4 Possible Market Scenarios, Updated

In April, I wrote Fork On The Road, which was published on Seeking Alpha as 4 Possible Market Scenarios. I think I have enough information now to update these scenarios and define investment strategy for the nearest future.

Scenarios, mentioned before:

Inflation and stagnation = stagflation

We had an amazing rally in commodities since March. Lately, we also had rally in gold, breaking through 1000 dollars per ounce. This is looking pretty much like dollar carry trade, or, as Nouriel Roubini said, the mother of all carry trades. Traders borrow dollars and buy everything they define as "hard assets", hoping for inflation. This might end bad, very bad indeed. Don't want to go into details, Roubini explains it much better. Despite bull run in commodities, inflation in USA is nowhere to be found. I still see probability of high inflation under 10%.

Japanese disease (Zero growth with zero inflation or low deflation)

Latest developments make this scenario less likely. The main problem in Japan is society, not economy. It's way too conservative, way too rigid, doesn't promote initiative, puts too much trust in managers and in government. I don't see anything like that in US. Banks are getting restructured, companies are laying off and cutting costs like crazy. It's painful for people, yes, but it's much better than sweeping problems under rugs, like Japan did for 20 years. The only similarity I see with Japan so far is carry trade.

Probability: around 10%.

Great Depression 2.0

Here I have to curb my enthusiasm. Probability of this development is higher now than it was back in March. The main change: higher taxes. They are creeping from all sides. Many local governments are raising taxes. Some states are raising taxes. Federal taxes are going to go up, it's almost given. I'm not against some tax increases in principle (no, I'm not Ayn Rand fan), governments provide essential services (at least some of them) and we need to pay for them. But I'm absolutely against any tax increases in the nearest future, i.e. before 2012. Otherwise we might repeat 1937 (just take a look at Dow chart!). All whining about deficit is misplaced, Japan has government debt at 160% GDP and counting, we are still below 100% GDP. Talks about reducing or ending stimulus programs are not improving my mood either.

Probability: about 35%.

Great Recession

Last quarter GDP numbers look great. Maybe US economy is recovering already. But accurate numbers are usually available 12 months later. And one quarter is not that important, in the last 20 years Japan sometimes had up years. Lots of good quarter reports, companies are beating profit estimates. But not many of them really grew revenues, profits are mostly driven by cost cutting. And dollar carry trade is looming huge. Despite of these developments, I still see this scenario as most likely one. After all, we just had a huge rally in stocks, and more importantly, in bonds.

Probability: about 45%.

Conclusion

I see lower probability of Japanese scenario and higher probability of GD 2.0. If we take a look at corresponding stock indices, it's bullish. Stocks went down and then stayed mostly flat in Japan in the last 20 years, but during Great Depression direction was up after 1932.

My stance continues to be bullish.

Comments

[The Economi...:]

There is a huge difference in Japan and the US that people rarely talk about. Japan has nowhere left to build, nowhere to expand and grow.

We have plenty of room to grow and we still are.

Nov 05 12:39 PM

[Alex_G:]

Alex,

I would swap the probabilities of GD 2.0 and an amended Japanese disease. I think the govt will do anything (including severely debasing the currency) to avoid GD 2.0, which will result in the substantially higher taxes you talk about. What this will do is make our economy look a lot like the Euro Zone’s, much slower growth, with lower levels of private investment and a higher level of unemployment going forward. Full employment might have a bottom 6-7% unemployed.

Nov 05 02:03 PM

[The Simple ...:]

Agree with this. US turning Euro AND Japanese at the same time, in limited fashion. Permanently higher structural rate of unemployment seems likely, as does perpetuation of zombie banks hoarding capital, and large fiscal deficits.


On Nov 05 02:03 PM Alex_G wrote:

> Alex,
>
> I would swap the probabilities of GD 2.0 and an amended Japanese
> disease. I think the govt will do anything (including severely debasing
> the currency) to avoid GD 2.0, which will result in the substantially
> higher taxes you talk about. What this will do is make our economy
> look a lot like the Euro Zone’s, much slower growth, with lower levels
> of private investment and a higher level of unemployment going forward.
> Full employment might have a bottom 6-7% unemployed.

Nov 05 02:12 PM

[jratl:]

Bullish stance with 45% great recession probability. I assume this is based on a repeat of the 1932 scenario. Is the bull market a reaction to debasing the currency? Do you anticipate domestic equity values to exceed the devalued currency or are you looking at emerging markets to hedge against a falling domestic currency?

Nov 05 03:12 PM

[untrusting ...:]

We have plenty of room to grow and still are.
======================...
Exactly who is "we"?
1) The federal government who has declining tax revenues and is borrowing like crazy to spend more. And who will have to increase taxes (and reduce consumer income), just to reduce part of the current borrowing.
2) The federal government who will have tens of billions more in annual interest payments due on the debt when interest rates rise above 0%, which surely they must in coming years.
3) The state and local governements who also face seriously declining sales, property, and income tax revenues. All of which are cutting expenditures and budgets as fast as they can.
4) The average American worker who has faced declining real wages for several decades now, which is a large part of the reason so many went heavily into debt to try and maintain living standards.
5) The small business in America which can no longer obtain credit and thus are closing shops in ever increasing numbers and laying off more and more employees.
6) Maybe it is the imports that will cost significantly more due to the decling dollar value which in turn will force average Americans to pay more for these imported goods and further reduce consumer spending power.
7) Or maybe it's the corporation that has declining domestic sales and revenues because 10-20% of the population is unemployed and has almost no purchasing power. But maybe there is a small amount of growth from those that cut significant American jobs, offshored the jobs, and are increasing sales in foreign countries.

So just wondering where you think any growth is coming from and exactly who is going to be able to pay for it?


On Nov 05 12:39 PM The EconomicJoker wrote:

> There is a huge difference in Japan and the US that people rarely
> talk about. Japan has nowhere left to build, nowhere to expand and
> grow.
>
> We have plenty of room to grow and we still are.

Nov 05 04:47 PM

[gettingfeetwet:]

I don't understand how you are bullish if 80 percent of your observation points towards a negative economy? Are you just bullish in the short term?

Nov 05 05:51 PM

[bartpr:]

inflation will come from the massive amount of reserves being held by banks in the form as a gift from the fed. this is now in treasuries, but it will eventually be distributed as loans and the money supply will explode. once these are issued they cannot be recalled. this will be the greatest increase in mony supplu ever. i am mostly in cash.

Nov 05 06:53 PM

[Alex Filonov:]

Yes, 1932 scenario. No, I don't see debased currency, I see deflation, not inflation so far. Yes, I'm diversified a little bit in Europe and emerging markets as a hedge.


On Nov 05 03:12 PM jratl wrote:

> Bullish stance with 45% great recession probability. I assume this
> is based on a repeat of the 1932 scenario. Is the bull market a
> reaction to debasing the currency? Do you anticipate domestic equity
> values to exceed the devalued currency or are you looking at emerging
> markets to hedge against a falling domestic currency?

Nov 05 11:44 PM

[Alex Filonov:]

No, bullish in the long term. Recession, especially (possibly) ending recession is a great time to buy. Even Great depression was a great time to buy starting 1932. The bearish scenarios are inflation and Japanese, 20%.


On Nov 05 05:51 PM gettingfeetwet wrote:

> I don't understand how you are bullish if 80 percent of your observation
> points towards a negative economy? Are you just bullish in the short
> term?

Nov 05 11:46 PM

[aussiereader4:]

Why Japan? Why not Zimbabwe or the Wiemar Republic?

Nov 06 02:24 AM