Extended markets ran into resistance where expected this week, within the Sept. S&P 2810-2820 (S...
Inflation or Deflation?
02/14/2003 12:00 am EST
"The opposite of one profound truth may very well be another profound truth," said physicist Niels Bohr. Indeed, it is an ironic fact in the financial markets that leading experts can view identical information and form opposite opinions. Such is the case in the debate between inflation and deflation. We turn to technical expert John Bollinger and Elliott Wave specialists Bob Prechter and co-editors Steven Hochberg and Peter Kendall (For detailed information on the advisors cited below, simply click on their photos.)
We first turn to John Bollinger, among the financial world's most respected technical analysts and the developer of Bollinger Bands, a common tool in the arsenal of technicians. Below are comments from his Capital Growth Letter:
"A recent quick trip to Europe to give a speech in Zurich left me speechless," says John Bollinger . "I simply have never encountered that degree of bearishness before. Everybody was bearish, some extremely so and some simply raving. Deflation was the topic du jour. Investors and analysts seemed to be trying to outdo one another in a contest of forecasting the most disastrous outcome. This seems like an important contrarian fact.
"The world is essentially playing a waiting game. The big question is, will the US manage to reflate? We believe the answer to that question is yes. What do we mean by reflate? The conventional economic cycle oscillates between inflation and deflation. After the Depression the government decided that the deflation side of the equation was to be avoided at all costs. It took a long time for that goal to be realized. However it finally was and deflation has been banished since WWII. Deflation has been battled primarily with monetary and fiscal policy with some accompanying structural change as well. An end to deflation meant there was little to keep inflation in check and thus from the 60s forward we have lived in a time of inflation. Even in such times waves of deflation are inevitable, but our government has been quite able at resisting deflation and reflating in the wake of each down wave.
"What creates such waves? The primary culprit is excess capacity created during the expansion; too much equipment and too many plants, too many office buildings, too much fiber optic cable, etc. Such excesses take time to work off and that means slack prices, slack employment, and economic malaise--deflation. To counter it, a potent brew of easy money and deficit spending is consumed. Usually the warming effects spread quickly, the economy reflates, and the authorities breathe a sigh of relief at having dodged the bullet once again.
"This time the malaise is global and the deflation is harder to shake off than at any other time in the past 50 years. A lot of people see that and are scared. It is that fear that is the real problem, and that fear is mounting. To counter the contraction the Fed has done everything right. They have cut interest rates dramatically and created plenty of money. The Congress has cooperated and cut taxes while increasing spending. However, our neighbors have been less bold. Japan is deeply mired in an out-of-hand deflation and Europe is having major problems digesting the new, vastly bigger country it has become. So all eyes are on the US. Will the consumer pull through and spend?
"A couple of years ago we'd have come down on the side of deflation, but now we take the view that we are already well into an inflationary cycle. The clues abound; an economy that refuses to slip back into recession, commodity prices that are rising strongly, substantial monetary growth, strongly rising real estate prices, low interest rates, rising consumer price indices, etc. These are not deflation indications; they are clear and immediate signs of reinflation. What is gold telling us? Everyone seems to think that it is donning its safe-haven mantle and talking about war in the Gulf. While that is the obvious answer and we suppose that it is true to some extent, our line of reasoning is that gold is waking up in fear of a massive bout of inflation.
"Mind you, even with the severe deflationary forces most so correctly perceive to be active in our system, consumer prices are up 2.2% on the year and producer prices are up 0.9%. If deflation were indeed wining the battle, we'd expect those price gains to be lower or even negative. However, a massive reflation is afoot, and gold is starting to think about the consequences of the end of a 22-year disinflation. That's right, 22 years. Paul Volcker broke the back of the inflation spiral in 1981 and Alan Greenspan presided over the disinflation. Several times along the way deflation reared its ugly head only to have it promptly chopped off. This last time the effort to turn back the deflation was so strong that the odds are it will break the back of the 22-year disinflation. It doesn't have to work out that way, but it could and gold is worried. So when you hear about new highs for gold, don't think of the Gulf--instead think of inflation."
While John Bollinger makes a compelling case for inflation, the other side of the inflation-deflation debate finds equal support. Here we turn to Robert Prechter and Steven Hochberg, both experts in the technical theories of Elliott Wave analysis and leading proponents of the deflation argument:
"While a few economists have openly expressed concerns about deflation, everyone from Fed governors to bankers to university economists to financial magazines is assuring us that deflation won't--or can't--happen," notes Robert Prechter, editor of The Elliott Wave Theorist . "It reminds me of the repeated insistence that 'dividends don't matter,' 'p/e ratios don't matter', and 'book value doesn't matter' with regard to the stock market. The more people insist that is true, the more you can be sure that it isn't. The loneliness of the unequivocal and bearish deflationist is hard to overstate.
"It is widely believed that there is no evidence of deflation currently in force. There are two responses to this reasonably correct assertion. First, the lack of deflation currently is irrelevant. The basis for forecasting is not a current indication of a trend change. Forecasting studies the precursors of a trend change and then takes a stance in advance of the event. That's what our deflation essays of recent years have been doing. That the money supply is not contracting is of zero value in the debate of whether or not it will contract in the future. Second, there is a great deal of evidence that deflation is already impacting the economy on a selective basis. The notable rises in bankruptcies, debt downgrades, delinquent loan payments, foreclosures, zero-percent loans, office vacancies, and home equity borrowing unequivocally point to pressures from debt and overspending, which I believe are precursors to deflation.
"The erratic but persistent fall in the Producer Price Index is a precursor to deflation. In November, the Labor Department reported that 40% of all goods and services were cheaper than they were a year ago. The bursting of the stock bubble has wiped out more than $9 trillion of perceived value. And while only conjecture at this point, I think that the real estate bubble peaked in 2002. And while the real estate market may take a year to erode slowly, a few years from now, a new downtrend in prices should be clearly evident. The fact that deflation--meaning a decrease in the overall supply of money and credit--has yet to begin simply means that the all-time record 87% drop in the Fed's discount rate last year freed up enough credit to fuel the housing boom and thereby keep the total volume of credit barely rising for another year. That stimulus is now spent.
"When economists tell you that the consumer is holding up the economy, they really mean that expanding credit is holding up the economy. This is a description of the problem, not the solution. The more the consumer goes into hock, the worse the problem gets. The more you hear that the consumer is propping up the economy, the more you know that the debt bubble is growing, and with it the risk of deflation. Meanwhile, the belief that the Fed will stop deflation is the big kahuna. Reflation refers to the government's efforts to pump up or reflate an economy that is in a slump. However, we'd note that the Fed has been flooding the economy with credit since 1933. It's latest effort has been the decline in the discount rate from 6% to 0.75%. Do you really think the Fed's schemes will work? You might ask yourself how its last cure has performed.
"For about ten years, the Fed has repeatedly asserted that Japan's persistent deflation resulted from its central bank's error in not lowering interest rates fast enough. Here, the Fed has avoided that mistake, by lowering US rates a record amount in record time, to the lowest level in 40 years. Yet what has happened? The stock market is lower and the economy is weaker than it was at the start of the program. We have seen seven decades of easy credit, which has become an unsustainable debt load through society. Nothing can relieve that load except what has always done so: a deflationary collapse. Temporary reflation began in 2001 and is already ending. I expect that deflation is the thing that we will be watching in 2003. Society remains entrenched in the early stages of a long-term deflationary psychology."
"In our opinion, the job losses of 2001 and 2002 are just the beginning of a massive rise n unemployment," says Steven Hochberg and Peter Kendall, research partners of Robert Prechter and co-editors ofThe Elliott Wave Financial Forecast :
This will undoubtedly contribute to the consumer stake that we have been anticipating. Everything--from the weakest Christmas sales increase since at least 1970 to UAL's use of the bankruptcy court to slash payroll as it initiates an airline price war--says that 2003 will be the year that deflation shuts down US consumers. Prices of TVs, autos, air travel, and hamburgers are already down over the last one, five, ten, and 20 years, respectively. Oil prices are up, but in a dramatic break from the inflationary backdrop of the bear market of the 1970s, OPEC is fretting about the rise. Instead of limiting production, members are jumping in to make up for any shortfalls caused by international conflicts. This willingness, the imminent peak of the commodity index, and the faltering economy, all say that the world will soon be swimming in oversupply.
"Meanwhile, the seeds of a declining price spiral are evident in the waning effectiveness of retailers' aggressive market-downs and car dealers' cannibalization of 2003 sales with no-interest loans. As deflation hits home, consumers will become strangely content not just to defer purchases, but to eliminate many altogether. The last gasp of the free spenders is most profoundly apparent in the housing sector, where builders are now so desperate to keep the boom going that they make down payments for prospective buyers. Another legacy of the housing boom is its contribution to the economy in the form of cash-out refinancings. Through these vehicles, consumers raised an estimated $172 billion in 2002. The figure is a shocking 400% increase from 2000. These funds have served as the last wall of resistance against the gathering deflation. With producer prices down from their levels of May 2001, deflation is already a reality for most manufacturers. As the job crisis emerges, all-out deflation should grab hold. When banks stop lending on homes because property prices are falling, the indebted consumer will have no source of funds and spending will collapse."
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