Wednesday, November 18, 2015

Has deflation been defeated?

The last 15 years have been among the most turbulent on record.  Since the year 2000, America has experienced two recessions (including a near depression), two stock market crashes, numerous selling panics, two terrorist attacks, and one of the slowest economic recoveries on record.

Just when it appears there might be some light at the end of the tunnel and the consumer is getting his confidence back, the threat of global deflation has appeared and has given them reason to remain cautious.    This time around the threat of deflation is coming from overseas, specifically from China.

Thankfully, the near brushes with deflation in the last 15 years have all been averted so far due to the aggressive monetary policy responses of the U.S. central bank.  Every time deflation reared its ugly head, the Fed was right there to ensure prices didn’t stay low for long.  In doing so, however, the Fed has short-circuited the natural process by which the economy is periodically cleansed of economic excess. 

The natural cycle of deflation also brings an important adjustment in the cost of living for everyone, especially the savers among us.  Those who sacrifice spending in the immediate term are typically rewarded for their thrift by the long-term economic cycle.  This time, though, the long-term deflation cycle wasn’t allowed to completely run its course.  The net result was that savers were essentially punished for their thrift while debtors were exonerated.  It means that the natural economic order was turned on its head by central bankers.

This begs a number of important questions: 1.) Does this mean the cycle inflation and deflation known as the K-wave has been defeated by the Fed?  2.) Or will the natural order eventually reassert its primacy over central bank manipulation?  3.) Has the Fed run out of ammunition for mitigating future economic downturns?

Samuel “Bud” Kress, for whom the long-term Kress cycles are named, taught that when it comes to attempts by government to circumvent the long-term cycles, “Mother Nature and Father Time” always prevail in the end.  If Bud were alive today I have no doubt he would maintain the Fed’s impotence in ultimately destroying the long-term economic cycle of inflation/deflation.  The effects of the long-term economic cycle, he always asserted, must win out.

The long-term cycle of inflation/deflation identified by Kress has a period of 60 years and is roughly analogous to the more widely known Kondratieff Wave (K-wave).  According to Kress’ numerical system, the cycle was to have bottomed in late 2014.  The period between 2000 and 2014 encompassed the deflationary portion of his cycle, and it was during this time that the U.S. economy experienced most of the aforementioned turbulence.  During this time frame the closest the U.S. came to the deflationary depression predicted by Kress was in 2007-2008.  The Fed stepped in, however, and unleashed record amounts of liquidity in a furious attempt at reversing the deflationary spiral.  Its efforts proved successful as depression was averted and prices recovered in the years that followed.

Yet the threat of deflation is ever present and remains a constant bugbear of central bankers, especially in Asia and Europe.  The U.S. Fed may have succeeded in forestalling deflation, but the austerity programs pursued by other countries in 2009-2015 are coming back to haunt them.  The interrelated global economy so passionately defended by many has revealed its ugly underside.  Deflation, it turns out, can be spread abroad even to countries that aren’t directly experiencing it at home. 

A classic symptom of the deflationary pressure many countries are experiencing is the steep decline in commodity prices.  The Reuters/Jefferies Commodity Research Bureau Index (CRB) is the benchmark price index for the broad commodities market.  As the following graph illustrates, the CRB is at its lowest level since the 2008 credit crisis.  This depressed level reflects the lack of industrial demand owing to the global economic slowdown.

When monetary policy fails, the classic political response to deflationary pressure of this magnitude is to start a war.  War is inflationary and always succeeds in boosting commodity prices and industrial production to above normal levels.  The military adventures of the U.S. between 2002 and 2011 contributed to an historic boom in commodity prices and likely forestalled the early onset of deflation after the 30-year cycle peaked in late 1999.

There is also a 24-year cycle component of the Kress system which typically harbingers war.  The last few times this cycle bottomed it was followed by a major military conflagration involving the major Western countries.  The most recent 24-year cycle bottomed in late 2014.  It will be interesting to see if any nations pursue this course of action in the years immediately ahead, especially in light of recent developments.  Of interest, the Dow Jones U.S. Defense Index (DJUSDN) suggests that perhaps preparations to that effect are in the making.

In answer to the question of whether the Fed has succeeded in destroying the long-term deflation cycle, the evidence points to the negative.  While there’s no denying the mitigating influence that six years of QE had on U.S. equities, the billions of dollars created by the Fed failed to produce any discernible inflation in the broad economy.  The fact that interest rates and commodity prices remain near historic lows illustrates this failure.

Essentially, there are two possible outcomes to the global economic slowdown: 1.) Either natural market forces will be allowed to run their course, or 2.) Governments will intervene with a vigorous monetary policy and/or military response.  The latter option is the most likely outcome based on history.  Although the central banks of China and Europe have already introduced stimulative monetary policies, these policies have so far failed at reversing the deflationary undercurrents still present in the global economy.  A much more aggressive stimulus effort will be required to achieve the effects desired by central bankers and bureaucrats.  It’s questionable whether they have the political will to do this, however.

By far the quickest route to reversing low commodity prices is the warfare route.  War lifts prices much faster than even the most aggressive QE could ever do.  As undesirable as it is, war unfortunately remains the most likely choice for governments desperate to boost their economies at any cost.

The short answer to the question, “Has deflation been defeated?” is “No,” at least not yet.  It will either be allowed to finish its course, which is a salutary and beneficial outcome for consumers.  Or it will be prematurely circumvented by policy makers, as it was in the U.S., to the detriment of the many and the benefit of the few.  History suggests the latter course will be the one most likely chosen.

Friday, November 6, 2015

Clif Droke in Trader's World Magazine

Traders World, the leading magazine on Gann, Elliott Wave and technical analysis, has published an article by yours truly on the topic of moving averages.  In it I explain the basics of some of my trading techniques involving harmonic moving averages based on Kress cycle time frames. Traders World issue #61 is now in circulation and you can view the article (on page 113) free by visiting the following link:

Wednesday, November 4, 2015

The bear indicator never lies

In the September 10 column entitled, “The bear makes a welcome return”, we discussed the return of the infamous bear image on the front cover of several news magazines and newspapers.  The most conspicuous example of the bear could be seen on the front cover of Businessweek magazine, shown below.

From a contrarian’s perspective, this was a most welcome return for it strongly suggested that the bottom would soon be in for the stock market after the August decline.  As I observed, “From a contrarian standpoint it doesn’t get any more emphatic than this.”  Since then the major indices have rallied off their lows with some even making token new highs (e.g. the NASDAQ 100).  I’ve never heard of a manifestation of the bear cover indicator failing to mark a decisive market bottom, and this time proved no exception.

Now that the Dow Industrials and the S&P 500 index have rallied back to the February-July resistance zones, should we expect a resumption of the selling pressure that plagued the market this summer?  Or should we rather expect a period of consolidation (i.e. backing and filling) and eventually a breakout to new highs?  As always, the answer to that question will be answered by the market itself but the current weight of evidence does provide us a meaningful clue as to the most likely outcome.

Before we look at the evidence, it’s worth making an observation about the previous sell-off.  What happened to the stock market over the three days between August 20-24 qualified as a classic selling panic, as opposed to a fundamentally-driven crash or credit episode.  This distinction is important, for if true it will make the difference between entering a bear market in 2016 and continuing with the bull market that began over six years ago. 

A market panic is catalyzed by an adverse and extreme reaction to a news event.  In the August sell-off it was the currency devaluation in China that panicked investors into selling.  One thing that history consistently has shown is that true selling panics are usually retraced in short order once the fear subsides, i.e. usually within a couple of months.  The less time it takes for the major indices to recover their losses, the less likely the selling was fundamentally driven.  Hence, a true selling panic isn’t typically the precursor of an imminent bear market.

It’s also worth noting that the market’s present internal condition is virtually in complete contrast to what it was earlier this summer heading into the August panic.  Prior to the summer swoon, the market’s extremely weak breadth could be seen on a daily basis for weeks on end.  From June onward the number of NYSE stocks making new 52-week lows each day was extremely elevated and showed that the market wasn’t internally healthy.  Moreover, this showed up in the NYSE internal momentum indicators (which are based on the new 52-week highs and lows).  Most of those indicators were in decline as I mentioned earlier this summer.

Since the August bottom, the situation has reversed.  The number of new 52-week lows has been drying up since September and have numbered less than 40 for most days since Oct. 5.  The NYSE internal momentum indicators are now mostly in a rising pattern as opposed to the declining pattern before the August crash.  Below is a chart showing the six major component of the Hi-Lo Momentum (HILMO) index.  Only the longer-term component (orange line) is still in decline; the others are either rising or bottoming, in the case of the dominant interim indicator (blue line at bottom). 

These indicators are very important because they show the stock market’s near-term path of least resistance.  There is at least one fly still in the ointment, namely the longer-term internal momentum indicator which is still declining, as already mentioned.  But all the other indicators – short-term and intermediate-term – are rising.  This implies that the bulls currently have the advantage and that the heavy internal selling pressure which characterized the stock market this spring and summer is not an issue right now.  This doesn’t preclude another (potentially sharp) pullback between now and year’s end, but the market’s main uptrend should remain intact.

Also worth mentioning is that the New Economy Index (NEI), our in-house measure of how strong or weak U.S. retail spending is, hit a new all-time high last Friday, Oct. 30.  Although business owners remain worried over growth prospects, mainly because of overseas woes, consumers don’t seem the least bit concerned.  They just keep spending as the NEI chart suggests (below).  What’s more, we’re about to enter the critical holiday season when retail sales typically hit their highest levels. 

After a major decline in the stock market it always pays to monitor the sectors and industry groups for signs of relative strength.  When, for example, the Dow Jones Industrial Average makes a series of lower lows during the final stage of a decline and certain individual stocks make higher lows, that’s a tip-off that informed buying is likely taking place.  When the market turns up again and these individual stocks continue leading the market, that confirms it.  At the bottom of the August panic, the industry groups which showed the greatest resilience to the decline were water, defense, and broadline retail stocks along with toy companies. 

Among Dow Jones industries currently showing exceptional relative strength are: Broadline Retailers (DJUSRB), Business Training and Employment (DJUSBE), Consumer Finance (DJUSSF), Defense (DJUSDN), Leisure Goods (DJUSLE), Restaurants and Bars (DJUSRU), Software (DJUSSW), Toys (DJUSTY), and Water (DJUSWU).  This group of industry leaders is very much in keeping with the bullish consumer spending patterns we’ve seen reflected in the New Economy Index lately.

There are, however, some industries that are conspicuous laggards which are close to their yearly lows.  If these industry groups don’t improve soon it could pose a problem at some point in 2016.  Not surprisingly, most of them are commodity and industry related and were heavily impacted by this year’s global economic slowdown.  They aren’t likely to a pose a problem for the balance of 2015, however, especially if they remain within their 2-month holding patterns.  They include: Aluminum (DJUSAL), Coal (DJUSCL), Healthcare Providers (DJUSHP), Mortgage Finance (DJUSMF), Pipelines (DJUSPL), Steel (DJUSST), Railroads (DJUSRR), and Recreational Products (DJUSRP).

If commodities can establish a bottom in the next couple of months, particularly crude oil, then the global economic woes of 2015 are far less likely to be of concern to the U.S. in 2016.  Moreover, if the stimulus measures of the ECB and China continue the global economic slide will likely be halted next year.