Increased Caution Is Warranted
by Jay Taylor
August 21, 2006
investorshub.com
I have seldom felt a level of uneasiness about the markets as I feel now, and judging by much of what I am reading, many if not most of my peers—who, by definition are those who think for themselves and outside the box the establishment would put us in—also feel this unease. There is a rising number of economists and market analysts both among the establishment and outside of the establishment who are calling for a recession to begin late this year or early next year. Let me give you just a couple of examples.
*Nouriel Roubini, chairman of Roubini Global Economics and professor of economics at the Stern School of Business, New York University. He is putting the odds of recession at 70%, up from 50% last month. He says it is likely too late for a Fed easing to avoid a recession. He sites housing, high oil prices, and higher interest rates, and notes that “The US consumer, already burdened with high debt and falling real wages, will be hard hit by these shocks.”
In the conclusion of an article he wrote for the Financial Times titled, “The World Must Prepare for America’s Recession,” he concluded, “Implications for financial markets of this global slowdown will be serious; although we may see a rally in the wake of the Fed's pause and later easing, one can expect a subsequent slump in the US equity market. When the reality of a recession sinks in, global equity markets will fall with currencies and bonds in emerging markets, especially those with large external deficits. Finally, the dollar risks a disorderly fall as the US current account deficit becomes unsustainable. Central banks and private investors are now concerned about losses on holdings of dollar assets. Thus, US consumer "burn-out" may be followed by the flight of foreign investment amid rising trade and protectionist pressures.”
*Economist John Williams, editor of Shadow Government Statistics, points out that absent statistical manipulation of inflation, the U.S. economy is already experiencing negative GDP. In his missive of July 29, 2006, John states, “Due to an unconscionable manipulation of the inflation data, those results masked a quarterly contraction that likely was in excess of 0.5%. A contraction would be consistent with the current, though officially unrecognized, recession. Please note that this contraction is before any adjustment for the upside methodological biases built into the existing GDP reporting.”
On July 17, John wrote: “Collapsing economic activity and mounting inflation dominated last month’s economic reporting. An inflationary recession is in play, and there is little the Administration or the Fed can do about it. This has created a nightmarish scenario for the financial markets. At the same time, international tensions have escalated to the point where risk of a conventional world war is the highest it has been in 61 years. With the U.S. economic and global political conditions unraveling so rapidly, underlying fundamentals do not get much worse for the equity and credit markets, nor much better for gold. Circumstances are fluid and disorderly markets are possible with little or no warning. The U.S. dollar faces severe selling pressure in the near future, although political flight-to-safety effects are providing the greenback with temporary, albeit short-lived, support. The timing of the dollar’s demise ultimately will determine the timing of the fate of the other markets.
I believe around 95% of my gold bug friends think policy makers will inevitably continue to print money until our system hyper inflates us into a devastating depression. Perhaps they are right. However, living through 1980 when Paul Volcker triggered a 180-degree monetary policy turn from an excessively easy policy under Arthur Burns and G. William Miller, I am not convinced a similar policy does not lie somewhere in the near future. How or why would the current landlords of the world—the powers behind the U.K. and U.S. thrones—allow inflation to crash and burn their dollar and hence their empire? Why would should we be surprised if once again, they chose to throw the U.S. economy into a sharp economic decline if they saw no other means of retaining the dollar as the world’s reserve currency and their position as dominant leaders in the world? Really, it was the threat of the U.S. losing control of the international financial system—not inflation—that led to the Volcker interest rate hike to 15% and 20% that saved the U.S. dollar in 1980. True, the demise in purchasing power of the dollar caused capital to flee from the U.S., but it was because of the threat of the inability of the current global ruling elite to own the world’s reserve currency and hence maintain their empire that the American people were sacrificed by way of the deepest recession since the 1930s during the 1980–82 time frame.
The rush out of the dollar has not yet begun in earnest, but as Dr. Nouriel Roubini points out, concern is growing among foreigners. When/if flight of capital from the dollar begins, I am not convinced Wall Street and my gold bug friends won’t experience a deflationary shock of a much greater magnitude than we experienced in the 1980–82 time frame when the Volcker medicine resulted in the deepest recession since the Great Depression. Indeed, Ian Gordon’s work suggests that was simply the Kondratieff summer ending event that set the stage for the disinflationary autumn and the asset inflation that was to follow in what is actually the most pleasant period of the 60-to-70-year Kondratieff cycle. As Ian points out, the real pain begins after the Kondratieff equity market peaks. At this stage, there is no reason in the world that 2000 was not the peak in equities this cycle. As such, there is no reason to think those of us who lived as adults through 2000 will see a new high in stock prices in our lifetime.
Yet I hold open the possibility, if not likelihood, that we will experience much more inflation before anything like a deflationary downturn takes place. In that environment, we might see stock prices remain high in nominal terms, but, as in the 1970s, lose real value akin to what was lost in the 1930s. We simply don’t know nor can we be certain what the future holds. As Richard Russell says, we’d best let the market speak, which is why I constructed my Inflation/Deflation Watch that I believe should be a leading indicator of future global economic activity. While my IDW is displaying some softness, it is waffling around at present and as such remains inconclusive in predicting which way things will go in the great inflation/deflation debate. Before concluding that we have tipped over to the deflation side, I would want to see the three-week moving average for our IDW break decidedly below the 10-week and 20-week moving averages and then ultimately for the shorter-term averages to move below the 52-week moving average. As you can see from the chart below, that has clearly not happened yet.
Most importantly, if we enter a deflationary period, I would look for our Global U.S. Dollar Liquidity reading to drop toward zero and ultimately into negative territory. At this juncture, this measure of liquidity, which is simply U.S. dollars with foreign banks plus the U.S. dollar monetary base, continues to grow at around 10% per year. The last time the world was facing a serious deflationary threat was during the Asian Crisis. Then the measure of money actually shrank by nearly 5% over a rolling 52-week period.
Other signs of the equity markets are looking ominous. The following is published on Dr. Robert McHugh’s Web site at technicalindicatorindex.com
The NASDAQ 100 is Crashing. The Dow Transportation Average continues to CRASH, down 125 points Wednesday, and down 16.3 percent from July 3rd through Wednesday August 9th! They could act as a magnet and drag the Blue Chips down with them. We received the 9th Hindenburg Omen since April 7th on Thursday May 11th, 2006. Since then, we have seen daily point declines in the Dow Industrials of 142, 120, 214, 184, 199, 99, 86, 120,135, 121, 166, and 107 points over five weeks, the latest drop on Friday, July 14th. This is not good price action, and is reminiscent of precrash September 1987. Both the 4 year and 8 year cycle bottoms are due in 2006. Equity Markets are dropping. Yet, worse, a surprisingly sharper decline is coming after this rally completes.
Richard Russell, who I consider to be among the few legitimate Dow Theorist practitioners remaining, has also been talking frequently about the major decline in the Dow Transports. So far, the Dow Jones Industrials have not confirmed the downside move by the Transports, but according to Dow Theory, if/when that happens, we could be looking at a major decline in stocks. One thing we believe is absolutely true are the following words of Austrian economist Ludwig von Mises: “There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later a final and total catastrophe of the currency system involved.”
Our sense is that we may be very near a tipping point in the equity markets, and as such, caution is warranted. We think the next leg down in the secular bear market that began in 2000 could well be underway and should it come, a recession or worse could be in the offing. The warning signs are all around us. To ignore them would be foolish. As such, we are making some suggestions below as to how we might seek to preserve our wealth in the midst of possible impending market turmoil.
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