Inflation Surprises And The Major Trend

By: Steve Saville | Wed, Mar 5, 2003
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The latest economic news
It was reported last Thursday that the US trade deficit for December surged to $44B, another record high. The fact that the trade deficit is still making new highs means the corrective process (the process through which the excesses of the 1990s get washed out of the system) is still in its infancy. This, in turn, means that the Dollar's bear market is still young.

A falling US$ is going to help address the problem of the large and rising trade deficit, but a weakening US$ won't correct the problem on its own. There will also need to be a substantial and sustained reduction in consumer spending. And, since consumer spending is the primary driver of US economic growth a sharp slowdown in this area will result in the US experiencing a severe recession. There is no other way out and the on-going attempts of policy-makers to 'cushion the blow' will just delay the time it takes for the economy to get from where it is now to where a sustainable expansion can begin.

The other 'news' worth mentioning was the announcement that producer prices increased in January at their fastest pace since 1990. This caused Bill Fleckenstein to quip that the Fed will now have to recall the "Whip Deflation Now" buttons it has been handing out for the past year.

The US has had a high inflation rate (money supply growth rate) for years, but the inflation has remained off the radar screens of most analysts and commentators because it hasn't caused the widely watched price indices to rise. Last week's report on producer prices therefore didn't tell us anything we didn't already know. However, if this is the first in a sequence of upside 'surprises' in the price indices then peoples' perceptions of the situation, as well as their expectations as to what the future holds in store, will change. This is important because perceptions and expectations drive the financial markets.

A change in inflation expectations and the effects of such a change on the financial markets (e.g., higher interest rates, a weaker US$, a higher gold price) will also exert considerable influence on the Fed's monetary policy. As long as most people believe that deflation represents the major threat to the economy the Fed will be free to keep official interest rates near zero and to facilitate massive monetary injections whenever 'needed'. However, if people start to see inflation as the greater threat the Fed will be forced to at least give the appearance of being an 'inflation fighter'. This is not the position it would want to be in with the economy in a fragile state and heavily reliant on large, regular liquidity infusions.

The Stock Market's Trend
Below is a chart of the S&P500 Index showing the downward-sloping channel in which the index has been moving since the first quarter of 2000. Notice that every significant rally in the S&P500 Index since March of 2000, with the exception of the July-August 2002 rally, has ended at either the channel top or at a trend-line (the red line on the chart) drawn parallel with the channel top. Notice also that the rally beginning in September-2001 made two peaks at around the same level, the first in January-2002 at the red trend-line and the second in March-2002 at the channel top. With the market having recently reached an oversold extreme it is quite possible that a similar scenario is playing out now, that is, having already hit the red trend-line and pulled back the market might now move up to the channel top. In this case the 2nd December peak would continue to stand as the ultimate peak of the rally that began on 10th October, but a major decline wouldn't commence until the S&P500 had first moved back to around 920. However, regardless of whether or not we get a bounce to the channel top during the next few months the most important point for most people to remember is that the major trend is still down.

There are a number of reasons why the major trend will remain 'down' until considerably lower levels are reached. Some of these are:

1) In order to get the average dividend yield and price-to-sales ratio to values that are normally seen near the ends of bear markets the major stock indices will need to fall by at least 50% from their current levels

2) Although fearful in the short-term, most people remain very optimistic with regard to the stock market's long-term performance. That is, the stock market is still widely considered to be a good place to invest for the long-term. Such optimism has never been seen at bear market bottoms in the past.

3) Very little money has left the market. In fact, there has been a substantial net addition to equity mutual funds since the major peak was reached in March of 2000. We doubt that this will turn out to be the first bear market in history during which the public bought all the way down and was therefore fully invested at the ultimate bottom. Reason no. 3) is, of course, directly related to reason no. 2.

4) During previous bear markets over the past 30 years the percentage of investment newsletter writers who were bearish always moved well above 50 and remained above 50 for at least a few months before the market reached its ultimate bottom. During the current bear market the proportion of investment newsletter writers in the 'bear camp' has never been higher than 43%. Currently it is 34%. Obviously, reason no. 4) is also directly related to reason no. 2).

5) The cash levels in equity mutual funds are near all-time lows, indicating that mutual fund managers are a lot more afraid of missing a rally than they are of catching a decline. These low cash levels mean there is very little pent-up buying power, that is, there currently isn't enough fuel to spur a new bull market.

6) There have been signs over the past few months that consumers have begun to 'hunker down'. This is very important because the US economy has been flying on only one engine over the past 2 years and that engine is consumer spending. Furthermore, as discussed earlier in today's commentary a slowdown in consumer spending is not only likely, it is necessary in order to reduce the massive US trade deficit.

7) The US Dollar's exchange value against most currencies is headed much lower and this decline in the Dollar's relative value will eventually prompt the large-scale liquidation of US stocks by foreign investors.

So, while there will be stock market rallies from time to time and while these rallies will, on occasion, be substantial, there is no reason at this time for long-term investors to be buying, or keeping money in, any mutual funds that tend to move up and down with the overall stock market. A MUCH better entry point lies in the future (during 2004 or perhaps even later).


Steve Saville

Author: Steve Saville

Steve Saville
Hong Kong

Steve Saville

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