Austerity And Inflation Will Go Together

You can hardly turn over an investing advice newsletter without finding a recommendation to buy TIPS, or Treasury inflation-protected securities, to preserve the purchasing power of your dollar-denominated savings.

Economists and investment pros look out three years and can't believe we aren't due for a powerful flush of inflation. The usefulness of their favorite hedging advice, however, depends on the U.S. government actually carrying out the promise embodied in TIPS, honestly to apply an inflation adjustment to protect holders from loss of purchasing power due to the government's own mismanagement of the currency.

Will the spirit and letter of this guarantee be observed? The question has to be asked because Washington has shown no hesitancy to delegitimize legitimate claims by vilifying those asserting them—GM and Chrysler debt holders being the most recent examples. By the time the TIPS question comes up, moreover, the slope will likely have been greased by states and municipalities reneging on promises made to government retirees and bond investors. It will have been greased by governments around the world setting example after example of the many flavors of default. The justice or lack thereof in each such case is not the question. What matters is to recognize that government promises are not written in stone.

Take Japan: It has debt in the hands of its citizens amounting to an improbable 225% of its non-growing GDP, at a time when an aging citizenry will be wanting to cash out its savings to support its retirement, including workers and business owners now prematurely retired by the recent earthquake and tsunami. Already policy makers at the Bank of Japan are openly talking about using the central bank's printing press to finance rebuilding, incidentally setting course to inflate away some of the government's existing obligations.

Take Europe: It continues to hope enough time can be bought with bailouts that transform the obligations of smaller countries into obligations of the larger ones to avoid either an open default or inflation default. The little-advertised prop behind this hopeful scenario is a money-printing program by the European Central Bank to support banks and governments that otherwise would already be belly-up.

Austerity and inflation are not incompatible. Austerity will be a buzz term everywhere as political leaders decide, brutally, which promises to which groups of voters or interests can be junked. When and if Washington has decided to reduce the real value of debt in public hands through inflation, don't dismiss the possibility that it would seek a way to make TIPS holders—or any other politically vulnerable group—shoulder their "fair share," perhaps through targeted taxes.

The same is true, of course, of Social Security and Medicare recipients, who think their benefits are indexed for inflation or otherwise protected because they pay for covered services. What is the perennial threat to arbitrarily slash physician reimbursements except a backdoor default on Medicare benefits? For that matter, even the most desirable kind of entitlement reform (e.g., the Paul Ryan plan) involves cashing out younger people's future benefits at some realistic discount to reflect the improbability of their ever being paid in full. With each year that realistic implied haircut only steepens as federal finances become more hopeless.

All this, let's make plain, is setting the stage for a potential inflation solution to the developed world's vast debt overhang, both official debt and unfunded promises to future retirees. Think it can't happen here? It can, especially when countries representing more than 60% of the world's GDP, including Europe, Japan and the U.S, are seeking the same escape from unaffordable commitments.

Central bankers like Weimar's Havenstein or Peru's Coronado or Zimbabwe's Gono didn't set out to become hyperinflationists. They made the best of a bad dilemma, financing the state through money printing rather than letting it collapse into anarchy. Many investors lately have had recourse to "Lords of Finance," Liaquat Ahamed's depressive book about the 1920s, in which he observes that Rudolf Havenstein, faced with a choice of evils, took a central banker's pride in executing hyperinflation well.

A wise short seller once told us the secret of his profession: People always underestimate how bad things can get. That is, they see the cliff coming and put faith in decision-makers to avoid the cliff. The problem with the metaphor is there is no cliff, just a succession of decision points in a worsening situation. Have no fear that our decision-makers will impose both fiscal austerity and inflation on us when it becomes absolutely unavoidable. The momentous question is whether they will do anything productive in the meantime.

Marc Faber: "Everything Is Going Up. Only At The Federal Reserve Is There No Inflation"

Marc Faber was on CNBC earlier, once again discussing things so patently obvious only the Fed can not grasp them. Namely that as long as cheap money floods the system hard assets will continue rising in value, and gold will continue surging. Which is merely part of the bigger picture: nominal prices continue rising as real prices, denominated in paper and linen, continue to decline. But have no fear: Bernanke can fix everything in 15 minutes. Only that's total BS: "One day they will increase it by a quarter percent. But what does it mean when commodity prices are going through the roof, energy prices are going up, health care costs are going up, insurance premiums are going up?" Somehow, Bernanke believes, a hike will immediately undo months and years of downstream costs progressing through the system. And surely subprime is contained... As for the proverbial gold bubble: "If it were a bubble a lot of people would have gold. The whole world would be trading gold 24 hours a day. But I don't think it's really a bubble. I think gold is maybe cheaper today than it was in 1999, when it was $252." Oddly enough nobody mentions that gold is the only market that is now not part of the Fed's central planning "wealth effect" mandate (and the price suppression mandate is failing by the day): surging gold prices are an indication of one thing only: the market's desire to impose its own gold standard at a mark to market price equivalent for dollar destruction. It is this aspect of the metal: to correlate with Fed stupidity, that makes it such an attractive investment. And since Fed stupidity is endless, does it mean gold's fair value is infinite?

Another Poor Intraday

The bulls and bears have been battling back and forth all week, with neither side able to gain much traction. This afternoon the steady rise in oil finally become too great to ignore and it triggered a bout of selling. We bounced back a little in the final minutes, but we ended up closing near the low-point of the week.

What has been most notable about the action for the last couple weeks is that we are acting poorly intraday. We have some gap to the upside to the start the day but every one of them has fizzled lately. We have not had a gap-and-go day in a while.

On the other hand, we haven't been breaking down either. The bears had their best success this afternoon, but previously we always found some support before the selling accelerated at all. I suspect that worries about oil pushed some folks to cut long exposure over the weekend. We are going to be seeing $4 gas prices and that is going to have a psychological impact.

Momentum in the market has been slowing for two weeks and we have the potential for a rollover-type pattern to kick in. This is a situation where further growth has been limited and the selling starts to accelerate as the recent buyers grow impatient and decide to move to the sidelines. That causes more folks to cut long exposure and the pullback begins to pick up steam. We still have some very good support, but we have more downside before we hit it.

Keep in mind that earnings season is starting soon and that creates a whole new set of market drivers.

Thoughts

With oil around $110, attention inevitably turns to alternative energy names. I see a bunch of activity coming, especially in biofuels. Similar to Web 2.0, Biofuel 2.0 is upon us. The first wave of basic ethanol companies boomed then busted, with GPRE the only successful play, mainly because the company managed its spread so tightly and is integrating up and down the supply chain to diversify the revenue stream. (By the way, Green Plains is partially owned by the important Irish cleantech player NTR, the old National Toll Roads, which is a very interesting play on cleantech in general.)

FF is an undiscovered value gem that plays in the biodiesel space. The company is dependent on the biodiesel credit but is diversified with a specialty chemical revenue stream that supports the business profitably during biodiesel downturns. This one is a specialty chem play with an option on biofuel upside with no analyst coverage and trading at a 18x trailing P/E. The stock recently uplisted to the NYSE, so liquidity issues are easing.

The real action now is in Biofuel 2.0, in which bioengineered algae and other processes are used to create fuels and other products. On the public side, I like CDXS. The company uses "directed evolution" to create enzymes for the production of pharmaceuticals and biofuels. Codexis is partnering with Royal Dutch Shell (RDS.A/RDS.B), so it has great technology and great business partners.

On the private side, watch for a potential IPO from Solazyme, which recently filed its S-1. This is a great company that will be one of the hot deals of 2011. It has created engineered algae that can produce oils from sugar feedstock. The innovation is that the company does it in the dark, in commercial brewing vats. This is a huge cost advantage vs. most algae oil players, which need huge outdoor ponds and thus have ROI challenges. Solazyme has a great business model, first custom-engineering oils for high-value end markets such as consumer products and foods, then the compnany will move into volume markets such as biofuel as it comes down the cost curve.

Another interesting private name out there is Enerkem based in Montreal. The company has an economic technology to turn municipal waste into biofuel. The process technology is modular so can be located close to feedstock supply. The company is backed by WM, which is a huge plus.

Who will fall next?

The Portugal bailout was fairly well anticipated, but it just raises the question of who will fall next. Greece and Ireland are the poster children, of course, and will default, IMHO.

Congress Passes Republican One Week Stopgap Budget Measure; Obama Veto Up Next

Congress has passed the stopgap budget measure. This is not a surprise. What will be a surprise is if the measure first passes the Senate (and they better move quick: 26 hours or so left), and then Obama has to not veto it. Which he has said he will. In other words this is a major non-event for the time being.

From Bloomberg:

The measure, passed 247-181, would cut another $12 billion in spending this year and fund the Pentagon at current levels through Sept. 30. Senate Majority Leader Harry Reid, a Nevada Democrat, called the bill a “non-starter.”

Reid and House Speaker John Boehner, an Ohio Republican, returned to the White House today to meet with Obama for talks to try to avert a shutdown at midnight tomorrow.

Leaders of both parties insist they don’t want a shutdown while they maneuver to avoid blame if one occurs.

An administration statement, in threatening a veto of the short-term House measure, said it would be a “distraction” from the budget talks. Reid said the one-week measure is a sure “way to close the government.”

Boehner called on the Senate to act on the bill.

The Indices Have Held Up

For the seventh day in a row, the market traded in very choppy fashion. We came close to breaking down on news of more earthquakes in Japan but found our footing and closed in the middle of the intraday range. While the bulls have not been able to gain much traction lately, the bears aren't gaining any ground either.

Despite almost 2-to-1 negative breadth on the Nasdaq, all major sectors except retail in the red and crude oil moving over the $110 mark, the indices refuse to crack. The convenient excuses for selling are there, but the underlying support is resolute.

The danger is that if we keep testing the recent support around 1325-1330 on the S&P 500, it may eventually succumb to the pressure. The bulls need to turn it back up here soon, or the momentum may completely dry up.

One of the positives today was that many of the liquid momentum stocks that were slammed yesterday came came back today, but there is still poor action in a number of key names, like AAPL and NFLX.

Thoughts

Valuation plays a key role in finding the most interesting names. Every value investor will tell you that low valuations are a proxy for low expectations. For a name with a great earnings trend but high valuation, expectations might actually be correct, or even high. The buy side has its own unpublished earnings estimate, and a high valuation means expected earnings could be far higher than the published sell-side number.

Best Earnings Trend and Low Valuation

-- CLF, DE, AAPL, DELL, MAT, XOM, DD, COV, EL, RL, ACN, DIS, AZO, UPS

Contracts Barely Worth the Paper on Which They Are Written

Is rich pricing really locked in if market prices collapse?

As one analyzes soaring commodity names, be wary. With prices soaring, many analysts are asking companies if they are locking in high prices with their customers. For instance, on the MOS call last week, investors were asking this about their fertilizer sales. This question is usually asked in commodity-like names with their products subject to large swings. Analysts love to see "take or pay" contracts locking in demand.

The reality is they are barely worth the paper on which they are written. If prices soar further, you miss the upside, but is rich pricing really locked in if market prices collapse?

I far prefer companies that are realistic about the enforceability of sales contracts, and simply enjoy the good times when pricing is high. Contracted demand at high prices is rarely realized in the bad times.....