Deflationary Transmission Through Stocks

The odds we are entering a nasty bear market in stocks have grown dramatically—price action as we saw yesterday is an example of the difference between bull and bear markets. Bulls remain supported on bad news. Bears on occasion fall on no news and have little support during bad news.

That said, the view commodities markets are oversold makes sense—no advanced degree required to see that. But the bad news for commodities is the deflation numbers keep lurching from bad to worse—becoming self-reinforcing to a large degree now.

So maybe despite the standard measure of overbought and oversold, there is another whole new leg down in commodities awaiting us. I have prepared long-term charts on oil in the past which target down into the teens for oil prices; and I lived and worked in Texas the last time prices went that low. But it sounds too extreme. Hard to get one’s head around those levels…but considering oil came from a speculative extreme at $147 per barrel to $30, i.e. an amazing $117—from $30 to $12 is less extreme, isn’t it?

In a self-reinforcing deflationary trend consumers don’t borrow and they don’t spend—the” lead a horse to water” idea applies; you can lead households to water (in the form of all types of government incentive for borrowing and lots of enticements from the private side for spending) but none of this can make consumers take on more debt or spend more once a self-reinforcing deflationary environment takes hold (Japan the poster child for this). And the other side of the coin deflation leads to hoarding of cash, i.e. increasing cash balances are part and parcel to the whopping decline in monetary velocity, as I showed on page 16 of the 2016 Outlook Part I.

Are we there yet—deflationary spiral land? Given the official improvement in the US economy and increased hiring reported, we haven’t seen much in the way of real earnings or consumer spending, we are already seeing pockets of self-reinforcing deflation (not to mention the growing rate of American who don’t participate in the labor force). But the next big kicker may be the stock market.

The US stock market is one of the largest repositories of collateral value. A significant fall in the stocks has an immediate and direct impact on collateral values in the real economy. Thus, a big fall in stocks can add to and exacerbate the self-reinforcing aspect of deflation in a big way.

This is from Deflation Rising special report Black Swan penned back in 2009—seems very apt after six unfulfilling years of credit expansion for the real economy; the party has taken place in financial assets and to a lesser degree the reflation of real estate:

Money in the standard definition must encompass not only money in circulation — the monetary base — but also encompass credit, which in a modern financial systems represents a massive amount of purchasing power—governments are hooked on credit, as Ludwig von Mises so eloquently warned us:

“Credit expansion is the governments’ foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.”

“The final outcome of the credit expansion is general impoverishment.”

In addition, keep in mind that inflation consists not only of an increase in the price of goods and services, but inflation can show up in the price of financial assets — stock markets, real estate, etc.– while the goods and services price measure remains subdued.

The point being, when this massive inflation of financial assets, relative to real assets, finally starts to deflate, it continues to push real asset prices lower. Thus, it is a direct transmission of more deflation into a real world already struggling with the same.

I said on the first page of the 2016 Outlook Part I the primary problem is governments have not let the market clear. This deflationary pressure in the global economy, al la rebalancing etc. is the market’s method of clearing. Despite all the money and credit governments and their central bank pawns have thrown at the problem, I think it is fair to say Mr. Market is winning again. The next level of powerful clearing likely is in the form of a major bear market in stocks. But it comes at a time when debt levels have never been so high and central bank available resources and reputations have never been so low. Taken this to its logical conclusion is a bit scary really. This environment may be prolonged—twenty years and counting now in Japan and still no exit from deflation. Or we see something swift and deep—and in that scenario the word’s “bankruptcy” and “sovereign debt crisis” abound.

In such an ugly environment, the world reserve currency—the US dollar—should be the primary haven play, and the developed world country with the largest allocation of offshore capital—Japan—will likely be another good hiding places for cash relative to other currency depreciation (but potential for sovereign debt crisis in Japan will also rise in a nasty deflationary spiral; so using induction to determine where the yen may be is suspect).

So despite the massive hit commodity currencies and emerging market currencies have taken—they have potential to go much lower in an ugly deflationary spiral. And at some point, and I suspect that point may be fast approaching; the euro will stop acting well on risk, and start to sell off sharply against the US dollar. Deflationary pressures in the Eurozone are already worse than in the US. A bear market in stocks and its real economy transmission suggest the first major sovereign default will likely roll out of Europe. And before that, the social/political problems will only get worse. The first major salvo of eventual sovereign default in Europe will likely be evidenced by an end to President Angela Merkel’s reign in Germany.

So, despite being open to playing an “oversold” bounce here in stocks and commodities, I remain painfully aware that sometimes markets don’t bounce even on okay news—that is a bear market.

S&P 500 Index Daily Wave View: So far traveling on a bear market path, with key swing support levels in sight…

S&P 500 Index vs. AUD/JPY Daily: Coming into a key test of support in stocks; AUD/JPY testing…