We have been warning our viewers since 1999 about the word
“deflation”, and the negative stock market action when the deflation occurs. In fact, we authored the chart, “Cycle of
Deflation” (first attachment) which shows the flow of the typical
deflation. The deflation starts with excess
debt and over-investment leading to excess capacity and weakness in pricing
power. This leads to the devaluation of
the countries’ currency. When that
starts to affect exports the deflationary country typically gets into a
“currency war” with its’ trading partners.
This competitive devaluation leads to protectionism and tariffs followed
by “beggar-thy-neighbor”, where countries affected by deflation resort to
selling goods and services below cost in order to keep their plants open. As you can see this is a vicious cycle that
eventually leads to plant closings and debt defaults until pricing power
The full effect of this deflation has not
really permeated the USA, but you can see many indicators point to more
deflation. The U.S. has not experienced serious deflation since the “great depression” but we can use the example of the
deflation that took place and is still taking place in Japan. Their deflation started in 1989 and has
continued for the past 26 years. Their
currency (the Japanese Yen) started declining as far back as the early 1980’s
as their debt accelerated sharply.
As you can see in the second attachment (Total Credit Market
Debt as a % of GDP) the U.S. total debt started accelerating sharply from 155 %
of GDP in 1981 to 367% at the peak in 2009, and is still staying at an
incredibly high percentage of 334% of GDP.
Keep in mind that the total debt to GDP was 260% just before the “great
depression” and troughed at 130% in 1953. As stated previously, the U.S. debt
to GDP peaked at 367% and if we were to follow the path of the “great
depression” the U.S. debt would decline from $60 tn to about $30 tn after the
unwinding of the debt we expect will continue to decline for years following
the compounding of total debt for the past 35 years. This kind of excess debt is responsible for the anemic recovery in the economy and stagnate wages over the past 15 years.
Commodities are clearly the “canary in the coal mine” as far
as deflation is concerned. Remember when
we first talked about this in 1999, (Windows Word) never heard of deflation and
kept trying to correct us by stating, “do you mean inflation?” Now, the world is concerned about almost
every commodity on earth declining in sync with each other. Ever since Saudi Arabia announced last fall that they will not decrease oil production to support crude oil prices, the price of crude has plummeted. The concurrent economic slowdown in China has exacerbated this decline not only for oil but also most other industrial commodities. Zinc, lead, copper, nickel, aluminum,
precious metals and many more commodities are breaking through technical
support areas that have held up for years.
Actually the CRB Raw Industrial Spot Index (Chart 3 from our best data
resource Ned Davis Research—middle chart) represents these metals as well as
many more commodities. Since we started warning
our viewers about the impact of deflation the CRB had some major declines and
rebounds as the Fed pumped in a flood of money to try to prevent the inevitable
deflation as the debt continues to decline.
This index peaked about 1998 as the dot com bubble was about to burst
and declined to the 220 area in 2002 (that also troughed after the 1987 stock
market crash). Then the Fed dropped the Fed
Funds Rate to 1% in 2003 and kept it there for a year. This started the housing bubble which was
made worse when sub-prime loans exploded as Alan Greenspan encouraged banks and
mortgage companies to make these loans (and put his blessing on the home price
frenzy). The peak of the housing market
in 2010 coincided with the next peak in the CRB at 610. The CRB has declined to 440 presently from
610 and it is our opinion that this decline will continue down below the trough
of 310 in 2009 and the 220 trough that occurred in 2002 and 1987.
Another key to the deflationary scenario we anticipate is
the velocity of money (chart 4-the personal income divided by M2) declining
substantially from 2000 as the dot com bubble burst to 2003 when the Fed
lowered rates to 1%. It was 180 at the 2000
peak and 159 at the 2003 trough. It rose
to 168 in 2007 at the housing peak before declining to 144 in 2009. It rose for a year to 147 in 2010 before
declining to 127 presently. The velocity
of money is measured by the number of dollars spent to buy goods and services
per unit of time. In other words, it is
the measurement of money circulating sharply when it is rising and not
circulating as much if it is declining.
We expect it to continue declining as consumers and businesses will not
be making transactions as frequently as they have in the past.
We are very surprised that the stock market has held up so
well with this pending deflation overhang, however, it is trading in a range
that we believe will break out to the downside.
The trading range for the S&P 500 is 2135 resistance, 2040 is
support, and the 200 day moving average is 2072. The trading range for the DJIA is 18,352
resistance, 17,036 support, and the trading range for the NASDAQ is 5233
resistance, and 4900 support. The
S&P 500 is now is 2083, the DJIA is 17,410, and the NASDAQ is 5056.