Is The Latest Inflation Scare For Real?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
May 23, 2006

IN THIS ISSUE:

1. Inflation Ticks Up – What Now For The Fed?

2. The Fed Was Supposed To Take A Breather

3. BCA Still Believes Inflation Will Slow Down

4. Conclusions – Next Few Weeks Are Critical

5. Revisiting Niemann Capital Management

6. Niemann’s Impressive Performance Record

Introduction

On Tuesday of last week, the government announced that the Consumer Price Index rose 0.6% in April, well above expectations. This followed a report earlier in the month showing that the Producer Price Index (wholesale prices) jumped 0.9% in April, also well above expectations.

The latest inflation reports caused a stir in the investment markets with the Dow Jones plunging over 500 points in the last week. Even the high-flying commodities markets – gold, silver, copper, etc. – took a major dive. So what is happening all of a sudden?

The fear, of course, is that with the latest inflation reports, the Fed will continue to ratchet-up short-term interest rates to the point it will choke down the economy. And the Fed certainly left that possibility open with its FOMC policy statement following the May 10 hike in rates. I suggested just such an outcome at the end of my May 9 E-Letter two weeks ago.

Yet while investors and market analysts are once again wringing their hands over inflation, it is still the position of The Bank Credit Analyst that inflation will trend lower in the second half of this year as the economy slows down. This week, I will share with you BCA’s reasoning and analysis on the inflation front.

One of the main reasons that inflation is remaining relatively low, in the face of the global economic boom, is the fact that industrial productivity is soaring. Specifically, workers are producing more than ever, thanks to the continuing rise in technology and cost-saving advances. Companies are reluctant to raise prices in this very competitive global economy. We will discuss this in more detail below.

This week, we will also look at one of my favorite professional money managers, Niemann Capital Management, which I first recommended to you in 2003. Niemann has been successfully managing mutual fund portfolios for 15 years, and they have an impressive performance record. I will give you the details on their programs and performance later in this E-Letter. Past results are not necessarily indicative of future results.

Is The Latest Inflation Scare For Real?

As noted above, the Consumer Price Index rose by a more than expected 0.6% in April. That report came on the heels of the Producer Price Index which jumped an unexpected 0.9% in April. The rise in both indexes was highlighted by spiking energy prices. For the 12 months ended April, consumer prices rose 3.5%, which is clearly above the Fed’s target.

It is widely believed that the Fed focuses more on the “core rate” of the Consumer Price Index, which excludes food and energy costs. In April, the core rate was +0.3% for the second month in a row, which is also above the Fed’s target rate of 0.2% or below. For the 12 months ended April, the core rate rose 2.3%, a 13-month high, and above the Fed’s target of 1-2% inflation annually.

Not surprisingly, the stock markets sold off hard in the first few days after the inflation report last week. The Dow shed over 500 points, and bonds fell sharply but then recovered. Even precious metals and high-flying commodity prices took a dive. The fear, of course, is that the Fed will continue raising short-term rates at upcoming FOMC meetings in late June, August, September and October – or some combination thereof.

But The Fed Was Supposed To Take A Breather

The recent strength in the stock markets has been largely attributed to the growing perception that the Fed was going to go “on hold” following the May 10 Fed Funds rate increase to 5%. New Fed chairman Ben Bernanke made several remarks in his recent congressional testimony which were interpreted by many to mean that an end of rate hikes was in sight. I reprinted Bernanke’s comments that led to the assumption of a pause in my May 2 E-Letter.

Because the assumption of a pause in Fed rate hikes was so widely expected, I issued the following caution in my May 9 E-Letter, just one day before the FOMC announcement on May 10:

“The stock markets have risen to new highs of late, largely on the assumption the Fed will go on hold after tomorrow. This assumption has also helped to accelerate the runaway bull markets in precious metals and certain other commodities. Yet if the Fed fails to give the good news the markets are looking for tomorrow, we could see some nasty setbacks. Specifically, if the Fed doesn’t hint that it is going on hold for a while, that will very likely be bad news for the equity markets, metals, etc.”

Well, as I’m sure you know by now, the Fed did NOT send the signal the markets were looking for on May 10. Here is the relevant text of the Fed’s May 10 statement:

“The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.”

This disappointment, along with the troubling inflation reports last week, were more than enough to wreak havoc in the markets over the last week or so. It remains to be seen if the sell-offs in stocks and commodities over the last week are only temporary “corrections” or if these markets have seen their highs.

BCA Still Believes Inflation Will Slow Down

The Bank Credit Analyst continues to believe that the US economy will slow down in the second half of the year. The BCA editors suggest the economy will slow to a rate of 3% or less in GDP in the second half of this year, down from the blistering pace of 4.8% in the 1Q. In this scenario, the editors see inflation falling in the second half of the year:

“Low inflation is very much a global story. The core inflation rate for the OECD [Organization for Economic Cooperation & Development] area is only 1.8%, and has been trending lower in recent months. Inflation is also low in emerging Asia – the region that supposedly has undervalued exchange rates. The fact that inflation is below 1% (and falling) in China is a powerful indication of the downward pressure on traded goods prices. While some may question the legitimacy of Asian inflation statistics, the data is supported by the fact that U.S. import prices from the region are also falling.

Inflation in emerging Asia will be a good bellwether of whether the inflation cycle is turning. These economies are more energy and commodity sensitive than their developed counterparts, and thus have more need to raise prices when input costs increase. The trend in Asian inflation tells us that it is still appropriate to stick with our low inflation theme.”

One of the main reasons inflation has remained relatively low, despite the booming global economy, is the fact that industrial productivity is soaring. Specifically, workers are producing more than ever, thanks to the continuing rise in technology and cost-saving advances. For the 12 months ended April, US industrial production of capital goods increased 12.5% to a new record high. Also, in April, US factories were operating at 81.9% of capacity, the highest since 2000.

And the increases in productivity are not limited to the US. According to the OECD, even “Old Europe” is catching onto this trend in higher industrial productivity, with Germany and France up 6.7% and Italy up 8.9% in the 12 months ended March. Productivity is also up strongly in Asia. It is a global phenomenon, and companies are reluctant to raise prices in this very competitive global economy. BCA notes:

“Rising oil and commodity prices have boosted production costs in many sectors, yet there is scant evidence of a pass-through into finished goods prices. A key reason is that companies are benefiting from continued productivity gains and tight control over wages. The level of corporate sector unit labor costs in 2005 Q4 was actually lower than in 2001 Q4. This helps explain how companies have managed to sustain very high profit margins at a time of weak pricing power and rising material costs. The correlation between raw material prices and consumer inflation has clearly broken down.”

And what does BCA think about the recent explosions in commodity prices? BCA published the following warning on April 27:

“It is hard to believe that the recent surge in commodity prices reflects underlying demand. Economic conditions have not changed enough in the past few months to validate such a massive jump in metals prices, and there have not been any major supply disruptions. The implication is that speculative activity has a lot to do with the run-up in prices and that is less worrying from an inflation perspective. Commodity prices have overshot on the upside, and are thus vulnerable to a sharp setback.” [Emphasis mine, GDH.]

As always, I highly recommend The Bank Credit Analyst as one of the most accurate forecasting groups around. For more information, visit them at www.bcaresearch.com.

Conclusions – Next Few Weeks Are Critical

The latest jump in the Consumer Price Index has more widely opened the door for the Fed to raise short-term interest rates in late June and early August, and perhaps beyond. On the other hand, if the economy slows down in the second half of the year, inflation should turn lower, and further rate hikes may not be necessary.

Two key reports will be released over the next few weeks which bear watching closely. At the end of May, the Commerce Department will release its “advance” estimate of 2Q GDP. If this report comes in above 4%, it is almost certain that we get another Fed rate hike on June 28. The second report to watch closely is the Consumer Price Index for May, which will be released on June 14. If this number comes in high, it is almost certain that we get rate hikes in late June and early August.

The bottom line is, if it becomes clear the Fed is going to raise rates another 2-3 times, this will not be good news for the stock markets or the previously high-flying commodities markets. As we have seen over the last few weeks, these markets can fall hard and fast!

With all of this uncertainty, and with market volatility soaring, now may be the time to consider professional management for a significant portion of your equity portfolio. With that in mind, let me re-introduce you to one of my favorite professional money managers.

Revisiting Niemann Capital Management

Back in 2003, I introduced two investment programs offered by Niemann Capital Management, Inc. (NCM), located in Capitola, California. Niemann is a very successful money manager that uses equity mutual funds as its investment vehicle.

At the time of my introduction in 2003, the Niemann “Dynamic” and “Risk Managed” programs already had long-term successful track records, and have continued to post favorable returns since my introduction. I thought it would be beneficial to share with you how they have done since I first wrote about them.

In addition, I’m going to introduce you to a third program from Niemann that I think you might want to consider. The “Equity Plus” strategy has a little different approach to limiting risk over and above that used by the Dynamic and Risk Managed strategies. Before going into more details about Niemann’s various strategies, here are their actual average annual performance results, net of all fees and expenses, for various time periods as of April 30, 2006:

Program	2006 YTD	3-Year	5-Year	From Inception
Equity Plus Strategy	+13.19%	+25.83%	+12.57%	+16.14%
Risk Managed Strategy	+6.04%	+17.38%	+8.47%	+15.80%
Dynamic Strategy	+9.00%	+23.93%	+12.17%	+19.36%
S&P 500 Index	+5.61%	+14.68%	+2.70%	+9.20%*
Nasdaq Composite Index	+5.32%	+16.62%	+1.88%	+7.60%*

See IMPORTANT DISCLOSURES at the end of this E-Letter.
Past performance is not necessarily indicative of future results.

* Since the three NCM programs had different inception dates ranging from September of 1996 to February of 1997, the benchmark inception-to-date comparison is as of the earliest inception date.

Note that these are actual performance results in real accounts after all fees and expenses were deducted. And these are not handpicked accounts; the numbers above are based on Niemann’s audited track record in compliance with the Performance Presentation Standards of the Association for Investment Management and Research (AIMR-PPS®).

While the historical gains listed above are impressive enough, Don Niemann also considers capital preservation to be a cornerstone of their programs. The table below reflects the maximum month-end drawdowns (worst losing period) of each of the three NCM programs, as well as for the S&P 500 Index and the Nasdaq Composite Index:

Program	Maximum Drawdown
Dynamic	-20.42%
Equity Plus	-17.39%
Risk Managed	-17.25%
S&P 500 Index	-44.73%
Nasdaq Composite Index	-75.04%

Thus, the NCM programs have historically produced returns that are competitive with the overall market, while keeping downside risk at less than half of that suffered by the major market indices, as measured by maximum drawdown.

See IMPORTANT DISCLOSURES at the end of this E-Letter.
Past performance is not necessarily indicative of future results.

Niemann’s Approach To Managing Money

Don Niemann has over two decades of experience in the money management business, much of it with various big-name investment firms. In 1991, Don formed NCM with his partner, Travis Silberman, who also has extensive money management experience. Since that time, Don and Travis have dedicated themselves to identifying market inefficiencies and taking advantage of them to attempt to increase risk-adjusted returns for their clients.

The backbone of Don’s business philosophy is the idea that a systematic and disciplined approach to risk management can potentially provide superior returns over the long-run, while also reducing the downside volatility that so frequently causes investors to give up. The process starts with a universe of over 2,000 mutual funds representing various asset classes and sectors within the stock market. These mutual funds are then ranked by NCM’s proprietary software to identify those funds with the greatest gain potential for the amount of risk taken.

NCM’s proprietary software is based on the concept of “money flow” within the various market sectors. Don explains that, as investors move their money among various asset classes, the relative value of each asset class fluctuates up and down. NCM analyzes market data in an attempt to determine early-on where money is moving, and then position client accounts accordingly. The financial industry phrase for NCM’s process is typically called “quantifying risk as the standard deviation of return.”

But the process doesn’t stop there. Once a short-list of mutual funds is determined, each fund is subjected to further analysis in which the risk and return components are evaluated over short, intermediate and longer-term time horizons. Each mutual fund is scored based on how it has performed over each timeframe, with funds improving in multiple time frames receiving a higher ranking.

The final step is for NCM’s investment committee to evaluate the overall health of the equity markets based on trend analysis, market breadth, volume, technical factors, interest rates and a host of other internal market factors. This analysis is used by NCM to determine the percentage of assets of each account to invest in the mutual funds selected using money flow analysis.

The Niemann Programs I Like Best

I happen to have a large chunk of my own money invested with Niemann, and I have money in all three programs. However, my two favorite NCM programs are Equity Plus and Risk Managed. The reason is, both of these programs have the flexibility to move to cash or “hedge” their long positions if their indications are that the stock markets will trend lower.

The Equity Plus Strategy may be a good choice for investors who want to have exposure to US stocks, international stocks and bonds, along with the ability to move to cash or ‘hedge’ in down markets. In rare cases, Equity Plus may even have net “short” positions, so this strategy is generally suitable only for more aggressive investors.

The ability for the Equity Plus Strategy to reach beyond domestic equities gives it a potential advantage during periods when the US stock market is at a lull, but the global equity markets, and/or bonds, are heating up. The ability to ‘short’ the market and use hedging techniques provides NCM with additional arrows in its quiver as it searches the mutual fund universe for funds that meet their investment criteria. It is for this reason that I have my largest NCM investment in the Equity Plus Program.

The Risk Managed Strategy is less aggressive and is designed for investors who want to participate in the US equity markets (no international funds or bonds), yet also want to limit the risk of capital loss. During down markets, the Risk Managed Strategy is designed to move to the safety of a money-market fund to attempt to avoid investment losses. In some cases, this strategy will ‘hedge’ long positions, rather than moving to cash, until market conditions improve.

The Dynamic Strategy differs from the two programs noted above in that it is designed to be fully invested at all times (other than limited cash positions occasionally). It does not go to cash or ‘hedge’ positions in the event of market downturns or corrections, as do the Equity Plus and Risk Managed Programs. As a result, the Dynamic Program is only suitable for investors who have a high tolerance for risk.

The Dynamic Strategy invests only in mutual funds that focus on US equities. There is no bond or international equity exposure in this strategy, so in periods when all US market sectors are in decline, the Dynamic strategy may have a greater risk of loss than the other two programs discussed above.

Maybe It’s Time To Get Started

As we have seen over the last few weeks, the equity markets can turn on a dime, or in this case, a disappointing announcement from the Fed or a troubling inflation report. As noted above, the Dow Jones plunged over 500 points last week, and it is far from clear whether this is a temporary correction, or if the market is topping out. For these reasons and others, maybe now is the time to add professional management to your equity portfolio.

If you are looking for a historically successful, professionally managed investment that seeks to maximize risk-adjusted returns, Niemann may have a program that will suit your needs. In particular, I recommend Niemann’s “Equity Plus” and “Risk Managed” programs that have the flexibility to move to cash or ‘hedge’ long positions in the event of a major market downturn. Both programs are profitable in 2006, despite the recent downturn in the markets.

See IMPORTANT DISCLOSURES at the end of this E-Letter. Past results are not necessarily indicative of future results.

Niemann manages all of its accounts through Fidelity’s institutional brokerage unit, and its minimum investment is $100,000. The account management fee is 2.3% per year, deducted quarterly. Note, however, that all performance information above is net of this fee and expenses.

I invite you to request more information on Niemann Capital Management as well as the other professional money managers I recommend. You can call us at 800-348-3601 or visit our website at www.profutures.com where their performance is posted, or e-mail us at mail@profutures.com.

Finally, if you are a frustrated conservative like me, you definitely want to read the Washington Post editorial below by Richard Viguerie. It sums up conservatives’ frustrations better than any article I’ve seen.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Why conservatives are unhappy (an excellent read!)
http://www.washingtonpost.com/wp-dyn/content/article/2006/05/19/AR2006051901770_2.html

IMPORTANT DISCLOSRES: ProFutures Capital Management Inc. (PCM) and Niemann Capital Management (NCM) are Investment Advisors registered with the SEC and/or their respective states. Some Advisors are not available in all states, and this report does not constitute a solicitation to residents of such states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. This publication is not intended as personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. PCM receives compensation from NCM in exchange for introducing client accounts to the Advisors. For more information on PCM or NCM please consult PCM Form ADV Part II, NCM Form ADV Part II and NCM’s Annual Disclosure Presentation, 2004, available at no charge upon request. Officers, employees, and affiliates of PCM may have investments managed by the Advisors discussed herein or others.

As a benchmark for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) represents an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of the S&P 500 or other benchmarks cited may differ materially (more or less) from that of the Advisors. Historical performance data was provided by the Advisors and where possible reviewed by PCM from selected customer account statements and/or independent custodian statements. However, since only selected accounts were analyzed there can be no assurance that the performance in these accounts was consistent with others. Statistics for “Worst Drawdown” are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Investment returns and principal will fluctuate so that an investor’s account, when redeemed, may be worth more or less than the original cost. Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund’s prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. All dividends and capital gains have been reinvested. Performance is based on actual accounts used as model portfolios, which are considered representative of the majority of client accounts with similar investment objectives. Individual account results may vary based on each investor's unique situation. No adjustment has been made for income tax liability. Some Funds also charge short term redemption fees and excess transaction fees (Special Fees), which are billed to shareholders at the time of the event causing the fee. All of these fees are in addition to NCM’s advisory fees. In selecting Funds in which to invest, NCM considers the nature and size of the fees charged by the Funds. NCM will select a Fund only if NCM believes the Fund’s performance, after all fees, will meet NCM’s performance standards. Consequently, NCM may select Funds, which have higher or lower fees than other similar Funds, and which charge Special Fees. When deciding whether to liquidate a Fund position, NCM will take into consideration any Special fees which may be charged. NCM may decide to sell a Fund position even though it will result in the client being required to pay Special Fees. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.