Dow 3,000 On Its Way

Everything I look at tells me the bear-market rally in global and emerging market equities is over. Any rallies should be used as an opportunity to get out, or better still, get short.

Anyone expecting an economic recovery or even hyperinflation in the US is about to get very confused as we enter the next leg of the US$43trn debt pyramid collapse.














Elliot Wave Confirmation – The Primary wave 2 (P2) bear-market rally appears to have been completed following an ABC correction since March, and a five wave advance since June. We are in the early stages of a primary wave decline at the beginning of a Supercycle bear market. The wave 3 decline will be at least as big as the wave 1 collapse seen in 2008, and as Robert Prechter states ‘third waves are wonders to behold’.

The EW pattern is even clearer in emerging market stocks, with the MSCI Emerging Market etf (EEM) having been rejected at the 61.8% retracement level– the hallmark of P2 bear-market rally.

Panic-Driven Gap Filled – The gap in the S&P at 1,100, created at the height of fear in October, has now been filled. As the chart shows, this was the case in 1930 when the bear-market rally in the Dow topped.









Volume Is Picking Up – After 7 months of declining volume, September marked 1st sequential month of rising volume. Again, this is consistent with the beginning of a third wave.

The Fear Gauge Is Back Up – following several months of sailing through the eye of the storm, the VIX has burst through support signalling the end of the low-vol fuelled carry trade. This is perfectly consistent with the beginning of a P3 decline.

Dow Theory – While the Dow made new highs in September, the Dow Transports failed to confirm this, and despite today’s Warren Buffet-fuelled rally, the uptrend is no longer in place.

Market Breadth – The sell-off has not been confined to a few indices. Everything from the Brazilian Bovespa to the New Zealand dollar look like they are past their peak.

Optimism Is At A Peak – Consistent with a market top, hope and optimism are at a peak. The trailing PE ratio is at an ALL TIME HIGH, and analysts are pricing in a perfect recovery in earnings.




Sentiment – try telling someone you are bullish on the dollar and see if they don’t look at you like you are mental. With sentiment so heavily skewed in favour of the reflation trade, there is simply not enough profit to reward all these people with the same outlook. This makes for a sharp and sustained reversal.

The Fundamentals

Despite the US economy supposedly growing in Q309, it is undoubtedly in worse shape: Thanks to the government’s ill-advised Keynesian policies, private consumption has actually risen as a proportion of GDP; Federal debt (involuntary and unproductive private debt) is much higher; Structural unemployment is higher; the Chinese economy has gone from being in a position to mount a long-term sustainable recovery to help drive global growth to the verge of a banking sector crisis. What is more, the Fed, who got us into this mess, has gained more control over the economy. In sum, the imbalances that caused the crisis have grown larger.


Deflationary Depression Just Begun
While the recession may be officially over, the depression is only just beginning. This is a once in a lifetime credit contraction. While I can see where inflationists like Peter Schiff, Jim Rogers, and Marc Faber are coming from, I think they are barking up the wrong tree. While they are likely to be proven correct eventually (the fiscal deficits and foreign central bank reserve diversification will catch up down the line), that’s no consolation for being wrong now. After all, timing is the difference between salad and garbage.














The above chart shows the extent of the credit excess seen over the last Supercycle, and almost guarantees that we are facing deflation and not inflation. We live in a credit money system, not a fiat money system. The banking system creates the vast majority of money in our economy, not the government – the conventional money multiplier model implies the tail wags the dog. No matter how much money sits on reserves at the Fed, if the banks don’t want to lend, and consumer don’t want to borrow, this money might as well simply not exists. For the hyperinflation threat to play out, the Fed would need to create cash to the tune of $43trn in order to replace our debt-based system with a fiat based system. Those looking for hyperinflation should be aware of this.

So there you have it: Technicals, Sentiment, and Fundamentals. The coming wave down will be epic.

Debt-Deflation Still In Play

What will be the main trend in US equity markets and the dollar over the next 6 months?

1) Dollar Strength & Equity Strength. Probability: 1%

2) Dollar Weakness & Equity Strength. Probability: 13%

3) Dollar Weakness & Equity Weakness. Probability: 16%

4) Dollar Strength & Equity Weakness. Probability: 70%




















Picking the correct number will be key to determining whether you make or loose money over the next six months. Below I give a brief summary of why I have assigned the respective probabilities. As you’ll see, whichever way you slice it, my outlook is grim, but a stronger dollar and weaker equities is my pick.

1) Dollar Strength & Equity Strength. We are currently in the early stages of a depression. This is just a plain fact. What is needed for the dollar to strengthen and stocks to rise in this depression, in spite of dollar strength, is a massive increase in the current rate of return on assets, which sees a return of capital back to the US. In the absence of rising financial leverage (unlikely due to the state of the banking sector) and with lower consumer spending guaranteed, this would require an almost impossible rise in productivity. Something akin to the dot.com boom cannot be entirely ruled out, however. 1%

2) Dollar Weakness & Equity Strength. This basically calls for a continuation of the current trend. Hyperinflation would certainly be consistent with this view, but it seems unlikely. What is slightly more likely is a steady decline in the dollar coupled with a continued rise in risk appetite backed up by improving US economic fundamentals, which all serve to prolong the current bubble. While this would not be sustainable, over a six month horizon it is certainly possible for it to continue. 12%

3) Dollar Weakness & Equity Weakness. This more realistic. The reasons to expect dollar weakness are all-too obvious, and while we have seen dollar weakness translate into equity strength in recent months this need not continue. In fact, as I write this post, the Dow is falling hard while the dollar is still weak (the Dow is getting KILLED in Aussie dollar terms, and the long-term downtrend is still in place). If emerging market demand for commodities remains strong and the Chinese revalue the yuan, commodities prices could rise substantially, squeezing companies’ top line growth and raising costs. While I don’t want to read to much into daily moves, I think it is significant that the Dow Transports rolled over today (not confirming the break-out according to Dow Theory) as oil spiked higher. While I would expect this trend to be short-lived, the period from H207 to H108 showed this relationship can go on for a long time.

4) Dollar Strength & Equity Weakness. This is my core view. True, I have held this view since Dow 9,000 and EUR1.4000/US$, but with the Dow now at 10,000 and the euro at EUR1.5000/US$, and the fundamentals unchanged, I like it even more. After all, the idea is to buy low and sell high is it not? I find it strange that people are jumping into the Dow now when they didn’t want any of it at 7,000, and are scrambling out of dollars when they couldn’t get enough of them at EUR1.3000/US$ a year ago.

Do you remember 12 months ago when the prevailing wisdom was that no matter what the government/Fed did to crush the dollar (and everyone new that’s what they were going to try and do), private sector deleveraging would ensure that the dollar continued to strengthen and asset prices continued to fall? If I had told you then that in less than a year’s time the Argentine Merval stock index would be pushing all-time highs, or that the AUD would be heading for parity against the dollar I’m pretty sure I would have been laughed at. Of course, I didn’t say those things. I was part of the consensus that thought the Fed could not overwhelm the natural deflationary pressures at play, and that the trend of deflation would continue. As far as I could see the Fed was just ‘pushing on a string’.

But my point is that the market works by exerting the maximum amount of pain on the maximum amount of people, and the thing that the fewest people expect is the thing that invariably happens. What if in 6 months time the DXY was back at the early-2009 highs? What if the Dow was below 6,500? What if the Fed indeed turned out to be impotent and a wave of private sector deleveraging overwhelmed their re-flation efforts? What if the rally since March turned out to have been driven by a temporary rise in optimism that was merely encouraged by the Fed? What if this has just been a bear-market rally within a longer-term debt-deflation spiral and the continued evaporation of the global debt pyramid?

Nikkei: Structural Bear Beats Cyclical Bull

After breaking through support the Japanese Nikkei index looks under serious pressure, with 9,700 the next level to watch. Fundamentally, the economy is a disaster, as weak global demand continues to expose the domestic deflationary stagnation. The recent high of 10,800 looks likely to have marked the cyclical high for Japanese equities, which would mark yet another lower high. A lower low is coming.

















There have been a number of factors weighing on the Nikkei in recent days. The unexpected improvement in Japan’s unemployment rate, which fell from 5.7% to 5.5% in August, has been outweighed by a confluence of negative factors. Firstly, the stronger yen, driven partly by Finance Minister Hirohisa Fujii’s comments that a strong currency has generally been good for the economy because it has boosted domestic purchasing power, was a major driver. The poor Tankan survey results, which showed large businesses are aiming to cut spending by 10.8% this year, more than the 9.4% planned three months ago, also hurt market sentiment. The two largest forces weighing on the market, however, which pose a serious threat going forward, were the Chicago PMI data suggesting that the US economy remains in depression, and Japanese CPI data confirming that domestic deflation is deepening.


















Export Dependence Remains Key Risk
These two factors sum up the struggles facing the Japanese economy. Starting with the fall in the Chicago PMI, this shatters any hope of a sustainable US andglobal recovery – something which the Japanese economy (and export-sector dependent equity markets), has relied heavily on in recent years to revive it from its deflationary stagnation. With the help of the weak yen (thanks to the carry trade) and strong global demand, the Japanese economy and the Nikkei staged a respectable recovery from 2003 to 2007, with the latter rallying 140% from peak to trough, as exporters lead the way. The current outlook, however, with a strong yen and weak external demand, is far less sanguine.

Deflation Accelerating
With that in mind let me turn your attention to the recent inflation data. As the accompanying charts show, Japan is clearly stuck fast in deflation. Core CPI came in at -2.4% y-o-y in August, the largest fall on record, and the September Tokyo CPI showed a similarly worrying trend. While the year-on-year figure fell by 2.0%, the actual index shows the extent of the deflationary mire that the economy remains in. The price index is the same level now as it was in 1992, and has fallen a staggering 9.5% since the October 1998 high.















Misguided Policies Mean A Slow And Painful Death
As underlying fundamentals of the Japanese economy continue to deteriorate, and deflation continues to trump re-flation efforts, any signal that global demand is waning is likely to weigh heavily on the Japanese economy and asset markets. It was no surprise that the Japanese economy contracted more than any other developed market in Q109 when the pillar of external demand gave way. Indeed, the failure of macroeconomic policies in the wake of the asset price collapse of the 1990s has been partially hidden by the strong export sector, while fostering a climate of mild and protracted deflation. The government has sought to reduce the debt load of the corporate sector and expand that of the public sector to fill the gap in demand. While low interest rates have prevented a debt-deflationary spiral similar to the Great Depression, they have also failed to force about the necessary liquidation of malinvestments created during the bubble era. As such, while public debt has ballooned, corporate debt remains high. The economy is no closer to embarking on a sustainable recovery as the private sector is yet to work off its imbalances and the public sector has created a host of new ones.



















Cyclical High Is In
Continued core deflation has been a symptom of the asset bubble bursting, and has come in spite of the inflationary policies pursued by the government. The large liquidity-fuelled cyclical rallies seen in the Nikkei have brought lower highs and lower lows, as the underlying fundamentals have continued to deteriorate. It is looking increasingly likely that the recent high of 10,800 will mark the top of this cyclical (rather than secular) bull market, which could open up much further downside for the index. While continued price deflation – a sign that the economy is trying to heal itself – will help to support real incomes, it is likely to result in further asset price weakness in Japan over the medium term. The sooner this occurs, though, the sooner a sustainable recovery will be enjoyed.