Murphy: Deflation 101

11/01/2002 12:00 am EST

Focus:

John Murphy

Head Market Analyst, Stockcharts.com

From an educational standpoint, the following is perhaps the clearest assessment I've seen explaining the inter-relationships between various financial markets. It also makes the issue of deflation clearly understandable. The speech was given at The New York Money Show by John Murphy, well known as a former CNBC technical analyst. I would note that his murphymorris.com site has just merged with stockcharts.com, an Internet-charting service. 

“About ten years ago, I wrote a book called Intermarket Technical Analysis. The idea is that if you are analyzing the stock market and all you look at is stocks, you’re only looking at a small piece of the puzzle. There are all kinds of financial markets, and they all feed off of each other. For example, what happens to the US dollar has an impact on the stock market. What happens in the oil market has an impact on stocks. What happens to the dollar has an impact on the gold market, which in turn has an impact on the stock market. And of course, there’s a close link between interest rates and stocks. 

"If you are a stock-market investor and you are not following interest rates, you are missing a very big part of the picture. Then there are global markets. Our basic message is that there isn’t any one financial market. There is a whole giant financial marketplace, and they are all related to each other. In order to understand one group, you have to understand all of them and the inter-relationship between them.

“There are four basic groups that we try to put together: currencies, stocks, interest rates (bonds), and commodities. Generally speaking, a rising dollar is considered good for US stocks and a falling dollar is considered negative. Thus, if you are analyzing the stock market, you should also look at the dollar as they tend to move in the same direction. Right now, the dollar is at a very, very critical spot. The US dollar is sitting on a seven-year uptrend line. If the dollar holds here, it’s good for stocks. If it breaks that – and we tend to think it will – it could be bad for stocks. 

“A weaker dollar suggests a loss of confidence in the US economy. In addition, the decision by foreigners to invest in the US is very influenced by the strength of the dollar. Generally, money tends to flow towards the countries with the stronger currencies. So if the dollar weakens, there is less incentive for the Japanese or Europeans to keep their money in US assets. In recent months, the dollar has been stabilizing, which could have a lot to do with why the stock market is bouncing right now.

“Another inter-market relationship that has held up very well is the US dollar relative to gold. In this case, there is a very strong inverse relationship, which means that they move in opposite directions. The key to inter-market analysis is that some things move in opposite directions and some things move together. So generally, when the dollar is moving up, gold is moving down. It’s not a perfect correlation, but it is a very definite tendency. As we’ve seen recently, as the dollar has been stabilizing and stocks have been bouncing, gold has been correcting.

“There is also a strong inverse relationship between the S&P 500 and gold stocks. Shortly after the S&P hit its peak in 2000, almost to the day, gold stocks took off. And gold stocks, despite correcting recently, have been the top-performing group since then. Gold often gets discredited. People ask why you would want to buy gold stocks when they have been a terrible investment for 20 years. And that’s exactly why. Gold stocks are an alternative to other stocks; they tend to move in the opposite direction. Gold peaked in the early 1980s, when stocks bottomed. So if you accept that the 20-year boom in the stock market has ended, what better place to have some money than in gold? In addition, keep in mind that the dollar has been going down, which as we’ve seen, also tends to be good for gold.

“There is another very key relationship that has been a hallmark of our inter-market work. And it is very puzzling at the moment. Generally speaking, if you go back over the last 40 years, there is a very close inverse relationship between bond prices and commodity prices. That means they move in opposite directions and there is a remarkable correlation. Right now, however, commodities and bonds are moving in the same direction. Although we don’t like to second guess our methods, we do not think this is a fundamental concern. Rather, we would note that oil is one of the commodities that make up the CRB index. We think the price of oil is being driven up by a war premium and when that is resolved, oil will likely come back down. 

“When looking at commodities, we prefer to look at industrial metals, such as copper. Indeed, copper is probably the best indicator of the economy as it is used in everything from appliances and houses to cars. So while the CRB index is rising along with bonds, copper and other industrial metals have been in a bear market and are at their lowest level in a year. Meanwhile, interest rates and industrial metals tend to move together. That makes perfect sense. Interest rates generally decline when you have a weak economy. Back in the spring of 2000, we started talking about a recession because interest rates and industrial metals were turning down. Industrial metals prices are still weak and are still in a bear market. That fits into our view of economic weakness and even some deflationary tendencies. If the economy is really bottoming out, we would want to see a bottom in industrial metals. So far we haven’t seen that.

“For the most part, the inter-market relationships described above have been closely correlated with what one would expect. However, deflation has changed some inter-market relationships. For example, why isn’t the economy responding to lower interest rates?  Traditionally, when the Fed lowers interest rates, the stock market goes up. Well in this case, despite falling rates, the stock market has kept going down. Some people are still worried about inflation. We believe that if there is a threat here, deflation is the greater threat. 

“Japan, which is clearly in a deflation, peaked about ten to 12 years ago. Then, about five years ago, we had a currency crisis in Asia. It lasted for about a year. Currencies and commodity prices crashed. Stocks crashed. But bond prices went up. There was a massive rotation into US Treasury bonds. That wasn’t what was supposed to happen. Normally, when bonds go up, stocks go up. But in this scenario, stocks and bonds did not follow their normal inter-market principles. 

“Basic economics suggests that falling interest rates are bullish for stocks. In the normal environment, when the Fed lowers interest rates, the stock market rallies. But in a deflationary environment, the Fed becomes irrelevant. You may have heard the expression that the Fed is pushing on a string. The Fed can lower rates, but there is no demand. And prices keep falling. We saw that happen in Japan and there is a debate right now as to whether or not we are following that model. During deflation, falling interest rates are not bullish for stocks. In fact, they are bearish, as falling rates are a continued indication of a very weak economy.

“First, you must understand the difference between inflation, disinflation, and deflation. During inflation, prices are going up. That’s bad. During disinflation, prices go up but at a very slow rate. That’s good. We’ve been in a disinflationary period for the last 20 years. During deflation, prices actually drop. That is very negative. You can see that in computers, as they keep dropping in price. During a deflationary period, companies can’t raise prices. Their only alternative is to cut costs, and that means laying people off. In turn, those people can’t buy things. It’s a negative spiral.

“Most economists look at the consumer price index and assume there is no deflation, as the index is still positive, but the bulk of that index is services.  If you look at the producer price index, which is just prices of goods, it has been negative for the last 12 months. We are not saying we are in deflation, but we think investors have to take these factors into consideration. This is part of the puzzle, and you can’t just put your hands over your eyes and say there is no deflation anywhere. We think this view that our economy has at least some deflationary tendencies is at least worthy of consideration. But when you look back in history at the Asian currency crisis, it seems like a dress rehearsal for what we are going through now. This doesn’t mean we can’t have rallies in the stock market, but it does mean that the environment is not that friendly. The boom is over in stocks. That’s the bottom line.

“Finally, I’d like to end on a more positive note. I do think we have hit the lows for stocks for this year.  Most of our technical indicators confirmed a low in October. That doesn’t make us particularly bullish on the stock market, but it does suggest that the worst is over for now. If we are reading it right, that would mean a move back to 9000 or so on the Dow by year end. At that point we would be at the 200-day moving average, and that would be a real test. My guess is that we will have trouble getting through there, and the market will back off from those levels. However, if we get through that level, we would get more bullish on the market.”

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