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Used car prices continue to rise

Used car prices have risen over 20% since the end of 2008. Not surprisingly, auto sales are up 14% over the same period. I take this as one more indication that deflation is dead. Here's how the folks at Manheim explain it:

Pricing strength in the wholesale used vehicle market became more broad-based in the first quarter of 2010 as record tax refunds and improved retail credit availability reinvigorated the market for lower-priced vehicles. Meanwhile, prices for late-model, higher-priced, units stayed strong despite the increase in new vehicle incentive activity in March.
Incentives helped new vehicle sales, but didn't hurt used vehicle values. March brought forth a significant increase in incentives (mostly in the form of no-down, low-rate, financing or lease deals) from a variety of manufacturers, some of whom - such as Honda - have generally stayed away from such promotions in the past.

On a year-over-year basis, all market classes of vehicles are up significantly in pricing and, in recent months, the differences between individual market classes have moderated. Likewise, the relative difference in price performance between the various price tiers has also evened out.

In short, demand is strong and there is no shortage of money.

Despite the problems in Greece, the Euro is still strong

This chart serves as a reality check to all the hand-wringing over the problem with Greek indebtedness. Greece has a problem, no question, but it could be solved by simply cutting government spending and not raising taxes. Even if Greece were to default on its debt, it wouldn't be nearly as tough on global financial markets as the subprime disaster or the Lehman failure; it would likely involve a restructuring of Greek debt that would cost bondholders some sizeable fraction (but much less than 100%) of their value. Default risk on Greek debt is now somewhat higher than that of your typical junk bond. Greece's problem is dragging down the euro because Greece might risk the unthinkable by pulling out of the euro and printing drachmas to inflate itself out of debt (which is simply another way of restructuring its debt, but probably the worst and most stupid way).

Despite all the problems, the euro is still relatively strong compared to the dollar—about 16% above its purchasing power parity according to my calculations. You might say that this is the market's way of telling us that on balance the outlook for Europe is still better than the outlook for the U.S.

Strong growth in capex is very bullish

More very good news on the economic front today, with the release of unexpectedly strong data on capital spending by US businesses. This is one more of those V-signs of recovery. Capital spending is up about 13% from a year ago, and as the second chart shows, that's almost as strong as it ever gets. Strong growth in capex tells us a lot of important things: businesses are confident in the future and thus willing to take new risks; businesses are generating strong profits growth to fund new investment; and new investment today, by purchasing the tools and building the equipment that make labor more productive, is sowing the seeds of future growth and rising living standards. Capex is one of those things that feed on itself; the more we invest in productivity, the stronger the economy is likely to be.

To be sure, the level of investment is still quite low compared to where it's been in the past. But it is clearly moving in the right direction, and it's moving at pretty good clip. It's particularly impressive that business investment is so strong despite the tremendous amount of uncertainty that exists with respect to out-of-control federal deficits and the threat of higher tax and regulatory burdens. Just imagine how good things could be if these clouds of uncertainty weren't rolling overhead.

Inflation at the producer level is alive and well

Thanks mainly to rising food and energy prices (in the past six months, food prices are up at a 13% annual rate, as Brian Wesbury points out), producer price inflation rose to 6% in the past year. Core inflation at the producer level remains pretty tame, but I note that the core PPI is up at a 1.9% annual rate in the past three months. It wouldn't be usual if the core PPI measure picked up further in the months to come, since the headline measure has tended to lead the core measure since the 2001 recession. Brian agrees, adding:

... core prices are showing higher inflation deeper into the production process. Core intermediate prices were up 0.7% in March and are up at a 6.3% annual rate in the past six months; core crude prices increased 6.0% in March and are up at a 41.1% annual rate in the past six months. These figures suggest the placid core price measure for finished goods will eventually start going up much faster.

More signs of a housing bottom

Data released today provide more support for the theory that we have seen the bottom in housing. The first chart is an index of the stocks of 18 leading home builders. It has reached a 19-month high, and is up 140% from its March '09 low. The second chart is the result of a survey of home builders that covers questions on present sales, sales expectations, and prospective buyer traffic. It is still quite low, but has more than doubled from its January '09 low. The third chart shows a continuing decline in the supply of unsold homes on the market. The pace of the decline looks very much like what occurred in early- to mid-1980s housing market recovery. The fourth chart shows a clear bottoming in the number of existing homes sold (the spike late last year was related to the anticipated end of the home buyers' credit).

Add to these signs of resurgent activity the fact that mortgage rates are at or very near all-time lows; that housing prices in 20 major markets have dropped by one-third in real terms since reaching a peak four years ago; and that signs of a general economic recovery are widespread. The resulting picture becomes quite clear: the great housing market bust is over, and a new growth cycle is underway.

Disturbing parallels between the U.S. and Argentina

I touched on this subject in a post last month, and return to it because creeping socialism (or American Peronism, if you will) is a very slippery slope with disastrous long-term consequences. I know Argentina and its history very well. In fact, I once had to take a high school equivalency exam that included a rigorous test and essay on Argentine history, and my first job as an analyst in 1981 was to prepare an extensive report on the outlook for Argentina. Additionally, I lived there four years in the late 1970s. My wife and I have countless friends and relatives that we have visited dozens of times over the years since. As much as I love the people, the food, and the wine, I detest the Argentine government for the unimaginable economic pain and suffering it has inflicted on its people. I've witnessed first-hand the destruction of Argentine living standards over the past 35 years.

I never thought I would see the day that counting the number of parallels between the U.S. and Argentina would require the fingers of two hands, much less just one. But Richard Rahn does just that in a very well-done article in today's Washington Times. Excerpts:

Argentina has extensive import bans and controls. The Obama administration has been advocating protectionist trade policies and has opposed the ratification of previously negotiated trade agreements.

Argentina has income tax rates roughly equivalent to those in the United States but also has a value-added tax (VAT) and a wealth tax. Officials of the Obama administration and some members of the U.S. Congress are flirting with a VAT.

Argentina has continued to run inflationary monetary policies while at the same time attempting to treat the symptoms through price controls. The U.S. Federal Reserve has greatly increased the money supply, which is likely to produce future inflation. Officials of the Obama administration, at times, have advocated price controls of insurance companies, medical suppliers, financial institutions and even fees for carry-on luggage on airplanes.

Argentina's largest bank is state-owned, as are a number of its other banks. The Obama administration forced a number of large American banks to become partially government-owned. The two largest mortgage institutions in the United States - Fannie Mae and Freddie Mac - are now largely government-owned-and-controlled.

Argentine courts are slow and corrupt. Property rights are not secure, and the government has willfully understated inflation statistics, causing foreign and domestic bondholders to lose much of their investments. The Obama administration unilaterally took away bondholders' rights in the GM and Chrysler cases and, in essence, took their assets and turned them over to the unions that had supported Mr. Obama.

Argentina has extensive labor regulations to favor unions, which greatly increase the cost of hiring. The Obama administration has supported costly labor regulations that the unions favor, which eventually will drive up the cost of hiring workers and result in higher unemployment.

Argentina has a long history of deficit spending, which, in turn, has made government debt burdens so high that the government refuses to pay the debt to the private domestic and international debt holders. Over the next 30 years, economists ... estimate ... that the U.S. public debt will rise to between 200 percent and 500 percent of GDP. (It is now about 60 percent.) Debt levels of 200 percent to 500 percent cannot be supported; hence, the debt holders will face erosion of their capital through either inflation or nonpayment.
We are clearly headed in the wrong direction, and it's now up to the people to demand change for the better come November. I think it can be done. If not, the long-term consequences are very disturbing.

I stand corrected

As an alert reader pointed out, the difference between the market caps of AAPL and MSFT is $40 billion, not $30 billion; I think my calculator failed me yesterday. Nevertheless, this is perhaps the most impressive David vs. Goliath story in modern finance: Apple's comeback from the brink of oblivion 12 years ago.

Another very interesting observation occurs to me: the amount of market cap that Microsoft has lost ($311 billion) since its late 1999 peak ($586 billion) is substantially more (32%) than Apple's market cap today ($235 billion). Even after adjusting for its $32 billion cash payout several years ago, and its ongoing dividend, it's remarkable the value that has been destroyed by Microsoft's inability to innovate.

The bond market's inflation-forecasting track record isn't very good

The market—which reflects the cumulative wisdom of billions of participants—is pretty good at discovering information and pricing things efficiently. I think there is great value to be found in market pricing, which is why I pay a lot of attention to things like the value of the dollar, credit and swap spreads, gold, commodities, the shape of the yield curve, and the implied volatility of options. But the market can and does make mistakes. One case in point is the bond market's ability to correctly anticipate future inflation.

I think these two charts provide evidence of the bond market's fallibility when it comes to inflation forecasting. If the bond market were an excellent judge of future inflation, then interest rates would always, after the fact, offer investors a yield that exceeded inflation. Real yields, in other words, would tend to be somewhat positive most or all of the time.

The first chart focuses on the past 50 years of interest rates and inflation. Note that in the early 1960s, when inflation was very low and stable, bond yields were also low and stable, but also consistently higher than inflation. Around 1965 inflation started rising, and bond yields struggled to keep up. If you bought the 10-yr Treasury bond in 1970 it yielded about 7%, but inflation over the next 10 years proved to be almost 8% per year. T-bonds were a lousy investment in real terms throughout the 1970s.

The bond market finally learned its inflation lesson by the early 1980s, as 10-yr Treasury yields soared to 14%. Once burned, twice shy: no one was going to be foolish enough to trust their money to the bond market unless they received a handsome premium over inflation, which was expected to be in the double digits for the foreseeable future. However, thanks to tough monetary policy from the Volcker Fed, inflation subsequently collapsed. As a result, real yields were enormous in the 1980s, and investors in T-bonds earned huge real returns (I should know, as I was lucky enough to buy 30-year zero coupon Treasuries in 1982 and 1983 for my IRA account—an investment which more than tripled in value over the next 10 years).

In short, the bond market underestimated inflation throughout the 1970s, and overestimated inflation throughout the 1980s and 1990s.

The second chart shows real yields (the difference between 10-yr yields and consumer price inflation) over a very long time horizon. As should be obvious, the bond market made some huge inflation-forecasting mistakes in the 1930s and 1940s.

On average, real yields on 10-yr Treasuries have been 2.6% per year since 1925, and that's the value that the market seems to gravitate around. But note how real yields have been for the most part below average since the early 2000s. Not coincidentally, monetary policy has been for the most part quite accommodative over this same period. The Fed has been unconcerned about inflation, and so has the bond market. I believe that is still the case today. Both the bond market and the Fed are underestimating future inflation, just as they did in the 1970s.

Why? Because the bond market pays too much attention to growth, and not enough to sensitive prices. Because the Phillips Curve theory of inflation is still dominant, despite having been disproved countless times over the years. See my many discussions of this here if you want more background.

Is this a great country or what?

Apple today reported a 90% gain in second-quarter profit; net income rose to $3.33/share, from $1.79 a year earlier; sales rose 49% to $13.5 billion, topping expectations of $12 billion; shares rose 6% in after-market trading. Apple's market cap is now only $30 billion shy of Microsoft's.

Current expectations for future interest rates

Here is Bloomberg's calculation of where the market expects Treasury yields to be in 1, 2, and 5 years (current yields are shown in the red line at the bottom, 5-year forward yields in the green line at the top). The market is expecting the Fed to raise the funds rate by about 1 percentage point over the next year, and another percentage point over the subsequent year. To me, this confirms what I pointed out in my previous post, namely that the market is not expecting great things from the economy over the next few years.

The bond market sees little inflation risk and very slow growth

Always on the lookout for the key assumptions that are lurking behind market prices, I offer this update to similar posts here and here. Real yields on TIPS are, I believe, very good indicators of the bond market's growth and inflation expectations. Currently they are telling us that the bond market expects sub-par growth and no significant increase in inflation.

I detect no sign that the bond market is unusually concerned about future inflation. 5- and 10-year breakeven spreads are in the range of 2.25-2.35%, which is actually lower than the 2.45% that the CPI has averaged over the past 10 years. The 5-year, 5-year forward breakeven spread is about 2.65%, again very much in line with what we have seen in the past. 10-year Treasury yields today are at the same level (just under 4%) as prevailed during the early 1960s, which was a time when inflation was extremely low and stable—about 1.5% per year.

I infer from the chart above that the bond market is not concerned at all about any significant tightening of monetary policy over the next year. The level of yields on 5-year TIPS is consistent with an expectation that real yields on short-term interest rates will be roughly zero. That expectation (of no Fed tightening, which I define as increasing the Fed funds rate by more than the increase in inflation) is in turn consistent, I believe, with a view that economic growth is likely to be sub-par (consistent with the popular "new-normal" forecast for 2-2.5% growth). If economic growth were expected to be 3-4% or more one year from now, I have to believe that the bond market today would be expecting at least some modest tightening, if not significant tightening.

Since there is no reason to believe that the expectations driving the bond market are any different from the expectations driving the equity market, I can further infer that there is little reason to believe that the equity market is a bubble waiting to pop. The capital markets today are priced to very conservative and unexciting assumptions about the future.

Still no sign of a threat to housing

Despite the conclusion last month of the Fed's program to purchase $1.25 trillion of mortgage-backed securities, today there is no sign that this has had any meaningful impact on mortgage interest rates. In fact, rates on 30-year fixed-rate jumbo mortgages are now as low as they have ever been. Furthermore, the spread between jumbo and conforming mortgages is now down to 50 bps, not too far above the 25 bps average that prevailed during the 10 years ending mid-2007. The absence of any upward pressure on mortgage rates, coupled with the continued tightening in conforming/jumbo spreads, is a good indication that the mortgage market is efficient and sufficiently liquid. If there's a threat to the housing market out there, it is not hiding in the bond market.

Message to homebuyers: interest rates on 30-year fixed rate mortgages are extremely attractive from an historical perspective, since they are now about as low as they have ever been. Given the great uncertainty surrounding future monetary policy (i.e., how much will the Fed have to raise short-term rates to keep inflation at bay, given the Fed's massive $1 trillion injection of bank reserves), fixed rates also look very attractive relative to adjustable rate mortgages.

Real estate prices still appear to have bottomed

The March value of Moody's Commercial Property Index fell, but in the great scheme of things I don't see this as significant. As this chart shows, prices of residential and commercial real estate have already experienced huge declines (29% and 42% respectively) in recent years. The market has been working very hard for the past four years to reduce the inventory overhang of homes and commercial space by slashing prices and slowing the pace of new construction. It appears to be working.

Commercial real estate has been lagging the moves in residential real estate, and residential prices bottom over a year ago, so it's reasonable to assume that commercial property prices are now in a bottoming process.

As evidence of a bottom in real estate prices accumulates, this paints a very optimistic picture for the economy and financial markets going forward. Since real estate figures importantly as collateral behind all sorts of debt obligations, reducing the likelihood of future price declines adds significantly to the value of collateralized debt. And this, in turn, provides substantial support to the value of all institutions that carry significant real-estate-backed assets on their balance sheets.

As I've been noting for quite some time, the prices of securities backed by homes and commercial real estate loans have risen significant in the past 6-9 months. There are just too many signs of a bottom here to ignore.

Leading indicators continue to look very bullish

As I said in a previous post, I don't usually put much stock in the Leading Economic Indicators published by the Conference Board. But the pronounced rebound in this statistic, whose growth rate is shown in the above chart, is so strong that it is probably risky to ignore it. Mark Perry has some amplifying comments here. I note that the current rebound is the third-strongest on record.

It then occurred to me to put together this next chart, which shows the level of the LEI index on a semi-log scale. I note that the index was roughly flat throughout the 1965-82 period, when equities delivered negative real returns for 17 years. But today the index appears to still be following the significant uptrend which began in late 1982. I don't want to make a big deal of this, but I do think it's worth noting. I've seen a number of people attempting to make the case that the bear market which began in 2001 is going to be a replay of the 1965-82 bear market. While I still worry that inflation will be higher than the market expects in coming years, there is no sign yet that inflation will be anywhere near as bad in coming years as it was in the 1970s.

Commodities continue to boom

The amazing action in the commodities markets continues. This measure of raw industrial commodity prices is only 2.6% below its all-time high, and looks set to break new ground soon. The commodities that make up this index are not the sort of commodities that lend themselves to massive speculative activity, so I think the price action here mostly reflects strong global demand. Demand can be influenced by monetary policy, of course, because easy money tends to boost people's desire to own tangible things, and these commodities are the raw materials for a lot of "tangible thing" production. Easy money + strong global growth = strongly rising commodity prices.

The message to investors: the action in the commodity markets is a strong sign that deflation risk is minimal, if nonexistent. Yet the Fed and many market participants continue to fear deflation: that is one reason why the Fed has kept interest rates at zero for a year and a half, and it helps explain why Treasury yields are still extremely low from an historical perspective. I think the market is over-estimating the potential for downside risk, and that means there is still plenty of upside in equities. Full disclosure: I am long equities, TIPS, corporate debt, and emerging market debt at the time of this writing.