Flirting With Deflation

• October 4, 2002
• Mark Boucher

The corporate sector’s price deflator has
just dipped into deflation territory. The CPI is not yet in deflation territory
only because of non-business components (like Medicare, housing, and education
costs of consumers). Deflation is a recipe for disaster for economies built on a
fractional reserve banking system, because such economies rest on a foundation of
huge amounts of credit existing at every level of production and consumption. In
a deflation, real debt burdens rise over time and this process creates an
unstable negative-feedback loop of credit destruction that is extremely
difficult to break out of. 

The Great Depression is the last time the US
experienced a contraction in nominal debt from deflation. Japan is the only
modern economy in present times to experience somewhat similar
conditions. Federal reserve policy has little effect in a deflationary
environment, and fiscal policy generally, has only temporary effect.

The current
environment does show some elements common to periods of history where deflation
took hold. And there are many strongly deflationary trends that are likely to
continue to consistently produce deflationary pressure on the global economy.
Some of these major deflationary forces include: 

1. Japan’s economic
   policy

2. The
   emergence of China as a global economic power

3. High oil prices, and 

4. The popping
   of the US tech bubble

1. Japan’s economy is
   already mired in deflation, the result of poor policy response to its equity and
   property bubbles being popped, starting in 1989. Japan’s huge savings rates made
   it the major source of savings in the global economy. If some of this savings
   were to be released as spending, it would translate into a huge stimulus toward
   global demand. But the focus of Japanese policy over the last 12 years has
   instead been trying to prevent the popped bubble in stocks and property from
   collapsing the corporate structures that have built political influence. The
   result has been the unsustainable propping-up of unprofitable corporations and a
   consistently negative return on capital. 

   Liquidation, re-organization,
   bankruptcy, and sharply rising unemployment have been held back somewhat, but at
   the expense of corporate profit growth, economic growth, an artificially high
   yen, and price deflation that makes every round of government intervention less
   effective. Japan’s recent shocking announcement that the central bank will now
   directly purchase corporate assets may or may not be followed-through with — but
   if it is Japan will ultimately devalue its currency and thereby export its
   deflationary pressure to the world via competitive devaluation. A break in the
   yen below 80 basis nearby futures will be a sell signal in the yen and portend a
   sharp devaluation to come.

2. China’s emergence
   into the world economy is also a strongly deflationary influence. Since WWII,
   emerging countries have slowly made their way into the global trading arena many
   times. A modernizing economy striving to participate in global trade normally
   grows initially via exports and export-oriented trade. While these exports tend
   to displace industries they compete with, a gradual increase in the new country
   incomes and standard of living takes root, and leads the new country to soon
   import from the rest of the world as well. The initial emergence can create
   deflationary influence, but eventually it balances out and leads to new
   alignment of respective competitive advantages. 

   The problem, in
   China’s case, is that it is not a small country easily absorbed into the
   world economy. Instead, it is potentially the largest economy in the world and
   the process of creating widespread wage and standard of living increases
   therefore will take decades longer than any other country’s emergence to world
   trade. Currently, China has the potential to export at almost any price,
   especially for low-skilled labor-intensive goods. The depth and breadth of its
   economy is nearly unfathomable. 

   Parts of China are rapidly moving up the
   technology curve such that China is already in important exporter of consumer
   electronics, semiconductors, and very soon, autos. Chinese exporters will
   rapidly displace its competitors around the globe, and economies that do not
   quickly adapt to this huge change will dramatically weaken. Chinese nominal
   export growth is exploding at a 25%+ annual rate, while retail sales are booming
   at a significantly slower rate of around 10%, showing the huge gap that will
   exert deflationary pressure on the globe for many years to come. Because of this
   gap, and the WTO forcing of pressure on State-owned enterprises, China’s
   domestic economy is experiencing deflation. And severe price competition is
   being witnessed by every industry Chinese business goes after for export to.

3. Oil
   is one of the
   commodities that both Japan and China must import. In fact, the entire
   global economy is currently dependant on oil. The present high oil prices
   depress domestic demand and are, in effect, almost similar to monetary tightening. The momentum in global economic growth has turned down, co-existent
   with the runup in oil prices. Oil prices are not rising from demand pressure,
   but rather from the risk of war and supply-side cutoffs. This factor is a wild
   card. If there is a quickly resolved war in the Middle East that does not
   destroy major portions of world oil supplies, oil prices could easily dip down
   again quickly following the conflict. However, the potential exists for major
   dislocations in global energy supplies which could render a death-blow to the
   forces trying to stave off all-out deflation if Saddam enacts revenge on Middle
   East oil supplies of countries aiding the US with chemical, biological, or
   even nuclear weapons.

4. The popping of the
   US tech bubble is another major source of global deflationary
   pressure. The US authorities, however, attacked this bubble much differently than they
   did during the depression or than Japan has done. US. authorities did not stop
   the economy from adjusting via collapsing stock prices, collapsing profit
   growth, and plummeting capital spending. The result is that the adjustment is
   showing evidence that it is nearly over. US Nasdaq stocks have fallen by an
   amount similar to previous bubbles this century. Capital spending has started to
   base out. And the profit outlook is starting to stabilize. 

   The Fed immediately
   slashed short-term rates and kept money growth strong throughout the adjustment
   process, a key and major difference with every other response to deflationary
   pressure in any other example where deflation was able to take hold of an
   economy for a prolonged period. Slashing interest rates at a record pace allowed
   housing and consumption trends to remain strong and exhibited a counter-balance
   for the rest of the world to deflationary pressure via the US’s massive trade
   deficit. Thus, if the Fed can
   keep consumer confidence and housing up, and push the economy into a sustained
   growth phase, it is unlikely that deflation will overrun the domestic economy.

The world economy is
therefore on a tightrope, balancing act currently between the forces of deflation
and reflation. The Fed has announced that it believes it has stimulated enough
to lead the economy toward an eventual sustainable growth path. However, the
global bond and equity markets are disagreeing with the Fed. And so are two Fed
bank governors, in a rare dissent. It appears that the markets may need to
reach a riot point — a degree of sharp movement down in stocks and up in bonds
enough to force the global central bankers to act to prevent a panic
and all-out deflationary collapse. If such a riot forces the hand of the Fed
and other global central bankers, a key question will be if they can act boldly
and quickly enough to stop it.

So, the two likely
prime keys to the global economic and market outlook are central bank policy
stimulus timing combined with the markets’ reaction to them, and swings in the
price of oil. A sharp change in the oil supply available could force crude
prices substantially higher and issue a devastating blow to an already fragile
global economy, thereby crushing global equity markets.

The central bank
faces a tightrope walk in its battle with deflation, while the administration
and UN face a tightrope walk in their war against Iraq and Saddam’s ability to
disrupt oil output massively if he uses his weapons of mass destruction on oil
supplies. While the odds still favor that reflation and a quickly resolved war
will develop, neither outcome can be anticipated with strong reliability, in our
opinion. And that means the markets are currently explosive in either
direction, and vulnerable to shocks in either direction, without it being
reliably clear which direction will develop. High risk, and high uncertainty, in
other words. 

Realize also that at least half of the above deflation forces are
not likely to quickly go away. That means even if the war is quickly resolved
and the Fed does or has loosened enough to allow growth to resume, we are likely
to see an ongoing period of mini-bull and mini-bear markets off of any bottom,
similar to what we witnessed from the mid 1960’s through 1982 as the deflation-reflation
battle rages on.

Continue to watch
for clues that reflation is working on the US market over the intermediate-term,
like another breadth thrust such as a 9:1 up/down volume day, the 5-day moving
average of advancing volume to be 77% or more of total volume, an 11-day A/D
ratio of 1.9 or more, or a 10-day A/D ratio of 2 or more. Such evidence of
breadth is unlikely without a major positive catalyst, like a Fed rate cut or a
successful war operation. But realize that even if the Fed begins to win the
war on deflation here, until the wild card in Iraq is clear, any such evidence
of victory could be short-circuited.

We still will be
watching for a possible low between late summer and early winter in the market,
followed by a better rally than we’ve seen since March 2000 — a “B” wave rally
for Elliotticians. However, unless breadth becomes very impressive in the
current minor rally, we suspect that a new downwave in stocks and further
economic crisis will be needed to kick global central bankers into the concerted
action that is likely needed to help fuel such a rally. And so, absent new war
news, a retest or another decline to new lows, possibly in climactic fashion,
may have to occur before a meaningful rally can develop. Whether these new lows
occur off of another short-term rally to or slightly above the August highs or
not, remains to be seen.

Bond prices are not
yet reacting enough to confirm a decent rally in stocks, and global bonds remain
at levels that are discounting further economic weakness. Remember that in a
deflationary environment bonds will need to DECLINE
to fuel a rally in stocks, as both are simply reacting to changes in economic
growth perceptions. Corporate yield spreads are still levels that are
discounting a near depression (in fact yield spreads are so high now and value
so prevalent in corporate bonds that should a recovery develop these may make a
better holding than stocks, as they did from 1991 to 1995). In addition, Asian
markets and economies are now showing signs of weakening. Oil prices, rising in
response to war risks are acting as a drag on Asian, and global
economies. Commodity prices show a mixed picture, but are also not inconsistent
with further economic retrenchment. Grains, softs, and oils are indeed fueling
higher overall commodity prices, but each of these moves is in response to
supply shortages, not increased demand fueled by stronger economic growth.

Therefore we
continue to suggest investors wait and watch for more indications of better
breadth on a large number of fronts. Most importantly, wait for a much larger
number of new highs on our lists and breakouts of valid 4+ week consolidations
in stocks that at least almost meet our criteria, before thinking of allocating
aggressively to this market.

Until we get substantially better evidence of a
potential rally, our strategy remains ultra defensive, but continues to slug out
small gains.
Since March 2000 the world index is down over 45%, the S&P
over 48%, the IBD mutual fund index is down over 62%, and the Nasdaq has crashed
over 76%. Meanwhile since March 2000 the long/short strategy we summarize and
follow-up each week in this column has made more than 38% on a worst drawdown of
under 6%. While this
performance is certainly underperforming our long-term growth rate, and it is
hardly thrilling to have been so heavily in cash since March of 2000, we have
managed to eke out gains with very low risk in a very dangerous market
environment where nine out of 10 traders have been big losers. We will hope and
watch for a better environment, but wait patiently until it arrives before
risking significant capital.

Our
official model portfolio overall allocation remains
EXTREMELY DEFENSIVE. We’re now 92% in T-bills awaiting new opportunities.
Our model portfolio followed up weekly in this column
was up 41% in 1999, up 82% in 2000 and up 16.5% in 2001 — all on a worst
drawdown of around 12%. We’re now
up around 7.05% for the year 2002. Let’s wait for a bit better
environment before positioning heavily.

Top RS/EPS New Highs never mustered up
one single solid week of consistent +20 or higher readings since the 7/24
lows. Readings this week were slightly improved but still pathetic at 2, 10, 7,
17, and 11, accompanied by just 5 breakouts and no close calls.

Bottom RS/EPS New Lows managed another strong week consistently above 20
consistently this week, with readings of 186, 72, 148, 76, and 44, accompanied
by 25 break breakdowns of 4+ week consolidations, and a few close calls. It will
be significant to see if a further rally in stocks can bring new low numbers
below 20 again.

For those not
familiar with our long/short strategies, we suggest you review my

10-week trading course on TradingMarkets.com, as well as in my book

The Hedge Fund Edge, course “The Science of Trading,” and

new video seminar most of all, where I discuss many new techniques.
Basically, we have rigorous criteria for potential long stocks that we call
“up-fuel,” as well as rigorous criteria for potential short stocks that we call
“down-fuel.” Each day we review the list of new highs on our “Top RS and EPS New
High List” published on TradingMarkets.com for breakouts of four-week or longer
flags, or of valid cup-and-handles of more than four weeks. Buy trades are taken
only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts
are similarly taken only in stocks meeting our down-fuel criteria that have
valid breakdowns of four-plus-week flags or cup and handles on the downside. In
the U.S. market, continue to only buy or short stocks in leading or lagging
industries according to our group and sub-group new high and low lists. We
continue to buy new signals and sell short new short signals until our portfolio
is 100% long and 100% short (less aggressive investors stop at 50% long and 50%
short). In early March of 2000, we took half-profits on nearly all positions and
lightened up considerably as a sea change in the new-economy/old-economy theme
appeared to be upon us. We’ve been effectively defensive ever since.

Upside breakouts
meeting up-fuel criteria (and still open positions) so far this year are:
NONE. Continue to watch our NH list and buy flags
or cup-and-handle breakouts in NH’s meeting our up-fuel criteria — but be sure
to only add names that are in leading groups, and now only add two trades per
week once again until the market environment improves.

On the short side
this year, we’ve had breakdowns from flags (one can use a down cup-and-handle
here as well) in stocks meeting our down-fuel criteria (and still open
positions) in Celera Genomics [CRA|CRA] @9.09 (7.55) w/ 8.5 ops; and we exited shorts in
Bowater
(
BOW |
Quote |
Chart |
News |
PowerRating)
via instructions from last week. Continue to watch our NL list daily and to
short any stock meeting our down-fuel criteria (see

10-week trading course) breaking down
out of a downward flag or down cup-and-handle that is in a leading group to the
downside but only add up to two in any week (and only in the weakest groups)
until we get better breadth numbers on the downside and better leadership.

Patience is one of
the most difficult and frustrating lessons a trader must learn to be
successful. These markets are an extreme test of it. But with so much global
political uncertainty and the markets on a high-wire act between deflation and
reflation, the outlook is not reliable and uncertainty is high. Particularly
when breadth numbers are not tilting their hat strongly in any direction,
investors need to maintain high amounts of cash and wait for real low-risk,
high-reward opportunities before risking precious capital. Watch the breadth
and leadership numbers the market gives off first and primarily, and everything
else secondarily. We will continue to try and navigate these treacherous
markets aiming for decent gains with relatively low-risk and safety. Please
stay tuned, now more than ever and emphasize the importance of patience.