What's driving this thing?

I've been doing a lot of research with my friend JT Smith (CIO of Aristar Funding), trying to figure out exactly what was driving this market.

The 'this market is cheap' argument hasn't made any sense to me for some time. Cheap does NOT refer to stock prices relative to where they've been, contrary to what is implied by a lot of folks. Historically, bear markets have bottomed at roughly 7-8x earnings. We only got to 10.2x forward earnings at the bottom in March - not low enough for my liking. Now we're trading at... sit down... 17.8x FORWARD earnings. Put another way, the S&P is more expensive than it has been in the past FIVE YEARS or more.

I might be 'of a certain age,' but my memory isn't so weak that I can't remember that the economy at least appeared to be much more robust at almost any time in 2004, 2005 or 2006 than it does now. And yet we're paying significantly more for a dollar of next year's S&P earnings now? Makes no sense. Unless...

What if this market isn't discounting future earnings right now? It's my belief that a lot of times the animal spirits of the market discount things without really knowing what it is they're discounting. So, what if... just what if... this market is actually discounting the inflation that almost certain to come? Gold over $1000 an ounce is telling us that either everyone is scared to death of this market (not confirmed by the VIX), or that inflation might be rearing it's ugly head. And yesterday's rumors that two Fed officials were ready to vote to tighten! Even today's Philly Fed numbers pointed out that the Prices Paid component is ticking up. Inflation.

Yeah, I know we've been seeing deflation in food and consumables. But that can turn quickly. And more importantly... how else are we going to dig ourselves out of this debt pit unless we pay it off with cheaper dollars?

If we're heading into inflation, folks, the game plan changes.

AHA!

As you might remember, I was confounded by the retail sales numbers last week. The number was higher than I expected, especially for apparel which was +2.8% from January.

Today the clouds parted and all became clear. Turns out the culprit was inflation. The apparel component in the consumer price index was up 1.3% for the month of February. I'm not 100% sure WHERE the prices were up, since it sure seems like apparel prices where I'm looking are falling... or at least discounted by huge amounts.

Try to keep up, please

Times, they are a changin'. It was just about 6 months ago that I sat down with Costco management and heard things that gave me chills. Part of it, I'm sure, was the fact that it was the day before they preannounced a Q4 (August fiscal year end) earnings shortfall, so they were glum anyway (although we didn't know about that until 12 hours later).

Back in July the discussion was all about inflation: food inflation, gas inflation. Remember that it was mid-July that gas prices peaked nationwide. Gas prices are now down 58% from that level. Fifty. Eight. Percent. Today on their first quarter conference call Costco confirmed that they are now also getting price concessions from suppliers on goods that had gone up significantly just a few months ago. While I want to be clear that they didn't specify where they are currently getting concessions, some of the major price increases had been for goods that used petroleum products (plastics, etc). You can bet those prices are headed down. In fact, it was a source of great pain for them that they had to take the price on their rotesserie chickens up from $4.99 to $5.49 to $5.99 all within the course of 6 weeks because of food price inflation. Guess what? They're back down again.

Gas, which was a source of huge LIFO charges because of inflation (if you want an explanation of how and why that accounting even exists, you'll need to find someone smarter to explain it), has now swung completely the other way. And whereas it was at best a teeny profit margin (perhaps even sometimes a bit of an unintentional loss leader) in July and August, it was for a bit of time these last few months 'wildly profitable' according to Costco. (Because they sell so much gas, they buy gas cheaper faster as the price is dropping, but can still stay at really cheap prices to consumers while their cost drops faster.)

There's been a lot of consternation about the huge amount of economic stimulus the government has been pumping into the economy in the name of stabilization, mostly because the great fear of further inflation. Eventually that may happen. Heck, look at what happen when they took interest rates down and flooded cash into the market at the turn of the century (see my August 2008 Post Modern fairy tale for more information). But I'm here to tell you, we can't see the whites of inflation's eyes from this vantage point. We'll remain vigilant. But in a really quick turn of events, we're much more troubled by the looming deflation at this point.