08/16/09 7:34 pm - Long Term Market Analysis Update

I’ve been looking at the big picture across all major markets lately, and have arrived at a turn of my long term view. I believe that we’ll remain in a deflationary environment for several years to come, at least two but likely more, and that inflation will only set in after the deflationary debt destruction has run its course. Credit is contracting faster than money supply is increasing, despite the efforts of the Fed to pump trillions into the system. The “financial holes” generated by credit that is marked-to-market (e.g. mortgages gone upside down by a 40% collapse of housing prices) are much larger and are growing much faster than the ability of the Fed to plug them. The trillions of dollars the Fed is pumping into banks is sorely needed to keep the banks alive, and even after several bailouts of mind boggling proportions the banks are in no position to lend, to direct the money where it’s needed to get us out of this mess (e.g. to pay down mortgages, credit card balances, etc.) Thanks to our fractional reserve fiat money system, the amount of credit in our economy dwarfs the amount of “real” money (cash and bank reserves), and it is the collapse of this giant credit bubble that soaks up any available cash out of the system as fast as it is printed or injected into the economy. The current state of our economy can be likened to a giant margin call hitting one over-leveraged investor, the Federal Reserve.

It is this situation coupled with recent economic events and developments and supported by economic data and chart patterns that have led me to the following conclusions of what I think will unfold over the next 3-6 months:

1. The dollar has made a major bottom and is turning up for a bull rally that may well last over a year. The pattern on the EURUSD dailies chart looks very similar to the pattern of last summer, just before the collapse of the Euro in August. The recent upleg does not look healthy at all, but tired and vulnerable to a break to the downside. The next few weeks will tell whether we’ve seen a top or not, it is possible we see an exhaustion rally first before the downside gathers momentum, but I believe it is more likely that this is it, that the dollar will move up from here.

2. The stock market is very close to a peak, and will turn down very soon to retest its March ‘09 low. Consumer sentiment came in lower than expected, banks keep failing (almost 80 banks have failed so far this year), the FDIC is almost out of money, banks keep lying about their balance sheets and refuse to mark their impaired loans to market just to stay alive, and the government is not very efficient in “trying to help”. Looking at a daily chart of the S&P500, we have hit major Fibonacci resistance near 1000, and the RSI has just turned down from overbought. The last leg of this rally looks weak and is running out of steam. The S&P500’s P/E ratio stands at a dizzying record high of 140. I believe we’re about to see a major collapse, possibly triggered by a big item of bad news, or the market will simply fall of its own weight.

3. Gold will not exceed $1000/oz and will turn down as the dollar goes up. Gold stocks will follow. I think gold will not do well in a continued deflationary environment. It has done well earlier this year in an enviroment of risk aversion, and in expectation of inflation when the government announced bailout after bailout, but I believe we’re headed into a market where the need for dollars will outstrip gold’s allure as a safe haven commodity. I think there’s a fair chance we’re seeing a return to $700/oz by the end of this year.

4. The real estate market has only made a seasonal high and will turn down. I live in California, and closely follow the California real estate market. The recent upturn in prices does not make the long term chart look like it has bottomed. It looks very much like a seasonal bump, and it is very likely that we have at least 2-3 years of falling prices ahead of us. Looking at the chart below it is clear that real estate markets don’t make V-bottoms, and I don’t see how this market can be any different. If anything, we’ll see a prolonged bottom since banks are unwilling or unable to cut their losses fast. Instead they put off foreclosures, NOD filings, and drag out short sales. I strongly believe that housing prices will stay depressed despite a record high affordability index. The bottom line is that people are simply out of money, cash strapped, and need every dollar they can get their hands on to deal with their debt. Very few have saved up the down payment needed to qualify for a loan today.

All of these events are coupled, and chances are that either all of them come true, or none. We’ll know very soon.