Its Deflation

We have seen a huge deflation of wealth in both the real estate and stock markets and we feel that on the macro level, the duration of this economic downturn has quite a ways to go yet. This situation is global and is the result of almost 40 years of credit expansion in the US, which was focused on the US consumer, who became extremely leveraged in his home equity, more than at any time in history. Add to that, we had a stock market deflation and the end result has been a wealth deflation of massive proportions, and we have yet to see more than the tip of the iceberg in regards to the impact of this meltdown.

This would suggest then that the stock market has further to go on the down side. But we just had the US elect the first colored president in their history. This election appears to have given the US a sense of hope and that optimism may well translate into investors feeling that things might not be as bad as first thought. People are now looking at stocks as being cheap here and there is some appetite to get back into the markets and not miss out on the big rally everyone is expecting.

But we are a bit more cautious here. We do expect that there will be a nice rally in the next week or so. We could see a rise of 20-25%, maybe seeing the S&P hit up to the 1200 – 1260 range. But if we get to those levels (say in 6 months) and then people look around the globe and are seeing economies still experiencing serious problems, we could see another strong downward decline, resulting in lower lows than we have just experienced.

We hate to sound so negative, but the reality is that after decades of the economy riding on the back of the American consumer, that consumer is tapped out. The troubling part is that these consumers are not holding back because they just want to save some money. They are not spending because they can’t – they don’t have any equity to borrow against and even if they did, many are scared that they could lose their job.

On Friday, we got the unemployment numbers and they were horrific. In October there was a loss of 240,000 jobs. This is the initial number, but as we saw with the revised August and September numbers, we can expect October’s number to be revised upward. The revised August and September unemployment numbers showed a further loss of 179,000

The US has already lost 1.2 million jobs this year and there are many more to come – we expect to see another 1 million jobs gone in the next 8 -10 months. Of that 1.2 million, over half of these losses have occurred in just the last 3 months, as the recession in the US ramps up.

Every age, race, and sex category saw increasing unemployment rates and worse – saw the duration of unemployment increase. In addition, we now have 6.8 million people in the US working part time due to economic reasons – an increase of over 2.5 million in the past eighteen months.

When you see this kind of income deflation, you know that it will spread and impact more and more industries. Even the sectors that were seeing employments numbers improve, areas such as health care, are now leveling off and turning down.

This is a rolling deflationary period that is moving like a steam roller, taking out industry after industry. Taking a look at the retail sector, the big US retailers have seen their stocks plummet in the past few months. JC Penny’s stock has gone from over $80 last June to under $20 last month.

In the past couple of weeks we have been hearing that the auto industry in the US is now looking for more bailout money. Having seen the retail numbers are we going to see this sector be the next in line for government handouts - or how about Las Vegas casinos? Betting on MGM’s stock price has not been a good bet as MGM has seen their stock price plunge from $100 down to $9 in the past year. When do these guys start lining up for bailouts? Our point here is that as this deflation rips through the economy, the consumer will not be consuming, which exacerbates the situation.

All of what we have talked about here has not gone unnoticed by the central banks of the globe. Day after day we are seeing massive stimulus programs being initiated. Yesterday it was China announcing a $600 billion program. Earlier Japan added a $275 billion program. Country after country has been slashing their interest rates, all in an effort to getting credit flowing again.

Unfortunately, we believe that it is going to require much more capital than has been put on the table to this point. And let’s not forget how much has been handed out to this point.  Earlier this week the U.S. Treasury announced that it will borrow another $550 billion between now and the end of the year — that is more than the entire deficit for fiscal 2008. Add this to what has already been announced and it is really quite staggering. In no particular order:

• The $700 billion for the TARP program announced in September  • $123 Billion for AIG • $30 billion for Bear Sterns • $25 billion for the big 3 automakers • $200 billion for Freddie and Fannie • $200 billion for the Federal Administration Rescue Bill for bad mortgages • $90 billion to JP Morgan to rescue bad Lehman debt • $200 billion for the Fed’s Auction Facility TAF • $30 billion each for Brazil, Mexico, South Korea and Singapore – totaling $120 billion • An unclear total to cover the increased bank insurance coverage to $250,000 per account.

There has been much more and certainly more to come - we are looking at over $2 trillion and counting. Yet to come is what will be required to fend off this rising unemployment crisis. We know that the auto industry will get more; and with the lack of consumer spending, there will no doubt many more stimulus packages coming from the central banks.

To our way of thinking the best we can hope for in the next 6 months is a leveling off of economic problems. In order to get the economies moving, there needs to be massive wealth reflation and we are talking trillion and trillions of dollars. At this time, the data and the math simply do not show that happening, at least not for a long time.

What is driving all of this is the de-leveraging and de-speculation, causing deflation. The lack of appetite for risk is the “fear” that is causing the volatility to be so high. The peak of the boom was when we had passive investors, borrowing money to invest in commodities. We had pension funds, hedge funds and the general public move into the commodity sector in a big way. Commodities were rising because there was wealth inflation, meaning there were more and more consumers of these commodities. Investors jumped on that trend, many investing on credit and all was well until the bubble burst.  We do not know how long this recession will last, nor do we know what the results will be from further stimulus packages and hidden surprises. As we have said in previous articles, trying to pick a bottom in the stock market based on some theoretical halfway point of this recession is a very risky business.  We have said many times that the market is a leading indicator and it will anticipate the recovery about six months in advance. Given that this may be a very long and slow recovery that could be quarters away, be very careful when you hear bullish commentators on CNN calling this the bottom.  As we move forward, we are going to have to be very flexible in our investment strategy and a simple buy and hold mentality can be dangerous in a climate like we are in. For example we see a real contrast of opinion for the bond market. On one hand there is the camp that believes that interest rates will continue to be low, resulting in rising bond rates. These folks believe that due to the declining economy, people will continue to put their money in bonds because they don’t want to be in equities or assets and they don’t want to leave their money in banks.  On the other hand, those who are bearish on the bond market believe that with such massive stimulus packages being created by governments around the globe, there is going to be a glut of bonds flooding the market. Watching this bond market will give us a real key on how the markets are going to respond.  Our view on this is that currently the governments are still in the midst of creating these packages and there are more to come. Until we have seen the global central banks stimulus endeavors expended, we will not see the results of the bond market tug of war. We are seeing some of the results now as even though we have seen the TED spread and LIBOR rate come down some recently, they are not where they need to be.  When these central banks are done stimulating, we will be watching the treasury market closely. When stress hits the treasury market due to a massive increase in supply from various central banks stimulus packages, we could see the credit worthiness of the treasury market come into question. We are already seeing credit default swaps on US treasuries and Japanese government bonds go up – something that we have never seen before.  We understand that Credit default swaps are not are not easily understood by most investors, but this situation could be very important to our investing strategy moving forward. Credit default swaps are contracts conceived to protect bondholders against default, and pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.  So when we see that the credit default swaps rising, this implies that there is some fear creeping in that the US and Japan could fail to meet their debt agreements. Now this is a very unlikely scenario, but we are seeing some pricing in the markets that they will completely fail – an amazing new sentiment. We will be watching this very closely.  Gold

When trying to determine what the story is with gold, we look at the ratio of gold to gold shares as one of the indicators. Looking at the XAU/Gold ratio, we can see that gold shares as depicted by the XAU index are trading at their lowest level compared to gold since back to World War ll.

What this suggests is that either the gold shares need to rise dramatically to catch up to gold, or that the shares reflect the true trend and that gold will decline to close the gap. With the deflationary pressures that we have been talking about, we will most likely see a bit of both scenarios – gold declining further, while the share prices rise.

The bullion price seems to have acknowledged the deflationary scenario and let’s face it, compared to the commodities; gold has done very well in not losing as much value as most every other sector did. The stocks on the other hand got caught in the massive sell off of equity stocks.

The price of gold is confirming what we have been talking about for a while now – we are in a deflationary period and it is going to take a massive effort to re-inflate from the current economic levels we are in today. Gold along with the bond market will be key indicators whether we will see new wealth creation, resulting in an inflationary trend in which gold will do well, or do we wallow in this credit deflation, resulting in some serious economic pain.

Remember that we will get through this. If you have used your sell stops over the past year, you should be in good shape here – with lots of cash and ready to pick up some bargains. But before you spend all your money at these prices remember that just because these stocks are down 40% or more doesn’t mean they are all good value here.

We will be buying some stocks soon and when we do, we will issue a Flash Report. For now though we are primarily holding on to cash and watching our key indicators. Stay tuned!