Inflation, The Feds, and the Stock Market

Since my last post the stock market has dropped considerably. Today close was the yearly low of 11215, the last close near this level was in july, 1006. Why? My last post regarding wage deflation has been born out and even verified by Bill Gross of PIMCO, one of the largest bond managers in the country. Mr. Gross estimates the inflation has been under reported, the reason, many government programs are index the the CPI. The components of corp inflation is made up of items we puchase infrequently such as cars, or washers and dryers. Increases inprice are adjusted for increases in efficiency; an item costing 100 yesterday may be 120 today, but the increase in the avereage life of the product adjusts the price back to 105. Non Corps inflation includes those item we have to puchase every day to live. Gas, food, tolit paper, water, gas, and eletric. Based ont hose items inflation is out of control.

Thep rice of oil is 140 and some change. Mopst estimates of earnings and inflation have used an average price of 90 dollars per barrell. What would the estimates of those compaies look like of the adjustment were made. This would be the equivalent of having to mark illiquade assts to market to for the earning of corporations; more importantly what would happen to the inflation estimates if mark to market were required as the Fed is demanding the banks todo. Companies whose cost of good sold included petromlum products would be pounded. Companies who produce petrolem earnings would expand tremendously.

The Fed is in deep deep trouble. The dollars collaps as a result to to many dollars. These dollars were added be the federal reserve and then financial institutions leveraged theses dollas much as 20 to 1 in the case of a bank. Print too many dollars by the fed or the fed allowing leverage thru the financial systems are the same thing , both acting in concert magnified the number of dollars circulating in the market. This cased the dollar to drop and commodities to rise. While the EU has increased interest rates even in the face of the financial crisis, the US has lowered rates. The EU will raise rates tommarow adding more pressure to the dollar and the FED to increase rates, but they will not due to the timing of the next several meeting cooinciding with the elections and holidays. The faint is they do not want to effect/affect the elections, but quite the oppsite is true.

Bottom line the Fed will have to eventually raise rates significantly over the next several years. The effect: a one percent change in rates will change the price of a 30 treasury bond by about 20 per cent, bot including the interest. In the early eighties when I was selling 7 and 8% GNMA's yeilding 13% and no one would buy them, they were trading all around 50 cents on the dollar. The risk premium assigned to 30 year treasuries was 3 per cent above the inflation rate. If the same risk premiumum was assigned today the yeild on the long bond would be north of 7%. Let the buyer be ware.

Next post: What effect an increase in rates has on the stock market and why.