record high in 1929, followed by a bone-chilling crash. In the 1970s, monetary expansion pushed consumer prices up, especially the cost of gasoline, which was suddenly in short supply due to the OPEC oil embargo of 1973 and the Iranian revolution of 1978. Recently, we have seen the stock market set new highs and real estate recover by about 10% in the last year. That’s where the Fed’s new money is going this time around – into the stock market, bonds, real estate, Tim Cook’s time, and weird modern art.
P.S. Happy Birthday to the ECB and the Federal Reserve
It’s well known that the Fed turns 100 this year, but did you know that the European Central Bank turns 15 next week? The ECB was created June 1, 1998 to administer the euro. And what a ride the ECB has faced in those 15 years. In particular, the ECB has had to step in to rescue Greece in three consecutive crises in the last three years – each falling in the month of May in 2010, 2011, and 2012. Therefore, it is with great joy that I report we are almost done with this month of May and Greece has not yet imploded.
Happy Memorial Day!