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 24^th (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 (3^rd 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.