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Posted 3/29/2004
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Contrarian Chronicles
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Yet another way the government hides inflation
The government may be the only institution that can say a price increase isnt a price increase. Heres how it masks the inflationary pressures building. Plus: Intel benefits from reputation inflation.
By Bill Fleckenstein
As we continue to shell out for higher prices, the Bureau of Labor Statistics is working overtime to crank out its inflation-is-tame data, picking from an arsenal of abracadabra. An inflation-busting device known as "substitution" is particularly effective (though for premium-brand ice cream lovers, as you'll soon see, it may be totally unpalatable).
Meanwhile, lovers of Intel (INTC, news, msgs) stock are willingly paying a premium valuation for its less-than-premium prospects.
The statistical minimization of inflation
I have long known that, in addition to hedonic adjustments (which I wrote about in "How the government manufactures low inflation"), government statisticians relied on "substitution." But until recently, I was unaware to what absurd degree. Their methodology is inaccurately labeled "geometric mean estimator," which it turns out is applied to about 61% of total CPI (consumer price index) spending. As my friend Joanie recently opined:
"Basically, this approach allows the BLS mathematicians to substitute lesser price items for those that might have had price increases. They assume, for example, that if tuna is pricey, you might just switch to cat food."
But don't trust us. Here, in the government's own words, is an example of the "geometric mean estimator" at work:
Substitution can take several forms corresponding to the types of item- and outlet-specific prices used to construct the basic indexes. . . . Thus, in response to an increase in the price charged by a store for a certain brand of ice cream, a consumer could respond by:
Redistributing purchases:- To another brand of ice cream whose price had not risen.
- To a larger package of ice cream with a smaller price per ounce.
- To ice cream at a different store where ice cream is on sale.
- To a brand of frozen yogurt.
The consumer also could respond by postponing the ice cream purchase until a later date.
Finally, the consumer could substitute from the ice cream brand to a specific alternative dessert item, such as cupcakes or apples, which is another CPI category.
This latter form of substitution, although across CPI categories, would still have the effect of reducing the quantity consumed of the higher-priced ice cream brand relative to the quantities of other items within the ice cream stratum. . . . In the same way, the use of the geometric mean formula within categories does not address the issue of whether consumers can, or do, respond to a general increase in the price of ice cream products by, for example, forgoing dessert.
This is how the BLS keeps the CPI in check at all times. By using hedonics, price increases can be deemed quality improvements and therefore wiped away with the government's magic wand. If that doesn't work, the bureau uses the substitution technique to banish the price increase.
Pricier Kleenex nixes the 'no inflation' myth
In that spirit, the BLS will have no trouble wiping away -- though not with a Kleenex-brand tissue -- the prospective 6% price increase just announced by Kimberly-Clark (KMB, news, msgs). The maker of Kleenex said the increases were necessary to "offset inflation in key raw material inputs, particularly fiber, as well as higher energy costs."
This buttresses a point I have made before (most recently in my March 15 Contrarian column), that the high price of oil will work its way through to lots of different products, thereby increasing their prices, though that does tend to take some time.
Bottom line: The inflation statistics don't come close to capturing price increases accurately, and it's particularly absurd to strip out the offending components, as gets done every month.
As the government loses credibility on this subject, which I expect (the process takes time, but is almost impossible to repair), the erosion of confidence will impact financial markets bearishly and precious metals bullishly. It's part and parcel of the change in psychology that occurs in bear markets generically. And it is all the more likely in this bear market, given the insanity that's been perpetrated and perpetuated by the Fed and the statisticians in the government. That erosion of confidence will bring about a transformed environment, in which stocks bypass being "fair-valued" on the way to being downright cheap.
Intel: the triumph of marketing over technology
Now, lets look at reputation inflation. I have long believed that Intel is not the technological powerhouse that most folks think. Rather, I think its predominantly a marketing organization.
Last year, I spilled a lot of ink about the competitive threat posed by Advanced Micro Devices (AMD, news, msgs). I said its new Athlon and Opteron processors were going to be quite successful, at Intel's expense. We have seen no shortage of supercomputer builders using AMD parts. Sun Microsystems (SUNW, news, msgs) and Hewlett-Packard (HPQ, news, msgs) are using the parts. In fact, Intel has had to scramble to attempt to rescue its Itanic, ne Itanium, due to the success of the new AMD processors.
Athlon bodes ill for Intel
Pressure from AMD also has led to a slightly more subtle, but I think perhaps more important, development:
Intel has been forced to abandon its marketing hype about clock speed -- as though clock speed really told you anything about throughput, anyway.
Over the last few days, some very tech-savvy readers of my daily column have sent e-mails on this subject. I'd like to share the most recent one in its entirety, as I think it will provide folks with important and useful food for thought:
The reader began that Intel's "entire company has been oriented around cranking the clock speed for years now (real performance be damned, we want clock speed!). The marketers took over the company, and their whole campaign has been: (a) You want Intel Inside, and (b) clock speed is all that matters. Their engineering focus, everything, has been around cranking up that clock speed. Problem is, their manufacturing prowess isn't keeping up with their clock speed demands, and, judging from how hot the most recent Pentium 4 Prescott processors are running (75C in an air-cooled system!), I think they're hitting the wall."
He continued: "They are shifting to a very, very confusing system of labeling. I can't even tell you what it was, from memory, and considering that I'm a tech guy, I think that's important. It's something to do with numbering their processors in three different lines. Interestingly, the Pentium-M core is getting the largest numbers (700-series), which may mean that they will start focusing there. IMO, over the last five years, the only truly brilliant piece of technology from Intel was the Pentium-M from their Israeli subdivision. It's interesting that the solution they intended for the mobile market may end up being the major focus of the whole company. Teaching consumers that 'no, it's not clock speed that matters,' after insisting that it does for the last six or eight years, is a very big deal. IMO, they have marketed themselves into a really serious problem."
He concluded: "AMD is becoming a very powerful competitor. The A64 is fast and very reasonably priced. Intel has to basically 'cheat' to stay on top of the benchmarks, by releasing their Pentium 4-EE, at something over $1,200, to compete with $300 AMD-64 chips. I think it's almost impossible to buy that chip, anyway. It's just a paper tiger."
Chunky chip faces low-carb multiple
I believe that Intel faces a potential double whammy to the downside:- First, the pressure from AMD will impact its earnings.
- Second, as it becomes clearer to people that AMD has won the battle -- illuminating the marketing machine behind this "technological powerhouse" -- that will impact Intel's multiple of 30 times earnings.
This valuation makes no sense in an environment where Microsoft (MSFT, news, msgs) trades at 23 times trailing earnings. For that matter, it makes no sense that Dell (DELL, news, msgs) trades at 33 times earnings, given the no-revenue-growth state of the PC industry, which has become a battleground for market share. Of course, that is also the marketplace Intel supplies. (Microsoft is the publisher of MSN Money.)
To compare this troika of companies for a minute, Microsoft uses GAAP accounting and no longer avoids deducting option expenses, as do the other two. If Intel and Dell used GAAP earnings, their P/Es would balloon. And Microsoft has about $5 a share in cash, so you could argue that you're buying "the business" for something closer to 18 times.
Dells and Intels warts are magnified
I am not advocating that folks go out and buy Microsoft. Even at today's prices, I don't find it particularly compelling, considering my view of the world. But if Microsoft isn't a screaming buy, Intel and Dell are probably screaming shorts. However, that doesn't mean they'll go down immediately or they are screaming shorts today. Ive decided to go long Microsoft versus being short Dell and Intel, although I can change my mind at any time.
My purpose in all of this is to underscore the total disconnect that's gone on with, if you will, the big three of the PC industry -- first, from a valuation perspective, and second and more importantly, from the perspective of fundamentals.
Folks have completely ignored the problems faced by Dell and Intel, even as they have some consternation about Microsoft. This is just one small example of the disconnect in today's marketplace, though in this particular case, the dollar value of the disconnect in market cap is about $500 billion.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. At the time of publication, he was short Intel and Dell and long Microsoft. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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