I had been increasingly concerned about the potential for deflation. The Consumer Price Index started a trend of monthly declines in the second half of 2008. I’ve never witnessed such a decline in prices before, so this was rather alarming. Under a deflationary environment, assets start to decline in dollar value and debt can increase in real terms. This impacts the assumptions built into company valuations, especially for asset or liquidation based valuations.

My fear of this deflationary trend is now fading with this latest release of the Consumer Price Index. The CPI-U increased 0.4 percent in February on a seasonally adjusted basis. This is just after a 0.3 percent increase in January. When I saw the January number last month, I thought the increase might have just been a one month deviation from the deflationary trend that started in 2008. This second strong increase in prices in February has started to give me confidence that the risk of deflation is getting much lower.

The price increases in February were led by a 3.3 percent increase in the energy component of the index The only significant decline in February was the food index, with a decline of 0.1 percent. The price index excluding energy and food increased 0.2 percent in February. No matter how you slice it, it appears inflation is back.

I probably should have taken Warren Buffett inflation warning during his recent CNBC interview to heart. This is especially true now given yesterday’s news that the Federal Reserve will be pumping $1.2 trillion into the markets by buying up government bonds and mortgage related securities. I think it is now safe to say that inflation is once again the primary threat.

In the remaining half of this year, which do you expect to outperform?

We received 51 responses to the poll over the four weeks that it ran.  Here are the results:

With 43% of the vote, it appear that the majority of value investors expect that international stocks will be outperforming U.S. large and small cap stocks in the remaing quarter of 2007. 

I actually voted for the U.S. large cap stock class, the second most popular choice.  My thinking is that international and small cap stocks have seen the most price appreciation over the past few years, so it might now finally be the time for large cap stocks to shine.  We’ll have to wait until the end of the year to find out. Please remind me to report on the performance of these three stock classes at the end of the year. 

You can review past Value Investing News polls and vote on the latest poll while you wait until the end of the year to see who guessed right.  This week’s poll on home improvement retailers asks investors to pick between Home Depot (HD) and Lowe’s (LOW).  Please go and vote.

Geoff asked the following question:

What annual total return do you expect from the S&P 500 over the next ten years?

Here are the results:

The poll closed on March 25, 2007.  It received 137 votes, which isn’t bad given that we only ran it on a few relatively low traffic websites for one week. The results of this poll might be bias by an over-weighting of value investors since it ran on at least 3 prominent value investing websites.  However, Geoff did try to broaden the scope of this poll by asking other investment blogs to also host this poll.

The median expected long term return for the S&P 500 is clearly between 7.5 and 10 percent. I actually also selected the 7.5% - 10.0% category when I voted. I was surprised to see that 3.6% of the voters decided that average returns would be greater than 20%.  Those 5 voters must be quite bullish.  I was equally surprised to see that only 2 people voted for negative average annual returns over the next ten years.  I thought there were more bearish investors out there.

How do these expectations match up with past S&P 500 returns?  The total return of the S&P 500 was 15.79% last year.  The average annual total return of the S&P 500 over the past ten years was 8.42%. It is therefore no surprise that most people polled expected average returns to be from 7.5% to 10.0% over the next ten years. What do you think the future holds for the S&P 500?

I currently own a REIT, Hospitality Properties Trust (HPT), that I purchased before I started this blog.  HPT was going to be announcing their earnings today, so I was thinking a lot about REITs when I ran across the Experiments in Finance article. As a value investor, something in that article caught my attention as a potential concern, so I decided to leave a comment.  Here’s what I wrote:

Hi Ricemut,

I’m glad to hear that you are considering adding some REITs to your portfolio. I added HPT to my portfolio a few months after 9/11 (yielding over 11 percent at the time) and I have loved it since.

However, REITs are getting pretty pricey now that everyone else is discovering them. I highly recommend that you read Ralph Block’s post at the Motley Fool at http://www.fool.com/community/pod/2006/061017.htm. Ralph wrote the book on REIT investing and is a real expert on the subject.

I would avoid buying a REIT index at this time and instead focus on identifying opportunities in the REIT sector that provide a margin of safety. International REITs may be the way to go right now if you really want to add REITs to portfolio in the near future. In addition, buying individual REITs helps reduce your costs buy avoiding the slightly higher fees associated with REIT index funds. I would also focus on identifying REITs that control important, hard to substitute pieces of property. Even REITs can have wide moats.

After I left this comment, I realized I really need to research REITs again soon and scope out the market for stocks with international real estate investments. After a quick search, the NAREIT International Forum looks like a good place to start learning about international opportunities.  NAREIT also has an interactive REITs Around the World guide. If you have been researching international REITs or other international real estate stocks, please share some of your thoughts in the comments section below.

What does this mean?  Nothing really, people just like to anchor to round numbers.  As a value investor, it just means that stocks are more expensive to buy.  It also makes finding wide moat stocks selling at a margin of safety all that much harder to find.

As I have mentioned previously, Ben Stein and Phil DeMuth’s website provides a nice set of graphs indicating the market’s valuation relative to 15-year moving averages. A new source of overall market valuation information is Morningstar’s Market Valuation Graph. The graph shows the ratio of price to Morningstar’s estimate of fair value for the median stock in Morningstar’s coverage universe of over 1,500 stocks.

Given the latest dip in the market, it appears the market is fairly close to fair value at this point. Any further corrections could lead to buying opportunities.

The Washington Post reported this week that:

New data, including Treasury Department figures released Monday, has stoked
debate over whether overseas investors — private individuals, institutions and
government banks — are growing dangerously bearish on the U.S.

I recommend reading this informative article. I’ll be closely watching interest rates over the next few months. This is not the time to go out and purchase long term U.S. government bonds, and I would also think long and hard before taking on any adjustable rate loans.

It looks like Warren Buffett has been preparing himself for this trend by getting out of long term bonds, holding lot’s of cash and purchasing foreign currencies. His portfolio adjustments might start to pay off soon.

Gross may run the world’s biggest bond fund, but his column amounted to an inaccurate and analytically flawed diatribe.

He virtually accused Fed Chairman Alan Greenspan of being part of a conspiracy by government officials to understate inflation and thereby boost estimates of real economic growth.

The main issue with the CPI involves the recent use of hedonic adjustments for the prices of items in the CPI basket of goods and services. Hedonic adjustments are used to standardize prices for differences in quality, such as the speed of computers. There are also adjustments for the substitution of other goods, especially food, when the price of a good rises.

Bill Gross didn’t let Mr. Berry’s critique slide by. He responded in his PIMCO newsletter with the following:

My point, however, was as follows. The CPI inaccurately calculates Americans’ cost of living. Since Social Security and pension benefits, as well as the level of wage hikes are predicated upon the specific number and/or the perception of annual increases, Americans are being in effect conned by their government and falling behind the inflationary eight ball year after year. After slamming the concept of the core CPI, the primary culprits I cited were the government’s use of hedonic and substitution adjustments to lower the CPI by as much as 1% in recent years. John Berry, the columnist, claimed my report was “inaccurate and flawed.” William Poole, the Fed Governor, in effect said I didn’t know what I was talking about. I think they read what they wanted to read, and I would hope that they would hear what needs to be heard.

I did not dispute the fact that the quality of goods and even services can improve and that the government shouldn’t recognize that “hedonically.” I do disagree with those adjustments being reflected in a CPI that is used to calculate the benefits of wage earners and retirees. The U.S. government has over 40 different CPI indices – there is not one sacred calculation. There is a CPI for medical care for instance, and a CPI for services, as well as a CPI for transportation. Take your pick. But in using for retirement benefits an hedonically adjusted CPI that lowers annual price increases by as much as 1%, they take money unjustly out of Americans’ pockets. Peter Bernstein, in an article I cited in the Investment Outlook, suggested the same thing. He recommended the adoption of a new form of the CPI, which he dubbed the CPI/DX that excludes all durable goods prices – the items most subject to hedonic calculations. He wrote that “what people see and feel as inflation is what they pay for services and non-durables” not hedonically adjusted durable goods such as computers and DVDs.

I don’t think this will be the end of this debate. This issue is important to our financial future, since it impacts Social Security payments and the interest paid on TIPS and I Bonds. I’m sure there will be more to follow.

Three out of seven value indicators for the S&P 500 index indicated the market was undervalued at the end of September. This is relatively unchanged since we last looked in August.

The market seems to be in a holding pattern. My guess is that we will remain in this pattern at least until after the uncertainty of the presidential election is past us.

James Puplava over at Financial Sense Online has a lengthy multipart series regarding his concerns that inflation is on the horizon. If the CPI is potentially understating inflation, we really should be concerned about a large rise in inflation surprising the markets.

Finally, Karsten over at CurryBlog discusses Bill Gross’ shocking comments regarding the CPI. He pointedly says that the governments measurement of inflation using the new CPI method is a con job! Bill Gross produces a widely followed investment outlook newsletter for PIMCO. His comments are definitely going to make an impact, but it might not be until after the elections that the public will key in on this important issue.

Three out of seven value indicators for the S&P 500 index indicated the market was undervalued at the end of July. Only two of the 15-year moving average indicators were showing that the market was cheap last month. With the recent declines in the market, it might be time to start looking for some high quality stocks that might begin to show up on the bargain rack.