Inflation, Deflation, or Goldilocks?

At last, the S&P500 turned down, ending the week witha 5% loss.  The bounce off the March lows defied skeptics and ran further than most analysts expected.  The VIX also crept up a bit, but not in any way that suggests panic selling. 

The equity markets marched up anticipating a V shaped recovery in the economy.  And leading the rally were the trashiest group of stocks–financials and retailers, the same groups leading this market and the economy downward starting in late 2007.

But the economy is not bouncing back so quickly, as this week’s data revealed.  Retail sales slid in April, as opposed to rising as projected.  Initial claims jumped back up into the mid-600,000 zone and continuing claims soared to 6.56 million (the 15th consecutive record high).  GM and Chrysler notified about 2,000 dealers (combined) that their franchises will be terminated; this move alone could wipe out over 100,000 more jobs.  CPI and PPI  both fell, on a year-over-year basis, the most since 1955.  And industrial production and capacity utilization both continued their relentless slide downward.

Green shoots?  Hardly.  The economy is beaten down and from this low point, still showing no signs of turning up.  The falling off a cliff may have ended, but a slow death by a thousand cuts is no cause for celebration.

Technically, the long term bear market trend is still in force.  The daily charts show a very overbought condition that is breaking down.  We need another week of data to confirm the correction to the downside.

Read the press today and you’ll get two contradictory forecasts for the future of the U.S. economy.  One forecast calls for massive inflation.  The Fed and the Treasury have lent, spent or guaranteed over $10 trillion to push up economic activity as well as asset prices.  The scale of the stimulus, relative to GDP, is unprecedented (truly, not just in recent memory).  The problem is that the government–in unleashing such massive fiscal and monetary stimulus–will have a hard time taking it away when the economy starts to turn up.  The result is that the government could overstimulate (especially on the money supply) causing inflation to rise. 

The other forecast calls for massive deflation.  With total credit market debt at record levels relative to GDP (370%), the debt load in the future must unwind.  If debt contracts (by default or principal paydown), then asset prices–both real and financial–should contract as well.  This push down in asset prices and wealth could restrain future lending and aggregate demand (especially consumption), causing economic activity to fall and prices to drop.

What’s the answer?  Actually both forces are at work.  Think of these forces as two tsunami-size waves, both crashing into each other from opposite directions. 

The result?  Not clear.  It’s possible that the two waves will perfectly cancel each other out.  As desirable as this is, it’s highly unlikely to happen.

What is clear is that one of the two waves will probably swamp the other.  And that’s the problem.  It’s highly likely that either inflation will spike or that deflation (Japan-style) will kick in.  Not knowing which wave is going to dominate is less important than knowing that one of them will.

Why?  Because it rules out the goldilocks scenario–the one that is currently priced into the equity markets.  If either inflation or deflation predominate, stock market prices should fall, possibly a lot more, sometime over the next 12 months.

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