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TERADIME MONTHLY NEWSLETTER - MARCH 2004 Topic:
Macroeconomics, statistics and other useless information. Dear TeraDime subscriber (or the guy who got this
newsletter for free): I do not know who is in charge of statistics in this
country or what prices �they� are looking at. �The Fed� (Greenspan) is talking
about �no inflation� and I am paying 30% more at the pump, my heating bill is
30% more than it was last year, and European goods (like Italian furniture that
my wife is buying now) costs 50% more than it was 5 years ago. It makes me
think there is an anti-inflation conspiracy! The reality is that the Fed is looking at the �Core�
inflation rate.� Inflation associated
with goods and services minus energy costs (and other items that went up in
price). Well, Mr. Greenspan (or should we call you Sir?) since I am regularly
paying for gas at the pump and I feel like keeping 72F in my house, I feel that
�non-core� inflation matters more to me than �core� inflation. But what do I
know? By the way, do you actually know how government calculates
inflation associated with the price of the car for example?� Here is the story.� �They� look at today�s price of the mid-size sedan (lets say
Honda Accord) and they say, well this car cost $25K.� It has 2 air bags, CD changer, cruise control, 225 hp engine,
etc�� Then they go back 3 or 5 years and
say, if your were to buy the same car 3 years ago it would cost you $22K but
you would have to pay extra 1K for CD changer, extra 2K for airbags, extra $500
for anti-lock breaks and extra $500 for 225 hp engine.� So, �the same� car 3 years ago would cost
you 22K + 1K + 2K +500+500 = 26K.� Now
it only cost 25K, so we have a deflation and not inflation.� I would argue that since I cannot buy a
midsize sedan now (even Korean one) without airbags and a CD changer, that I am
forced to buy a 25K car vs. 22K car if I want a sedan.� It sure feels like I am paying 3K more, but
I am wrong, I am actually paying 1K less (statistically speaking J). So, as far as I am concerned, a falling dollar sooner or
later will force inflation, and especially in the country that has the �current
account� deficit.� Current account
deficit is the same thing as trade deficit, which in simple terms means that we
are importing more than we are exporting, which means that if the dollar falls
in value, sooner or later the price of foreign goods will go up.� Case in point, in today�s Wall Street
Journal there is an article that says that the BMW, SAAB, and Mercedes are not
going �to eat� the currency loss and are planning on raising prices of their
cars by 1 � 3% starting this June.� So,
if you are in the market for a new BMW, you better visit your tri-state
dealership this weekend. So, what are CPI (Consumer Price Index) and PPI (Producer
Price Index) and why should we care.�
CPI is the consumer inflation index in �the Fed talk� and PPI is
business inflation index.� PPI jumped on
3/18/04 and the market sold off, but why?�
Because if the cost of raw materials or parts/components rises, sooner
or later businesses are going to start passing these cost increases to
consumers (that is us).� And if
inflation will start rising or even better get this, if people think that
inflation is going to happen they will demand a higher return on their long
term investments (read higher yield on the 10 � 30 year bond). The only way to
keep the �long end of the yield curve� (read interest rates/yields on the long
term bond) from rising is to increase the rate on the short-term bond.� The only way �the Fed� can do it is to
increase the short-term rate of the federal fund rate (the rate which
theoretically banks pay the Federal Reserve Bank for overnight borrowings from
the central bank).� OK, stop it, what
does it mean to me and my 401K?! Example: ��������� You bought
a 10-year bond 1 year ago because it was �safe� via mutual bond fund or
directly through your broker and you were sitting happy for a year collecting
interest.� This 10 year bond was
promising you 4% return annually for the next 10 years + return of your initial
investment after 10 years.� Sounds like
a pretty nice deal.� Keep reading. ��������� So, price
of bond $100 � 100% of your investment. �����������������
Yearly interest $4 - 4%. Now, because of some stupid stuff that I wrote above, the
brand new 10-year bond that you can buy today from the US Treasury will cost
you the same $100 and pays 5% interest.�
Your bond (the one that you bought a year ago) is trading on the open
market, but now it has to yield around 5% (why would I buy yours that pays $4 a
year if I can buy a brand spanking new issue from Uncle Sam that pays $5 a
year).� So, your question is how much
can I get for my �safe� government bond that is a year old? How will a 1% rise
in long-term rates affect the price of my 1-year-old bond? Let�s see: $4 that you are collecting � has to represent 5% yield on
the investment now. $X is the price people are willing to pay for your bond on
the open market represents => 100% of your investment Now here comes 4th grade algebra:� 5X = 4x100, solving for X = 4x100/5 = $80!
One percent rise in the long-term rates will cost you => (($100 (original
price of the bond) - $80 that you can fetch for it now) divided by $100
(original price)) * 100% = 20% loss.� Pretty steep loss for �the safe� government
bond, don�t you think?� But wait; here
comes �the good news�! You CAN and will get your $100 back if you sit on it for
another 9 years. The moral of the story � inflation is bad for bonds.� Buy bonds when the rates are going down, you
will get your original coupon plus the price appreciation, and sell bonds when
the rates start moving up. So, we need to be in stocks � WRONG.� Inflation is bad for stocks too.� To �fight� inflation the fed will start
raising rates.� That means that every
new bond will pay a higher interest rate. If the stock market returns on
average 7.5% over 30 years and a new government 30 year bond will start paying
7.5% or more, then why should I be in stocks and take the additional risk, if I
can just buy 30 year bond and collect my 7.5% return guaranteed by the full
faith (and printing press) of the US government.� I do not care about the price fluctuation, I am just going to sit
happy for 30 years and collect my coupon (interest rate on the bond).� Life sucks, doesn�t it? So, what do we do?�
Short answer � I do
not really know because I do not really know what is going to happen.� The rates may go even lower if �the Fed�
thinks that the �risk of poor economy outweighs the risk of inflation� and does
not raise the rates. Here is what I would suggest.� For now, while rates are still low and are not moving up yet, and
prices for commodities and natural resources in dollars have moved up, we need
to be in natural resource stocks.� That
is why I was buying IGE index, plus it looks good technically.� Businesses that are able to increase the
price of their products in inflationary environments will do well too. I am
looking currently at XLP (consumer staples component of S&P 500 � food,
tobacco, soap, toothpaste, razors, etc�) Also, for the long haul (like 20 year
investment) I suggest BRK.B or BRK.A (if you can afford the A shares).� What is BRK.B? This is Berkshire Hathaway
(or AKA Warren Buffett�s company). Buying his company is like buying a very
well diversified mutual fund. Berkshire not only invests in stocks and bonds,
but also does currency trading, leveraged buyouts, etc�� The stuff that hedge funds do, he just does
them well.� Plus they own a bunch of
great businesses.� BTW, did you know
that if you are a shareholder you could somehow get an 8% discount on car
insurance through GEICO?� I did not know
it either. I read it in Warren�s annual letter to shareholders.� So, here you go, you can get 8% return on
your investment upfront J The moral of the story is that being in one class of
investments is never safe.� Even
government bonds can and will lose value.�
Stay very well diversified among stocks, bonds, real estate, precious
metals, etc�� Stop reading this
newsletter and get back to work, the best asset class because it pays cash
every 15th and 30th of the month.� |