Is Deflation About to Rear Its Head? Part 1

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 |  Includes: AGG, DIA, SPY
by: Graham Summers

The Financial Crisis, thus far, has been about two MASSIVE forces butting heads. Those forces are Deflation (housing, stocks, earnings, wages, production, etc) and Government Intervention, or Re-flation (commodities, stocks, gold, etc).

For most, if not all, of the 20th century (1932 onwards), the US operated under an “inflation” mentality from the perspective of the financial markets, the US Dollar and especially credit expansion. This is clear in the Dollar losing roughly 96% of its value post 1932 as well as the explosive boom in credit expansion from the 50’s onward.

This all came to a screeching halt in 2007 when we hit a point of debt saturation - a point at which debt was so out of control that the idea of counter-party risk (that the person you lent to may not pay you back) seized the markets (first credit, then bonds, then stocks).

Thus began a slow motion implosion which accelerated into the deflationary nightmare in which asset prices of all kinds (houses, securities, and eventually commodities and stocks) fell. This was the market saying “ENOUGH!” as far as debt expansion is concerned. And it marks the culmination of the “Market Forces” element.

The Federal Reserve - which lives, breathes and eats the Inflation mentality - went head to head with Market Forces by trying to RE-flate the US economy AND financial markets. This marks the introduction of the second force: “Government Intervention.” The Intervention came in the form of extremely low interest rates, the suspension of accounting standards, money printing, bailouts, and stimulus spending.I want to make one key point here: the Fed DID NOT have a plan for ANY of this. Ben Bernanke didn’t even SEE the Financial Crisis coming. So the idea that he somehow had a “plan” or general idea of how to deal with it is completely wrong and off-base. Instead, he and his cronies literally made their policies up on the fly. This is most evident by the fact that each new policy or strategy was only introduced AFTER a major blow-up occurred.

Blow Up

Fed Policy Response

Credit markets jam up

Begin lowering interest rates/ suspension of accounting principles for US banks

Bear Stearns goes under

Shotgun marriage with JP Morgan

Fannie/ Freddie Collapse

Nationalization of both

AIG Collapse

Ditto

Investment Banks go under

Merrill marriage to Bank of America, Morgan Stanley with Smith Barney, Wachovia with Wells Fargo

Commercial Paper market jams up

Fed backstops it

Money Market Fund market jams up

Ditto

Click to enlarge

… and on and on.

Thus, Government Intervention is a “REACTIONARY” force. It is not proactive, nor is it forward thinking. It is merely the Feds attempting to plug each leak as it starts. I wish to point out at this point that the Fed has NOT actually fixed anything: the same Market Forces still exist and if anything will be even stronger during the next push.

So why did the Fed’s policies work? Put another way, why did the financial markets stop their implosion and why did stocks and commodities rally as the Dollar fell (why did the market begin to RE-flate)?

The reason it worked is because the Financial system continues to have faith in the Federal Reserve’s ability to RE-flate the economy/financial markets and refuses to come to grips with the reality of Market Forces (more on this in a moment). In other words the Fed’s actions appear to have worked because of SENTIMENT.

With all of this in mind, we can now dissect the Financial Crisis as having two stages or periods.

  • From mid-2007-early 2009 was a period dominated by Market Forces.

  • Early 2009 to the present was a period dominated by Government Intervention.

These two periods each had respective investment themes that can be defined as the “deflation trade” and the “inflation trade.”

The deflation trade features virtually every asset class on the planet falling as US Treasuries and the US dollar rally on a “flight to safety.” This represents the “fear” side of the “fear VS. greed” paradigm for market sentiment and is fueled by Market Forces.

The second trade, the “inflation trade,” features the exact opposite of the deflation trade in terms of investment trends: for the inflation trade, every asset class rallies as the Dollar and US Treasuries fall. From a sentiment perspective, this represents the “greed” paradigm.

Historically, Government Intervention has ALWAYS been trumped by Market Forces. However, 2009 was a year that defied this trend for the following reasons:

  1. The Government Intervention taking place was/is WITHOUT precedent
  2. Most if not ALL market participants today have little if any knowledge of historic trends and so do not operate based on this information/ insight
  3. Most if not ALL market participants operate under the belief that the last 30 years of credit/ financial expansion are “the norm.” This belief system features the following sub-beliefs:
  • That the Fed can fix or save the market always
  • That stocks are meant to go up and that bear markets are a thing of the past
  • That deflation is not possible in the US

2009’s market was virtually ENTIRELY dominated by those who buy the Fed’s ideology hook, line, and sinker: Wall Street. These folks and their sentiment (AND SALARIES!) are steeped in the myths that the Fed can solve the Financial Crisis, that the 2008 period was a fluke, and that the underlying issues that created this Crisis have been resolved.

There are many forces at work in a market, but ultimately the sentiment of its participants is what decides where stocks go in the near-term. With the market being dominated by those expressing the sentiment of desperately wanting to believe that the worst has passed (how many times have we heard this proclamation in the last 18 months?) it is not surprising that the market was dominated by the “inflation trade” with stocks and commodities generally rallying higher and higher, becoming more and more divorced from reality or Market Forces in the process.

This fact is most evident when you compare the performance of a company that believes and lives (literally) based on Government Intervention - Goldman Sachs (NYSE:GS) - to that of a company with little if any exposure to Government Intervention - Coca-Cola (NYSE:KO) - and the general market itself - S&P 500 (SPX) (Click to enlarge)

Click to enlarge

As you can see, companies influenced by Government Intervention clearly TROUNCED those that did not, as well as the market itself (more on this in a minute).

Meanwhile, those who DON’T/ DIDN’T believe in the Fed’s policies and the sentiment that “all is well” made for the exits. You can see this in the following:

  • Individual investors pulled $18 billion from equity-based mutual funds from August to November ‘09
  • Hedge fund withdrawals were $12 billion from April to November ‘09
  • Bond funds (income plays) saw a record $375 BILLION in inflows last year (the all time record for stock fund inflows was $260 during the Tech Bubble).
  • Market volume is falling lower and lower to a trickle (NYSE volume for Monday, January 4, 2010 was 965m shares. Compare this to last year (2009) when everyone thought the world was ending yet the NYSE STILL traded 1.36 BILLION shares)

The above facts are also evident in the ever-dwindling market volume during the rally started March 2009. Here’s an image that should give the bulls pause (remember high frequency trading programs accounted for 70% of market volume that year).

The main question now is… are market forces returning to crush the market?

Click to read Part 2 >>