Juggling Dynamite

A Bloomberg article yesterday:  Credit Bubble May be Bursting quotes credit analysts sounding concern about the effects of over zealous leverage and its resulting risk in world capital markets at present:

“We are growing extremely negative on credit markets, which we see as in a bubble,” Tim Bond, head of asset allocation at Barclays Capital in London, wrote this week. “U.S. companies are releveraging aggressively in an attempt to substitute earnings-per-share growth for earnings growth. 2008 should see a fairly savage bear market for credit, a large rise in defaults and an end to easy liquidity conditions.”

Weedon & Co. L.P. reprinted a very articulate interview with money manager John Hussman recently called Going Full Cycle.  The Husman Strategic Growth Fund has trounced the returns and particularly risk-adjusted returns of the S&P 500 over the past 7 years, even though it has only averaged the risk free rate over the past 3 years. By avoiding the declines of 2000-2002, Husman is once again living proof that investors who can avoid big losses in a down market only need to make about 1/3rd of the gains in the up market to come out dramatically ahead overall. Hussman makes some key points about why current valuations are historically very high again and why he currently has the defensive posture of a fully hedged portfolio, opting to earn just the risk free cash rate while equity markets are raging on to new all-time highs.   A present duration of 60 on the S&P 500 is one of the many metrics he points out as likely to present a poor risk/return for investors from here.  Worth the 9 page read.

Government pensions are indexed yearly in accordance with the Consumer Price Index (CPI).  So naturally it should not be surprising to learn that governments have a vested interest in keeping CPI as low as possible year over year.  It was this very logic that prompted a change in how CPI was calculated over 8 years ago, ex-ing out volatile items like food and energy:

“The Advisory Commission To Study The Consumer Price Index (aka The Boskin Commission) was appointed by the Senate Finance Committee to study the role of the CPI in government benefit programs and to make recommendations for any needed changes in the CPI. The Commission's December 1996 report recommended downward adjustments in the CPI of 1.1%. The CPI is the basis for Social Security COLAs and this recommendation, if adopted, would reduce future Social Security COLA increases, as well as impact numerous other government programs.”  For more view the full report: The Boskin Commission Report.

Not surprisingly, after these changes were implemented the core rate of inflation as reported in the CPI has pretty much flatlined over the past 8 years, while the headline rate has jumped up.

This chart reflects the real life inflation that governments in most developed nations have been trying to deny for the past 8 years. Real people know that inflation is building quickly and prices are mounting in almost every major consumer category that counts.  “As you can see, since 2000 the Core has been under-stating inflation for some time now. And, the amount it is off by has widened dramatically. The gap between core and headline is now greater than it was in the early 1980s, and — hard as it may be to imagine — we are only slightly off the spread of the terrible 1970s.” See: Inflation Errors Part II