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The "Great Deleveraging"

One of the strangest ideas to take root over the past few years is that the US economy is immersed in a "great deleveraging", where deleveraging refers to a reduction in the amount of debt. This is a strange idea because not only has there not been a 'great' deleveraging, on an economy-wide basis there has been no deleveraging whatsoever. In fact, the US economy is more leveraged today than it was at the beginning of the 2007-2008 global financial crisis.

The "great deleveraging" myth has undoubtedly been spawned by the modestly successful efforts of the US Household Sector to reduce its indebtedness. These efforts led to the roughly $1T (7%) decline since 2007 in the total debt owed by this sector of the economy. Refer to the following chart for details. It could be argued that a 7% decline in outstanding debt doesn't constitute a 'great' deleveraging, but it could also be argued that the 'great' label applies since we are dealing with the first household deleveraging in generations and a major trend change.



What cannot be argued, at least not with a straight face, is that there has been an economy-wide deleveraging (great or otherwise). The following chart shows that the total debt owed by US non-financial sectors has risen from around $32T to around $39T (a roughly 22% increase) since the beginning of the 2007-2008 crisis. Not only hasn't there been a trend change, there hasn't even been a meaningful slowing in the rate of ascent.



An implication is that a great economy-wide deleveraging still lies ahead and will possibly be ushered-in by the next financial crisis.

Every new financial crisis turns out to be very different from the most recent preceding crisis. One reason is that a crisis necessarily involves the vast majority of people being taken by surprise, but for many years after a crisis the average financial-market participant will be on guard against a recurrence. Another reason is that central planners invariably address the superficial characteristics of the most recent crisis while ignoring its root cause, thus ensuring that the next crisis will have different characteristics while doing nothing to make the financial system more robust. Therefore, something that we can be fairly certain of is that the next financial crisis will look very different from the 2007-2008 episode.

The focal point of the 2007-2008 crisis was private mortgage debt. When the markets for mortgage debt and all the associated derivatives began to crumble, there was a mad scramble for cash. For several months this created the impression that deflation was happening, because even though the supply of money was growing the demand for money within the private sector was growing much faster. It's an open question as to what will be the focal point of the next crisis, but one of the most likely candidates is government debt. If the focal point does turn out to be government debt then the safest place to be during the last crisis will be the most dangerous place to be during the next crisis.

This leads us to our final point, which is that when a private debt market implodes the participants in the market have no choice other than to retrench. Their desperate need for more cash requires them to sell whatever they can, which causes prices to fall. However, when a government debt market implodes the government in question has a choice. The choice occurs because modern governments, via their central banks, have unlimited access to money. To put it another way, a government that has its own central bank can only ever run short of money by choice. When placed in a desperate situation it could opt to make a drastic retrenchment and set in motion a truly great deleveraging, or it could opt to run the virtual printing presses even faster. The former leads to deflation, the latter leads to hyperinflation.

The Stock Market

The following chart shows the TSI Index of Bullish Sentiment (TIBS). We calculate TIBS at the end of every week based on the results of four stock market sentiment surveys, the 5-day moving average of the equity put/call ratio and the 5-day moving average of the VIX.

TIBS is presently at an 18-month high, but note that it was slightly higher in early 2011. The early-2011 sentiment extreme turned out to be very important, in that it occurred just prior to a peak in the Dow Jones World Stock Index (DJW) that is yet to be decisively breached. The 2011 sentiment extreme also occurred just prior to the start of a 20% downward correction in the US stock market.

The point is that while sentiment could become a little more extended into optimistic territory, there doesn't appear to be much additional scope for the conversion of equity bears to equity bulls.



We continue to fixate on the NASDAQ100 Index (NDX) due to its divergence from the other senior US stock indices and its unusually narrow short-term trading range. The narrow range dates back to the second trading day of this year. On the first trading day of the year (2nd January) the NDX was sharply higher in reaction to the "fiscal cliff" news. It closed that day at 2746, which is exactly where it closed on Wednesday 6th February.

A daily close below 2700 would be evidence that a short-term top was in place and that a significant decline had begun.



Gold and the Dollar

Gold and Silver

On each of the past six trading days, the US$ gold price rose to its 50-day moving average (the blue line on the following daily chart) and then pulled back. The top of gold's short-term price channel lies just above the 50-day MA.



The most important nearby support is in the low-$1630s, but there is also significant short-term support at around $1650. A daily close below $1650 would suggest that gold was on the way down to its channel bottom at around $1600. That's one possible outcome over the next couple of weeks.

A more likely outcome is that gold breaks out to the upside from its short-term channel and begins to make its way to major resistance at $1800.

The daily silver chart displayed below looks similar to the daily gold chart displayed above, except that silver's price swings have been larger. If gold breaks upward from its short-term channel then silver will do the same, but silver's short-term upside potential appears to be greater than gold's.

Silver has been stronger than gold over the past 6 months and this relative strength is likely to persist until after it becomes clear that the broad stock market has commenced an intermediate-term decline (silver usually outperforms gold when the broad stock market is in a rising trend). Note that major stock market peaks are usually tested, so even if the senior stock indices are now very close to major peaks they are probably still a few months away from commencing downward trends. The price action between the ultimate peak and the start of a downward trend would likely involve a 5%-10% decline followed by a rebound to test the peak.



Gold Stocks

Recent price action has been tedious, but the tedium should soon end. It's likely that the gold sector will soon commence a strong multi-week rally, although there remains a possibility that the HUI will spike down to intermediate-term support at 375-385 (the shaded area on the following daily chart) before a tradable rally gets underway.



Currency Market Update

Over the past month we've devoted an unusual amount of commentary space to the Yen. We are now going to devote some more. After all, it isn't every day that a major currency reaches its most 'oversold' extreme in decades. When something like this happens it is appropriate to fully consider the implications, especially when there isn't much else happening.

As well as being significant in its own right, it is becoming increasingly apparent that the recent relentless decline in the Yen is linked to the recent relentless advance in equities. This could be the result of the infamous Yen carry trade (in this case, borrowing Yen to finance long positions in equities) making a big comeback, or it could be due to 'black box' traders buying equity index futures whenever the Yen declines and selling equity index futures whenever the Yen rallies. Either way, there's a good chance that important reversals in the Yen and the stock market (up for the Yen, down for the stock market) will roughly coincide with each other.

Having begun this week at what was by some measures its most 'oversold' extreme in more than two decades, the Yen bounced a little on Monday (as the stock market pulled back), made another new low for the move on Tuesday (as the stock market rallied), and then essentially went nowhere on Wednesday (as the stock market moved sideways). Tuesday's price action had the effect of pushing Market Vane's Yen bullish percentage to 14 (meaning: only 14% of traders surveyed by Market Vane were bullish on the Yen following the price action of Tuesday 5th February). This is not only the lowest Yen bullish percentage recorded by Market Vane in at least a decade, it is also close to the lowest bullish percentage recorded by Market Vane for any major currency in at least a decade (our Market Vane data doesn't go back any further than that).

We could only find two other examples over the past 10 years of a major currency achieving such a low level of bullish sentiment. We are referring to the 13% bullish percentage achieved by the Dollar Index in November of 2007 and the 15% bullish percentage achieved by the British Pound in November of 2008. It is worth reviewing what happened in each of these cases.

The sentiment extremes mentioned above are indicated with green arrows on the following charts of the Dollar Index and the British Pound. Notice that in both cases there was a quick rebound up to or above the 50-day moving average (the blue line on the chart) and then a decline to a new low, with the ultimate bottom being put in place 4-5 months after the sentiment extreme. Also notice that in both cases the price was much higher 12 months after the unusually depressed sentiment was recorded.

Here is a similar chart of the Yen.



Based on the Yen's history and the performances of other major currencies following extremely low levels of bullish sentiment, we arrive at the following conclusions:

1) The Yen probably hasn't reached its ultimate bear-market bottom.

2) A rebound in Yen futures to at least as high as the 50-day moving average (presently at 115, but in a steep decline) and possibly as high as the 70-week moving average (presently in the low-120s) will probably soon begin.

3) The Yen will probably trade at least 10% above its current level during the second half of this year.

A few weeks ago we shifted about 10% of our cash reserve into Yen. Given that Yen futures have since plunged from 116 to 106, our timing was bad. However, the position is relatively small and totally non-levered (just a change in the currency in which part of our cash reserve is denominated). With the Yen's long-term fundamentals remaining more bullish than those of its main fiat currency competitors (the US$ and the euro), we are prepared to be patient and wait-out a recovery. We might even double the position a few months from now if the Yen appears to be following the bottoming patterns of the Dollar Index during 2007-2008 and the Pound during 2008-2009.

Update on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://stlouisfed.org