Fed Confirms It: Deflation Less Of A Threat Than Inflation Now
We have been discussing the
massive reflation globally and that the world is in transition from reflation to
inflation for some time. The increase in employment was critical in shifting
investor sentiment toward realizing that growth may decelerate some, but is
becoming sustainable. Further increases in employment will solidify this
attitude. This past week Alan Greenspan confirmed that deflation is less of a
threat and that rates will have to rise down the road if the global recovery
continues. Bond futures plummeted and stocks have gyrated in response.
Investors should realize how
sensitive markets are to even the threat of higher interest rates in the US.
Bond markets typically decline about 40% of their full bear market BEFORE the
central bank begins to raise rates. We expect bonds to hit support near last
year’s lows and trade range for some time. But the trend is down. And the
markets are volatile and risky, as we have been repeating.
The US and China, as well as
Japan and the rest of Asia have been the most forceful reflationists in terms of
monetary and fiscal policy stimulus globally. For this reason inflation is more
developed in these regions than anywhere else on the globe.
A critical question for
investors to answer and strive to understand is HOW FAST inflation will rise.
Because of the nature of the global environment and the makeup of inflationary
pressures, our best guess remains that it will take years for the inflation
process to become fully developed and that inflation will SLOWLY develop and the
magnitude will be MILD INITIALLY.
The world still is biased
toward disinflation and selected deflation mostly as a result of the swift
industrialization of many key developing economies such as China and India. And monetary and fiscal
reflation have not overwhelmed the over supply of goods and excess global
capacity created in the bubble years, meaning that despite massive stimulus
there remains no evidence of excessive growth in aggregate demand leading to
inflationary pressures. Indeed the current inflationary uptick seems to reflect
a spike on raw commodity prices in a fairly isolated way. When a price spike in
one key area is accompanied by massive liquidity injection, general prices rise
eventually. Yet this is not the broad-based total over demand that fuels rapid
and strong across the board inflation upticks. And the global recovery forces
are still uneven. Japan is barely out of the woods in terms of deflation, and
Europe is still lagging.
The S&P has so far mirrored
nearly perfectly the average performance of the typical post bear market rally
since WWII. This average profile shows only about another 10% gain likely in
2004 and 2005. The risk/reward profile is therefore much less advantageous this
year than it was in 2003. Emerging markets still offer better growth prospects
and have better valuation than developed markets, so their relative performance
should continue to do well during the duration of the recovery.
Commodity prices have peaked,
at least in the intermediate term. Global growth rates have peaked too, with
economies decelerating in China and the US. This likely means outperformance by
Asia over Latin America re-emerging as well.
The dollar is rallying into our
target zone, and investors should continue to watch for Asian currencies to lead
any new leg against the dollar, and for Euro support in the 1.14-1.19 level and
gold support in the 375-390 level.
Top global themes include
small cap Japan, Korea, Taiwan, lagging resource stocks like papers, coals and
chemicals, E&P energy stocks, Eastern Europe, and EM’s/Developed, Eastern
Europe over Europe, global small cap value, Energy/tech, health care/consumer
discretionary, interest rate spreads, and short JGB’s. Investors need to be
very flexible and nimble to make good profits this year.
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Instability in Iraq and in the
global terrorist war continues to provide a wild card that makes risks and
uncertainty even higher that would normally be the case.
So far our US long/short model has been relatively inactive during 2004 (only
one official long and one official short), and we continue to suggest investors
use some caution until stocks meeting our criteria expand in breakout breadth.
Investors should continue to cautiously add stock exposure as trade signals are
generated that meet our strict criteria, as well as allocate to our favorite
segments on breakouts and signals as advised above. Our model portfolio
followed in TradingMarkets.com with specific entry/exit/ops levels from 1999
through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in 2001, 7.58% in
2002, and we stopped specific recommendations up around 5% in May 2003 (strict
following of our US only methodologies should have had portfolios up 17% for the
year 2003) — all on worst drawdown of under 7%. This did not include our
foreign stock recommendations that had spectacular performance in 2003.
This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 18, 24, 49, 40, and 19 with 9 breakouts of 4+ week ranges, no
valid trades and no close calls. Upside breadth remains neutral with a positive
bias. Position in valid 4+ week trading range breakouts on stocks meeting our
criteria or in close calls that are in clearly leading industries, in a
diversified fashion. This week, our bottom RS/EPS New Lows rose from the
depths, registering readings of 21, 8, 1, 6, and 14 — not yet at levels
consistent with good shorting opportunities, but improving.
For those not familiar with our long/short strategies, we suggest you review my
book
The Hedge Fund Edge, my course “The
Science of Trading,”
my video seminar, where I discuss many
new techniques, and my latest educational product, the
interactive training module. 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 long 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 of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.
We continue to advise keeping allocations low until the trend is more certain
and emphasize global leaders noted above until more trade signals are generated
and the trend is more certain. On the short side, we exited TRMS and await new
opportunities.
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