Inflation / Deflation Perspective 9/30/12
INFLATION / DEFLATION PERSPECTIVE 9/30/12Last entry: 10.10.12
A betting person would say that the chances of deflation replacing inflation are very low after years of an inflation based Federal Reserve Monetary Policy; in fact, the gold market is saying that the probability is virtually zero. The facts, however, point to a real risk that global macro issues could take over.
The big fact is that the FED believes there is a much bigger chance of deflation than inflation, otherwise their guidance would not be what it is. So the real question is: can the FED keep deflation at bay. History would say that reflation after assets reach extremely low price levels can be done. Reflating when assets are generally high priced is another story and one must keep in mind that in 2008 some calculations had the real estate market 46 percent overvalued based on long term trend. Markets tend to go below trend when they deflate, that has not happened yet because the Fed has put in an artificial floor with the various QE’s. As such a very real risk for all of us is that the Fed will be forced to abandon the floor. Furthermore, one must keep in mind that many other asset class prices are still well above the Macro trend.
Here are some points to ponder:
1. First the dollar. For me the value of the Dollar is mostly a reflection of our Fed and Fiscal policies and is for me not predictive of stock prices. The US has since 2001 attempted to run a cheap dollar export economy to try and handle the fact that the economic long cycle topped in 2000. They were partially successful in the export part but the import side led by the US consumer turned the trade exchange into a big cumulative trade deficit. The importation of a lot of relatively cheap Asian products and oil were the prime culprits.
Moving forward I expect both imports and exports to drop as the world economies try to tackle the liquidity trap deflation that is setting up and the fact that the US need to import oil is dropping dramatically. As such I expect that trade issues will take a back seat as no one, not us, Europe, or China, will be in the driver’s seat. The dollar will seek its own level and the charts say that that will be higher.
2. The long term charts of the dollar topped in July 2001. The combination of being the world’s largest economy and the topping of the 72 year long economic cycle were the primary causes in my opinion. The unfunded Iraq war and the speculative nature of the US housing boom kept the dollar under pressure until mid 2008 when the first leg of the dollar double bottom was put in place (the right side of the double bottom occurring in May 2011). The timing was partially due to changes that were being seen in the US political scene and the topping of the ill fated housing boom. At the same time the EURO which had been relatively strong in the 2001 to 2008 period topped out in July 2008, right when the dollar started its wide bottom.
3. The long term gold chart also bottomed out in 2001 and steadily moved higher with a few fits and starts to its long term top in September 2011, basically starting with 911 and ending on the 10 year anniversary of 911, maybe a coincidence, maybe not. Being long gold in the 2002 to 2007 period was a home run period, with gold climbing 400 percent, and speculative players being absent. Since 2007 the public and speculative players predominate and while the gold market has doubled during that time, it is sitting at a risky juncture if 2011 was the major top. A rising dollar, deflation and the liquidity trap that both the public and banking sectors face will mean cash will reign supreme and interest paid to borrow it will climb. US bonds will not escape this scenario.
4. Going back to the dollar, if is important to keep in mind that other economies are on a different economic cycle. For a while their currencies were relatively stronger than the dollar, in fact the Euro topped when the dollar bottomed in 2008. Now going forward from this point Europe and China will be the economies under the most pressure, although through globalization we will all be affected.
5.The Macro commodity bubble (CRB data) took off into its final blow-off stage in 2004 and peaked in July 2008, interestingly at the same time as the top on the Euro and bottom on the dollar. Since, in spite of various QE’s and a run towards the highs in May 2011 (when the dollar completed its double bottom) has not been able to mount a meaningful rally , even this year with the Fed’s Twist and drought in Ag commodities. In fact chartists could make the case of July 2006, July 2008, and May 2011, as the elements of a macro head and shoulders top.
6. As to the US stock market which investors seem to focus most of their attention, here is my Macro take. Since the start of the so called “Great Recession” in October 2007 the US stock market has steadily built a premium to the European and Chinese stock markets, a premium such that it almost masks the deep trouble that the US market faces. Part of the premium is based on the fact that the US is in a different part of its long-term economic cycle than the other major countries. It is important however to keep in mind that this premium does not warrant the making of new highs. From a charting standpoint the Macro head and shoulders top in the S&P, left shoulder in 2000, head in 2007, right shoulder in 2012, looms large. It also is important to keep in mind that the Global Dow peaked in December 2007 and rallys attempted since are finding resistance well below those 2007 highs.
7. A new perspective in the world economies could be developing. The inflation based parameters that began in the 1930’s and on which Ben Bernanke did his research and dissertation may not prevail over the 72 year cycle that started in 2001. Maybe a new order is moving to the forefront, helicopters dropping cash are old stuff. Evidence that things are changing can be seen in the real world economy’s response to the various QE’s, only the speculators profited in the liquid stock markets. Maybe all of us need to look at a new way to live life and maybe it won’t be watching CNBC.
8. And lastly, the topic of attention these days, the “Fiscal Cliff” is really only a headline that keeps investors from looking at really what is going on around them.
IMPLEMENTATION OF A MACRO STRATEGY
1. Implementation of a macro strategy involves, first a fundamental model of factors, and second a reliance on macro relative strength indicators, and lastly a view of macro chart patterns. Moving average indicators, a core ingredient of short-term trading models, are too slow to activate a long term model.
2. What would it take to convince us that Deflation is off the table?
A) The three markets that to me provide useful information are the CRB cash Commodity Index, the Global Dow, and the Dollar. I would not be surprised if the CRB Index is what keeps Ben Bernanke up at nights, not the employment numbers. The Global Dow is a real representation of what global asset prices are doing. And the dollar is out there for all to see. So If the CRB took out the 2008 highs, The Global Dow took out the 2007 highs, or the dollar took out the 2011 lows I would need to look at a reset, especially if all three happened.
B) I tend to view the other markets as trading vehicles which are highly affected by speculative assets and provide less useful information. In this category I would put the S&P 500 and Gold markets. Crude Oil is in its own special class, a non-market, run by Harvard trained Saudi’s who have a wide array of games that can be played. They will take as much as they can of your money. And not to forget T-Bonds, another manipulated market these days, in this case by the Fed and U.S. Treasury, no information there.