Market Comment: Stagflation -- Not

Did you ever wonder why the comments of the Fed seem to be taken so seriously by stock market traders? Yesterday Ben Bernanke said in speech to a group of international economists that inflation was running near the high end of his comfort level, and if it did not show signs of slowing, further rate increases may be necessary. His comments sent the Dow Jones down nearly 200 points. If you think about it, the Dow Jones started the year at about 10,700. It then rallied just above 11,600 on the notion that the Fed was near the end of its string of rate hikes. When the media were full of the "Fed is almost done" talk, a reporter from CNBC, Maria Bartiromo, asked Mr. Bernanke if the market was correct in its optimism. Mr. Bernanke said no. Ms. Bartiromo was quick to report Mr. Bernanke's answer the next morning, and the markets have been heading lower ever since. Although Mr. Bernanke has apologized for spilling the beans to a reporter at a non-public function, it was a goof that has put everyone on edge. He has stated that he wants the Fed's actions and thinking to be more transparent, but passing the word to a reporter is not what most of us had in mind by the word transparent. Having said this, I believe all the fuss about the action or inaction of the Fed is missing the point. I have never doubted that the Fed would raise rates for as long or as high as they needed to to keep inflation under control. That is absolutely what they should do, and, indeed, the current core inflation rate is trending the wrong direction. However, it is clear that the economy is slowing, and a slowing economy will diminish inflationary pressures in the months ahead. The reason the sell off has been so sharp in recent weeks is because of the fear, on the part of some, that "stagflation" may be returning. If you search the web, you will find that the name was coined in the late 1970s and early 80s when inflationary pressures were persistent and kept the Fed on the alert for years. As the Fed kept pushing rates higher and higher in response to the inflation reports, the economy grew weaker and weaker, as did corporate profits. This became a double-edged sword for investors. Let me give you an example of this double-edged sword. I found many years ago that you could add 3% to the CPI and divide the sum into 1 to provide a "rule of thumb" normal PE for the Dow Jones Industrial Average. The expected price level of the Dow Jones 30 can then be found by multiplying the rule of thumb PE by the expected earnings for the Dow. I have provided a chart comparing my rule of thumb predicted level of the Dow Jones with its actual level over the last 46 years.

Currently, the CPI on a year over year basis stands at 3.4%. Adding 3% to that level totals 6.4%. We then divide this amount into 1 to find an expected PE of 15.6X. We can then multiply the predicted PE of 15.6 by $744, the 2006 expected earnings for the 30 companies in the Dow Jones. This computation indicates that the Dow should be selling about 11,600, or about where it was a month ago when the market thought the Fed was about finished with its rate hikes. As I write this, the Dow is selling just over 10,900. This would imply an inflation rate of 3.8%, if we hold earnings stable. The problem with stagflation quickly becomes visible. If inflation really takes root and pushes toward 4%, it would keep the Fed raising rates, and the higher rates would surely slow the economy. That would mean the $744 of earnings for the Dow is called into question. Let's say the earnings come in for the year at $700. With an inflation rate of 3.8%, that would imply a Dow of 10,290. That is the reason the market has been selling off ever since Bernanke indicated inflation is at the high end of his comfort level. But let me stop this line of thinking in its tracks. Stagflation is not a reality, and the odds of it returning are very low. Paul Volcker taught us how to deal with runaway inflation in the late 1970s, and there is not a central banker in the world who does not know the script. All investors bemoan higher interest rates, but my studies show that the correlation between inflation and PEs is much greater than the correlation between interest rates and PEs. In short, the market can handle higher interest rates if it believes that inflation will be held in check. The Fed's job is to push interest rates where ever they need to go to fight inflation. The sell off in the market, as usual, is making the worst case for both earnings and inflation. That is simply not the most probable outcome for either. I said at the beginning of the year that inflation will be trending toward 3% by the end of the year, and I still believe it. In addition, in both of our dividend styles of investment management dividend growth is far surpassing what we expected. The Rising Income Portfolio has shown dividend growth of over 11% and the Blue Chip Growth Portfolio has shown dividend growth of over 15%. Dividends are real money. The companies we own would not be surprising us with better-than-expected cash distributions if their results were falling off the table.

Do you remember in 2002, the great worry was deflation. The deflation did not materialize and neither will stagflation, and the reason will be the same: The Federal Reserve. I am convinced that deflation could have sprouted in 2002, but the Fed used the tools at its disposal and headed it off. They will do the same with stagflation. They have the tools and they will use them.

My Rule of Thumb model says the fair value of the Dow at 3.4% inflation is approximately 11,600. At 3% inflation the level is 12,400. That's not my prediction, but that is what comes out of a model that has called a pretty good game for a long time.