PETER BRIMELOW
Bond, bill charts say inflation coming
By Peter         Brimelow & Edwin S. Rubenstein,
Last Update: 12:01 AM ETApril 18, 2003
Third in a three-part series.
HULBERT FINANCIAL DIGEST
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NEW YORK (CBS.MW) --     Deflation? Possible. But v-e-r-y unlikely, given the last hundred years of     financial history.
In fact - wait for it - inflation may be coming back.
We conclude this on the basis of two centuries of data on real returns to     key financial assets developed by Jeremy Siegel of the University      of Pennsylvania's Wharton     School of Business (obtainable from his Web site http://www.jeremysiegel.com/).     Siegel is the author of the classic book "Stocks For the Long     Run." http://www.jeremysiegel.com/book.asp
In our column on     Monday, we charted the 1801-2002 total cumulative real return (that is,     counting capital gains and interest or dividends, plus adjusting for     inflation) for stocks, bonds, treasury bills, and cash (i.e. the purchasing     power of a dollar bill under the bed - not counting any collectible value).
The main message of Monday's column: the remarkably consistent     underlying growth of cumulative total return in stocks - averaging about 7     percent annually for two centuries.
Because the growth rate is so consistent, it shows on our log scale     chart as a straight line slanting up -- our line is actually a regression     line, derived from a statistical method of averaging Siegel's annual data     points.
That is the indisputable truth at the heart of the buy-and-hold philosophy     so popular in the late 1990s.
But in     Wednesday's column, we zeroed in on the stock market. We found that     stocks are now slightly (14.7 percent) below their long-run trend line.
So stocks are not at the extreme overvaluation of 1999, when they     reached 81.3 percent above trend, at the high end of their historic range.
But stocks are nowhere near the low end of their historic range - for     example, they were 40.6 percent below trend in 1974.
Obviously, it's difficult to draw short-term conclusions from these     long-term numbers. But they do provide perspective. Our interpretation: the     market does not have much upside energy. It still has downside potential.
Short of going down, the market could very well just stooge along     sideways for several years, give or take a few thousand points. Or show     mediocre gains. It's done that before - it's perfectly compatible with that     7 percent long-run real average growth rate.
Now look at Monday's chart again. Look at the total cumulative real     return line for bonds and bills. Note that, unlike the line for stocks,     these lines inflect somewhere around the start of the last century. The     underlying growth in rates of return for bonds and stocks apparently     changed. See     related column.
We don't know why these inflections occurred. But we hypothesize it had     something to do with the advent of the Federal Reserve system in 1913 and     its subsequent impact on the monetary environment.
Another reason we hypothesize this Fed connection: look at the value of     a dollar bill on Monday's chart (the drooping green line.)
The dollar bill was surprisingly stable, i.e. held its purchasing power,     right through the nineteenth century - it was about as good as gold. Then     it tanked in the twentieth century -- after the advent of the Federal     Reserve.
Hmmm.
NOW (Ta-Ra!) look at today's chart. It zeroes in on bonds, bills and the     dollar over the twentieth century.
Because the annual real total cumulative return rates have been     relatively consistent in the twentieth century (1.18 percent for bonds.     0.03 percent for bills) we've been able to draw regression lines through     them.
The result looks ominously like the stock total return chart in 1999.     Both bonds and bills are actually above or near historic highs by the     standards of the last century - 92.4 percent above trend for bonds, 32     percent above trend for bills.
Earlier highs: 85 percent above trend for bonds in 1940; 55 percent     above trend for bills in 1932.
This is why we are dubious about the likelihood of deflation. Deflation     would drive the total cumulative real return lines for bonds and bills even     higher. That's because the nominal value of bonds and bills would remain     the same. But their real value would increase, as deflation increased their     purchasing power. So the real cumulative total return would on bonds and     bills would reach levels unprecedented since the advent of the Federal     Reserve.
We're not saying it can't happen -- just that it would be a radical     departure from the financial patterns that have prevailed for nearly 100     years.
Deflation seems particularly unlikely given the experience of the dollar     bill's value in the twentieth century. It tanked -- so completely that even     the celebrated deflation of the Great Depression itself shows as an almost     undetectable twitch. (Look at 1932 - don't squint too much.)
Moral: inflation was the central reality of the twentieth century. And     it continues. For deflation to occur, the cumulative value of the dollar     bill would have to turn up -- something it hasn't done, decisively, for a     hundred years.
Our chart shows that, throughout the twentieth century, bonds and bills     have moved in very long bull and bear cycles. The current bond bull cycle     began in 1980. Before that, there was a bond bear cycle that began in the     1840s.
These cycles occur because of the ebb and flow of inflation --     especially relative to interest rates. It is fact that real interest rates     have been positive, i.e. nominal interest rates have exceeded inflation     that have made Treasury bills such an excellent (albeit unsung) investment     over the last two decades. Conversely, negative real interest rates are the     only way the total cumulative return of Treasury bill can decline.
Both the bond and bill cycles, however, are now at peaks that they have     found unsustainable over the last century. If and when bonds and bills     reverse, it will be because real interest rates are falling. In other     words, because inflation has returned.
Overall, our three charts suggest we are entering an era when all     financial assets will be under pressure -- stocks, bonds, and bills.
This sounds alarming. But it's not new. It's merely what happened in the     1970s. The combination of a weak economy and inflation was called     "stagflation." The ultimate 1970s antidotes: stockpicking     rather than buying the market, real estate, tangible assets, gold.
And Jeremy Siegel? Naturally, as befitting an academic, he's more     cautious. And over the years, we've found he'd more cheerful.
In the short run, Siegel expects a resumption of 5 percent to 7 percent     real growth in the stock market, simply because his broad measure of stocks     is back down to the middle of its range and 5 percent to 7 percent is the     average growth rate.
But he does think bonds are vulnerable -- and he agrees with us that     deflation (probably) ain't going to happen.
Edwin S. Rubenstein is president of ESR Research in Indianapolis.
Editor's note: The April edition of the Hulbert Financial     Digest is now available by either e-mail or regular mail. Highlights this     month include:
A special report on how the          most popular stock picks by newsletter editors outperform the market,          and what they are.
Profiles of Timer Digest          and John Dessauer's Investors World
Complete performance          scorecard, and more
For more information or to subscribe to the Hulbert Financial     Digest, click     here.
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