More thoughts on inflation and deflation

We discussed the inflation/deflation debate most recently in the 18th November Weekly Update, at which time we made the following two points:

1. The money supply can only be expanded via new borrowing/lending, so irrespective of what the Fed does it is likely that the US will eventually experience deflation. There is, however, no evidence that deflation will be a genuine threat over the coming 12 months.

2. It is senseless to try to predict when a bubble - in this case the great US credit bubble - is going to end. By their very nature bubbles always continue for much longer than a rational observer would ever expect, so it makes more sense to wait for the signs of failure to appear before writing-off a bubble. Provided you are paying attention and don't get sucked into the bubble there is little danger that you will be too late to recognise these signs of failure. This is because a lot of time always passes between the bursting of a bubble and the realisation of this fact by the majority of market participants. Witness the US stock market. The stock market bubble was justified in the collective mind of the majority by false beliefs that a) the US had entered an era of extraordinarily-high productivity growth, b) inflation had been eliminated as a serious threat, and c) the US Federal Reserve would always do the 'right' thing. It has now been two-and-one-half years since the bubble burst and these beliefs are still widely held.

We'll now take another look at the first of the above points. Via its regular Open Market Operations the Fed adjusts bank reserves in order to keep the Fed Funds Rate near the target rate. For example, the current Fed Funds Rate target is 1.25%. If the actual Fed Funds Rate (the rate at which banks borrow overnight money from each other) moved up, to say 1.35%, then the Fed would add enough reserves to the banking system to bring the actual rate down to the target rate. However, if banks decide to reduce the amount of money they lend, or if the banks' customers decide to increase their savings rather than increase their levels of indebtedness, an increase in bank reserves will not result in an increase in the total supply of money. In such a case the Fed would be powerless to inflate provided it stuck to its routine Open Market Operations.

The Fed does, however, have powers in addition to its abilities to alter short-term interest rates and bank reserves. For example, the Fed could start buying private real estate with newly-created Federal Reserve notes. In this way it could, if it chose to do so, inject a huge amount of currency into the economy, thus devaluing all the existing currency. The idea that it would act in this way, that is, step outside its normal operating procedures and begin directly injecting currency into the economy, seems farfetched. After all, the Fed's goal is not to inflate, it is to inflate without the effects of inflation becoming obvious to those who adhere to the absurd belief that inflation is an increase in the CPI. In other words, to inflate without the inflation becoming evident to the majority. Directly injecting a large amount of currency into the economy would, however, make the inflation obvious to all and destroy the illusion that a dollar is something of real value. It is extremely difficult to rebuild confidence in the ability of a currency to maintain its purchasing power once that confidence has been shattered. As such, when it came down to a choice between experiencing genuine deflation or destroying the value of the US Dollar, we thought the Fed would opt for deflation. But, following comments by both Fed Chairman Alan Greenspan and Fed Governor Ben Bernanke over the past 2 weeks we no longer have any reason to think that this is, in fact, the case.

In a recent speech Governor Bernanke made some interesting comments with regard to deflation (which he wrongly defines as a fall in the general price level). For one thing, he said that the structural stability and resilience of the US economy would act as a protective shield against deflation. He then went on to point out that even if the 'deflation monster' did rear its ugly head the Fed certainly had the power to reduce the value of the Dollar to such an extent that prices would have to move higher.

We found it amusing that he referred to structural stability as a guard against deflation because if the US economy really were structurally stable then deflation wouldn't be something the Fed would have to fear. Deflation is only ever something to be feared when the viability of the financial system is reliant on an on-going increase in the total amount of debt, that is, in a structurally unstable economy. Furthermore, falling prices (Bernanke's definition of deflation) are a natural result of higher productivity. Therefore, in a healthy economy with sound money there will be extended periods when the general price level will fall. In the current situation, though, it appears that an increase in the purchasing power of the currency (falling prices for goods and services) is something to be feared. So, if US businesses become more productive and this improvement in productivity causes prices to fall, the Fed will try to offset this fall by depreciating the US$. 

We found it interesting, to say the least, that Bernanke spoke candidly about the ability of the US Government, via the Fed, to "produce as many U.S. dollars as it wishes at essentially no cost." According to Governor Bernanke, "by increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services." This is true - if the Fed tried hard enough to reduce the purchasing power of the US$ it would definitely be successful. The thing is, the basis of US economic strength over the past 7 years has been the ability to inflate the money supply whilst maintaining the purchasing power of the US$ relative to those things that 'count' as far the popular price indices are concerned.
 
At this time last year our view was that the probability of the US experiencing genuine deflation over the coming 12 months was so close to zero as to not be worth considering. The 'deflationists' were, at the time, strident in their calls for an imminent deflation, but here we are with another year of inflation under our belts. Looking ahead at the coming 12 months we still see almost zero chance of deflation. And, the apparent willingness of the Fed to go down the 'printing press' route rather than let the US experience deflation probably means that we can expect several more years of inflation before deflation finally becomes a legitimate threat. It certainly seems as though inflation will have to be perceived as a life-threatening problem for the US financial system before deflation will be permitted to occur.

The US Stock Market

1932-1934

Below is a chart showing the Dow Industrials Index (in blue) and the Advance-Decline Line (in black) during 1932-1934. The stock market's major bottom occurred in July of 1932 (point D on the chart), so the chart shows the final 6 months of the 1929-1932 bear market and the ensuing rally.

Referring to the above chart, the stock market reached a short-term bottom at the start of 1932 then rallied for a couple of weeks (to point A). It then dropped to a slightly higher low (point B) before rallying to a higher high (point C). You can just imagine that by the time the market reached point C there would have been a lot of hope that a new bull market had begun. After all, the market had just completed what must have appeared, at the time, to be a successful re-test of the low, and had then rallied to a higher high. However, with the benefit of hindsight we know that point C on this chart was one of the worst times in history to buy stocks because the Dow dropped by more than 50% over the following 4 months.

After bottoming in July of 1932 the Dow surged by around 100% (to point E on the chart) in the space of only 2 months. It then spent 6 months grinding lower and by February of 1933 (point F) had given back about 75% of the initial rally. Also, the advance-decline line was lower in February of 1933 than it was at the major bottom in July of 1932. So, anyone who was lucky enough to have gone from 0% invested to 100% invested in the stock market on the exact day of the major bottom in July of 1932 would barely have been breaking even 8 months later. 

We are reviewing the above chart of 1932-1934 for two reasons. First, to show that rallies during a major bear market can be deceptive and can end with little warning (as per the rally during the first two months of 1932). Second, to show that the best time to make a large commitment to stocks might not be right at the long-term bottom. In the 1932 situation anyone who tried to 'buy the bottom', but who was a few weeks early, would have captured a large decline, while the bottom-fishers who were a few weeks late to the party would have bought near the peak of the initial surge. The best time to buy during the early-1930s would actually have been about 8 months after the major bottom when sentiment would probably have been even more bearish than it was at the bottom (especially considering that the banking crisis reached its peak in early-1933).

Over the past few years the NASDAQ100 Index has followed a similar path to the Dow of 1929-1932. We could now be close to the equivalent of point C on the above chart, but even in the extremely unlikely case that the early-October low was THE bottom (the equivalent of point D) there will probably be a much better entry point for longer-term investors over the coming 12 months. In other words, there is no reason why any investor should consider buying into the current speculative mini-mania.

Current Market Situation

From the latest Weekly Update: "Over the past few weeks we've included 2 trading positions in QQQ put options in the Stock Selections List. We will probably add to this bearish position in the future, but before we do so we will need to see either a) greater evidence of universal belief in this rally, or b) evidence that the rally has failed." At this stage there are no signs of either a) or b).

The sentiment picture has shown a marked improvement over the past week. For example, since the close of trading on Tuesday 19th November the NASDAQ100 Index has gained about 10%, but the NASDAQ100 Volatility Index (VXN) is higher now than it was then. This suggests that fear has increased as the market has moved higher, a bullish development. Also, put/call ratios have remained elevated during the days when the market has rallied (even during Wednesday's pre-holiday ramp the CBOE equity put/call ratio was above 0.5 and the QQQ put/call ratio was above 1).

Furthermore, market 'internals' have recently taken a turn for the better. For example, in terms of the changes in the major stock indices Wednesday's rally was almost the same size as Tuesday's decline, but over this 2-day period during which the indices made very little progress the number of advancing stocks was much higher than the number of declining stocks.

The improvements in market sentiment and market internals over the past week mean that the rally is probably going to continue for much longer than we had previously thought. The most constructive thing that could happen over the next 2-3 weeks, as far as prolonging the overall rally is concerned, is for the market to pullback while sentiment becomes very fearful. If this happens we would most likely take the opportunity to exit our current put-option positions with the aim of re-entering some time in January following another up-move.

If the market does pullback over the next 2-3 weeks there are two main things we will be watching to determine whether this is just a correction within a continuing short-term uptrend or the start of another major decline. One is the ability, or otherwise, of the NASDAQ Composite Index to hold above 1420. The other is the performance of the Cisco stock price.

Below is a chart of CSCO covering the past 15 months. Note that after CSCO broke above its 200-day moving average in November of 2001 it held above this moving average during all pullbacks until it (and the overall market) was ready to resume its bear trend in February 2002. After the Feb-02 break below the 200-DMA every subsequent rally failed at, or below, this moving average until November of 2002. Therefore, any normal pullback in the market over the next few weeks should result in CSCO holding at, or above, its 200-DMA. Conversely, if CSCO closes below its 200-DMA we will have a sign that the bear trend has resumed.

By the way, the greater fear that has recently become evident in some measures of sentiment might be associated with the threat of terrorism. If there is going to be another dramatic terrorist attack against the US then the coming 4 weeks are a likely time for such an attack to happen because this is the period during which it would do the most amount of damage, both psychologically and economically. Terrorists always want to do the most amount of damage and therefore probably have the desire to perpetrate, over the next few weeks, something that a rational person would think of as senseless destruction, although they might not have the capability. In any case, a heightened awareness of the risk of attack might be behind the less-than-exuberant response by market participants to the recent bullish price action.

Gold and the Dollar

Current Market Situation

Below is a daily chart of the December Swiss Franc. The SF broke above its medium-term downtrend towards the end of October, rallied during the early part of November, and has since fallen to near its previous downtrend-line. At this stage the recent decline appears to be a normal breakout pullback, but if this is the case the SF must reverse higher from near its current level. Last-ditch support for the short-term bullish case is 0.66 - if the December SF trades below 0.66 then the SF chart will take on the appearance of a 'double top'.

Below is a chart showing the gold price in euros. The euro gold price has trended higher over the past 3 years in a well-defined channel. It recently moved to near the bottom of this 3-year channel and turned higher.

In a gold bull market the gold price trends higher in terms of all currencies, not just the US$. As such, if we are in a gold bull market then the gold price in euros should continue to remain above the bottom of the channel shown in the above chart, regardless of how strong the euro gets relative to the US$. To put this another way, a decisive break below the bottom of the channel shown on this chart would be a substantial blow to the bullish case for gold.

Below are charts of the Amex Gold BUGS Index (HUI), Newmont Mining (NEM) and Harmony Gold Mining (HGMCY). On 27th November Harmony began trading on the NYSE under the symbol HMY, but at this stage the stockcharts.com web site hasn't been updated to reflect the new symbol and the chart shown below therefore doesn't show Wednesday's trading. HMY closed at $12.47 on Wednesday, slightly below its uptrend-line.

The HUI has continued to hold above the bottom of its triangular consolidation pattern, but both NEM and HMY broke-out to the downside on Wednesday. At this stage we are assuming that the marginal breaks below support by NEM and HMY are 'head fakes' rather than trend reversals. We are making this assumption because most of the major gold stocks rebounded late in the trading day. However, we are clearly now 'on the edge' and any significant weakness in gold stocks over the next few trading days will tip the balance firmly in favour of the bears.

With the major gold stocks and the gold stock indices so close to important support, now is a good time to be doing some buying. This is not because the risk is low, but because the close proximity to support allows risk to be well managed using sell stops. At the same time, the potential rewards are great if support does hold. For example, a reasonable approach would be to buy HMY at around Wednesday's closing price of $12.47 and set a sell-stop at $11.95. If the stop is hit then the loss on the trade will be about 4%, but if support holds then the percentage gains will probably be substantial.

We bought some gold stocks in the Australian market today and plan to do some buying in the US market on Friday. We will, however, quickly exit these positions, as well as the trading positions purchased near the lows in mid-October, if support is breached. As mentioned in the latest Weekly Update, we will send out an e-mail alert if this happens. 

Bonds

Bonds have done nothing over the first 3 days of this week to negate the 'crash setup' that we've discussed over the past 2 weeks. The critical level for the December bond futures contract is 107 (the October low). A drop to 107 by the end of this week would set the market up for a crash during the first half of next week.

Update on Stock Selections

For the first time in what feels like an eternity, LightPath Technologies (LPTH) has begun to show signs of life. LPTH broke out to the upside on heavy volume on Wednesday. 

The stock prices of LPTH's customers - companies such as Lucent - have surged over the past few weeks. If business really is going to improve for companies such as Lucent and Nortel (as the recent stock market action seems to suggest), then the companies such as LPTH that are further down the food chain will also benefit. We are certainly skeptical that any improvement in business conditions is going to occur next year. However, if the current stock market rally can extend into January, as now seems likely, then the LPTH stock price could go for a run (especially following the completion of any tax-related selling in December).

Lihir Gold in Australia (ASX: LHG) is not one of our current selections, but we think it is a reasonable speculation at around today's closing price of A$1.11 with a sell-stop set at $1.05. 

Chart Sources

Charts used in today's commentary were taken from the following web sites:

http://stockcharts.com/index.html
http://www.decisionpoint.com/
http://www.futuresource.com/