Predictions of the future are never anything but projections of the present...that is, of occurrences that are likely to come to pass if...nothing unexpected happens; every action, for better or worse, and every accident necessarily destroys the whole pattern in whose frame the prediction moves and where it finds its evidence.
- Hannah Arendt
Outlook & Predcitions 2003:
The Deflationary Spiral Deepens
Chart Courtesy Elliot Wave International
Every financial mania is followed, in its time, by a mirror image of panic and despair. Over-optimism necessarily over corrects to the realm of over-pessimism, and the ideas that propelled the initial optimism are disgraced and discarded, relegated to the junk heap history. At least for a while.
The investing climate of the late 1990's was one of fast, loose money, with little regard for risk or fear of loss of capital. This was exemplified both by the dot-com/technology mania and the index mutual fund craze. Investors neither knew nor cared where their money went, as long as it went up in value. People were optimistic, credulous, and trusting.
As the mania deflates, investors are gradually shifting their stance to one that is pessimistic, incredulous and mistrustful. Instead of seeking gains on capital, the mindset shifts to retrenchment and preservation. The new rush will be on for what is perceived to be the safest investment instruments - those that are guaranteed by the government. This will cause interest rates to fall further in 2003. The deflation will only be complete at the point of over-pessimism, when stock prices and real estate values are paradoxically dirt cheap and at the same time unwanted. This ending is assured. How long it will take, and how we get there is a matter of details.
Financial time moves at a glacial pace, and one year is a mere a twinkling of the eye. This being said, we will begin at the beginning with the surest, most tangible event of the coming new year - the event which is likely to color all other events throughout the year and the decade ahead: War.
Buy the rumor, sell the news. It is one of the oldest, most well known trading axioms in the book, and one that everyone always seems to manage to forget. The recent rise in the price of gold ($350) and oil ($33) are reflecting the fear, uncertainty and anticipation of war. The Battle of Iraq will begin in the first quarter of 2003. A decisive resolution to the Iraq situation, which like in 1992 is likely, will decisively reverse the price trends of these commodities.
Just as in the last war with Iraq, the prices of these commodities rose in anticipation of war, but stood down almost immediately after the bombing began. This time will likely be no different. Once it becomes clear that the U.S. is on the way to full control over the oil supplies in Iraq (2nd largest reserve in the world), oil prices will fall. Gold, as a calamity hedge, will fail to breach $400 /oz and as calamity fails to materialize, fall back to under $308 / oz.
From a longer term perspective, however, it is clear that the United States is on a warpath, and Iraq is but one battle. The next, more complex and challenging target will be North Korea, but that is another story. The vague war against the 'Axis of Evil' that the U.S. has embarked upon will go on and on for years to come and will drive and shape our domestic economy in ways that we cannot currently imagine. Over time, there is no doubt that gold and oil will rise to heights beyond current belief, but not in 2003.
Falling gold and oil prices will contribute to, and confirm the reality of a global deflationary spiral. Japan has seen it for the past 12 years. A deflationary spiral means that the price of nearly everything falls in relation to the purchasing power of cash. This is the result lack of demand, which is the result of a lack of money which is the result of massive liquidations of debt. It is important to remember that "money" really doesn't exist any more - one entity's debt is simply another entity's asset and vice versa. For example, the "money" in your bank account (your asset) is simply money that you have loaned (or given) to another entity (the bank) for their productive use (their liability). Your "money" in the stock market is financing who knows what kind of activities? Should the counter parties to your assets decide that they cannot repay their debt and default (the way Enron, Worldcom and UAL have), what you believed to be a rock-solid asset simply disappears. Poof. This leads first to falling prices in the stock market, which we have already begun to see, then falling prices in every sector of the economy, which we are only just beginning to witness.
For future consideration, remember that all of our dollars are ultimately the liability of the U.S. government - an entity that is already $6.5 trillion in debt. In the long term, there is only one way for the government to pay this enormous sum back, and that is to inflate the currency to oblivion. As I stated, the financial world moves at glacial speed, and this eventuality is still years away. But it is clear that the necessary prerequisites for future inflation are firmly in place in the United States. We have rock bottom interest rates, a declining dollar, rising imports, and falling exports. But the current countervail to these factors that will hold inflation in check throughout 2003 are rising unemployment, lackluster corporate profitability, falling consumer spending, and the massive liquidation debt in all sectors of the economy.
Furthermore, there is the matter of China
China has become the world's premier manufacturing outlet, offering the lowest cost of production anywhere on the planet. China's exports to the U.S. rose again last year and account for 10% of all U.S. imports. They are low cost leaders in apparel, furniture, telecom and electronics, and their products have deep penetration throughout the world. China is first in the world in foreign direct investment, and they enjoy a huge trade surplus with the U.S. China has $275 billion in foreign exchange reserves - second only in the world to Japan. As the rest of the world struggled, China's economy grew by 8% last year.
Most importantly, the yuan is not a freely convertible currency, is extremely undervalued and fixed by the government at the wildly cheap 8 yuan / dollar. You can thank this rate for your high standard of living in the form of inexpensive shoes, clothes, electronic and just about any other manufactured goods you buy. The fixed exchange rate means that even as the U.S. Dollar falls in value, the yuan will fall in concert. This will keep Chinese imports cheap, and pull other world currencies down as other nations struggle to compete with China's low prices. Continued worldwide deflation is assured in 2003.
IV. FINANCIAL MARKETS
U.S. Financial markets will fall for an unprecedented fourth straight year in the U.S, with all major markets reaching fresh, multi-year lows. Technical patterns indicate steep, violent declines ahead. Target lows for the year are as follows: Dow: 6000; SPX: 600; Nasdaq: triple digits.
The "what-me-worry?" serial home mortgage refinancers will find that they are little more than renters in the end, or worse, indentured servants to the banks. Home prices will be caught in the larger deflationary spiral and decisively turn down in 2003. In 2002 we barely began to see the first cracks. Next year the cracks will begin to yawn open wide.
The overriding theme of 2003 will be one of value destruction - everything will be falling, from bombs to stock prices, to the value of the dollar and gold and U.S. consumer confidence. This is not gloom and doom, but part of the natural and eternal cycle of life.
As it is in Genesis 41:29 "Seven years of great abundance are coming throughout the land of Egypt, but seven years of famine will follow them. Then all the abundance will be forgotten, and the famine will ravage the land. The abundance in the land will not be remembered, because the famine that follows it will be so severe."
So will it be in this great country. We have already seen our seven years of feast. Ignoring the wisdom of the ages will not help you when times get hard - it is best to have your eyes open to the reality of what is happening and prepare, like Joseph did.
In summary, prepare for the following in 2003:
- American bombs falling in Iraq in the first quarter of the year
- Declining interest rates
- Declining value of the dollar
- Declining price of gold
- Declining oil prices
- Declining housing prices
- Dow decline to 6000 or below
- SPX decline to 600 or below
- Nasdaq decline to 999 or below
While everything will be falling, not everything will be falling at the same rate. Government issue bonds will rise, and gold will, as always, remain a store of value.
Best of luck to you and yours in the coming new year.
M. A. Nystrom
January 1, 2003
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