By Derek Moore
Source: BofA Global Fund Manager Survey
It would seem that the majority of prognosticators on the daily finance shows are talking up the possibility of higher inflation. The word “transitory” has become part of the vernacular as the Federal Reserve has told us to be ready for short term ticks higher in inflation over the next couple of months due to the base effect. That is a fancy way to say you are comparing a current month against the same month a year ago that was lower due to Covid lockdowns in full swing.
Bank of American’s graph above highlights inflation expectations being at all-time high when conducing a manager survey. It was not noted if all-time means that, or back to 1995 which the chart shows. None the less, people think higher inflation is coming. So, is inflation out of control or can the crowd be wrong? Remember, being right and wrong on something is a little more nuanced. You can be right on direction but wrong on timing.
Inflation measured by the CPI or Consumer Price Index is a little more complex than you might expect. Plus, when you are looking at a chart, a short window view can look different that a longer perspective into the same data. Around 2010 the Cleveland Fed put out some research discussing Sticky vs Flexible CPI.
It is the idea that some goods and services are much more apt to see prices be more volatile in the short term. Things that are sticky do not change as much but may be a better indication of long-term shifts in inflation higher or lower. You can see the complete list in the link above, but an example of a flexible item would be fresh fruits and produce. Sticky items would include things like infant and toddler apparel or rent of primary residence.
So if we look at the Atlanta Fed’s site, we can see that in March of 2021 Flexible CPI was up +21.8% month over month (Feb to March 2021). On a year over year basis, it was up 6.3% (March 2021 to March 2020). In that same time Sticky CPI was up 1.8% YoY. We can see this on the graph below.
Source: Federal Reserve Bank of Atlanta
This is where the time frame you look at matters. Going back only to around May of 2018, this looks like Flexible CPI (dark line) is leading inflation higher. Also notice how the orange Sticky CPI has not really budged much just oscillating a little around the 2% level.
Now if we pull back and instead expand the time frame it looks a little different.
Source: Federal Reserve Bank of Atlanta
What is striking is how the two different measures act over the long term. You can see that several times Flexible CPI made sharp moves while the Sticky CPI has stayed relatively constant. When we really had elevated inflation back in the 1970’s you can see how that Sticky CPI also rose.
So, before we get too carried away with inflation expectations, the Sticky CPI may be a good thing to check in on now and again. Off course, instead of trying to rearrange portfolios or pick tops and bottoms, just Buy &Hedge!
Buy & Hedge Retirement Update: Selling Upside Call Premium
Some of you might have noticed in your clients Buy & Hedge Retirement accounts that ZEGA’s traders executed some call selling. This involved selling calls with maturities out 3 months against our existing long call positions. This morphs the position into a long calendar spread thru maturity where the short calls are covered by the long calls.
So why did we do this and what does it mean for you? Well, we are always analyzing markets and based upon a combination of things like the premium available and the historical levels on subsequent all-time highs after a new all-time high has been met. We looked at the annualized return available and determined that there was an opportunity to bring in additional income (premium) by the sales of these calls.
At the same time, we still want additional market upside to be possible. This is not a directional decision and is rather based our systematic rules for the strategy. To put some numbers on the page for you we are short the 455 strike SPY calls with an expiration date in July. This roughly puts the market around 10% lower than the strike price.
We know given that new clients are coming into Buy & Hedge Retirement all the time and many have not experienced covered call premium selling against long positions before. We tend to use is sparingly in that our rules must be met on many levels first.
As always, contact ZEGA with any questions on this or other strategies.