Zbigniew Piekarski on The truth about deflation
The stock market went sideways throughout 1994, sentiment was extremely bearish and the market metrics of valuation were indicative of a low. Then, between late February and early May 1995, the Dow closed up 10 weeks in a row and marked the start of a market mania.
Should the Dow close up this week it will equal that record at a time when sentiment has reached bullish extremes and when most valuations using the price/earnings ratio are on the high end. Malaysia, Indonesia and South Africa are trading at 17 times earnings while most of the rest of the world's stock markets are much higher, with the Dow around 28. Japan is trading at 111, but is second to the Nasdaq speculation machine, currently trading at 126 times earnings. Remember that the historical mean is about 12.
The Dow may set new records in its move upwards, so may the other bourses, but this time it will mark a top and not a bottom. In his most recent report to shareholders Jeremy Grantham in his Investment U e-letter made this statement: "Today we have substantially the worst prospects for long-term global investment returns of my 35-year career when all asset classes are considered, particularly for U.S.-centric investors. The asset classes collectively are simply the most overpriced they have been. There are no large categories [of stocks] that are good hiding places." Richard Russell, the noted Dow Theorist probably put it best when he said that from now on: "He who loses least, wins."
With the fever for stocks running rampant and the Bush re-election beginning to dominate the news cycle, most pundits are optimistic. Last May, USA Today surveyed 67 economists and each one of them rejected the possibility of deflation.
In separate year-end surveys of economists, The Wall Street Journal and Business Week independently reported unanimity that the U.S. economy would expand throughout 2004. Such unanimity is rare and exceptional and reinforces the lack of both independence and thought in the mania that prevails.
To quote R.R. Prechter, founder and president of Elliott Wave International, "I think that the continual denials that deflation can happen, against a backdrop of evidence to the contrary, appear to be part of a typical social psychological progression toward a credit crisis, which in turn will lead to economic contraction. The money supply might rebound for a quarter or two as the stock market and economy top out this year, but at the largest degree of trend, the credit bubble - 70 years in the making - has burst."
Virtually everyone believes that inflation will accelerate. Stock-market bulls think that the economy is going to boom, bringing inflation. Economic bears expect an inflationary, if not hyperinflationary, monetary crisis. Economists believe that the Fed can inflate at will and is committed to an inflationary policy. The general population is convinced that the prices of their homes and property can only go up. This consensus is not merely overwhelming but reflects a belief as vast and deeply held as a religion.
Against this backdrop of opinion, the money supply M3 has fallen over two percent since September, its largest decline in 60 years. This is different from a lack of inflation. It is real, actual, deflation. What's more, M3 has declined despite the strongest quarter of economic growth in decades, the lowest interest rates in half a century and a central bank committed verbally and by action to facilitating the expansion of credit. There is no interest rate spike or recession to explain away the decline in the money supply.
The dichotomy between what is happening and what people think will happen is colossal. Inflation is dead. Deflation is here, now. The monetary trend is no longer close to the edge of the cliff; it is beginning to slide down its face.
Yet not a single major newspaper, magazine or TV network has done a story on the dramatic contraction in M3. People are so drunk with inflationary certainty that they can't even see that deflation is happening. And if they can, they don't believe that it is meaningful.
On June 25, 2003, the Fed lowered the federal funds rate for the 13th time in a row, to one percent. Most observers think that the Fed still has that one percentage point of "ammo" left. But consider the following: The USA has a thriving money-market fund industry, which costs one percent of assets per year to administer. As it stands now, investors are getting extremely low returns from money-market funds. If the Fed were to let its funds rate drop to zero and other short-term rates fell along with it, money-market investors' return after fees could go negative.
For over a year, the Fed has lowered the price of renting money. It has participated in the initial phase of the deflationary process. It did so in response to slack demand for its product, credit, just as the auto manufacturers and others are doing with their products. Deflationary psychology brings about lower prices, and the Fed has been lowering its prices. It is now powerless to stop the trend.
A persistent decline in the money supply will have consequences. Some things will have to give. One of them will be prices for goods and services.
The Producer Price Index has been flat for three years, and now even the Consumer Price Index has had a down quarter. Severe deflation will also devastate the economy, as it has done in each of the rare times it has occurred over the past 300 years. With M3 dropping, it should only be a matter of months before the economy follows suit.
On the WSE: I hear that external investors are encouraged by the anticipated stability that the new Royal House of Hausner will bring, however, the markets are still undecided.
Should the Dow close up this week it will equal that record at a time when sentiment has reached bullish extremes and when most valuations using the price/earnings ratio are on the high end. Malaysia, Indonesia and South Africa are trading at 17 times earnings while most of the rest of the world's stock markets are much higher, with the Dow around 28. Japan is trading at 111, but is second to the Nasdaq speculation machine, currently trading at 126 times earnings. Remember that the historical mean is about 12.
The Dow may set new records in its move upwards, so may the other bourses, but this time it will mark a top and not a bottom. In his most recent report to shareholders Jeremy Grantham in his Investment U e-letter made this statement: "Today we have substantially the worst prospects for long-term global investment returns of my 35-year career when all asset classes are considered, particularly for U.S.-centric investors. The asset classes collectively are simply the most overpriced they have been. There are no large categories [of stocks] that are good hiding places." Richard Russell, the noted Dow Theorist probably put it best when he said that from now on: "He who loses least, wins."
With the fever for stocks running rampant and the Bush re-election beginning to dominate the news cycle, most pundits are optimistic. Last May, USA Today surveyed 67 economists and each one of them rejected the possibility of deflation.
In separate year-end surveys of economists, The Wall Street Journal and Business Week independently reported unanimity that the U.S. economy would expand throughout 2004. Such unanimity is rare and exceptional and reinforces the lack of both independence and thought in the mania that prevails.
To quote R.R. Prechter, founder and president of Elliott Wave International, "I think that the continual denials that deflation can happen, against a backdrop of evidence to the contrary, appear to be part of a typical social psychological progression toward a credit crisis, which in turn will lead to economic contraction. The money supply might rebound for a quarter or two as the stock market and economy top out this year, but at the largest degree of trend, the credit bubble - 70 years in the making - has burst."
Virtually everyone believes that inflation will accelerate. Stock-market bulls think that the economy is going to boom, bringing inflation. Economic bears expect an inflationary, if not hyperinflationary, monetary crisis. Economists believe that the Fed can inflate at will and is committed to an inflationary policy. The general population is convinced that the prices of their homes and property can only go up. This consensus is not merely overwhelming but reflects a belief as vast and deeply held as a religion.
Against this backdrop of opinion, the money supply M3 has fallen over two percent since September, its largest decline in 60 years. This is different from a lack of inflation. It is real, actual, deflation. What's more, M3 has declined despite the strongest quarter of economic growth in decades, the lowest interest rates in half a century and a central bank committed verbally and by action to facilitating the expansion of credit. There is no interest rate spike or recession to explain away the decline in the money supply.
The dichotomy between what is happening and what people think will happen is colossal. Inflation is dead. Deflation is here, now. The monetary trend is no longer close to the edge of the cliff; it is beginning to slide down its face.
Yet not a single major newspaper, magazine or TV network has done a story on the dramatic contraction in M3. People are so drunk with inflationary certainty that they can't even see that deflation is happening. And if they can, they don't believe that it is meaningful.
On June 25, 2003, the Fed lowered the federal funds rate for the 13th time in a row, to one percent. Most observers think that the Fed still has that one percentage point of "ammo" left. But consider the following: The USA has a thriving money-market fund industry, which costs one percent of assets per year to administer. As it stands now, investors are getting extremely low returns from money-market funds. If the Fed were to let its funds rate drop to zero and other short-term rates fell along with it, money-market investors' return after fees could go negative.
For over a year, the Fed has lowered the price of renting money. It has participated in the initial phase of the deflationary process. It did so in response to slack demand for its product, credit, just as the auto manufacturers and others are doing with their products. Deflationary psychology brings about lower prices, and the Fed has been lowering its prices. It is now powerless to stop the trend.
A persistent decline in the money supply will have consequences. Some things will have to give. One of them will be prices for goods and services.
The Producer Price Index has been flat for three years, and now even the Consumer Price Index has had a down quarter. Severe deflation will also devastate the economy, as it has done in each of the rare times it has occurred over the past 300 years. With M3 dropping, it should only be a matter of months before the economy follows suit.
On the WSE: I hear that external investors are encouraged by the anticipated stability that the new Royal House of Hausner will bring, however, the markets are still undecided.
