As you will see from your July statement, the stock market over the past few weeks has produced positive returns in your account. Some of the old stock market adages such as the “January effect”, “don’t fight the Fed”, etc., have fallen by the wayside. If you had bought into the “sell in May, go away” strategy, you would have missed a significant rise in the stock market over the past two months. Even though earnings for most companies are down from a year ago, many analysts predicted earnings would be far worse than what they have been. More than 70% of S&P 500 companies reporting thus far have exceeded analysts expectations. In other words, it isn’t as bad as expected. This is why the stock market has performed well recently. Companies have been aggressive in cutting costs and inventories over the past few months in anticipation of a bad economy. Companies are now lean, mean operating machines. Any sales increases will go directly to the bottom line resulting in higher earnings. Higher earnings = higher stock prices.
Many people are concerned that inflation is going to rise in the near future given the record amount of government bond issuance and spending. Is there a chance of much higher inflation in the future? Yes there is if the Federal Reserve doesn’t act aggressively when it begins to appear. At the moment, inflation is not a concern. Deflation presently is more of a concern. Credit contractions are deflationary in nature as leverage is taken out of the system. This credit crisis is no different.
Some of the reasons we believe inflation is not currently a threat are: 1) Wages – according to an Associated Press article published today, “Employment compensation for U.S. workers has grown over the past 12 months by the lowest amount on record.” In fact, many people have taken pay cuts. One of the biggest costs for a company is wage expenses. If wage costs are not rising, the price of goods will not rise significantly. We believe many people are happy to have a job and will not be demanding higher wages for quite some time; 2) Home prices – this is unlike the 1970’s when home prices skyrocketed. We are just starting to see some stabilization of home prices (at significantly lower levels than a year ago). We see no evidence of home prices rising significantly in the months ahead; and 3) Falling Velocity of Money – the velocity of money is simply the average frequency with which a unit of money is spent in a specific period of time. Below is a chart from a Forbes article earlier this year.
The chart shows that the velocity of money has fallen dramatically as more people and businesses are saving money rather than spending it. Because of reduced spending and less leverage (lending), the typical dollar was spent just half as often as it has been in the past. We know the Federal Reserve is increasing the money supply to combat deflationary forces. Based on the sharp reduction of the velocity of money, they can do this. If people start spending more freely and the velocity of money rises, the threat of inflation will increase, especially if the Federal Reserve does nothing.
We are closely monitoring wages, home prices and the velocity of money to help us determine when inflation will become an issue. Right now, we do not see any significant inflationary pressure.