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?

Australia: Hiking Rates… But For What Reason?

The Reserve Bank of Australia (RBA) hiked interest rates on Tuesday, from 3.00% to 3.25%, in what appears to have marked the first act of monetary tightening since the 25 basis point hike by the ECB back in August 2008.

I salute the RBA. Unlike the rest of the global central banking community, it has shown an ability and a willingness to act pre-emptively to tame asset price inflation. Rather than sit idly by and watch house prices soar to bubble levels and deal with the subsequent bust, it has been pro-active, and this prudence should underpin the currency and lay the foundations for sustainable economic recovery.

HOWEVER, the key question is why did the RBA hike? If the RBA acknowledges that higher interest rates will encourage savings and prevent another asset price bubble, and is willing to bite the bullet and sacrifice near-term growth to avoid this fate, then well played indeed. However, if the RBA thinks that the economic slump has passed and growth will accelerate from here, and as such inflation is the larger threat, I fear the worst.

Household debt in Australia is larger than that in the US relative to GDP, and private sector deleveraging has only just begun. If this deleveraging process goes into full swing, the RBA may find that it overestimated Australia’s growth outlook, and move swiftly to reverse the hike, much like the ECB did not so many months ago.

Seeking Safety In Aussie Bonds

Despite the current re-flation attempts by the world's monetary policymakers, I still see deflation as the overriding theme going forward, owing to private sector deleveraging. With this in mind, Australian long duration bonds look particularly attractive for a number of reasons:

1. Yield Looks Attractive:
The current yield on the Australian 10-year bond is an attractive 5.4%, having risen from a low of 3.7% in December 2008, and is back to levels seen in 2006 when the global credit binge was in full swing. The nominal yield compares with the trailing dividend yield of 4.2% for Australia's ASX200 equity index.

2. Public Sector In Credit, Private Sector In Turmoil:
At the end of 2008, the Australian government was actually a net creditor, with net assets of roughly 7% of GDP. While the figure is likely to deteriorate this year as a result of the fiscal stimulus measures, the government's net debt ratio is still expected to remain in balance. This is extremely rare in today's world, and compares very favourably with Japan (95%), Italy (90%), and the US (60%) according to OECD figures.

By comparison, Australia's private debt burden is massive. Having peaked at roughly 165% of GDP in 2008, it has since fallen to around 150% and remains at twice the level seen at the start of the Great Depression. While government handouts have helped support private sector demand so far this year, a major private sector deleveraging process has begun, which will see savings rates rise for years to come. Indeed, the household saving ratio rose to 3.6% in Q209, continuing the uptrend seen since 2002 when the rate reached a low of -4.0%. This should continue rising towards the long-term average rate of 7.6%, with an overshoot highly likely. This could make for a perfect storm in the long-term government debt market.

3. Prudent Policy Limits Inflation Risk:
Unlike in the US and UK, where there is a huge risk that policymakers will continue to try everything they can to devalue their currencies to combat the ensuing deflationary forces, the Reserve Bank of Australia (RBA) is likely to continue acting relatively prudently. The Australian government has also been less willing to assume the debts of the corporate sector than the US and UK governments, which should keep gross debt levels low over the coming years. The government, which has run surpluses in its fiscal accounts for the past decade, will run a nominal fiscal deficit of 'just' 4.6% of GDP this year, way below the double-digit levels of the US and the UK. The relatively low willingness to take on more debt should continue to drive down perceived default risk at a time when other developed world governments are facing heightened default concerns.

JGB Bull Run Nearing An End?
One way to hedge the near-term risk would be to take a bearish stance on Japanese 10-year government bonds, as we see increasing potential for yields here to rise over the medium term.
I know I am not the only ones over the past decade to suggest that the bull market in Japanese government bonds could be ending. However, given the continued deterioration in the economy, this is becoming increasingly likely. Indeed, it is not inconceivable that Japan's balance of payments surplus could turn to a deficit, such is the weak outlook for global demand, which would likely force the Japanese government to offer higher interest rates on its debt in order to entice savings from overseas. On the contrary, we could also see Australia's current account deficit flip to a surplus as the private sector pays down the external debt it has accumulated from decades of current account deficits. This would add to the forces driving down long-term yields.

Australia More Creditworthy
Supporting my view that Australian long-term bonds will outperform those of Japan going forward is the current 10-year bond interest rate differential. At 411bps the spread is historically high and we believe that it is nearing its cyclical peak. What is more, given that the CDS market is currently pricing in a higher default risk in Japan than in Australia (and rightly so), this highlights the attractiveness of the current sovereign bond spread in terms of default risk.

Hayek About To Be Proven Right

As I write my first blog post the US dollar is strengthening and everything else priced in it is weakening, particularly stocks. This is a theme that has continued since last night, when it was revealed that the Fed would slow down its mortgage backed securities and agency debt purchase programme. If they are true to their word (and don’t announce an even bigger monetisation programme), this trend of asset price deflation will continue for a long time to come.

It seems that traders are better schooled in Austrian economics than I gave them credit for, having clearly read Hayek’s work - specifically, his contention that when monetary stimulus is slowed, never mind being withdrawn, recession-like symptoms in the economy emerge. I think he is about to be proven more right than even he would have wanted. The global economy (in particular the US and the UK) is in dire straights (more on this later) and we remain stuck in the early stages a depression that will play out in its entirety regardless of the actions of the Fed or anyone else. The reason is too much debt and too much malinvestment, and all the policy efforts so far have done is delay the day of reckoning, while ensuring that it will be even harsher than it would otherwise have been.

http://www.amazon.com/Tiger-Tail-Keynesian-Legacy-Inflation/dp/0932790062