Friday, August 6, 2010

The Case for a Bear Market of Historic Proportion and a Deflationary Depression

There have been many signs lately that the economy is slowing at a rapid pace. The financial media is debating whether or not we will have a "double dip" recession or whether this is just a slowdown. Since the global economy has come back from the abyss, there has been a debate about what type of recovery we would have in the U.S. economy. There is talk of a "V" shaped recovery, which would be the most optimistic assessment, the Nouriel Roubini "U" shaped recovery, whereby we would see anemic growth for a number of quarters, or even a "W" shaped recovery, which would imply a "double dip" recession before the U.S. economy got back on its feet. However, I see it differently. I do not think the recovery will take any shape currently being discussed by economists, financial commentators and analysts. Rather, I believe the U.S. economy is headed for a very large bear market and a deflationary depression. I also believe that we have been in a developing depression since 2000. Most people are looking at the start of the recession as December 2007. This might make sense given that the Stock Market topped out in October 2007. However, as I have illustrated in previous posts, that was only in nominal terms. The "Real Dow", which is the Dow in terms of Gold, peaked in 1999 at 43 ounces of Gold. By the time nominal stock prices topped out in 2007, the Dow/Gold ratio had already fallen significantly from its 1999 peak, and as of today, Friday, August 6, 2010, the Dow in terms of Gold is sitting at 8.84 down 80% from its 1999 peak, as illustrated below:

In my opinion, we have been in a bear market since 2000 because the western world has completed at least a 70-year economic expansion, and in the work of Robert Prechter, a 200-year econoimc expansion dating back to the 1720's following the bursting of the South Sea Bubble in england. In Elliott Wave terms, we have completed a supercyle bull market that started at the 1932 low, and we are now set up for a deflationary collapse, as illustrated in the following Chart of  of the Dow  Jones Industrial Average dating back to the 1920's. One of the guidelines of Elliott Wave principle is that a 5-wave uptrend is complete, prices retrace back down to the previous fourth wave low, which in this case is 777 on the Dow. So, my target for a bear market low is below 800 on the Dow Jones Industrial Average. Often times mania's are completely retraced and then some, as was the case in England in the 1700's with the South Sea Bubble. That is, the bear market following a mania retraces back down to below the starting point of the mania. In my opinion the global credit bubble is no exception, and if anything it is even more severe than anything we have seen before. Therefore, using the logic the Dow should bottom below 777, the 1982 low, or even 572, which was the 1974 low. If this is a Grand Supercycle Bear Market and we undo all of the inflation since the creation of the Federal Reserve in 1913, the Dow should bottom closer to Elliott Wave International's target, below 400. a few specific support levels that Robert Prechter cites in his book At The Crest of the Tidal Wave (1995)  are  95, 161, 195 and 295 on the Dow, These targets sound extreme to most, but so did Robert Prechter's call for Dow 3,000 in the 1980's. The Dow rose more than 4 times that high!

The primary case for deflation, where Dollars gain in value, stems from the fact that the U.S. economy is a credit based system, whereby 95% of outstanding credit has been created by banks using the fractional reserve lending system. A good video to illustrate this is called "Money as Debt" and can be found on Youtube. When the U.S. Dollar was backed by Gold, a Dollar represented a promise for physical gold. However, since the U.S. has been off the Gold standard, the U.S. Dollar has simply been a promise for more promises, or dollars. Many inflationists talk of "devaluing the dollar", but the problem with that argument is that it is not valued against anything, so there is nothing to devalue. The inflation camp also makes the argument that the Fed can just monetize all the debt that is imploding, and it will cause high inflation or even hyperinflation. I make the case that the amount of outstanding credit (hundreds of trillions of Dollars including unfunded liabilities) is far greater than anything the fed would be willing to monetize, so the result is net deflation. The inflationist camp will point to Argentina or Zimbabwe to point out the mistakes the Federal Reserve is making. Rather, I think our current situation can be modeled by that of Japan in the 1990's, where Japan's central bank made monetary policy mistakes that most thought would be inflationary, yet interest rates are at historical lows and their currency is rising in a deflationary environment. This is similar to what the U.S. is going through, where short-term interest rates are at historically low levels. I make the case that the amount of outstanding credit (hundreds of trillions of Dollars including unfunded liabilities) is far greater than anything the fed would be willing to monetize, so the result is net deflation as credit is vanishing from the system at a much faster pace than the amount of new Dollars entering the system. Bank credit is also near historical lows, because banks are  hoarding cash and not willing to lend and consumers are not willing to borrow, both wanting cash (saving in the case of the consumer) more than anything else. I believe interest rates will remain low until creditors start demanding higher rates of return due to a perceived increase in default risk. At this point, as I have illustrated in a previous post  on March 25, 2010 showing monthly charts of the 10-year yield, interest rates should start rising as the bond bubble bursts. Credit should collapse even faster as higher yields force people to default on their debt. This will not be inflationary as most people associate with rising interest rates, because of the reason interest rates will be rising (default risk, not inflation risk). In fact, it will be highly deflationary. I will post monthly interest rate charts when the long-term downtrend line on interest rates is broken, whenever that may be. Deflation appears to be winning the battle, and should until the markets (stocks, commodities) make their final low and there is virtually no credit left. At that point, as Robert Prechter mentions, anything is possible, even hyperinflation if the government decides to start-up a printing press. In the meantime it is best to keep money in the safest possible cash equivalents such as short term treasury bills. The return won't be there now, but at the final bottom investors who keep their money safe now will be able to take advantage of what should be the best buying opportunity in history.