The deadly undercurrent of deflation

Despite the overall positive state of U.S. equities and the improvements in the retail economy, the stealth enemy known as deflation is still lurking in the shadows. 

Consider the following graph of real disposable income, courtesy of Zerohedge.com.  This shows the true underlying state of the real economy and is a testament to the continued presence of deflation. 

Commenting on the plunge in disposable real income, David K. Barker (www.marketcycledynamics.com) wrote: “The most shocking thing about [this] is that disinflation is on the verge of deflation when the pumps were running at $85 billion a month. The only real solution is to restore the pricing mechanism of markets, give Mr. Market the deflation he wants, and the global economy can move into the coming long wave spring season sooner rather than later.”

The good news is that the long-term deflationary cycle responsible for suppressing income and wages is scheduled to bottom later this year.  What’s troubling, however, is that deflation wasn’t allowed to work its magic in cleansing the economy of imbalances, including (and especially) high retail prices.  The Zero Interest Rate Policy (ZIRP) of the Federal Reserve has kept many producers in business which should have gone out of business during the credit crash.  Moreover, ZIRP has obscured the total impact of deflation on financial assets and consumer prices.  When the next long-term inflation cycle kicks off in 2015, we’ll be starting from a much higher price level than we would have if deflation was allowed to proceed unchecked. 

The Fed’s monetary policies of the last few years were undertaken with the idea of throwing everything but the kitchen sink at deflation.  Politically speaking, deflation is unacceptable to Washington since it means lower corporate profits, hence (temporarily) lower tax revenues.  The long-term benefits of allowing deflation to run its course, however, are boundless.  With the 60-year Kress cycle in its final year of descent, a final flare of deflationary pressure in the global economy can’t be ruled out.

As it turns out, even the IMF is concerned over the possibility of deflation re-emerging this year.  In a recent Businessweek article entitled, “The Lurking Threat of Deflation,” IMF Managing Director Christine Lagarde was quoted concerning Europe’s slow economic recovery and its potential impact on prices.  “We see rising risks of deflation,” she said, “which could prove disastrous for the recovery.” 

Lagarde’s attitude toward deflation is made obvious by her choice of words: “Deflation is the ogre that must be fought decisively.”  This is how virtually all central bankers and politicians feel about deflation; it’s an “ogre” that must not be allowed to rear its ugly head.  If only they had the courage and foresight to simply stop fighting deflation and let nature take its course.  The global economy would be so much the better for it.

While the effects of deflation aren’t discernible in U.S. stock market performance, investors aren’t so easily fooled.  They’re still worried about the potential impact of an emerging market crisis or a China credit crunch and they obviously believe deflation is a very real threat in the coming months.  This can be clearly seen in the charts of two major safe haven assets, namely Treasury bonds and gold. 

Let’s start with Treasuries.  The iShares 20+ Year Treasury Bond Fund (TLT), an excellent proxy for long-term bonds, has established a new uptrend since the start of the year.  Notice that TLT is above its rising 30-day and 60-day moving averages and is making an attempt at retracing its short-term losses since the Feb. 3 peak.

It’s also worth noting that the Coppock Curve indicator for TLT has recently confirmed a turnaround signal for long bonds.  The Coppock Curve is one of the single best indicators for issuing buy signals on bonds (though it is less helpful for determining tops).  The Coppock Curve is derived by adding the 14-month and 11-month rate of changes for bond prices and smoothing the result with a 10-month weighted moving average.  You can see in the above chart that this indicator turned up just a few days ago and is signaling a period of outperformance for Treasuries. 

The recent Coppock Curve buy signal for bonds, assuming it pans out, means that Treasury yields will be declining while bond prices rise.  Declining yields are very much consistent with the Kress cycle scenario for 2014, which suggests that disinflationary if not outright deflationary pressures will increase until the long-term cycles bottom later this year. 

The other major safe haven asset which investors have recently been flocking to is gold.  The yellow metal has rallied for the last two months on a combination of emerging market uncertainty and technical factors. 

I’m often asked why, if the long-term deflationary cycle is still down until, should investors be interested in gold?  After all, isn’t gold known for being a hedge against inflation?  I lately came across one very good answer to this question.  Charles Gave of GaveKavel writes in his latest article, “Gold as a deflation hedge,” that gold becomes for many investors the preferred substitute for international assets in a diversified portfolio.  And since the monetary and fiscal policies of the nations is mixed and confused, gold becomes the ideal hedge against bad policy as well as equity bear markets. 

Below is a chart produced by Gavekal Data/Macrobond.  It shows the performance of gold in Brazil’s currency versus the country’s Bovespa stock index.  

“Fed policy risk offers another motive for gold-hoarding in emerging markets (EM),” writes Gave.  “If US monetary policy adds to the volatility of EM exchange rates, then residents need to hedge against this—and, as mentioned, their hedging options are limited.  This is how we get the bizarre situation where holding gold protects against devaluation and growth/deflationary pressures in the emerging markets.”

Gave’s conclusion is that gold “will keep rising as long as US policy is exporting volatility.”

The A-D line leads the way

As explained in Friday’s [Feb. 21] report, the NYSE Advance-Decline (A-D) line is the key indicator to watch right now.  It predicted a rally to new highs for the major indices last week and it continued its march to new highs on Monday (see below).  As I wrote in the Feb. 21 report, “As a general rule, leadership in the A-D line tends to be bullish and usually precedes a new high in the major indices.”  Despite the intraday pullback on Monday, the indices should push higher this week based on the clear leadership of the A-D line. 

It’s also worth mentioning that NYSE market breadth continues to show improvement.  The number of stocks making new 52-week highs has been gradually expanding for the last two weeks and on Monday hit a year-to-date high of 254.  Meanwhile the number of new 52-week lows has remained low, with only 16 new lows for Monday.  That’s well below the “danger zone” of 40+ that normally signifies internal weakness.  The new highs-new lows is telling us that internal selling pressure is virtually nil right now, and that’s conducive for a buoyant stock prices.

[Excerpted from the Feb. 24 issue of Momentum Strategies Report]

The counter-intuitive gold play

Gold has so far enjoyed a terrific start to the New Year, most recently closing at its highest level late October 2013.  It has even succeeded in closing above its psychologically significant 200-day moving average for the first time in over a year.

In summary, gold futures have risen over 12% through Feb. 18, reversing its biggest annual drop in over three decades.  It also hit a three-month high on Tuesday.  Holdings in ETFs backed by bullion increased by 3.2 metric tons last week – the greatest amount since December 2012 – after slumping 869.1 tons in 2013, when prices were down 28%.

Yet despite the impressive rally, gold analysts remain bearish on the yellow metal’s prospects for 2014. An article appearing in the Feb. 18 International Business Times underscores just how negative many forecasters remain on the metals’ interim trend. 

According to the article by M. Rochan, “A majority of all gold forecasters are sticking with their bearish forecasts for 2014 even after the precious metal logged its best start to a year since 1983.”  The article quoted Robin Bhar, head of metals research at Societe Generale in London, who said she sees the recent gold rally as merely a “corrective move.”  To her credit, Bhar was the most accurate gold analyst tracked by Bloomberg over the past two years, yet she stated “we would still want to be bearish about gold.”  Bhar predicts a fourt-quarter average gold price of $1,050.

Meanwhile Goldman Sachs chief commodities analyst Jeffrey Currie believes that gold will “grind lower” as U.S. growth improves, reaffirming a forecast for prices to hover at $1,050 by the end of the year.  The likelihood of weakening currencies in emerging-market economies will increase the risk of further declines for gold, “given the price-sensitive nature of jewelry demand in local currency terms,” Goldman said in its report last week.

The bearish bets of most institutional analysts who track gold seem to be based on the expectation of an improving U.S. economy.  What these analysts have apparently failed to factor in is the possibility of a weaker U.S. dollar, which would likely put upward pressure on gold and silver. 

Could it be that gold is setting up for the ultimate counter-intuitive play in 2014?  Already a majority of analysts have found themselves on the wrong side of the gold trade at the start of the year.  Perhaps 2014 will be the year these same analysts – who mostly were on the right side of the gold short trade in 2013 – will end up with egg on their faces.

Another factor driving higher gold prices so far this year, ironically, is China.  I’m not just speaking of China’s voracious demand for physical bullion.  After all, China imported 1,158 tons of gold through Hong Kong in 2013, more than double its 2012 total.  But I’m also referring also to the growing potential for a China credit crisis.  China’s stock market (below) is definitely reflecting major vulnerabilities to the country’s business sector, if not outright internal weakness. 

To put into perspective how vulnerable to a credit crisis China has become, consider the following analysis by the esteemed economist Dr. Ed Yardeni:  “When China joined the World Trade Organization during December 2001, the country’s banks had $1.4 trillion in loans outstanding, which was equivalent to 35% of US commercial bank loans. At the start of this year, Chinese bank loans rose to a record $12 trillion, now equivalent to 162% of their US counterparts! Those numbers don’t include the lending of the shadow banking system.” 

Yardeni’s blog (http://blog.yardeni.com/) depicts a graph of just how perilous China’s debt situation has become:

Yardeni points out that China’s Producer Price Index (PPI) is down 1.6% year-over-year through January.  “It has been deflating since March 2012. China’s CPI is still inflating at a moderate pace, with an increase of 2.5% y/y through January,” he said.  Yardeni’s conclusion is that “The combination of lots of debt and mounting deflationary pressures increases the risks of a credit crisis in China.”

If 2014 is the year that China’s credit market melts down, as many respectable analysts expect, then this could explain why gold has suddenly become the safe haven asset of choice for many investors.  The anticipation of economic pain in the world’s number two economy is an easy answer for gold’s latest rally since the metal benefits from uncertainty and economic volatility. 

Indeed, the combination of a weak dollar and the potential for a weak credit market/economy in China is all the fuel gold theoretically needs to continue confounding institutional analysts in the months ahead.

A stock picker's market

The March issue of Money magazine featured an interesting article on technical indicators.  It profiled three leading indicators, including the price-to-sales (P/S) ratio for the S&P 500, the NYSE Advance-Decline (A-D) line and the AAII investor sentiment survey.  The P/S ratio is currently 1.6, which is 15% above its historical average.  This reading often signals subpar returns for stocks ahead, according to the article: “Since 1993, in the three years following a reading of 1.6, stocks have eked out average annual gains of 1%...” 

As for the AAII sentiment poll, the Money article noted that at the end of 2013, AAII “found that only 18.5% of investors were bearish, vs. a long-term average of 30.5%.”  This reading has typically “delivered underwhelming returns the year after such a reading, but not losses.” 

I found the article interesting in light of my current take of the market’s technical profile.  While I see no outright bearish signals in the immediate term, neither do I see an abundance of “buy with both hands” signals out there.  In other words, we could be in for a very pedestrian market performance for a while.  Until the cycles and indicators get back into alignment it will almost certainly continue to be a stock-picker’s market where relative strength and momentum are a trader’s best friend.  

Bitcoin's silent crash

Bitcoin has recently suffered what may be termed a “silent crash” after a stellar performance in late 2013. 

After a blow-out performance in November, the Bitcoin price suffered a sharp pullback in December and spent most of January in a temporary holding pattern above the 900 level before finally sinking under the weight of selling pressure in February.  As of Feb. 14, the Bitcoin price was testing its dominant longer-term 40-week moving average, which answers to the widely followed 200-day MA.  This marks the first major test of a significant trend line for Bitcoin since last July.

The sell-off in the last two weeks has occurred under a veil of near silence among the mainstream media.  The same financial press which so vigorously praised the virtual currency’s prospects earlier this year has largely ignored the slide in value since Feb. 6.  This can be largely attributed to the recent equity market sell-off, which stole the spotlight from other investment vehicles. 

It’s nevertheless unusual that the media continue refusing coverage of the loss of Bitcoin’s value.  This leads us to speculate as to a possible motive.  One possibility is that the hedge funds which recently entered the Bitcoin market are using the decline as cover for accumulating a large stake in the market.  It’s no secret, after all, that many members of the financial press are in the employ (if not the outright ownership) of hedge fund moguls.  It’s therefore possible that the media silence on Bitcoin’s recent crash is bought and paid for by those who intend to ultimately profit from it.

Of course another reason for the lack of media interest in Bitcoin’s latest swoon is perhaps that the virtual currency has been temporarily overshadowed by the rally of the gold price.  Gold’s rally is a testament to its demand as a safe haven among investors spooked by the recent financial market turbulence, as well as the media hype regarding an emerging markets “crisis.” 

Until the media begins talking up Bitcoin’s crash in histrionic tones, investors should be wary of assuming the slide in the currency’s value has terminated.  The Bitcoin bear market is likely to persist until we see gloom-and-doom headlines announcing the currency’s demise, at which time we can justly assume a psychological turning point will be made.

Is a crash needed before the 120-year cycle bottom?

Question: “Aside from technical analysis and the Kress cycles, from a valuation standpoint the bottom of a bear market is normally between 14 and 20 years away from the prior top and prices for stocks are so low that you find good quality stocks at PE- rations under 10 and dividend Yields in the Dow around 5 or 6%.  If I am correct, then it is your thesis that the long-term deflationary cycle will bottom later this year and we go into a more inflationary period.  Given the fact I mentioned above we would need a crash like 1929 or 2008 to come along with those prior bear market bottoms, what is your opinion?”

Answer: If the 120-year Kress cycle bottom materializes later this year as expected, what it portends for the economy is the gradual re-emergence of inflation over a period of many years.  This doesn't necessarily mean that we’ll see a jump in inflation starting next year, for it could take several years for inflationary pressures to mount.  The worst of the next inflation cycle likely won’t be until the 2020s when the first 30-year cycle of the new 120-year cycle is peaking.  

As for stocks, the Kress cycle theory suggests that while the next year or more following the 2014 bottom should be bullish for stock prices, it won’t necessarily be a time to be a long-term stock investor.  If inflation does increase in the years ahead, while it may initially be beneficial for stocks, increasing inflation will more than likely be a drag on corporate earnings at some point.  

It’s doubtful that the upcoming 120-year cycle bottom this fall will bring about a 2008-type market crash.  Perhaps a 20% or so correction is about as much as we can expect.  Most of the PE contraction you mentioned above was already effected during the credit crash of 2008.

One more low before March?

I’ve been asked if the upcoming Feb. 21 cycle event could be a catalyst for a lower low in the S&P.  Evidently there are more than a few respected market analysts who are predicting at least one more low by late February before the market’s next rally phase begins.  While a move below the Feb. 3 low is possible between now and Feb. 21, my best guess at this point is that the Feb. 3 low will hold as the correction low. 

There are some compelling reasons for holding this opinion.  For starters, several technical indicators reflected a completely sold out internal condition as of last week.  Unless the S&P price oscillators, for instance, move very quickly back into “overbought” territory, the oversold condition created by last week’s low is likely to last through the Feb. 21 cycle event.

Another compelling reason for suspecting the Feb. 3 low in the S&P is the low for this correction can be seen in the dramatic performance of the dominant intermediate-term momentum indicator for the NYSE.  This important measure of internal momentum has been running hot in the last few days, even as other components of the NYSE hi-lo momentum (HILMO) index have lagged.  Granted, a fully healthy market requires more than just this indicator trending higher but this indicator is important enough that it could keep the market above the Feb. 3 price low by itself.

Another factor which points to the Feb. 3 bottom as being the pivotal low is the possibility that the January decline was overdone.  That is, the decline may have been more of an emotionally-driven reaction to poor earnings reports, fears of a China economic crisis, etc.  In view of the fact that the Dow Jones Corporate Bond Index never pulled back during the January stock market correction, this view has some credence.  Check out the DJ corporate bond chart below.  There’s saying on Wall Street that when corporate bonds are trending higher while stocks are trending lower, the direction of bond prices usually wins out.  If this relationship holds true then we can expect stocks to stay above the Feb. 3 price low and either mark time until the Feb. 21 cycle event or else push gradually higher.

[Excerpted from the Feb. 10 issue of Momentum Strategies Report]

How accurate is the U.S. unemployment report?

Question:  Are the unemployment numbers in the U.S. accurate?

Answer: Unfortunately there is no decisive answer to this question.  The unemployment numbers as reported by the U.S. Bureau of Labor Statistics (BLS) are treated as accurate by most economists, though there is no way for a civilian to verify the accuracy.  There are some independent analysts who have attempted to conduct their own unemployment surveys, but there is too much contradiction among these various polls to believe these to be superior to the numbers released by the BLS.

The closest we can come to making an overall assumption as to the overall unemployment trend is found in the collective stock price movements of several stocks sensitive to the job market.  When the combined average price of these stocks is rising we can assume that the unemployment rate is falling, or else is on the verge of falling.  Conversely, when these stocks are falling we can assume that conditions are not favorable for rising labor participation. 

The five stocks that most accurately reflect the overall soundness of the U.S. business/retail economy are: Amazon (AMZN), Ebay (EBAY), WalMart (WMT), FedEx (FDX) and Monster Worldwide (MWW).  Collectively, these stocks form the basis of the New Economy Index (NEI).  The NEI chart is shown below.

As you can see, NEI is still in an intermediate-term upward trend.  The last formal “sell” signal of this index occurred all the way back in the early part of 2010, and it lasted all of two months.  Since then NEI has signaled a gradual expansion of the U.S. retail economy.  This assumes an improving underlying employment trend, however painfully slow it might be.

It’s also worth pointing out that one of the components of the NEI, namely Monster Worldwide (MWW), has shown a rather dramatic improvement in the last few months.  Monster reported a blow-out earnings increase last week, resulting in a 25% jump in its share price.  This implies an improved picture for U.S. job hunters.

This could change later in the year with the major yearly Kress cycles bottoming into the fall.  But until NEI actually gives us a "sell" signal, we should assume that the U.S. employment and retail sales picture remains fairly healthy.

A look at the gold market

Reuters reported that the SPDR Gold Trust (GLD), the world’s largest gold-backed exchange-traded fund, had a “rare” inflow of fresh investment.  Holdings increased by 2.10 tons to 792.56 tons, though that figure is still near a five-year low.  The multi-month trend of net outflows was finally broken this week as investors flocked to the traditional safe havens of Treasury and gold instruments in the wake of a mini-panic in the emerging markets. 

If nothing else, this demonstrates that the inverse correlation between the precious metals and stocks is still alive and well.  It also shows that investors are still very open to the flight-to-safety trade whenever equities come under pressure.

Elsewhere Bloomberg points out that banks led by Goldman Sachs Group and Citigroup are maintaining that commodities are heading for losses in 2014 as rising supplies and slowing demand should exacerbate the bear markets in gold, copper and other metals.  Goldman pointed out that open interest measuring holdings across the 24 commodities tracked by the Standard & Poor’s GSCI Spot Index (BUSY) fell for three straight quarters through December, the longest slump since the global recession in 2008.  The super cycle that led commodities to almost quadruple since 2001 is reversing, with prices set to drop 3 percent in 12 months, Goldman said.  The asset class will be a “wallflower” compared with equities, Citigroup said.

By contrast, JPMorgan Chase says commodity bears are “overly confident on the reliability of supply” and underestimate demand.  All but eight of the 65 commodity indices the bank tracks will gain over the next two years, with five of them posting double-digit annual returns, analysts led by Colin Fenton wrote in a Dec. 30 report highlighted by Bloomberg Businessweek.  The “super cycle” is “just beyond its midpoint,” said JPMorgan, and the markets are still in the “bull phases.”

This conflict of opinion among major analysts is typical of a transition phase in the markets and normally coincides with congestion, i.e. a lateral trading range.  Based on the wide divergence of opinion among investors and analysts alike, an intermediate period of volatility where neither bulls nor bears gain a prolonged advantage is a likely outcome.

[Excerpted from the Jan. 30 issue of Gold & Silver Stock Report]

A stock market in desperate need of decline

Just how bullish were investors before the decline began?  According to Bloomberg Businessweek, advisers surveyed by the National Association of Active Investment Managers had 98.3 percent of their clients’ portfolios allocated to stocks in January before the decline began.  By comparison, exposure to equities averaged 72 percent during 2013.  It’s easy to see from this near-unanimity of belief in equities why the correction was bound to occur.

As discussed in Friday’s [Jan. 31] report, the latest investor sentiment reading according to AAII was evenly split between bulls and bears.  There hasn’t been a decisively negative bull-bear ration since Aug. 21, so we’re definitely overdue one now.  My guess is that this week’s AAII poll will show a plurality of bears and will show some measure of capitulation, allowing the market to bottom out at least on a short-term basis.

The following graph depicts the AAII bull-bear ratio going back to 2012.  The line should ideally plunge well below the “zero” point and fall deeply into negative territory to let us know that investors have thrown in the towel.  From a contrarian standpoint this normally marks a bottoming out point for the market.

[Excerpted from the Feb. 3 issue of MomentumStrategies Report.]

Will this year be a repeat of 2008 for the stock market?

Question: “Based of the prior history of the 120 year bottom in conjunction with the concurrent bottoming of the various sub-cycles, do you have an expectation of the magnitude of the probable decline?   The stock market declined about 58% basis the S&P 500 into the early March 2009 low.  Would the final down phase of these great cycles be expected to at least match that decline in intensity (at least on an inflation adjusted basis)?  Or, because of QE, did the majority of the cyclical stock market decline this time occur during 2007-2009?  The 50% off type of declines occurred in 2000-02 and 2007-09. Perhaps we have one final 50% off type of decline coming in the future.

“The one index that truly crashed in 2008 which has not significantly recovered is the Baltic Dry Index.  The May 2008 high was 11,793 and the low in December 2008 was 663.  The past year's range was 735-2,337 with a recent reading around 1,700.  The 2,000 level appeared to be resistance from 1985-2003.  The 2,000 level might be a good indicator to focus on as representative of international trading and demand of certain commodities.”

Answer: Unfortunately there is no way of determining the magnitude of the decline associated with the Kress cycles.  Bud Kress himself was always the first to caution that he couldn't be held responsible for magnitude; his primary concern was with direction.  As he used to say, magnitude is the result of cycles + technicals + sentiment.  

In holding to this formula, I can't make any specific predictions about how low stocks may go before the 120-year cycle bottom is in later this year.  You make a good observation that the severity of the decline during 2007-09 may have taken some of the downside potential away from this year's cycle bottom, just as the 1929-30 decline took much of the emphasis away from the 40-year cycle bottom of 1934.  However, with the emerging markets (China in particular) a problem, we could see some serious spillover effects as the year progresses.  I suspect it won't be as bad as 2008, but by the same token 2014 will probably be much worse than what the average Wall Street analysts is expecting.

As for the Baltic Index, this is an excellent barometer of the deflationary pressure being exerted by the bottoming 120-year cycle.  If this correlation holds it will probably put in its final low by the end of the year.