A Dose of
Reality
Here are extracts from commentary
recently posted at www.speculative-investor.com.
An "unwelcome
fall in inflation"
The statement issued by the Fed following
last week's monetary policy meeting included this gem:
"...the Committee perceives that
over the next few quarters the upside and downside risks to the attainment
of sustainable growth are roughly equal. In contrast, over the same period,
the probability of an unwelcome substantial fall in inflation, though minor,
exceeds that of a pickup in inflation from its already low level."
When the Fed talks about inflation
it doesn't mean inflation in the correct sense (an increase in the money
supply), it is referring to rising prices for goods and services. Therefore,
Greenspan and Co. appear to be worried about a substantial fall in prices.
The question is, why? After all, computer prices fall substantially every
year, yet no one complains about being able to buy better computers for
less money and the computer industry hasn't collapsed. Why wouldn't it
be good, rather than bad, if prices throughout the economy mimicked computer
prices and fell every year?
As a result of on-going productivity
improvements the natural long-term price trend for most goods is down.
This trend is blatantly obvious in the computer industry because the gains
in productivity over the past two decades have been spectacular, but it
is also applicable in most other industries. The reason that prices actually
spend most of their time rising, rather than falling, is because credit
growth is typically a lot faster than productivity growth. Therefore, what
the Fed is really worried about isn't falling prices, it is slower credit
growth (high credit growth is what prevents prices from trending lower).
In our 23rd April commentary under
the heading "War Cycles and Peace Cycles" we explained why slower credit
growth could be such a huge problem. In a nutshell, under the current monetary
system almost all new money comes into existence as the result of a loan.
Every newly-created dollar therefore brings with it a liability in excess
of one dollar due to the obligation to pay interest, and this, in turn,
means that the total of all obligations to pay money will be greater than
the total supply of money. Furthermore, the more money that is borrowed
into existence the greater will be the gap between the total supply of
money and the total of all obligations to pay money. Obviously, all attempts
to keep the system afloat by facilitating faster credit growth will only
provide momentary relief while creating an even bigger problem for the
future. Momentary relief is, however, the overriding goal of current Federal
Reserve policy.
Interestingly, after trending lower
for much of the past 16 months the rate of credit growth has recently begun
to move away from what the inflation merchants at the Fed would probably
consider to be the danger zone. As evidence, note the definite up-tick
in the year-over-year M2 growth rate illustrated on the below chart. Based
on US Government and Federal Reserve actions and statements over the past
two years, we suspect that a year-over-year M2 growth rate of 6% is now
considered to be dangerously low. That is, the money supply must now expand
at the rate of at least 6% per year to allow most existing debts to be
serviced. The M2 growth rate had fallen to 6.4% in early January this year,
but thanks to massive government borrowing to finance the war in Iraq and
to the lowest interest rates in many decades, momentary relief has been
accomplished.
The break
of the downtrend isn't 'real', yet
We regularly include a chart of the
S&P500 Index showing the downward-sloping channel in which this index
has moved since the first quarter of 2000. We won't include the chart today,
but will note that the latest rally has done something that none of the
other bear market rallies has been able to do - break the S&P500 Index
out of this channel. This upside breakout does not indicate to us that
a substantial up-move is going to occur in the near future, but it does
reinforce our view that a major decline is NOT on the cards as far as the
next 1-2 months are concerned.
Interestingly, although the S&P500
Index in US dollar terms (the way it is typically reported) has broken
out to the upside from its 3-year channel, the S&P500 in terms of hard
money (gold) has NOT broken out. As the following chart shows, the S&P500/gold
ratio appears to be 'rolling over' below its channel top. In fact, in terms
of gold the S&P500 is below its 21st March peak.
We place greater importance on the
chart of the S&P500/gold ratio than on the chart of the nominal S&P500
Index. We do this because the speculating herd pays far less attention
to the S&P500/gold ratio than it does to the S&P500 Index.
The above comment warrants additional
explanation. Millions of traders and investors look at charts these days
and most of them can figure out where to place trend-lines and can recognise
many of the chart patterns. As such, an obvious upside breakout will usually
prompt the legion of chart-followers to buy while an obvious breakdown
will prompt this crowd to sell. Therefore, if you were a large player with
a lot of stock to distribute one of the ways to do so at the most attractive
price would be to manufacture a breakout above obvious resistance. You
could then distribute your stock into the buying frenzy created by the
breakout. Similarly, if you wanted to buy a substantial position at the
best possible price one way to do so would be to first manufacture a breakdown
below obvious support.
Further to the above, it is very important
to observe the behaviour of price following a breakout rather than just
reacting to the breakout. Also, it is our opinion that a chart that is
not followed by many market participants is less likely to be manipulated
(is more likely to represent the true situation) than one that is followed
by almost everyone.
Regular financial market forecasts
and
analyses are provided at our web site:
http://www.speculative-investor.com/new/index.html
One-month free trial available.
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