We ended the
last special comment, “DEFLATION”, by explaining the support and resistance levels
of the stock market and concluded that the stock market will break below the
support level of 2040 on the S&P 500.
We continue our very strong feelings that we still have much more
downside risk. We will also explain why
we believe the deflation we have been warning you about for years will spread
into a much more globally based deflation than was experienced in the
past. The reason for this is that
significant economies around the world are overloaded with debt levels that are
similar to the United States.
The main
reason we believe the stock market will decline sharply is because the
deflation we discussed with you over the last few years has finally permeated
the globe and the only thing missing from the “Cycle of Deflation” (first
attachment) is the significant stock market decline. As the chart shows, we have been stuck in the
part of the cycle called “competitive devaluation” for years. Many of our
trading partners have been attempting to devalue their currencies in order to
compete and export deflation. China just
recently devalued their currency by 4% and Jack Lew stated in a recent
interview this morning that China will be accountable to the U.S. for the less
transparent manner they used to devalue.
They have been pegging the renminbi (Chinese Yuan) to the dollar for
years.
We were
absolutely astonished that the stock market didn’t collapse before we started
hitting the worst part of the cycle. The
market usually discounts any serious problems before they start. The commodities collapse was the only “canary
in the coal mine” to give a clear indication of what to expect in the
future---debt defaulting, or collapsing, as well as plant closings.
The S&P
500 finally broke and collapsed through the trading range (both the 8 month
trading range support as well as the 4 year uptrend line going back to October
of 2011). We believe it will break down
sharply and eventually break through the October low of 1820 and continue down
to around the 1500 area (30% from the peak), but more likely it will reach the
1070 area (50% from the peak).
Another
reason we believe the 1820 support level won’t hold up is due to the fact that
when the S&P 500 broke on Monday, August 24th (during the 1,000
+ point decline) the futures on the S&P 500 declined to 1830 while the cash
market only retreated to 1867. After
these major market crashes with both the cash and futures, we suspected
strongly the market would rise enough to pull investors back into the stock market,
believing the crash was caused by the robot traders (high frequency traders). The market has already lured many of the
investors back in, but we suspect the market will not rise up to the prior support
area of 2040. Stocks (DJIA, and S&P
500) are now on the way to the worst quarter since the third quarter of
2011.
The next
thing we want to explore is the premise that this deflation will not be
restricted to the USA. As you recall
from last month’s report, deflation starts with excess debt and over-investment
leading to excess capacity and weakness in pricing power. This combination leads to deflation. The key to the cycle is the excess debt. Deflation
is the consequence of eventually deleveraging the debt. The last report showed just how over
leveraged the U.S. is by viewing the chart (second attachment) showing the debt
relative to GDP was 260% at the beginning of the “Great Depression” before the
deleveraging and eventually grew to 367% of debt to GDP in 2008. Subsequently this debt was deleveraged down
to 335% of GDP, but is still way too high to prevent deflation. In fact, the
Fed instituted Quantitative Easing (QE) three times, one “Operation Twist” (buy
LT government bonds and sell ST government bonds), as well as increasing their
balance sheet over $4.5 tn to $18.5 tn over the last 4 years.
This excess
debt has to be either defaulted on or paid off, and is almost always
accompanied by the Federal Reserve and other central banks doing whatever they
can to reverse the deflation. This is
usually done by lowering interest rates, increasing the money supply, or buying
bonds and stocks to flood the system with “liquidity” (money). Many times this is easier said than done
since in order to grow the money supply that’s needed, you to have to make sure
there is strong circulation of the money (3rd chart -- velocity of
money). If the population is afraid of
spending the money, but would rather save it or even put in under their
mattress it is impossible to reverse the deleveraging of the debt. Right now the central bankers around the
world are getting very frustrated by the fact that whatever means used, they
can’t seem to control the deflationary forces.
Japan’s
economy entered their deflation in 1989 with their stock market close to 40,000
(NIKKEI 225--4th chart). They did whatever they
could to reverse the deflation but to this day they are still suffering from its
impact. They resorted to QE from 2001 to
2006, where they bought both bonds and stocks attempting to reverse the
deflation. They stopped as soon as there
was a touch of inflation and subsequently went right back into deflation as
their stock market fluctuated between 7,000 and 20,000. Just imagine how difficult it has been for
Japan to extricate themselves from deflation for the past 26 years while trying
everything under the sun. Keep in mind
that there market peaked in 1989 at more than double where it is trading
presently. The ECB and Peoples Bank of China
are just starting to experience this frustration presently. The Euro Zone just lowered their forecast of economic
growth and inflation even with the promises from the head of the ECB, Mario
Draghi, that he would do “whatever he has to do” in order to save the Euro and
Euro Zone.
The last few
attachments (by our best source of data-- Ned Davis Research) shows that the
world’s public and private debt is similar to the U.S. (some worse and others
better) but they are in just as much trouble as the U.S. This is because we still have much more
net worth per capita than our trading partners.
As the U.S. leads the globe with enormous debt relative to GDP we will
be followed by the rest of the globe that is also constrained by an abundance
of debt.