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  Posted on: Wednesday, October 1, 2014
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A Global Deflation
As the Fed Tightens Monetary Policy
The Cycle of Deflation-authored by Comstock Partners 

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We, at Comstock, believe as the Fed tightens by ending Quantitative Easing 3 (QE-3) this month, and plans on raising rates next year, that the stock market will not do well and may wind up crashing.  Logic tells us that the Fed’s reduction in interest rates, and three QE programs of buying Treasury Bonds and Mortgage Backed Securities has put all other QE programs to shame.  Clearly, the programs we used to stimulate the U.S. economy was what drove the stock market up approximately 200% from 2009.  Now, that they are in the process of ending this stimulus, isn’t it logical that the stock market will decline substantially as these policies are reversed. 


Remember, this shouldn’t be difficult to understand since when the 1st QE program ended in 2010 the stock market declined 13.2% in 3 months.  When the 2nd QE program ended in 2011 the stock market declined 18% over the next 3 months.  Now, you may think that if the Fed decides to come up with another  QE-4, if stocks decline, they can get bailed out again, but we don’t think they can pull another rabbit out of the hat a 4th time.  


We continue to believe that we are in the midst of a global deflation that will end in stocks following the same path as Japan after the Nikkei traded at close to 40,000 at the end of 1989. The reason for the Nikkei collapsing at the end of 1989 was because it became obvious that Japan was in the midst of a serious deflation.  It subsequently dropped to about 7,000 and has been trading between 7,000 and 20,000 for the past 14 years. 


The global deflation we have discussed with our regular viewers over the past decade was confirmed by other economic data released this week.  For example the news of a weakening Eurozone economic data with an unexpected rise in unemployment in Germany.  The German PMI came in at 49.9 (the first contraction in the past 15 months).  The German 10 year Bund is trading at .91% which is sharply lower than the U.S. 10 year Treasury at 2.38%.   Also, the economic sentiment surprised on the downside as factories slashed prices and inflation slowed to the lowest reading since the height of the financial crisis.  The European Central Bank (ECB) is meeting today and they probably will be announcing some form of QE and rate reduction tomorrow.  It looks like the Eurozone will be entering another recession, as well as most South American countries, and Japan which just reported the second quarter GDP at negative 6.8% as they raise consumption taxes.  China’s debt continues to grow as their credit cycle peaked, and their attempt to build empty buildings and homes has backfired while their debt to GDP ratio has grown to over 217%.  All this, and commodities continue to collapse.


The current Geneva report stated that “global debt levels are still rising mostly in developing countries.  Contrary to widely held beliefs, the world has not yet begun to deleverage and the global debt to GDP is still growing, breaking new highs.  At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected.  Debt levels are also rising in the fragile eight countries of India and Indonesia in Asia, Brazil, Argentina and Chile in South America, plus Turkey and South Africa.  These are all major emerging markets that suffered credit bubbles and escalating current account deficits following quantitative easing by the Fed.”


This bull market, measured by the S&P 500, has gone to extremes from the low in March of 2009 (5 ½ years) without a bear market (down 20% or larger), or from the high level mark since October of 2011 (1100 days) has not had a correction (down 10% or larger).  This bull market is what you would consider to be “long in the tooth” anyway you want to measure it. 


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