Deflation and Uncertainty - Unnerving Signs For The Market

by: Bio Insights

Earlier this week the markets have rallied upon the hope that Europe was going to finally get its act together with its new plan. In addition, the selling was probably a bit overdone for the time being. While I was personally expecting that we'd rally to a respectable 1200 or more on the S&P in that run, we've fallen short and are on the way down yet again. Today erased almost all the major gains made this week, and as I'm writing this S&P futures are continuing the drop over market anxiety. Due to the effects of deflation, even safe-havens like Gold have been falling. Silver has taken a massive haircut and is now trading near $30/oz because of margin rate hikes, it's status as an industrial metal, and it's particularly strong inverse correlation with the dollar.

Let us neglect these meaningless fluctuations and focus on the thing that's a real threat to our well-being right now. Deflation is increasingly apparent, as the world (especially Europe) undergoes capitulation. Many financial institutions on the old continent have poured funds into treasuries out of fears of additional depreciation of the Euro. It was almost the complete opposite just a few months ago, where the inflation hype over QE2 was still continuing. Everyone now wants greenbacks - oh how the world has changed in just a few short months!

If you look at the chart of almost any major commodity you'll see that it's been nothing but downhill lately. This is even true of precious metals - especially silver. Not only has demand been relatively stagnant for basic materials, but the dollar's strength has been brutally crushing the prices of these goods in recent weeks. Below is the dollar index, which is in the midst of a rally of epic proportions.

Source: Bloomberg

One of the first things you'll notice is that the index has yet to reach the 80's. There's plenty of reason to believe that we could reach those levels in the near future, and even surpass them. While the leaders of the ECB induced a strong relief earlier in the week with rumors of their latest plan to save Europe, the endgame hasn't actually changed. Bullish sentiment has largely been based on hope rather than concrete evidence.

The timing is very unclear, but when the funds stop coming for Eurozone bailouts we're going to see capitulation on a level we hadn't observed since 2009. It's hard to think about given how cheap stocks are already, but there's nothing that markets would hate more than the uncertainty that would arise if we had a domino-collapse of Europe. European officials are getting nervous. They've even gone as far as to implement another short-selling ban on financial stocks in Italy and Spain. If that isn't a sign that the next straw is going to snap the camel's back, I'm not sure what is.

Although the declines in commodities have hurt the super-leveraged commodity bulls more than anyone else thus far, it's only a matter of time before the economic indicators begin to hit stocks with more bad data. As I've mentioned in another article, copper (just one of many leading economic indicators) looks extremely weak. Commodities and their exchange are the life-blood of an economy, and stocks will try to react proactively to estimated changes in economic health. In a deflationary environment, firms will have no incentive to hire, and there will be no way to grow their markets (or even keep them from shrinking). If the macroeconomic indicators continue to deteriorate, the microeconomic indicators (like corporate earnings) will follow suit.

There are many more reasons to distrust and probably avoid this market, but that would require a whole book full of data. I've included a list of observations and tips that could maybe help you navigate this insane market:

  • If you are still going to hang onto your stocks despite the chance of a major market crash in the near future, you should probably hedge your bets. Gold alone isn't good enough any more because of the deflation factor
  • You might even want to try holding an inverse ETF, which goes up as the market goes down. (DOG for the DJIA, SH for the S&P500, and PSQ for the Nasdaq)
  • If you're willing to make a stronger bet on the bear side, try SPXU or SDS (two leveraged ETFs that inversely correlate the S&P)
  • Since the market is convulsing violently in both directions due to uncertainty, if you have profits you may want to take them quickly. They can disappear very quickly.
  • Gold (NYSEARCA:GLD) will be hurt by deflation, but it's still a safe haven asset that will be in investor demand if the world comes crashing down. It's the only commodity I would recommend at these levels, but it would fall far indeed in the event of another 2009-like crash.
  • Europe's equities have been strongly correlated to our own lately - you can get a good estimate on how our stocks will open based on how Europe has traded that day
  • The forex market will rule the fate of the stock market until the Eurozone crisis steps out of the limelight. You can short the Euro through Proshares (NYSEARCA:EUO)
  • The easiest way to win during terrible times of deflation is to just sit in cash and spend some time outside the market - come back when macroeconomic factors are less ugly!

As we can see from how markets have been behaving, deflation and uncertainty come in a package. This is especially true with recent market history. Every increase in uncertainty will induce a round of deflation. Every round of deflation makes the markets even more uncertain, and since it's toxic to all assets there is little reason to be in the market right now on the long side. Buy and hold has worked fine since the bottom of the 2009 crash, but there is much reason to believe that our bull market is finally on its last legs. Worst of all, there is a lot of room to fall.

Disclosure: I am long GLD, SPXU.