CPI Stands for Nothing Real; Wall Street Understands This

I do a lot of reading about financial matters.  Recently I was in Barnes & Noble and picked up the December 2011 copy of “Futures” magazine.  Browsing through it an article on investing and inflation caught my eye.  I bought “Futures”, took it home, and afterwards felt very happy about my $6.95 investment.

There were several interesting articles, and a few that did not strike my fancy… involving MACD and other technical analysis methods.  Overall I found it a worthwhile read.

First and foremost I found the reference to CPI-U and shadowstats.com to be the most exciting aspect of “Futures”.  I have long been a casual follower of ShadowStats (SGS) and I was pleased to see in print what I have seen online.  What Wall Street and many economic statisticians understand is that the government-reported CPI (specifically the CPI-U) has become a bogus indication of inflation.  CPI-U  remains relevant because of it is tied (directly or tangentially) into many things such as Social Security benefit changes, COLA and TIPS.  CPI-U is a “headline number”, but many on Wall Street use their own inflation models.  These Wall Street models routinely show CPI-U to understate actual inflation.

Here’s the deal.  U.S. Bonds today, while “safe”, simply do not keep up with inflation.  Their performance in taxable accounts is even worse.  The same holds for money markets and savings accounts.  This knowledge is part of the inside baseball of finance, that I like to call financial baseball.  For the investor that wants to keep up with inflation, this “inside knowledge” pushes them towards riskier investments including stocks (and stock ETFs), junk bonds, and international stock and bond investments.  The bottoms line is that investing is either more risk-prone or inflation-ravaged… or a combination thereof.

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Fallout from the S&P US National Debt Downgrade

Kudos the S&P for being the first major debt rating firm to downgrade US debt to AA+.  Essentially they warned Congress that $4 trillions in cuts was required in a debt ceiling deal, Congress only ponied up about $2 trillion.  Bill Gross of PIMCO saw this coming as did many, many others including this finance blog.

The importance of the credit downgrade is the message it sends to voters and to Washington:  The US Treasury  is not immune the market realities of global economics.  The giant US credit card has terms and conditions ultimately dictated by global bond markets.  As debt-to-GDP ratios increase so will borrowing costs.  The long-term trajectory of US debt growth, under current law, is staggering.  Further the cocktail of massive debt, out-of-control debt growth, and a weak US economy do not bode well for future US debt ratings.

Unfortunately I don’t think this message is being heard or understood by a sufficient number of Americans.  Gross and El-Erian get it.  The US House of Representatives is starting to understand. The Senate and the White House do not.  Neithe does the US Treasury saying “There is no justifiable rationale for the downgrade?”  Seriously, what meds do they have to be on to say that with a straight face?  The American public has a degree of understanding, but not sufficient concern or attention.

The fallout of the downgrade will be modest but wide-ranging.  It will be good news for AAA rated companies and countries like Exxon Mobile, Britain and German.  The debt rating will be bad news for adjustable-rate mortgage holders, US bond holders, and entities that are required to hold US Treasuries.

Bitcoin: The Inflation-proof E-Currency of the Future, or Not

If I were to design a new currency I would design something very much like BitCoin.  It is a digital currency with about 6.5 million units in circulation. BitCoin will never have more than 21 million units of currency in circulation…. ever.  Bitcoin is divisible into tiny fractions of a unit down to millionths of a BitCoin and smaller.

BitCoin is digital money.  Imagine PayPal but without the hassle, or the commissions.  Image digital gold.  Gold which is mined (by computers), but has a known maximum supply of 21 Million ounces.

Gold’s value is largely related to its relative rareness.  Gold’s usefulness is pretty limited except as jewelry and a form of currency.  Industrial uses of gold consume only a small fraction of gold’s supply.  And gold can be mined faster than it is consumed.

Gold cannot be as easily traded or exchanged as BitCoins.  Yes gold ETFs can be exchanged for cash which in turn can be used for web transactions, but this is a multi-step process.  BitCoins, however, can be easily exchanged from person-to-person or person-to-business with ease.

Today each BitCoin is worth more than $13.  BitCoin valuations have fluctuated rapidly.  One person, according to Forbes, turned $20,000 into $3 million by buying Bitcoins early then selling them for a killing.

BitCoins may one day be worthless relics on discarded hard drives.  Or BitCoins may become the E-commerce alternative replacing PayPal.  Right now BitCoins seem to be priced about what the current mining cost will bear.  The cost of mining is measured in 1) electricity (energy) and 2) depreciation of the graphics cards used to mine new BitCoins.  This tends to put a short-term ceiling on BitCoin prices.  However, the BitCoin system makes the cost of BitCoin mining escalate geometrically.  Eventually, if all goes optimally, the mining cost will be come prohibitively expensive.

If BitCoins gain wider and wider acceptance I anticipate they will hold or increase in value.  However if either of the following happen they will end up virtually worthless: 1)  BitCoins simply don’t gain wide acceptance, and lose acceptance over time.  2) The algorithmic infrastructure underlying BitCoin is found to be flawed.  There is yet another alternative:  That a BitCoin-like system is created the competes with the original BitCoin.  Finally one more possibility:  various governments outlaw BitCoins.

In closing, BitCoin is a brilliant idea and a risky “investment”.  It is riskier than gold, silver, or index ETFs.  It is similar in risk to buying options, because the value can rapidly go to zero.  However, it is an interesting speculative play that is potentially inflation-proof.  Inflation-proof because, unlike government currencies, the printing presses (BitCoin mines), are held in check.  Buying 1500 dollars worth of BitCoins is no sillier to me than buying a $1500 gold coin. Just make sure you guard your BitCoins like you would your expensive gold coin… security, security, security.   Because BitCoins can be stolen, just like gold.  And they can be stolen without the thief even setting foot in your house.

9.2% Unemployment, not just for Europe

When did I wake up in Europe? I want to go home, to the USA that I remember.  9.2% unemployment is for France and Italy.  I’ve been to these countries — nice places to visit — but not to work hard and get ahead.  High unemployment is cultural, normal, systematic.

Is Germany the new USA?  It’s the only European country doing well.  Germany has pride and strength of purpose.  Germany has its fiscal house together.

Is the USA becoming the next France?  Jobs for government workers, modest jobs security for those with jobs, and very few prospects for the unemployed and for recent college graduates.

The fixes for our current economic mess are not rocket science.  I agree with Bill Clinton’s recent comments… the corporate tax rate needs to be reduced.  The U.S. government needs to reduce the self-employment tax that is a huge drain on U.S. small businesses.  Congress and the Administration need to encourage, rather than stymie, domestic oil and natural gas production.  Finally,  an intervention is needed to halt Washington’s latest spending bender.  Washington has been drunk behind the wheel of a massive M1 tank, trying to drive the economy, whilst drifting lane to lane and taking out the odd car here and there.   That tank, fueled by 14+ trillion of debt, is about to find the price of fuel is about to rise.

Now is not the time for platitudes, or experiments.  Now is the time for prudent action.

I am sad that the Space Shuttle is being retired.  Such action is merely a symbol of where the US Government, en masse, sees the USA heading.  This need not be the case.  The US, as a whole, has all that we need to succeed.  We are are free, independent, creative, and motivated.   The US has shown repeatedly the resilience to challenge adversity and thrive.  Why so few lawmakers can see this — communicate this — is baffling to me.  Are they simply economically ignorant?  Or indifferent?

Until some economically sane action emerges from Washington, I am hedging my personal finances.  I’m positioning against the real possibility of long-term, government-sponsored inflation.  I’m factoring in the likelihood of the government CPI (CPI-U Urban Consumer Price Index)  understating true inflation and overstating the real US GDP.

There is a chance, a glimmer of a chance, that the current debt ceiling negotiations will lead to economically sound changes.  I think the chances of that are less than 20%.  I will watch closely and act accordingly.

Just don’t call it QE3 nor Inflationary

Whether it’s Barack Obama releasing 30 million barrels of oil from the Strategic Petroleum Reserve, or Ben Bernanke saying they might buy another $300,000,000 worth of U.S. Treasurys… even after QE2.  But, no, it’s not QE3… nah.

The oil gambit was, from a purely stimulative standpoint, an interesting move.   It would have been more effective when oil was at $110 and rising rather than in the $90’s and falling.  But, perhaps there was some political hay to be made.  Short term this was not an inflationary move.  However, someday, those 30 million barrels will have to be repurchased… which will have an inflationary effect.  It was a short-term political move.  From a geopolitical perspective, it also signals a US willingness to manipulate the oil markets… rather than being truly “Strategic” (aka for military and other strategic purposes).    Ironically the Obama administration is accusing others of oil price “manipulation” while they just did just that with the SPR oil release.

And for Helicopter Ben, QE and QE2, both unprecedented;  it seems that maybe a little more magic juice is called for.  He doesn’t understand the current economic problems, other than to call them (mysterious) “headwinds”.

The situation, as I see it, is inflation-triggering non-stimulus.  The magic “CPI” may not reflect this right away.  In fact I believe inflation is currently outpacing “CPI Index” inflation by 1 to 2 percent.

I’m not fully aware of the whats or whys of QE3, I just know that I’m not supposed to call it QE3.

Wired in High Finance

There are two economies, the real economy and the financial economy (the financial markets). The two economies are linked, but sometimes the linkage is almost imperceptible.

Take for instance the recent run up in stocks, up ~20% in the last year, and up a total of ~40% in the last two years. This stock run up in the financial economy is in spite of the dismal real economy which was (still is?) in the midst of the Great Recession. The classic explanation for this jump in stock prices is anticipation of strong economic growth that many were guessing was just around the next fiscal quarter or two.

But continued lackluster economic growth, high unemployment, and inflation fears have the stock markets retreating 4% in the last month. QE and QE2 have driven commodity, gold, silver, and oil prices up (and the dollar down to a degree). Low interest rates have also helped fuel the commodity boom. I don’t say commodity bubble, I say boom, because I don’t believe it is a bubble… merely a precursor to higher inflation.

Further the prospects of Congressional legislation past and present loom as large economy and business-dampening prospects.

1. Dodd-Frank Act regulating all sorts of financial and non-financial items.
2. Obama Care.
3. The real possibility of tax increases as part of debt ceiling deal.

The danger of Dodd-Frank, which deals primarily with the financial economy, is that it may spill over into the real economy as well — a form of fiscal contagion.   Obama Care hits right in the solar plexus of the real economy soon.  Potential tax increases are a kidney shot to the real economy.

Also on the horizon is the debt crisis in Europe, currently centered around Greece, but with dominoes in Portugal, Spain, Italy and Ireland ready to fall.

So, why on earth would I be neutral to mildly bearish (long term) on US equities?  The title “Wired on High Finance” sums it up.

1. Wired, as is in connected, by wire, cable, fiber optics, or wireless.  The continuing computational and connectivity revolution is only accelerating.  This helps business productivity, which helps business (the real economy) and inevitably the financial economy (the stock market).
2. High Finance.  High finance in the US eventually finds a way.  Take for instance GE which managed to pay zero income tax last year.  Big money always finds a way.   Call it industriousness, creativity, or greed… it gets things done.

Without all of the governmental fiscal and regulatory “headwinds” (as Bernanke has called them), my outlook would be bullish.  Despite them, I believe that the power of a wired world of high finance will find ways to resist the government onslaught.  Either through back-room deals (the new and no-so-new crony capitalism) or the ballot box (voters tired of 9% unemployment), these “headwinds” will be reduced, skirted, or avoided.

And while CPI stands for Consumer Price Index, most commonly, it also stands for Cycles Per Instruction — one measure of computer processing speed.  So while the mainstream CPI may understate prices, the other CPI is very favorable to computation power.  (In both cases keeping true CPI down is desirable.)

Notice I am neutral to mildly bullish on the US (and global) economy.  That is why I, personally, am increasingly invested in investments that reflect that believe — namely covered-call market-index strategies.  That is why I have switches some of my ETF investments from SPY (an S&P500 index EFT) to PBP (an S&P500 covered-call ETF).  Inflation fears and low interest rates have continued to cause me to shy away from most bonds and bond fund… with the exception of high-yield (junk) bonds.

Disclaimer: These are my personal investing thoughts, opinions, and choices as of today.  No one can reliably predict the markets (stock, bond, futures, options) or interest rates, certainly not me.

Know Unknowns: Bank Balance Sheets & The Federal Reserve

I consider myself knowledgeable about many things financial: ETFs, stocks, bonds, options, the stock market, for example.  I know the difference between an income statement and a balance sheet, and can read financial statements and prospectuses as a matter of course.

I’ve had little luck deciphering bank balance sheets. Income statements yes, balance sheets no.  They tend to be very opaque, which is one obstacle.  Loans are assets while deposits (other than Federal Reserve deposits) are liabilities.  Accurately determining the quantity, quality, type, and duration of loans can be difficult if not impossible… at least to me.  Perhaps some of this info can be found in the bank’s 10K statements.  Also opaque are details of the bank’s interest rate swaps and other OTC financial contracts.

Historically, the old-style (commercial) bank followed the 3-6-3 rule:   Borrow at 3%, lend at 6%, be on the golf course at 3:00.   Such a bank would take in deposits and lend out with loans (mortgages, car loans, commercial loans).  However, banks could not lend out all the deposits; banks had to keep a fraction of the cash in reserve.  This reserve helps to avoid the “run on the bank” problem, where too many depositors ask for their money — all at the same time.

Keeping all of this spare cash at the bank (about 3-10% of assets) is cumbersome, and also encourages bank robberies.  Banks can transfer much of this physical cash to the Federal Reserve and sometimes even earn a tiny bit of interest (0% to 0.25%, “the Fed Funds Rate”) on it.  Thus the Federal Reserve serves as the bank’s bank.  The Federal Reserve System (or “The Fed”) also helps clear checks (remember those?) and move money between banks simply by moving reserve deposit balances between banks.  No need to shuttle hard currency to and fro.  Deposits are moved with a pencil, or computer transaction in the Fed’s books.

The Fed also lends out money to banks.  Banks can borrow from the Fed at 0.75% (the so-called discount rate).  This system leaves a 0.5% profit for the Fed on the difference between the Fed Funds rate and the discount rate.

Classically the Fed would try to guide the economy by moving the Fed Funds rate and discount rate.  If the Fed thought the economy was overheating (generating excessive inflation) the Fed would raise rates to “cool off the economy”.  The Fed tried to adjust the rates so as to give the economy a “soft landing”.    If the US economy got too sluggish, with high unemployment, the Fed lowered rates.  The interesting thing (no pun intended) about these rates is that they are all short-term rates.  So short-term that the Fed funds rate is sometimes called the overnight rate.

I keep saying “classically” and “historically”, is this is how things used to be done by the Fed.  What’s new, since Fed Chairman Bernanke, has been the manipulation of long-term rates with “quantitative easing” QE, and QE2.  Also new (with the cooperation of US Treasury Sec. Timothy Geithner, Congress, and President Obama) are measures such as the AIG bailout and TARP.

The Fed has shifted into uncharted territory, and in the process neglected one of its two prime mandates: price stability and low inflation.  It also seems to have overlooked the concept of real economic growth (GDP growth adjusted for inflation).  Instead the Fed seems to be fluttering in a course of wide-ranging, unprecedented, knee-jerk reactions.

Today’s Fed is not my father’s Fed, nor are today’s banks.  Today they are increasingly known unknowns.  This path is new and the ticket stub is unclear.  I don’t see a destination nor ETA, but when I look close, very close, I see a dim watermark.  Subtle, like grey on grey, I believe I see in faint yet bold letters INFLATION.

Millionaire by 40? Inflation says Big Deal!

40 years old is still several years off for me, but I it is very likely I will be a millionaire by the time I reach 40.  In fact, if you count my contributions to Social Security (including my employer’s half), the current value invested in my personal “Social Security Trust Fund” puts me there already.  But I’m certainly not counting on Social Security.

So, I’ll be rich right?  Wrong!   First there’s inflation.   Many economists say US inflation has been about 4% per year over the last century.  There’s a handy rule of 72 that says, for example, 72/4 = 18.  That means 4% inflation means that a million dollars today is only worth $500,000 in 18 years and $250,000 in 36 years.

Second, there’s taxes.  Over $300,000 of my holdings are in tax-deferred accounts such as 401k accounts and IRA accounts.  Sure this money is part of my net worth, but when it comes out at retirement I’ll likely be paying something like 30% tax on it.  That’s about $90,000 to Uncle Sam.  Poof!  Gone!

Back to inflation.  Inflation works like a stealth tax.  According to government CPI figures, US inflation increased just 1.5% in 2010.  That simply doesn’t jive with my experience.  My HOA fees increased 7%, my electric and water bill increased 8%.  Car insurance, home insurance, satellite TV, health-insurance premiums, internet, rooms at my favorite hotel, and meals at my favorite restaurant went up, by 4-10% last year.  Even the local sales tax increased almost 1%, making everything that much more expensive on top of everything else.  In Balhiser World 2010 inflation was about 4-5%, rather than the 1.5% according to the CPI.   Thus I have some new ideas about what CPI stands for…

• Cagey Price Index  (Price? What price?  Prices are relative.)
• Calming Price Index  (Nothing to see here. Relax. Inflation is under control.)
• Clairvoyant Price Index  (Far away someone is substituting chuck steak for Filet Mignon.  Meat is meat.  And prices are low.)
• Creative Price Index (2+2=3 for sufficiently small values of 2)
• Cowardly Price Index (Please don’t be mad, prices aren’t that bad… see?)

Of course CPI officially stands for Consumer Price Index.  Let just say that for the next 72 years the official CPI is 4%, but actually inflation is 5%.  That handy rule of 72 says that at 4%, one million dollars today will be worth $62,500 of buying power.  At 5% buying power is cut in half to $31, 250.  Of a long enough time a 1 percent difference in inflation is a big deal.

So what?  Well, the CPI is used for a lot of things such as government cost of living adjustments, tax bracket adjustments, Social Security benefit increases, and money paid on Treasury Inflation-Protected Securities, to name a few.

It’s bed time so I’ll cut to the chase.

1. One million dollars is not what it used to be, and is certain to be worth much less in the future.
2. To try to remain solvent (and avoid unpopular austerity measures) the US Government has a powerful incentive to under-report inflation.
3. Many investors and economists are beginning to believe that the CPI significantly under-reports inflation. Examples: “CPI Controversy”,  “Bill Gross says so”, “Forbes, pastries, and gold say so too”.

Choose your Fear: Motivating Financial Choices

I freely admit fear is a motivating factor behind my financial decisions.  High on my list of fears (worries, concerns) is inflation.  For a variety of valid economic reasons, long-term bond returns are generally worse than equity returns in an inflationary environment.  In other words, an uptick in inflation hurts bonds more than it hurts stocks.

Fear of market volatility steers me away from stocks, fear of inflation steers me away from (long-term) bonds.   In the current interest rate environment, real rates of return on short-term Treasury debt are negative.  High-quality corporate bonds are only paying a pittance.  And as I have recently blogged, TIPS based on the CPI-U, are not looking so good either.

What options are left to the anxious investor?  Some remaining choices are:  foreign-debt ETFs (as a hedge against US and US dollar inflation), foreign-equity ETFs, and junk bonds.  Perhaps, value stocks as well.  Unfortunately each of these options comes with their own particular set of risks and worries.

The moral of this stories is there are few low-anxiety options for the investor who fears volatility, uncertainty, and inflation.  Retirees looking to reinvest expiring bonds and CDs are finding few good investment options.

There remains on strategy to fall back on to help ease financial anxiety: diversification. Diversifying between equities, bonds, and cash.  Diversifying between US and foreign equity. – Diversifying between large-cap and small-cap. Diversifying between long-term and short-term debt.  Diversifying between high-quality and high-yield (junk) debt.  And, yes, even diversifying between value and growth.

Still, I choose my fears.  Inflation is number 1.  Volatility is number 2.  Fear of missing gains is number 3.  Inflation concerns and dismal interest rates are motivating me to hold more equities (via low-cost equity ETFs) than I otherwise would.

CPI Really Stands for…

Ostensibly, the CPI stands for Consumer Price Index. I have a few alternate suggestions:

• Contrived Price Index
• Controversial Price Index
• Captive Price Index

There are several thing that I don’t like about the CPI, specifically the CPI-U (The Consumer Price Index for All Urban Consumers).   Most troublesome, is that it is used interchangeably with the term “inflation” or “US inflation”.  While CPI-U includes food, energy, and medical expenses, for example, it does so in ways that are far removed from the way many consumers purchase.

For me, the CPI-U appears to understate the inflation I’ve seen in the last 10 years.  The price of my satellite/cable TV has doubled.  The share of health-care insurance that comes out of my paycheck has gone from $20/month to $200/month.  I still remember getting a Big Mac value meal for $2.99, but now it’s about $5.00. It’s hard to believe that consumer inflation has averaged just 2.3% annually over that time period.

That’s why I’m glad other folks are developing their own price indexes.  Two examples are the Billion Prices Project Index, and the upcoming Google price index.

I’ve read a number of articles saying CPI-U understates inflation by about 1.0-1.5% annually.  If so, this is  a big deal.  Real interest rates are not only negative they are substantially negative.  And real GDP growth is dramatically overstated.