In Peru we celebrate Independence Day on the 28th and 29th of July so I will be closed down since I can’t get anyone to work for me on those days. So please keep in mind that you will not receive anything from me on those nights and next Sunday (the 27th) will be an abbreviated report.
There is a lot of contrasting opinions as to whether we’ll experience inflation, deflation, or the ever popular inflation followed by deflation. With the latter version you get the worst of both worlds. Most folks are firmly entrenched in the inflationary camp while just about everyone else believes that we’ll see inflation followed by deflation in a year or two. I heard an interesting hypothesis the other day expounded by no less than Jim Rogers during a Bloomberg interview. He said that we are guaranteed inflation because “demand for commodities may shrink but supply is shrinking even faster”. At first blush that sounds profound, but the more I think about it the more I find fault with his argument. Rising prices almost always guarantee that supply will increase, at least with things like grains, cotton, sugar, rice, meat, and pork. You can always plant a few more acres or fees a few more head. There are exceptions like oil and gold where supply is finite, but that isn’t the case with a lot of commodities. If I want more corn I can always plant more acres and higher prices are the best incentive in the world to do just that. It seems to me that Mr. Rogers should know that.
At any rate, I have been turning this whole inflation/deflation debate over and over in my head for two years in an effort to come to some sort of definite conclusion and I’m finally there. There is no doubt in my mind that we’ve experienced significant inflation over the last seven years; all I have to do is look at an historical chart for the Commodity Research Bureau Index ($CRB) and it as plain as the nose on your face:
First you need to understand that the CRB is composed of a basket of goods all of us use on a daily bases, and anyone who goes to a supermarket can and will identify with this chart. Not only have we had inflation, for all practical purposes we’ve had hyper-inflation. How can that be when the Federal Reserve tells us that “core inflation”[1], a useless and fraudulent indicator, says the rate of increase is less than five percent a year? It’s really quite simple when you stop to think about it; the government lies to you.
The CRB pictured above has risen from 185.00 in early 2002 all the way up to its present level at 562.00 as of Friday’s close. That balances out to almost a 30%/year rise in prices but I contend the first year or two was less while the last year or so was probably close to 50%, and that’s hyperinflation. Throughout this period of rising prices, wages were rising in both nominal and real terms; that is until the wheels started to come off in July 2007. Don’t get me wrong, they never rose anywhere close to the price inflation experienced by the consumer, but they did rise. Aside from that houses did keep up with the rise in the CRB and even surpassed it in some years so the average American was able to refinance and walked away with the illusion that he was growing wealthy. Unfortunately, that’s all it was, an illusion! Housing topped out back in June of last year and it was no coincidence that the stock market topped out the very next month. What’s the significance of all this? As I have mentioned on many occasions, the United States is a consumer based economy. Consumption ac-
counts for 75% of the gross national product (GNP) while producing little or nothing. About the only thing left are autos and the big three (Ford, GM, and Chrysler) have one foot in the tomb and the other on a banana peel. Until the downturn in housing prices, people would borrow against their house and spend on imported goods. That’s why foreign countries were so willing to lend to us. What’s more they went to great pains to see that the US didn’t fall too much against their local currencies, printing large quantities of their own fiat currencies in support of the greenback (and their own exports).
Unfortunately for America, everything seemed to come apart at just about the same time. Housing and the Dow topped out in July and real wages began to decline in September, and to make matters worse, nominal wages began to decline in December of last year. It should then come as no surprise that consumption topped out just
before Christmas and has been falling ever since. I contend that the trend in declining real wages will continue and gradually accelerate to the downside so much that nominal wages will likewise turn negative as well. The combination of a declining real wage along with decreased consumption indicates to me that deflation is now the problem to be dealt with, and once nominal wages turn negative, we’ll have a full blown deflationary crisis that will surpass anything seen in 1930. During the Great Depression the US was a large creditor nation with bad economic policies. Today we are a huge debtor nation with bad economic/fiscal policy and that is the worst possible combination. Think of it as a hurricane that spawns tornados.
Given what I believe I have to decide on a course of action that allows me to first protect my capital and secondly make money in real terms. Given the economic conditions I see coming down the road, such a goal is a lot easier said than done. If I am right
That means that commodities have topped, or are in the process of topping. That would be very bad news for any number of exporting oriented economies like Brazil, Australia, new Zealand, Canada, and just about all of Asia. There are two commodities in general that should give an excellent indication as to a top. Copper and oil are found is just about everything we use on a daily bases and therefore their price movements make great indicators for future demand of finished goods. I have posted the three-year weekly chart for oil above and the same chart for copper is posted below:
Both the oil and copper charts have some technical faults but not so much that you could say that the top is definitely in. The oil chart has RSI, MACD, and the histogram all headed down. What’s more the current price is no below the 50-dma (not shown) and that not a good sign. Copper is a bit more suspicious in that we’ve experienced a huge sideways movement with marginally higher highs and obviously higher lows. Under normal conditions in a bull market, that type of price compression would imply that price should break out to the upside. On the other hand when I see such a formation after a seven year leg up in commodities, I have to ask myself if trees can grow to the sky and if this isn’t distribution for a significant move down. I think it is.
Significant commodity bull markets can easily last fifteen years and even run as long as twenty-five years, but that doesn’t mean that prices rise for twenty-five consecutive years. After eighty-four months of an almost uninterrupted rise in prices most folks seem to have forgotten that corrections do occur. A correction, not a bear market but a simple leg down, could run twenty-one months with ease and a ten month reaction would be a walk in the park. As most of you know by now, I have been long commodities (gold and silver are not commodities, they are money) since dinosaurs roamed the earth, but I covered all my oil, copper, cotton, and sugar last week along with most of my grains. In fact, I even took a small short position in copper and oil and will sit on that position unless I see new all-time closing highs in either of the two. Most people fail to comprehend just what a bout of deflation would mean to a debt ridden country like the US. Deflation makes the cost of carrying debt rise substantially while income declines substantially, and the subsequent squeeze is something close to catastrophic. Right now the US has to drum up two billion dollars a day just to service the present debt load, but with deflation the sky is the limit. Can you see the problem? Some folks think that rising demand in Asia will offset any problems in the US, but I just can’t buy that. Since many of them have positive trade balances, they’ll be in a somewhat better situation to deal with a problem but they’re still swamped with dollars that no one else wants.
This last week the markets seemed to like the wonderful balance sheets produced by Citibank and Wells Fargo, but as we saw with Enron things aren’t always as they appear on paper. Once deflation grabs hold of the economy people will stand in line to give back their cars and houses. If you look at the rising risk of default, you don’t
have to be a genius to project the affects of deflation. The average American has no savings and he’s tapped out his house and credit cards, and oil acts as a severe tax on his reduced real income so he will consume less. The three day rally that we saw in the stock market this week is not a rally off of a solid bottom. The rally began almost as soon as the SEC announced new rules with respect to naked short-selling and the rally was narrow at best with the main focus on bank and brokerage shares that had been heavily oversold. That means the rally was a forced short-covering rally and we have not yet seen the bottom. Another reason for believing that we’ll see a lower low
has to do with the fact that the decline never produced a capitulation low, i.e. the type of low where you throw out the baby with the bath water. Such a low almost always comes with one, and sometimes two, 90% down days and they are customarily followed by a 90% up day. Finally the Lowry’s selling pressure actually increased on Thursday and Friday and that shouldn’t happen if the bottom was in. Likewise I know the Dow is quite oversold, even after the three day rally, but I also know it can stay oversold for a long time.
It is no secret that I was looking for a major bottom at 10,725 whereas the closing low was at 10,918, almost two hundred points short of the mark. Friday’s close at 11,501 in the September Dow futures contract was almost on the high, typically a sign of exhaustion, and three days off of the low. Furthermore the September S & P closed at 1,260.40 and that is right where it broke down from while the September NASDAQ actually closed down 11.00 for the day. I believe the Dow is going lower and will not rally much beyond Friday’s intraday high, will not exceed 11,668 under any circumstances, and will turn down to test critical support at 10,725 by Monday afternoon or Tuesday morning at the latest. Significant declines like we’ve experienced for the last month or so do not just die quietly on the vine. They must exhaust themselves in a violent fashion and this decline will not be any different. Once we do make a lower low, then one of two things will happen:
· We continue lower and crash here and now, or
· We rally back up to +/- 12,060 and then trend sideways in a distribution pattern. This whole process could take as long as 60 days and then we crash.
Either way we crash but I think we’ll get the relief rally and then we’ll crash but that’s just my opinion. There is a popular school of thought that feels we’ll head up to new all-time highs later on this year. I couldn’t disagree more.
In conclusion, I am now certain that deflation is about to descend down upon us and, given the amount of debt and the fact that no one expects it, it will be particularly brutal. During one part of Bernanke’s testimony last week one Senator had the nerve to ask the Fed Chairman what would happen if we got caught up in a deflationary trap, and he avoided the issue altogether in his answer. One sign of the deflation has been the dollar’s stubborn refusal to break down- L had mentioned months ago that any signs of deflation would be accompanied by unexpected strength in the US dollar and that is exactly what we’ve experienced. The dollar initially declined once the housing and stock market topped, but then began to rally in mid-March. That “rally” just might be due to the introduction of deflationary pressures as a debt strapped nation hunts for liquidity. That may also explain why most interest rates have rallied even while the Fed was lowering the prime rate.
That also goes a long way toward Bernanke’s refusal to even discuss the possibility of raising interest rates to combat inflation. He is only too aware of the deflationary pressures lurking around every corner and is all too conscious of the possibility he may yet be forced to reduce rates before the year is out. Such a path will catch more than a few savvy investors by surprise. It will also play hell with stocks, bonds, the dollar, and lead to the first real correction in the commodity bull market. What’s left? In a word, gold! Gold is money and it is a store of wealth and that will drive investors toward it as value melts away due to deflationary pressure. In fact, that may go a long way toward explaining gold’s resurgence during a time of year when investors take a decline for granted. Just two weeks ago gold broke out to the upside and caught an awful lot of investors with nothing in their pockets but their own hands. Take a look below:
The recent intraday high of 989.60 in the August gold futures contract came quite close to testing critical resistance at 999.40, and rest assured that we will test it again. Deflation will slow gold down but it will not stop a rally or turn a bull into a bear because gold is true wealth and we always desire true wealth. More so even when things get ugly!
When gold broke out I told you that it would surpass the 999.40 resistance without anything more substantial than a 4.5% correction and I stand by that. That means the August gold will hold strong support at 945.30 on a closing bases, and then it will continue on its upward path. In fact not only will gold surpass resistance at 999.40 without much of a hassle, I believe it will take out resistance at 1,077.60 under the same circumstances, i.e. without anything more than a 4.5% reaction. Finally, gold will rally to a minimum of 1,219.20 with no more than two 7.5% corrections along the way before going even higher. I had projected an original top of 1,705.00 by this time next year but I am revising that down to 1,447.50 precisely do to the deflationary effect I see. If I am wrong about deflation and inflation prevails, then my original projection will come to pass. As far as I am concerned, it’s a win/win situation unless of course I own stocks, bonds, or the US dollar (or commodities over the short run). One finally word about a possible rally in the Dow to 12,060; if it does happen it could just serve to prolong the rally in commodities another thirty to sixty days but that remains to be seen. When thinking about gold, look at it as a financial panacea, i.e. good for whatever ails you.
[1] Core Inflation is a measure of inflation that excludes food and transportation.
ebo@dtanalysis.com
Dow Theory Analysis SAC
July 21, 2008
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