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INFLATION WORRIES TRUMP CORPORATE EARNINGS

Throughout the morning, the broad stock averages tried valiantly to add to yesterday’s gains amid strong corporate earnings reports, but fears of higher interest rates took center stage today. Right out of the gate stocks opened higher, especially technology shares, with good reports coming from Intel and Yahoo after the bell yesterday. There were solid earnings reports from a number of different sectors, but the Labor Department spoiled the party with the CPI showing worse than expected inflation data. Consensus expectations for the headline number was for a gain of 0.5% and the reported number was 0.6%, while the core-rate came in with a gain of 0.4%, double analysts expectations of 0.2%. The bond market sold-off immediately driving interest rates higher, but buying came right back into Treasuries as the stock market began selling-off through the lunch hour. Stock market bulls are looking for a rally here after the brutal sell-off last week, but if these corporate earnings aren’t enough to bait investors back into stocks, what will it take?

Intel beat street estimates for both revenue and earnings, Yahoo said first quarter profits more than doubled as its online ad revenue came in above $1 billion for the first time, Caterpillar reported sales jumping to $8.34 billion from $6.48 billion with first quarter earnings of $1.63 versus $1.19 a year ago, United Technologies said revenue moved from $8.6 billion to $9.4 billion and earnings went from $1.08 to $1.28 per share, Altria Group said first quarter profits jumped 18%, and Google was upgraded to outperform by RBC Capital Markets. As I write, stocks are at their worst level for the day with the Dow Industrials down 65 points and the NASDAQ off by ten points. I won’t say too much more on stocks heading for a meltdown, because I’m expecting another one of those 2:00pm rallies to pull the indices back up to breakeven…we’ll see if it happens.

As I said, bond prices sold-off hard with the release of the CPI data, but money continues to move into Treasuries as the day progresses. Ten-year Treasury Notes fell from 111 8/32 to 110 24/32, but are now all the way back up to 111 12/32. Higher than expected inflation data would normally cause interest rates to move higher as they did initially, but it appears the market is still screaming of an economic slowdown ahead. Otherwise, stocks would be rallying and bonds would have continued the early sell-off. Rick Santelli on CNBC said that Eurodollar futures were indicating the market expects the Fed to raise interest rates by 25 basis points in three out of the next four meetings between now and October. I have strong doubts they will raise as expected…maybe one more increase, then go on hold. Remember the Fed will talk tough on inflation, but in reality they want more of it! The Fed’s real job is to create inflation, but in a controlled manner.

Yesterday the PPI was released with the headline number of prices moving higher by 0.7%. On an annualized basis, that represents an inflation rate of 8.4% and the markets yawned at the number, sending interest rates lower. Today we get the CPI headline number for March at 0.6% or 7.2% annualized. If you invest your money in one-year Treasuries, you earn a yield of 3.25% before taxes. The proof is in the pudding that the Fed is way behind the curve in raising interest rates. They will do everything possible to remain behind the curve and keep interest rates artificially low, but must also keep an eye on the strength of the dollar. Conservatively speaking, we have inflation coming in at roughly 7-8% and the U.S. reports GDP growth at 3.8%. If we take away monetary inflation, it sure looks like we have some serious contractions in our economy!

Now let’s compare the U.S. GDP growth rate of 3.8% versus China. Analysts have been calling for growth in China to slow, but they just surprised the markets with their GDP growth rate unchanged with a gain of 9.5% for the first quarter. Chinese exports surged 36% year over year, while industrial production rose 16% from a year ago. Certainly some of their growth was due to inflation just as here in the U.S., but it’s obvious they have REAL growth. They have taken jobs from the U.S., Japan, Europe, Mexico, and just about everywhere else! The rest of the world is blaming their job losses to China on the fact that China’s currency is way under valued making China’s exports more competitive globally…who can compete with them? Under the current conditions U.S. Congressmen know the U.S. is not competitive with China. Congress has a bill in place that will slap a 27.5% tariff on all Chinese goods entering the USA if China doesn’t revalue its currency. If implemented, I will enjoy watching Wal-Mart’s business come to a grinding halt after seeing all the damage they have done to small businesses across the USA. While noting these points on China, please remember that the Chinese authorities do not take kindly to outside pressures. They tend to get upset if they are strong-armed into changing policy. All we can do is watch to see how it all plays out.

I just checked back in on the markets and the 2:00pm rally didn’t happen today! It turns out the Fed’s Beige Book was released at 2:00pm and it served to reinforce the concerns for more inflation. The Dow continued its afternoon decline and closed the session just off the lows with a loss of 115 points to close barely above the 10,000 mark at 10,012. The NASDAQ also took it on the chin with a loss of 18 points to 1,913 and the S&P 500 dropped 15 points to 1,137. Some of the bulls are trying to spin today’s action as “capitulation selling” with declining stocks at 9 to1 over gainers. Just six weeks ago the Dow touched 10,984 and at 10,012 stocks are certainly less expensive, but with no doubt, they can still get much cheaper from here. Buying into this stock market would be like trying to catch the falling knife…you might grab the handle, but could easily get bloodied-up by grabbing blade. If 10,000 doesn’t stick, I see the next target as 9,750 for the Dow.

Change of Leadership

For me it’s almost comical to hear all the Wall Street bulls pounding the table on powerful earnings from Intel, Yahoo, eBay, and the like. These are the leaders of the past. They are beating a dead horse. There has been a change of leadership over the past couple years from technology and financials to commodities and necessities. It’s probably been three years since Jim Puplava wrote his piece called “The Next Big Thing” that describes this change of leadership in the markets. Remember the transition is a “process” and not and event…and also that “the process” usually takes much longer than we expect it to. At Financial Sense we have been writing of this transition from paper to things for a few years now. I believe we are barely halfway through these transitions.

Look at what happened to U.S. asset prices as a whole today. They basically all went down. The Dow Industrials off by 115 points, all maturities of Treasury paper declined in price (higher interest rates), and the U.S. dollar declined against all major currencies. Please notice the three items listed (stocks, bonds and the dollar) are all “paper” assets. Now let’s look at what happened to some select “tangible” asset prices in today’s trading. Oil moved higher by 33 cents a barrel to $53.90 after the Energy Department said crude inventories declined by 1.5 million barrels. Corn, wheat, coffee, hogs and cattle all moved higher. Gold and silver added to yesterday’s gains and Dr. Copper moved higher by 2.4% to $1.507 a pound telling us this commodity boom is very far from over. What seemed to bother the bulls on CNBC was the fact that we have very obvious signs of an economic slowdown, but it is mixed with rising inflation…that is where they coined the term “stagflation.”

Investors are scratching their heads in this market wondering what to do. Stock bulls are afraid of another 2001-2002 style decline while the stock bears are afraid of getting squeezed by another intervention to ramp stock prices higher. Interest rates (bond prices) are stuck somewhere between rising inflation and a slowing economy. The dollar needs to go lower, but nobody wants it to move lower in value because everyone has so many of them. My investment strategy is to throw all that paper out the window and stick with the fundamentals of tangible assets.

Silver supply has been in deficit to demand for about 14 years, as the market lives off existing above ground inventories to supplement the lack of mine supply. Gold supply is decreasing, especially as miners in South Africa close non-profitable operations. We have not invested enough money for infrastructure to meet our growing needs for natural gas. A Bloomberg article today says, “U.S. imports of LNG increased 27% last year, and probably will rise another 20% this year, according to U.S. Energy Department data. Imports may increase another 49% next year, the agency forecasts.” My interpretation of that sentence is pretty simple; we don’t have enough! We need more natural gas, but guess what…China is building a fleet of LNG carrier ships to secure their own supply and India wants to build a gas pipeline from Iran to India. Competition is increasing for available energy supplies.

Basic supply and demand favor commodities over stocks and bonds. Bond supply is literally unlimited. In another month the U.S. Treasury will conduct another quarterly refunding and will probably issue near $100 billion in T-bonds and notes. Stock valuations need a serious reality check, and we all know that U.S. dollars can be created with the push of a digital button…I think the Feds refer to unlimited digital money as “helicopter money.” Mr. Ben Bernanke suggested the Fed could drop money from the sky if deflation ever becomes a problem. The price of paper assets really comes down to a confidence game with currencies and economies. The prices of tangible assets can be influenced on a short-term basis, but in the end the fundamentals of supply and demand will prevail for commodities!

Have a Great Evening!

Mike Hartman

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