DEFLATION TO THE RESCUE
by Clif Droke
August 27, 2007

Time is the least common denominator of all things, including in the stock market.  We’d all be lost if we couldn’t look at the clock throughout the day since time is our frame of reference for the day’s activities.  So are the days of the calendar and so are the dominant equity market cycles.

With that in mind, let’s step back for a minute and consider where we are in the grand scheme of the 60-year cycle.  The 60-year cycle is one of the most profound market cycles of our lifetime since it usually bottoms at least once during the average lifespan.  The 60-year cycle also closely correlates with the 50-70 year Kondratieff economic long wave (which as the name implies is a wave, not a cycle).  The K-wave averages 60 years and is expected to bottom at about the same time as the current 60-year cycle, in or around 2014.

The 60-year cycle is the dominant half-cycle component of the Kress 120-year Master Cycle series, which governs the major bias of the financial markets over a 120-year period.  The last 120-year cycle bottomed in 1894, accompanying the end of a major depression at that time and kicking off the acceleration of the Industrial Revolution as well as a secular bull market in stocks.  

Since the last 120-year cycle bottomed in 1894, from a time cycle perspective the period that most closely resembles our own in terms of the configuration of yearly cycles is the period of 1884-1894.  This naturally corresponds to the period of 2002-2014.  It’s easiest to start with the fourth year of both decades since this is when the 10-year cycle bottomed in both instances.  The year 1884 was also the bottom of a major stock market decline as measured by the Axe-Houghton Industrial Stock Price Average.  It also coincided with the Depression of 1884.  From the major market low of 1884 the U.S. stock market went on to record all-time highs by 1887.  Then in ’87 there was a decline beginning around mid-year followed by a lateral consolidation before stocks took off again in 1888.  

Stock prices then peaked, forming a double top between the years 1889 and 1890.  From there stocks declined mildly into 1891 then bounced back to a token new all-time high in 1892.  Then came the major crash of 1893 which coincided with the final bottoming of the 120-year cycle.

Fast forward to 2004 and we see remarkable similarities.  Following the 10-year cycle low of 2004 the Dow Jones Industrial Average, much like the Axe-Houghton Industrial Average, has since rallied up to all-time highs in the seventh year of the present decade.  We’ve also seen a summer decline and are in the consolidation period following the latest decline.  If history repeats we should see a further recovery from here and then a stellar year for stocks in 2008 before a peak occurring sometime in 2009-2010 as the latest 10-year cycle peaks.  It’s hard to predict what will follow from there but the law of probability states 2011 is likely to be a bad year for the markets and maybe also 2012.  As mentioned previously, the 120-year cycle is due to formally bottom in 2014 along with the latest K-wave.

Now why have I taken the time to enlighten you with this rather dry history lesson?  Because I believe it provides a useful road map to lead us through the current market environment and into the next two years ahead.  Everywhere we hear talk of how the coming 60-year/120-year/K-wave bottom will mean significant downward pressure against the financial markets from here onward but that clearly isn’t self-evident.  The heavy downside pressure against the stock market back during the “hard down” phase of the last 120-year cycle didn’t really hit stocks hard until around 1892, some two years before the cycle bottomed.  

Were the comparable years 1887-1889 bad for stocks on balance?  Absolutely not!  They were mostly bullish years.  So why can’t the 2007-2009 years be bullish for stocks as well since we’re the same amount of time away from the 120-year cycle bottom?  Answer: there’s no reason why the coming two years won’t be bullish for stocks on balance. 

More than anything else the 120-year cycle is a guideline for the forces of long-term inflation and deflation.  These inflationary and deflationary forces are more often visible in the economy than they are in the financial markets in the grand scheme of things and we’re currently experiencing K-wave deflation.  While you wouldn’t know it from looking at your grocery or gasoline bill, you can see the forces of cycle-related deflation by looking at prices for electronic goods among other consumer goods prices.  This is partly a function of demographics and emerging market logistics as the former Third World countries are able to produce and export goods much cheaper than the mature, developed countries such as the U.S.  This is one way of looking at the effects of cyclical deflation.

Another way of looking at deflation is to see the effects that 120-year/K-wave deflation have recently had on the housing and property market.  While there has been much speculation on the effects the sub-prime mortgage lending problem and the housing price decline will have on the financial markets and economy, the overall effect is likely to be much less detrimental than commonly supposed.  An argument could even be advanced that the housing price deflation is a good thing in the overall scheme.  In the face of the current 6-7% consumer price inflation, lower housing prices will mean greater affordability to those who were previously priced out of the housing market.  There is already preliminary evidence that younger buyers are buying condos and houses in the Washington, D.C. metro market in response to the reduced prices.  This shows us that while the volume of activity isn’t nearly as vibrant as it was 2-3 years ago, the demand is still there and in the end lower prices always creates its own demand.

This is just one example of how, in a financial system loaded with liquidity as ours is, deflation can sometimes be a good thing inasmuch as it tends to benefit consumers and retail investors who recognize the opportunities it brings.  The deflationary tendencies of the falling 120-year cycle also keep economic inflation from getting out of hand in spite of the government’s relentless tendency to increase the volume of money.  Indeed, history shows that until the final 3-4 years of the 120-year cycle come upon us there is likely to be an upward bias in the stock market based on the complex set of factors that make holding stocks profitable during all but the final stages of a deflationary cycle.  

The effects of deflation were extremely visible back in 1998 as commodity prices sagged while the U.S. dollar index rallied.  Oil prices were $10/barrel and the price of a gallon of gasoline was in some cities just under $1.  Retail and consumer prices were also low at that time.  Much of the impetus behind the considerably higher commodity prices of today in the face of K-wave deflation can be attributed to the effects of the war in the Middle East.  War is the great cure for deflation as history shows time and again.  The last time the 120-year cycle bottomed it was the Spanish-American War that lifted the economy out of the doldrums and lifted the general level of stock and commodity prices.

Already the comparisons are coming in for the LTCM crisis of 1998 after the Fed pumped money into the system last week.  The latest infusion of money has been commanding newspaper headlines around the world with the media engaging in a feeding frenzy of scaremongering.  The front page of the August 10 business section of the Washington Post asked, “Where did all the money go?”  The article pointed out that the European Central Bank injected $130 billion into the system as the interest rate fell to 4%.  This in turn led to “financial institutions scrambling for crash, lifting the federal funds rate as high as 5.5%, well above the Federal Reserve’s target rate of 5.25%,” said the Post.  “As a result, the Fed put $24 billion into the system to bring the federal funds rate back down to 5.25%.”  This headline was accompanied by two related stories, both on the same page, with these headlines:  “New order ushers in a world of instability” and “Low-risk borrowers now feel the crunch.”  

Can you smell the fear in the air?  I certainly can and it’s showing up big time in the market’s leading psychology indicators.  Several of these indicators have given super-bullish signals and these signals are telling us that we should ignore the headlines and remain bullish on the stock market, including the natural resource sector.

Speaking of the resource stocks, in last week’s commentary I pointed out the massive oversold reading in the 20-day price oscillator for the XAU gold/silver index, which reached its lowest reading in over two years with last week’s correction low.  This showed the market is stretched like the proverbial rubber band to the snapping point.  A rally lasting several days was predicted and that’s exactly what we got as the XAU bounced off its correction low of 125 (closing basis) to its latest rally high of 139.43 as of Friday, Aug. 24.

Our resource sector focus in this week’s commentary will be the Ishares Silver Trust (SLV) which tracks the silver price.  

The above chart shows the 5-day and 20-day price oscillators for the SLV and as you can see, the 20-day oscillator (blue line) is still in the oversold zone.  This suggests a relief rally lies ahead for SLV and the silver price.  The decline in silver along with the PM stocks in the recent panic selling was overdone and the indicators suggest the market will compensate for the extreme selling that was done by taking price back up to its pre-panic level.