GoldenBar Briefs
01 July 2001

But Deflation Argument is Not Real Deflation
Are we getting off track? Let's review our expectations: we called for a Dow plunge in May/June and it's now July.

The Fed inspired April rally peaked in mid May, just short of breaking out. Since then the Dow has fallen back into trend. Except for the two "days" after each of the last two rate cuts (April 18th and May 15th), excluding the most recent, most anyone who has bought stock is likely at breakeven now. Additionally, regardless that Fed officials keep telling us that it takes six months for a rate cut to work, had investors waited 6 months in 1998, they would have been buying the beginning of a long top, at best.

Consequently, the only way to make money in the stock market today remains the same as it has been for two years, in most cases: "tell" someone else to buy stocks and persuade them to pay you for the advice.

3 year Dow chart

The Dow is priced at 29 times earnings! It is priced to sell, not buy, and accordingly, it has been developing the largest top in history. Our call for an imminent 4000 point crushing defeat for the Dow bulls remains intact, firmly.

We haven't cared much for the Nasdaq, nor have we commented much about it, but it had started to come up for air again, last week, undoubtedly brought to life on the Microsoft news and prior gains. The broad SP500 is still locked in a downtrend. The Russell 2000 and the AMEX, which the bulls have been pointing to all week, have been somewhat better performers, raising the prospect for a small cap rally. However, experience with small caps shows that they will not be able to buck the trend in the blue chips... which is still broadly down. Thus, when the Dow buckles, so will they.

Bonds got clobbered today (Friday), which is extremely important because they have not been able to stay above the 200 day moving average - the approximate trend line. It is also troubling because the dollar has been quite strong, as you know.

In fact, the overtly strong dollar has been one of the thorns in our analysis. It has risen by about 5% since the start of May - against a basket of international currencies with which the U.S. trades - which is why we devoted such a long piece on the subject in The Goldenbar Report this week.

In that report - Say, Can You Hear - we discussed the effect of the strong dollar and inflation policy duo, on the state of the economy, and we concluded that the dollar deflation, while wholly responsible for the decline in commodity indexes (since January the CRB is down by 11% and the Dollar Index is up by exactly the same - implying that the decline is a dollar induced "price" adjustment rather than the result of falling demand), is not the same as a real deflation, which happens when the supply of money contracts.

In fact, last week the Fed reported its money supply statistics for the week and they continue to accelerate:

13 week rate of Increase till Jun 18:
6 week rate of Increase till Jun 18:

Nonetheless, the break in the bond this week is that much more important, for it confirms rather than rejects our analysis, so far. And let me tell you something else, for the record: if bond yields begin to rise from here, as we expect that they will, you can bet your fanny that the FOMC will follow, sooner or later! Though probably sooner if the dollar starts to decline. The moral of the story is that as an investor; if you're watching the Fed and/or the CPI/PPI for your direction, get a new broker.

Both of them lag the markets!

Anyhow, the point of last week's treatise was to have you think about how the strong dollar policy will create shortages in markets where there may exist less relative demand, for the moment, while the aggressive inflation policy of the Fed will accelerate prices, and thus production, of the assets or commodities, which are in higher relative demand. Indeed many of the declining commodities, such as coffee and corn for instance, we had found that both, consumption was on the rise in accordance with Say's Law, and that their stocks to use ratios have been steadily declining over the past decade reflecting a persistent underestimation of consumption trends by producers.

Yet mainstream analysts not only continue to read lagging indicators, but also claim that there is too much supply in many commodity markets.

In 1998, when oil prices were at $11 a barrel, analysts thought there was too much oil. When (after) they rose to $30, the same analysts thought there was a shortage. Now when prices have been retracing, they have come to believe that there is too much oil again. They may be right one of these times, but they haven't been so far. In fact, according to Say's Law, there is no such thing as over supply.

Again, as you look at most commodities, both consumption and production has been rising, and it is only the price, which helps us ascertain whether it is the result of a rise in demand or a rise in production. Certainly, a rise in inventories is a sign of something, but whether it is a sign that there is too much oil and gas, or whether it is a sign of the inflation induced hoarding behaviors we've been discussing remains to be seen.

That said, the Fed continues to inflate, and we expect that concurrently, the strong dollar policy, if it continues, will discourage producers, in the industries that are affected by it, from investing in additional natural resource capacity. Thus, we expect to see more upside in the commodity markets, broadly, as the focus shifts from one imbalance to another until one day, the resonance (Fekete) begins to move them all together, higher.

We further believe that the FOMC's more gradual rate reduction is a sign of change to come. The ECB has made it clear that it cannot tolerate inflation. They don't mean to be nasty, but the fact is that they're dealing with a new currency, inflation rates are soaring in Europe, and within the next year or so they will have to introduce Euro paper into circulation.

Thus, the policy that the Fed and Treasury have pursued, of exporting the Fed inflation overseas, may soon come to a climactic ending. If US policy makers want to persuade a rate cut in Europe then they will have to let the dollar fall... if Europe chooses to submit to US pressure otherwise, the Euro will collapse, and even more important, the dollar will soar. Thus the U.S. may get what it wants without having to make it so. Collapsing foreign currencies will induce a strong dollar all on their own.

However, we've also noted last week, that collapsing foreign currencies have an even greater potential to accelerate the price of gold, regardless of how high the dollar goes.

If dollar policy makers believe that the world will choose dollar over gold at that point, when other world currencies are falling apart, they will be under the same delusion that Congress was when it allowed Nixon to break the dollar gold linků they were convinced that the dollar would be the people's choice, and that it would rise against gold if they broke the link. But there is a simple reason that it didn't work then, and why it won't work today:

The source of the problem is the dollar and Fed.

Good Luck,
Ed Bugos

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The Goldenbar Report: is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you toconfirm the facts on your own before making important investment commitments.