Recovery Patterns and Inflation-Deflation Trends

March 18, 2009 Edition, Volume III

Inside Signature Update

- Recovery Shapes and Sizes
- The Ongoing Battle of Deflation vs. Inflation
- An Important Note Regarding ROTH IRA Conversions and Required Minimum Distributions (RMD)


Recovery Shapes and Sizes

There’s been significant conjecture in recent weeks over the size and shape of the coming pattern of economic recovery. Encouraged by an equity market rally of almost 14% on the DOW over the last six trading sessions, most investors are no longer speculating over whether or not there will be a meaningful recovery, and the discussion has shifted to when the recovery will begin, how long it will last, and what shape it might take. Recovery shapes are the stuff of legends and are about as accurately foretold as Bull Market highs and Bear Market lows, but with the proper perspective, may not be that difficult to ascertain.

In most cases market patterns are relatively predictable, however, but data will inevitably be presented to give market insiders the courage to suggest that ‘this time it will be different’. In truth things are rarely different, but for some reason even the most seasoned of investors, asset managers and traders want the emergent patterns of contemporary market cycles to provide different results than when the same patterns were presented in previous cycles.

Some have proffered why the coming recovery will be shallow and may take many years to regain lost market value, suggesting that there will be extended period during which we will have flat economic growth and market values. A sort of an elongated ‘U’ shape.

Others point towards possible Bear Market rallies (perhaps indicative of the recent market movement) that could follow our steep decline, then reverse course one or more times before actually presenting a real market recovery; something like a repeating ‘W’ with multiple internal slopes.

Even though the market declines of the last year have been sharper and more harmful than those seen in many decades, there are patterns that ought not to be ignored, which patterns may well tell us something of what comes next. There appears to be a few important and observable trends that have emerged and which tell us that we are most likely to see a ‘V’ shaped recovery pattern, though one in which the upward trend may be less steep than the downward decline. Those signs are 1) the steepness (or velocity) of the market decline, 2) the seemingly counter-intuitive market reaction to news (positive or negative, and 3) the slope of the treasury yield curve.

Few would argue that the recent market declines were anything other than swift and steep. Tens of trillions of dollars of market capitalization evaporated in just a few short months; sometimes at a pace of nearly a trillion dollars on any given day. We experienced record point movement on the DOW, and the VIX (volatility index) broke records on a regular basis.

Too many times, negative economic news was rewarded with temporary market gains while positive economic results garnered counter-intuitive market declines. The argument after these trading sessions invariably included commentary regarding the market having already been discounted for the bad news or having over-anticipated the good news. True perhaps, but virtually impossible to gauge.

The yield curve, which traditionally represents longer duration debt instruments attraction of higher yields and shorter term bonds, notes and bills provision of lower returns, reversed itself. For a time, longer debt maturities provided lower rates of return than did those of shorter duration. In eight out of the last ten recessions an inverted yield curve accurately foretold a coming recession and in hind sight, last summer’s inverted curve was an excellent barometer of the market that lay in front of us. Too many of us succumbed to the ‘this time is different’ attitude as we experienced market phenomenon never before presented, but in some respects it was the equivalent of not being able ‘to see the forest for the trees’. Alternately, a traditionally sloping yield curve reflecting greater reward for longer term investing is a relatively accurate indicator of market gains and over time, the steeper the upward slope of the curve, the steeper the upward movement of the market in the coming months. This time it will likely not be any different

This set of circumstances, which appears so obvious in retrospect, most often yields a ‘V’ shaped recovery. True, we may not have experienced a market with identical dynamics to the one in which we now operate, but the bigger picture has been seen before. It’s not unlike the ‘boy meets girl, boy loses girl, boy gets girl back’ story line of oft repeated Hollywood love stories – every time it’s told it’s just enough different to make you wonder what comes next, but inevitably romance comes next – because this time is not that different from the time before.


The Ongoing Battle of Deflation vs. Inflation

In recent months the economy has been haunted by concerns over a possible deflationary cycle in the value of goods and service, and ultimately labor. Decreasing energy and commodity costs, coupled with higher unemployment have heightened this concern and economists are closely watching the Producer Price Index (PPI), Consumer Price Index (CPI), and other manufacturing indexes for ongoing deflationary signs. Somewhat counter intuitive, is the sense that at the same time, consumers and others are leery of another round of inflation similar to what temporarily surfaced with last summer’s surge in energy prices.

Most economists agree that mild inflation is healthy, but deflation of any kind can be devastating. Last summer we repeatedly discounted long-term inflationary pressures as being unsustainable in the face of decreasing employment figures. This remains true today. However, the inverse is just as true; rising unemployment can fuel deflationary pressures, and this is a far more likely scenario; at least in the short-term.

The recent increase in the domestic money supply, as a result of stimulus packages and recovery efforts, will likely lead to longer-term inflationary pressures, rendering the markets in a pseudo manic-depressive mode as it pertains to inflation-deflation pressures. So… what comes next? The February PPI and CPI figures.

PPI data was released Tuesday and suggested a stabilization in the wholesale price of goods in our economy. The index increased 0.1%, led by a 1.3% rebound in energy prices. Core prices, which exclude food and energy goods, rose 0.2% for the month. CPI data was released early Wednesday and reflected a seasonally adjusted increase of .4% for February, or .2% higher than February 2008.

These moderate numbers are a welcome sight as they hint that prices may be stabilizing, not falling into a deflationary spiral that could extend and worsen the global recession. But elsewhere in the PPI and CPI reports, deflation lurked.

Prices of crude goods (mostly commodities) fell for the seventh straight month, down 4.5%. Prices of intermediate goods (which are partially processed goods) fell for the seventh straight month, down 0.9%. Prices of core intermediate goods fell 0.6% in February and are now down 0.1% in the past year, the first time they've been negative since 2002. As recently as last summer, core intermediate prices were rising at a 12% pace.

Over the past six months, farm product prices have fallen at a 35% annual rate. Chemical prices are falling at a 25% rate. Metals prices have fallen at a 38% rate, including an 80% annualized drop in copper scrap prices. Commodity prices are ruled by the forces of global supply and demand, so their path will be determined largely by how deep the global slump turns out to be and how quickly it turns. It takes more than dropping commodity prices to get persistent deflation in consumer prices. Labor costs need to fall as well. That hasn't happened yet, but as the unemployment rate inevitably rises, the pressure on workers to accept wage cuts will increase.

What may all of this portend for our economy? We expect deflationary pressures to loom through late 2010, along with higher than optimal unemployment figures in the 8% + range. In the interim, the domestic money supply will increase as stimulus and recovery efforts pour money into various sectors in the market, the stock market will likely stage a sustained rally in advance of real economic growth, perhaps with enough strength to close out 2009 at or above 9,000 points on the DOW, and the resulting inflationary pressures will counteract what otherwise might have become a troubling deflationary cycle. Regardless, and without economic foundation, the current administration’s temptation to increase income and capital gains taxes, coupled with the US Congress’s appetite for spending, is likely to prevail and may slow both market gains and economic growth, stretching a recovery out over several years before we recapture the losses experienced in the last 17 months.


An Important Note Regarding ROTH IRA Conversions and Required Minimum Distributions (RMD)

Many investors understand that if one holds a traditional IRA or a former employer 401(k) plan, these accounts may possibly be converted to a ROTH IRA and the investor may benefit from the different tax rules that govern these types of accounts. A Roth IRA includes after tax dollars which may be withdrawn free of federal income taxes for retired investors, whereas a Traditional IRA includes pre-tax investment dollars that may become taxable when withdrawn during retirement – both types are governed by rules of age, income and amount and may garner penalties if not handled properly.

A ROTH IRA conversion, or the conversion of a tax deferred retirement account into a ROTH IRA, may be attractive when one values the tax advantaged nature of this type of IRA over the tax-deferred structure of the Traditional IRA. The conversion comes at the cost of the investor having to declare the value of the converted IRA account value as taxable income for the year in which the conversion took place. With careful planning, this may yield great benefits; entered into hastily, such a conversion may compound an existing tax problem.

Many investors are looking at what may be lower retirement account values this year, in light of the market declines, and are choosing to perform a ROTH IRA conversion under the presumption that the tax bite for 2009 will be more than offset by the tax advantaged value of the investment account as it may regain value in the future. Not a bad idea, but one that deserves careful consideration before executing.

In 2010 the IRS will allow a ROTH conversion and at the same time offer the investor the opportunity to spread the resultant tax liability over two years, accepting payment in 2011 and 2012. As with all ROTH conversions, or any other type of IRA investing, there are income limits that dictate whom may or may not be eligible, but for some this will represent an opportunity that ought not to be ignored.

Also, a few months ago the IRS announced that the Required Minimum Distribution (RMD) will be suspended for 2009. The RMD, which affects retirement account investors over the age of 70 ½, forces many such investors to make taxable withdrawals from their accounts, regardless of whether or not they need the income. With the reduced market values of so many of these accounts the federal government is allowing for an RMD holiday for 2009, which some expect to continue into 2010. Stay tuned.


Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management