Mustard Seeds for Deflation: The Deflationary Cycle Full Monty

By: J.D. Rosendahl | Tue, Aug 11, 2009
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It seems if you listen to certain cheerleading bobble heads on financial news networks, we are always on the path to bigger and better days. They ramble on about mustard seeds and green shoots. What makes it worse, is they present financial information like a Pachinko game with the financial ball bouncing erratically between bullish and bearish market guru's, TV commentators and/or between republicans and democrats.

This pinball effect from their 'he-said-she-said' journalism only serves to over emotionalize the financial news. Sadly, this only goes to further confuse investors trying to gauge what to do with their assets, and creates what I like to call financial paralysis with their decision making, thereby forcing one to ultimately make a late financial decision stemming from fear or greed, which leads to a highly flawed financial decision or plan. I have yet to figure out how anyone can watch financial news networks and "consistently" make good financial decisions or a comprehensive money plan. Did the financial news networks lead anyone to believe they should exit the market at the end of 2007? Or even early 2008? Sell real estate? Or buy gold back in 2003, 2004, or 2005? Not for the majority.

In late 2007, my analysis said the markets were ready for a significant correction, and shorting the stock market would be very profitable. However, it was 9-12 months later before the news told us why the correction took place, and by then it was too late to shift assets to avoid the correction or make money from shorting stocks in any significant manner. Yes, I'm a big fan of technical analysis, and not so much of financial reporting.

So, what does my long term technical analysis tell me? A deflationary period or spiral is a very likely outcome in the coming 1-5 years. Frankly, I see very little wiggle room to get around it. Sure, we might get an economic bounce, spat of inflation or hyperinflation, but that will only make the deflationary period afterwards even worse.

Putting the technical analysis aside, I wish to build my somewhat complete case of why I believe the deflationary spiral is on its way. I'm going to build the fundamentals stories or news today that will happen in the coming years to cause the deflationary spiral. My view stems from the risks I see heading our way economically. However, before I build these stories, I wish to share the current mustard seeds of deflation. These are the pockets of the United States already in a deflationary condition.

THE MUSTARD SEEDS OF DEFLATION:
I have a simple test for gauging deflation. I believe, in its simplest form, deflation stems from a significant level of unemployment, a sizeable decrease in business activity, and a "large" correction in real estate values. In my view, these are collectively what deflation is all about. And while the United States doesn't fit my definition of deflation yet, there are some local/regional markets I believe do, and quite easily.

These markets are the mustards of deflation, or the early clues of what to look for or how to identify deflation. The three most prominent regional markets that already display a deflationary impact are Michigan, Las Vegas, and "The Valley" of California. Let's look at each regional market briefly.

  1. The Valley of California is a regional market place from Sacramento south to Fresno or Bakersfield in general. It's an area of California that has an economy highly concentrated in agriculture and real estate development. In some ways, "The Valley" has been the eye of the foreclosure hurricane in the United States.

  2. The Valley displays the 3 major qualities of deflation. First, because this area lacks true economic or industrial diversity, it's an easy target of poor economic fundamentals when its major industry goes through a down turn. The once large real estate industry is dead compared to that of 4 years ago. One of the largest regional lenders (County Bank) has recently been closed down by the FDIC.

    Second, the largest real estate value declines on a percentage basis within the State of California are mostly within "The Valley", and it is not uncommon to see price declines from the peak in mid 2005 of 50% or more.

    Lastly, this area has some of the highest unemployment in the country. The Bureau of Labor Statistics reports the rate of unemployment as of May 2009 was 14.2% in Bakersfield, 18.1% in Merced, 16.7% in Modesto and 15.6% in Stockton. All of which are within The Valley of California, and well ahead of the state average of 11.2%.

  3. The Las Vegas area has similar traits to that of The Valley of California: a local economy that is highly concentrated via the casino and real estate development industries; a sizeable correction in real estate values; and high unemployment.

    The local economy in Las Vegas has a concentration in the casino industry and real estate development, both of which are struggling severely. This has transpired into poor local economic fundamentals.

    Real estate values in Las Vegas are off quite sharply, and from what I've read its price declines are in the neighborhood of at least 40-50%. A review of residential real estate for sale in Las Vegas from www.prudential.com reflects there are 9,011 properties currently for sale. Of these, 517 are homes or condos for sale at or below $50,000. That's a lot of homes for sale for the price of an SUV.

    The Bureau of Labor Statistics reports the rate of unemployment for Las Vegas as of May 2009 at 11.1%, which is higher than the national average, but not as dramatic as the numbers reported for The Valley of California.

    While Las Vegas is feeling the affects of deflation, the unemployment rate has yet to hit levels that are more deflationary, so I would say they only display 2 of the 3 qualities of deflation. However, I have included them in this review because both of their significant industries are in sizable down turns and they have had a stout correction in real estate. Further economic erosion is a probable risk at this point.

  4. Like Las Vegas and The Valley of California, Michigan has a concentrated economic base, which in this case is the auto industry. I think the entire world is aware of how bad things are for auto sales and the auto industry in general. In Michigan, the heart of the domestic auto industry, the result has been a compression of the economy which has driven unemployment higher.

    The Bureau of Labor Statistics reports the rate of unemployment as of May 2009 at 13.9% for the entire state, making it the highest state unemployment rate in the United States.

    And when we look at the real estate market in Detroit, as an example, there are 2,128 homes/condos for sale at or below $50,000. In fact there are 1,448 homes for sale priced at or below $25,000. Sadly, there are 640 homes/condos priced for sale at or below $10,000, which leads me to believe that some of this real estate will need to be bull dozed. Their real estate market leads me to believe they have experienced a wash out in values unlike any other part of the country.

The above regional markets all display deflationary traits, and provide a clear picture of the difference between a past recession and deflation. You'll notice these three areas have been hard hit in large part because of the concentration, or lack of diversity, in their local industrial/economic base. When their major industries turned down, they were subjected to sizeable and rapid economic corrections.

This differs greatly from metropolitan areas that have diversified economies, and hence, the reason we have not seen the effects of deflation on a more global scale in the Untied States, YET. So, why should we review this kind of economic information?

As someone who manages money for his parents, I've always used the approach of understanding and managing risk first and making money second. It's a philosophy that has worked very well for my parents, and if you've read my prior articles you know my parents have avoided all the bubble meltdowns of the past 10 years.

When I think of managing risk going forward, I try to understand the economic forces that I believe most likely have to play out regardless of business or governmental forces/inputs today. Sadly, I still talk to far too many people who don't see the risks ahead of us in any complete form. Because of this, I would like to review some of the major risks I see ahead for our country.

BELOW ARE MY EIGHT SIGNIFCANT FUTURE RISKS:
1) Higher Taxes:
www.truthandpolitics.org reports historical tax rates for the United States. The top tier tax rate from 1932 to 1980 ranged from a low in 1932 of 63% to a high of 94% in 1944-1945. These levels are much higher than today's tax rates. In addition, the top tier income level applicable to higher tax rates decreased from $5,000,000 in 1941 to $215,400 in 1980.

After the collapse in 1929, our government raised tax rates and lowered the income bar in order to qualify more earners for paying higher rates. Isn't that interesting? In the heydays of the roaring 1920s, the top tier tax rates were merely 25%.

Times haven't changed much. No politician wants to kill the good times or bubble days by raising tax rates to cover government spending and budget short falls, primarily because they want to stay in power.

As government budget short falls continue at the federal, state, and local levels, we will experience a wave of higher taxes in the coming years. Our politicians will start with things that they can promote as technically "not" an increase in taxes, like raising certain fees, closing loop holes, and/or letting certain temporary tax reductions expire.

As these "non tax increases" fail to cover budget short falls, higher tax rates will be upon us, but not just at the federal level. The short falls in many states and local municipal governments will pressure high taxes at the local level as well. In fact, in some areas we already see the beginnings of this phase at the state and local level.

Not only do we need higher taxes as part of the budgetary short fall solution (since lower government isn't happening) at every level of government, we also need higher federal taxes to send a message that our country can repay the government bonds its issued. Without this assurance, we may suffer a mass selling wave of government bonds currently held by foreign governments.

I have discussed the affects of a mass correction in government bonds below under "The 30 Year U.S. Treasury Bond Market". The simple consequence of higher taxes is reduced net income for all Americans, which translates into less consumer spending and less home ownership affordability: a continuation of the very problems we have today.

2) The 30 Year U.S. Treasury Bond Market: Below is a chart of the 30 Year US Treasury Bond Market. It's been in a massive bullish channel for almost 30 years.

There's an inverse relationship between bond prices and bond yields. This means that a large downward correction in bond prices will drive bond yields higher. Unfortunately, most mortgage loan rates are set off the 5 and 10 Year U.S. Treasury Bond. Therefore, should the 30 Year UST Bond price decline, the 30 Year UST Yield will go higher, dragging the 5 and 10 Year UST yields higher with it. And therefore, we should expect much higher mortgage rates stemming from a sell off in the UST Bond Market.

The chart above shows that the bond market has been in a bullish trend for almost 30 years. A break below the channel around $110 would signal that the massive bull market in bonds has ended, and that a potential correction of size is coming. Higher rates should be expected to accompany such market forces.

What's not being discussed openly as far as I can see, is what would happen if rates go higher, and then for some reason the yield curve inverts and short rates go higher and faster? This would exacerbate the move higher in mortgage rates well beyond the move of long rates.

The consequences of the bond market are quite severe. The sad reality is that the price of assets, especially the vulnerable real estate market, does "NOT" have higher interest rates discounted into current values. And, doesn't it seem more like "when" the bond market finally corrects rather than if? Technically, it's losing a great deal of momentum on each new price peak, which is a sign of a tired market that is ripe for a large correction.

A correcting bond market would exacerbate another round of wealth destruction via decreasing bond values to those who rushed into bonds as a safety move in 2008; it would also discount real estate values of all types even lower. The combined affect is another significant round of wealth destruction in this country, which will continue the reverse wealth effect and the pull back in consumer spending. Since consumer spending is the majority of our economic engine, the result would be stagnation or a decrease in our economic levels. A decreasing economy and reduction in consumer spending would trigger lower income tax collections, widening budget gaps and forcing higher taxes. Sound familiar?

3) Wage Deflation: Wage deflation has already begun in certain industries. It really began years ago with the renegotiated income levels in the airline industry when they went through their bankruptcy phase.

Realtors and mortgage brokers are making less a lot less than they used too. Most that I know are working 3 times as hard for a third of their former income levels, or less. As a Commercial Banker, I have several clients in the contracting industry (various types of subcontractors) that have all gone through salary reductions, some twice. Some are forcing people to work 3 or 4 days a week to lower payroll expenses and this is after cutting 2/3s of their work force permanently.

Wage deflation is decreasing income levels, salaries, and benefit packages. We already see it intensely in the real estate related industries, but the pressure for wage deflation in other segments of life is mounting, and quite severely. The auto industry is under substantial pressure to re-price employees. The compensation package for state and local government employees is becoming a large target. We also see strong income deflation in the small business operator, who has experienced a large contraction in business levels.

While high unemployment is a difficult pill to swallow, it creates a secondary issue: the over supply of human talent looking for work. This ultimately cheapens the value (compensation) of that talent through the supply-demand equation, which means lower compensation levels. This trend is likely to continue and broaden to all industries for a number of years for a few reasons:

  1. The recently devastated net worth of baby boomers' will require they work well into their retirement and, even if just working part-time, they create a large supply of human talent. Over supply will continue to apply downward pressure on the value all people, new or existing, employed or self-employed.
  2. As companies have stabilized their profit and loss statements, it has come by cutting costs rather than organic growth. The pressure on corporations to grow earnings will always be there from shareholders, and so too will be the cost cutting machine to aid earnings growth in a continuously weak economy. Even if a company completed layoffs, they can always reduce salaries on existing employees, as they know it's an employer's market and there's no where for their employees to find another job of comparable pay.
  3. Something that rarely gets discussed is the impact of globalization. The sad truth is that for Corporate America to remain financially competitive, their cost of doing business must be competitive. This means that there will be an eventual reversion to world wide compensation levels to some degree for most Americans. Corporations will need to lower salaries in America to remain competitive with foreign companies who have lower cost structures.

All of these wage trends are barely beginning, and we should expect a continuation of lower income or wage deflation in the coming years, which is a drag on our economy. Lower income levels equate to a reduction in consumer spending, less home affordability, and decreased tax collections. The very problems we have today will get pressured further under wage deflation. With the average American over leveraged, it only takes a small cut (10-30%) in income levels to have a large negative impact.

4) The Next Wave of Residential Foreclosures: We've experienced a large wave of residential foreclosures in this country, and there is another wave pending. The next wave stems from the Option ARM programs underwritten during the real estate bubble. Many of these exotic loan programs come with low teaser rates or flexible loan payment structures that only last for the first few years of the loan and then convert to a full amortizing loan payment at a higher rate.

The first thing one should notice in the above chart is that it's only a few months from now that we should experience the adjustment in the payment structure of these loans, and secondarily the impact is quite large on those who have these types of loans.

In many cases, people are choosing to make less than an interest only payment, which means their loan balance is growing (neg. amortization) while values have declined.

A great deal of these loans were underwritten in the bubble days on high end homes because that was the only way someone could afford to move up: by taking a teaser rate and making a less than fully amortizing payment, never considering they really couldn't afford that home on a real (fully amortizing) mortgage payment.

On July 23, 2009, CNBC reported there was a 20-month supply (inventory) of homes for sale valued over $1,000,000. That's enormous supply, which should ultimately pressure values downward at the same time that these loans underwritten on expensive real estate convert to larger payments that the owners cannot afford. Ouch!

We all know that when someone cannot afford the payment and the home is worth less than the loan amount, eventually that house goes back to the bank. It's not rocket science.

I believe the next wave of foreclosures will stem from the Option ARM, Alt A., and Jumbo Subprime markets, which will concentrate in the higher priced real estate markets. The supply is already overwhelming and demand is essentially non-existent because the affluent are starting to see income decreases at the same time the banks are forcing larger down payments and tougher underwriting standards. Qualifying for the higher priced home has become very difficult, which has cut off demand. A sharp price reduction in the high priced real estate market has already begun and the chart above shows it should gain momentum soon.

Another round of foreclosures creates continually more issues. It creates more supply, lower values, and more bank losses to deal with. This will create or add to bank closings through the FDIC, and even tougher lending standards. More foreclosures also equate to more net worth destruction, which leads to a pull back in consumer spending. So, more bank losses and lower consumer spending will equal less tax revenues for governments, which ultimately place pressure on either higher taxes or lower government spending. It's just more of the same old same old!

5) Non Primary Residential Real Estate (Farms, Vacation Homes, Commercial, and Multi-Family): Another wave of real estate price declines will stem from the non primary residential real estate market, which collectively is a broad category, so I will offer my views on each sub-segment, and why I feel they are ripe to fall sharply:

A) Vacation Homes: During the real estate bubble, we witnessed an explosion in vacation real estate prices. The problem for this sub-segment is that a great deal of these properties were purchased using "funny money" coming from equity cash outs of over inflated primary residences in order to buy secondary (vacation) real estate, which were subsequently financed with exotic mortgages that begin to convert soon.

Since a great deal of this real estate is tied to the affluent, which have greater financial means to ride bad economic times, it makes all the sense in the world in this cycle for this sub-segment to lag the overall real estate market price declines. However, as the fundamentals don't bear out current values, demand has already begun to dry up, and properties will become upside down. While lending standards tighten, the pricing dynamics will ultimately force a large correction in this non-necessity real estate market.

To further intensify the problem, the affluent are starting to experience their own cash flow problems, primarily due to decreased income levels from the self employed/small business owners. During the bubble days, the affluent bought up their life style by moving up/adding a large vacation home with the expectation that income levels would stabilize or go higher from those peak levels. The market forces behind this sub-segment are just beginning to show signs of stress, and its momentum to the downside should accelerate soon.

B) Farms/ranches: Having reviewed real estate for sale in several western states, and having family members who have been farmers/ranchers for decades, I hear or see a re-occurring theme within the agriculture space. It's over priced as the next great real estate development, hunting camp, golf course, fishing retreat, etc. If you tried to buy a farm/ranch today based on the cash flow as a farming operation, it just doesn't pencil out.

As the money traveling around the U.S. continues to dry up, the agriculture sub-segment will be re-priced over time based on a practical multiple of the cash flow from ranching or farming operations. This trend will force this type of real estate values much lower.

C) Commercial: Commercial real estate includes office, retail, and light industrial space. Commercial real estate values are highly sensitive to rental rates and vacancy factors, and the early trends for commercial are not good at all.

The early trends include an increase in vacancies stemming from the closing of title insurance, mortgage, and real estate offices. There are also new vacancies from single purpose buildings from closing auto and boat dealers. And with diminished consumer confidence and higher unemployment, we are beginning to see small retailers and restaurants closing, again creating more vacancies. All of these vacancies result in an increased supply of commercial space at a time when demand is decreasing. This ultimately does two things: first, it creates new vacancies for owners of commercial buildings, and second, with the over supply of commercial space, it lowers the amount of rent land lords can charge. These two factors decrease the gross rental stream of a building and thereby the net income from that building, which will ultimately, decrease its value over time.

The next sign that this sub-segment is struggling is the number of small businesses that are currently hitting up their land lord for a reduction in rent to stay in business. From what I can tell in California, the decline in commercial real estate has already begun; its velocity has yet to be determined.

D) Multi-Family: The overwhelming problem with this sub-segment is that during the real estate bubble, people bought up multi-family buildings – not because the net cash flow made sense on a yield basis, but because values were going up. The underlying values went up based on speculation of even higher values to come, not based on the fact that the fundamental reasons behind multi-family real estate made any sense.

A perfect example of this is in California where we witnessed buildings bid up, and the corresponding capitalization rates pushed down to 3-4% on most apartment buildings. It doesn't take a Harvard MBA to realize just how dangerous this is financially. If capitalization rates simply trend back to more normal levels (7-8%) without a corresponding increase in rental income from the building, then values almost have to drop by 40-50%.

If rental income levels remain constant, capitalization rates and building values have an inverse relationship just like bond yields and bond values, so it's easy math to see a large correction in this sub-segment if Cap. Rates rise. Add in the potential for higher vacancies and lower rental rates and that 40-50% correction will easily turn into 65-70%.

I was reviewing property for sale in Arizona on www.Loopnet.com the other day and I've noticed this trend has already sprung to life in Mesa Arizona. There were several 4-plexes with Cap. Rates well above 10% (12-15%), and in this market the correction has already begun for multi-family.

As the real estate correction continues, it will broaden to the non-primary residential real estate markets and gain momentum, creating an entirely new problem for the banking sector. People will begin to walk away from vacation homes, commercial building, and maybe even apartments. More wealth destruction is ahead of us in real estate, and yes, that means a continued pull back in consumer spending and a reduction in tax collection, spurring higher taxes in the future.

6) The Baby Boomer Switch: The baby boomer switch is really the analysis of risk behind the changing spending demographics of the largest portion of the American population. And this massive segment is scheduled to hit retirement age in mass in the coming 2-5 years.

The demographics behind the boomers are not encouraging. If they stay employed because their net worth's have imploded and they can't afford to retire, that intensifies the over supply of human talent in the labor force and intensifies wage deflation.

However, when they finally do retire, their spending habits will consist of moving down in real estate, going on social security income (their incomes will decline), and they will lower their consumer spending habits and hold onto what funds they have remaining to support themselves for the remainder of their lives.

None of those traits of a retiring boomer bode well for an American economy driven by consumer sales and real estate values. In fact they are the very problems we have now, and more of the same is "No Bueno"!

7) The Local Municipal Government: On May 23, 2008, the City of Vallejo, CA. filed for bankruptcy. They're one of the first cities to do so in America. In the state of California, Vallejo is relatively small, but by being the first within the State of California to file bankruptcy, they definitely took the "stink" off filing for bankruptcy protection. They have opened the door of bankruptcy as a tool for budget strapped local municipalities (cities and counties) to consider it more aggressively in an effort to help restructure their bloated budgets.

Recently, the City of Oakland, CA has been talking up the possibility of bankruptcy as a way to deal with their massive budget short fall. While the small City of Vallejo took the initial stink off filing bankruptcy, if a large city like Oakland, CA were to file bankruptcy, it would serve to open the door for cities and counties not only in CA. but other states.

Local governments filing bankruptcy will put them in greater control over renegotiating union compensation packages for teachers, firemen, and policeman. It allows them to reduce salary levels or operating expenses, which is the sign of the times for every segment of society.

One small city filing bankruptcy is insignificant, but a wave of cities and counties is quite significant when we view the collective reduction in salary levels to so many municipal employees. And, lower income levels once again reduce tax collections, reduces consumer spending, and reduces home affordability. Does it sound like I'm repeating myself?

8) The Bubble State "California": No where in the United States are the excesses of prior bubbles as great on a "Statewide" level than California. If we look collectively at where the majority of the population lives, the increase in real estate values, the increase in exotic mortgage loans, the excess spending and budgetary issues by state and local governments, and the size of the state economy, nowhere in the U.S. is there a state that looks and feels like a bubble more than the State of California.

If a smaller state like Wyoming, Maine or Louisiana had serious economic troubles with their state economies it would barely be felt on a national level. No disrespect to these or any other small states, but when we look at small states, their industry base is usually narrow and the population small, so if they have economic problems their economy would not impact the greater economy in a noticeable manner.

However, California is the world's 8th largest economic power with a substantial portion of the U.S. population. Any sizeable economic decrease in California has to affect the entire U.S. because of its size and shape. The quantity of business that is done in California that subsequently flows to other businesses in other states is huge. So too has been the flow of money out of this state into real estate markets in other states.

It only makes sense that the state (California) that benefitted the most from the bubble real estate days and the bubble economy will experience one of the sharpest economic declines within the United States. Unfortunately, it's "too big to fail", in that a large economic contraction in California will only exacerbate problems for the national economy.

That concludes my eight significant future risks. Before I summarize "The Deflationary Spiral Full Monty", we should discuss the possibility of an economic and market bounce because its a real possibility that will draw many into believing the worst is behind us when its clearly ahead of us, so understanding the potential bounce is important.

THE EXPECTED MARKET BOUNCE:
On November 30 2008, I wrote in an article for safehaven.com titled, "An Update to My Primary View and The Risk Chart".

"The charts suggest more volatility in the markets in both directions. The daily chart suggests enough bullish divergence that we could see higher prices in December. However, none of the data suggests a buy and hold market place, and the markets are for traders only. Should the weekly MACDs finally turn higher, trading the long side will gain some ease and momentum. That being said, "my primary view is that after the markets unwind some of it's over sold nature, the DOW will take another run at breaking below the 2002 lows, and I'm looking for that sell off to be large, go below 7,000, and happen during the 1st quarter of 2009 with February as my primary month".

I pretty much got it dead right, and if I'm being honest, back in November 2008 the technical analysis on the markets seemed quite obvious, which is not always the case.

I've always felt that after the markets bottomed it would be purely logical for a market and economic bounce, and I feel that way for several reasons:

  1. You'll notice in the chart above, we've put in a new low in March 2009 that took out the 2002 lows, so we have in place lower lows. To confirm a greater bear market of size and deflation, I would expect confirmation from lower highs, so a bounce is needed to create that lower high to set in place another market based confirmation of a great bear market and deflation.

  2. Secondly, one of the parts of Elliott Wave Theory that I love is the notion that markets, through fear and greed, go through phases of chaos (impulse waves) and order (consolidation). From the Peak in late 2007 to the bottom in March 2009, we've experienced one large impulse wave or chaos period, and now man is trying to control his financial surroundings through government intervention, and corporate cost cutting to prop up asset values, which should ultimately create a period of consolidation or a bounce from the bottom.

  3. Technically, the monthly MACDs are trying to turn up and cross. When they do, we should be in a period where the markets trend sideways-to higher, and create in Elliott Wave terms, a wave B up, within a greater ABC correction downward.

My Primary View: Since there are no bullish divergences on the monthly MACD, the greater correction in the market has years before it puts in a real bottom. To create a bullish divergence, we need to move higher, and then sell off to new lows in price, while failing to make new lows on the monthly MACD, all of which takes possibly years to accomplish on monthly charts.

The SP500 has reached a Fibonacci retracement level of 38.2% or roughly 1,015 and traded up to it's 200 month moving average, and while I can make the case it could technically reach 1045 or 1080 in the near future, we should expect a consolidation of the gains from the March 2009 low to begin in the near future. I think an interim top in the market will occur during August-October 2009. My initial downside targets for the SP500 are 945 and 870.

I'm not of the mindset the next move down will be the ultimate sell off to DOW 3000 in a massive Elliott Wave 3. That's the uber-bear analysis, and I believe that is a much lower probability. Frankly, I don't like that view at all.

After a consolidation of the current gains, I would expect the markets to move up again, forcing the monthly MACDs to cross and turn higher, which should signal we are in the middle of wave B up in the greater bear market. That move might last into late 2010 to 2011, and so we'll create the lower high needed to confirm a larger bear market supported by lower highs and lower lows.

In addition, such a move higher will once again suck in all the novice investors at the top, setting up one last wealth destruction move and thereby scaring generations away from investing in the stock market, which is ultimately what deflationary periods and large corrections do.

THE DEFLATIONARY SPIRAL FULL MONTY: There are several reasons why I feel a deflationary spiral is coming.

1) The first is to look at the stock market from a technical perspective. On long term weekly or monthly charts of the SP500 there are no bullish divergences yet to suggest a long term bottom is in place. In fact, it may take years before we see this, and new price lows are needed for the markets to create those bullish divergences.

2) Second is my philosophic view: The long term business cycle is no different than the cycle of life (birth, growth, maturation and then death). In the business cycle, we are long in the tooth of maturation with one foot in the grave and the other on the respirator. I would argue that through government intervention over the past few decades, we've only forestalled the inevitable. No matter the medical tricks to keep an ailing patient alive, eventually it comes to an end. So too must our long business cycle come to an end. Deflation is the end or death phase of the long cycle, and it must take place before the birth of a new long cycle can truly begin in earnest.

3) Risk Management--The Deflationary Spiral Full Monty: From the perspective of risk management, at the core of a deflationary environment is a correction in real estate of size well beyond what most can imagine. The reason real estate values are so integral to a deflationary environment is because it's the one asset owned by the majority of people, and deflation is only deflation if it impacts the majority. So, in order for the mustard seeds of deflation to expand from regional markets to a national deflationary economy, a sizable correction in real estate across the United States must occur, and in size.

When we review my eight significant risks, they all have some direct or indirect impact on real estate values. It might be directly through the supply and demand equation for real estate, or indirectly through lower income, higher taxes, or higher rates, etc.

In my view, what makes a deflationary spiral are several significant factors that occur during roughly the same window of time (the next 5 years), and compound or create additional economic pressures, which in turn, pressure real estate values lower. I've identified the risks that I feel compound the very issues we have today: lower income, lower home affordability, and lower consumer spending, and possibly higher taxes and higher rates; all of which will force asset prices lower.

And, when I think of the eight risks identified, I get really concerned. Why?

Does it not seem like these risks are likely to play themselves out during the next 2-5 years?

What really concerns me is the lack of understanding evidenced by the fact that none of the identified risks are factored into asset values today in any meaningful way. When these risks eventually get priced into assets, we will get the sizeable correction in real estate well beyond what most can imagine... and that is how the mustard seeds of deflation turn into "The Deflationary Spiral Full Monty".

Hope all is well.

Feel free to email me.

 


 

Author: J.D. Rosendahl

J.D. Rosendahl
http://roseysoutlook.blogspot.com

J.D. Rosendahl is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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