Bull, muddle, bear?

The problem with finance and economic analysis is that it mostly relies on history. Their bias is the assumption that nothing is new; that everything will or should, return to a norm. They are ahistorical, in other words. So let’s try something a bit different. Scenarios of the future. We will begin with a report by Deutsche Bank about the Australian stock market. It starts with, unsurprisingly, a historical analogy:

The last couple of months have brought a sense of déjà vu – this time last year markets were also dominated by concerns around European debt, soft US data, and the extent of China’s slowing. We expect these concerns to abate in coming months, which should buoy equities in the second half of 2011. In Australia this could see a rally in resources and banks in particular.

It notes that in the US, employment data (both payrolls and weekly jobless claims) have disappointed, and the ISM dropped sharply. In Europe, there are renewed concerns around the fiscal outlook for the peripherals, especially Greece. Inflation remains high in China, and the PMIs have fallen in the past 2 months. Then it says that while the US has again hit a soft patch, it should be only temporary (return to norm, that is). China, Japan and Europe will also return to norm:

The impact of Japan supply disruptions and poor weather will abate, and a double dip is unlikely given discretionary spending remains low. Private sector job gains have been on a steady uptrend for the past year (ex. May), which we find encouraging. And while the ISM has fallen, it remains consistent with good growth. Strong corporate profitability, a pick-up in corporate loan demand, and very low real interest rates are also positives. Our economists expect that the 23-24 June European Council meeting will endorse a new lending package for Greece, which could calm the market. Spain is by far the biggest peripheral, and an improvement in their public finances and the boost from tourism exports is comforting. Meanwhile, conditions in core Europe, particularly Germany, are solid. While inflation in China remains high, the recent trend in daily agricultural prices points to some moderation in coming months. And while the PMIs are down, they remain above 50 and thus point to solid growth. Further, the OECD’s leading indicator points to solid growth continuing in coming months.

These “return to norm” scenarios are always the safest for analysts. Thus we get this for the Australian market:

The Australian equity market has seen very limited sector divergence this year, as is common in soft markets. If the global environment improves, the market should move higher, benefiting at least some sectors. Better risk sentiment could see commodities head higher (as in 2H10), buoying resource stocks. Banks look cheap and have limited near-term downgrade risk. Across the rest of the market, cyclicals have been weak but don’t look overly attractive – earnings downgrades have limited PE de-rating, and further downgrades could be in store as the high AUD persists. Valuations for defensives look reasonable, given they inherently have less downgrade risk. In sum, we retain our portfolio strategy of O/W resources, banks, resource capex plays, food retailing and utilities.

So far, so predictable. The report then goes on to look at which sectors are cheap (figures 23-33), concluding that only building materials, packaging and contractors are expensive by long term historical norms. Mining looks cheapest on 12 month forward earnings multiples.

So let’s have a little experiment, one in which I hope you participate. Three scenarios for the ASX: bear, muddling through, bull.

Scenario 1. Bear.

Over the next year, the Chinese economy starts to experience something it has not had for over two decades: a business cycle. Iron ore prices fall sharply, causing a widespread correction in the Australian resources sector. The complacency in Australia is shattered, which contributes to what is already a rapidly weakening housing sector. The All Ords has a major correction, hit by the twin effects of less valuable holes, and less valuable houses. The banks start to get into serious trouble, and require the re-establishment of government guarantees. The Australian dollar gets weaker as the trade weighted index falls, but still remains high because it is seen as an energy play because of Australia’s massive LNG reserves, coal and uranium. So there is only a mildly relieving effect for an already battered manufacturing and services sector. The Reserve Bank drops rates, leaving investors with few decent choices for decent returns. Perhaps the best plays are cash, gold miners and emerging markets (which is both a growth and currency play, but which is also a complex investment option). The US economy goes into a double dip recession, greatly increasing the need for a war to re-establish spending and increase employment (soldiers). It is the beginning of the death throes of the hegemony of the American empire. Likelihood: 20-30%.

Scenario 2: Muddle

The global economy experiences moderate growth rates and China continues to power on at 9-11%. Commodity prices are reasonably stable and because the value of mining stocks is mostly priced in capital gains are just alright. Energy and food prices continue to strengthen, rewarding Australian investors in those few stocks that are available on the ASX. Investors who look at overseas energy and food options do OK, but the strong currency trims returns. The US economy has low growth, and Europe bumps along the bottom but manages to keep the Euro zone together by finding ways to help smaller countries default without imperilling the banks (debt for equity swaps are the preferred method). The All Ords goes mostly sideways, putting an emphasis on high dividend paying stocks: Telstra turns out to be the surprise performer. The housing market eases slightly, causing the banks to be under performers and further denting consumer sentiment. The Australian dollar stays high, meaning that manufacturing and exports are subdued outside primary resources. Interest rates go nowhere, and Australia starts to get used to a low growth Eastern seaboard and a high growth resources and energy sector. High tax revenue from resources keeps the government in a strong fiscal position, but the Australian economy starts to be permanently skewed away from secondary and tertiary industry. Only companies that start to successfully globalise, or which have strong domestic market shares, have good strategic options. The best plays are defensive stocks, good global companies, resources and energy, emerging companies and local cartels that pay strong dividends. Banks and retail struggle. Likelihood: 50-60%.

Scenario 3: Bull.

China’s strength continues and it starts to aggressively open up its financial markets. This begins the unleashing of capital as China looks to ensure security of supply in raw materials and energy. This electrifies the resources sector of the Australian market. China struggles to get control of local companies but the mere presence of Chinese buying pushes up valuations. China also starts listing companies in Australia to find new avenues for capital. The Australian dollar hits new highs, harming manufacturers and services exporters, but the Australian government, which has strong tax revenues from the mining boom starts to look at ways to support the old economy through direct support. On strong income growth, Australian houses flatten out and even inflate a little, relieving pressure on the banks and retail. Interest rates rise and savings remain strong but not enough to choke the services sector. The long awaited boom in life sciences stocks starts to materialise, helping offset some of the weakness in retail and banking. Investor sentiment and fear start to decrease, in part due to a better than expected recovery in the US, which leads to stronger earnings multiples on the ASX. Perhaps the best plays are: resources, life sciences, construction, wealth managers, food retail. Emerging markets may also be good, but there is likely to be a negative currency effect. Likelihood: 15-25%.

OK, see what you think. I’m a bear, myself.

http://www.scribd.com/doc/57561036/0900b8c0837607a7

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Comments

  1. My view is a mix of the above, SON.

    I reckon we’re going to see a long slide in equity prices, accompanied by a meltdown in commodities and rally in the $US.

    As we get towards the end of the year and the underlying deflationary forces in developed economies return, we’ll see a mad rush for stimulus (QE3) which will immediately return global markets to the inflation trade and we’ll enter a 2008 global inflationary blowoff that will explode in 2012.

    Sometime next year this cycle ends in an emerging markets inflationary meltdown.

    Either that, or the bar for QE3 is so high that John Taylor is right – this cycle is already in its death throws…

    • I mainly concur – halfway bear/muddle. The major thrust of the ASX200/All Ords for the foreseeable future (2-5 years) is sideways bearish.

      5000 points is almost equivalent to the 6700 point high of 2007, because valuations are coming off a much larger equity base but hugely reduced Return on Equity.

      Hence, profitability is lower and investors are less willing to pay higher earnings multiples.

      High and/or stable dividend stocks will likely go nowhere, but shouldn’t fall in price as much as growth/resource stocks.

      Might be a good subject to discuss next week?

      (paradoxically Cochlear has fallen over 12% and now has a good dividend yield)

      This is a trader’s market – without the March 2009 reflation rally, the market has been going sideways for 2 years, and volatility will include corrections, impulse rallies (e.g post Japan Earthquake) and fluctuations around lower valuations, in my opinion.

      I remember Gerard Minack’s graph about likely trading range post-GFC which illustrates the point clearly – have you seen that one Sell on News?

    • I sound like a broken record I suppose because I simply do not understand how you can have such confidence about QE3. As I pointed out in comments to another article it has done nothing, particularly w.r.t the labour force participation and share of income which that article was about.

      Whereas the US media seemed equally divided on QE3 — now the balance is against it based on my reading (confirmation bias?) — over here, removed from life on the ground in the US and US politics the assertions seem near unanimous that QE3 will happen. Crazy stuff IMO.

      Try this link:

      http://pragcap.com/the-qe3-conundrum

      • I have confidence in QE3 for the following reasons:

        a) the money printer will print
        b) the money printer will print
        c) the money printer will print (h/t Marc Faber)

        Nothing in Fed rhetoric or thinking has changed from the past thirty years so far as I can tell.

        Say it with me: the money printer will print.

        When enough deflation is obvious to enough people, the money printer will print. The only question is when that will be, before a US recession or after.

        • Have you turned into a 60 year old Swiss man with a ponytail?

          “Mr Bernonke vill prvint prvint prvint! Eet is ze unly ting he knows!”

          • MontagueCapulet

            So far the Fed has printed in measured doses whenever deflation seemed to be gaining the upper hand. And they’ve signalled a pause in printing when people started to make noises about inflation.

            I expect they will do this for the rest of the decade. Look at Japan during the last 20 years.

            Their goal is to print just enough extra money to counterbalance the decline in M3 that would otherwise have happened. Enough QE to stave of debt deflation and keep Treasuries afloat. But not so much that oil gets expensive and kills the economy.

            I expect we’ll see QE3 and QE12. But they won’t simply print to infinity, they’ll pause and let inflation subside after each burst. In that way they they condition the market to expect a trading range – the Fed won’t let the deflation take hold, but they won’t let inflation get above 3% either.

            They’ll pause until people start screaming for QE, then they’ll pause when people start clamouring for them to stop.

            Repeat for the rest of the decade. They are not aiming to fix anything, its all about kicking the can down the road until after 2020 and hoping a miracle comes along eventually.

          • MontagueCapulet excess reserves are not counted in M2 and M3 therefore QE has no effect on M2 and M3.

        • a) QE is an asset swap not money printing

          b) QE is an asset swap not money printing

          c) QE is an asset swap not money printing

          Say it with me: the money never leaves the Fed therefore by definition has no effect on the economy.

          (As with your post, I liked it so nice I have posted it twice.)

          • Believe that if you will. But it doesn’t matter. What does is that markets don’t agree with you. When the Fed goes for QE, markets go for inflation. It’s a self-fulfilling prophecy that has plenty to do with the symbolic power of monetary policy.

            And who said anything about the economy? How quaint.

          • But it doesn’t matter. What does is that markets don’t agree with you. When the Fed goes for QE, markets go for inflation.

            yeah right. And how are treasuries working out for PIMCO?

            By any metric, bonds, Bond-TIPS spreads etc. bond markets haven’t “gone for inflation” other than noise.

            bond markets = smart child

            equity markets = average child.

            commodity markets = idiot brother.

            Bond markets get it. Eventually the rest will catch on.

          • Sorry, should have been more precise. I meant equity, commodity and currency markets will back the ‘inflation trade’. The US bond market is right that the underlying current is deflationary but that doesn’t mean that cyclical impulses won’t be strongly inflationary in EMs and those exposed to the commodities complex ie us, Latin America etc.

            Looking for clean answers in US monetary aggregates is paralysing your thinking.

          • To revist your comment above you see the Fed as a money printer, i.e. if things are bad they have plan A which is to “print money.”

            Therefore your position seems to be a reflexive “if things are bad bring on QE3.” You’ve painted yourself into a corner by not adequately considering that the Fed is already investigating why this hasn’t worked and the political dynamics that drive these decisions.

            Back to the bond market, you were trying to present a point of view not so long ago, when debating me in comments, that the market for US debt will dry up (a discussion about the US default fantasy).

            So I guess the two things we need to mark down and follow in coming months are the market for US debt from July onwards and further QE.

            Just to reiterate my predictions: there will be no shortage of buyers for US debt and there will be no QE3.

          • ‘und yoo need a machine-gun now und a farm. Und buy ggoooldd…’

            Agreed Troy, QE THUS FAR hasn’t been about money printing and rather lowering real rates on bonds.

            However, I’ll risk turning in to a stuck record here as well and say that with regards to Feds potential measures to stoke investment, we haven’t seen anything yet. Bernanke has openly talking about inflating the house market in the past and taking extreme steps to actually raise M3 (which we did, come to think of it….).

            We should all be discussing what QE3 could actually look like rather than assume we’ll get an exact repeat of QE2.

          • Alex78, short of actually buying housing stock the Fed cannot do anything to stop the fall in house prices. The US equivalent of a first home owners grant worked for a little while but that is a government tool not a Fed tool.

            Also any additional hand outs by Obama would be blocked by the republicans.

            The point many seem to be missing is that a willingness to lend is useless unless there is a willingness to borrow.

            You cannot create a willingness to borrow using any of the tools that are left. (though I’m sure acolytes of failed economic theories will say that this could work)

            If Bernanke did actually do helicopter drops of money then this would help but I don’t think anyone has yet suggested that the next round of QE would involve helicopters. If he wanted to credit everyone’s bank account this would help as well. Neither of these ideas would eventuate. You need to factor the political atmosphere — something that no one seems to do from Australia.

          • Assets????

            Try toxic. Try no value. Try rewriting accounting rules to fabrication.

            Show me the money?
            Bollox! Show me the assets!

        • the money printer will print

          No, no, no, you have it all wrong. It goes like this…

          “Mr Bernanke is a money printer. He will print, and print and print!”

          Oh yeah and…

          “If I were you I’d buy a farm and a gun”

          I’m sniggering just typing this.

        • Seriously though, if the US economy keeps weakening, and Wall St keeps doing this swan-dive impression, they’ll print alright.

          What else have they got? Congress is in gridlock, the Republicans best idea is austerity (that’s working well for the UK, not) and the Democrats best idea is spend money they don’t have.

          Its looking more and more like a lost decade or two for the US. Meanwhile, what’s gonna drive China’s export engine? I see China’s exports are slowing again. Will China open the credit floodgates again, and go on yet another investment binge, or will they really try to get consumption going this time?

          The latter choice is good for China. The former choice is good for Australia.

          • …we could just all accept that we can’t escape the consequences of our collective actions, and that the only decent answer in the long term is outright deflation, selflessness and a lot of hugs!

            My 2c

        • -1
          The money printer hasn’t printed anything other than phantom theories. Check out some of Paul Kasriel’s work.

    • MontagueCapulet

      “…we’ll see a mad rush for stimulus (QE3) which will immediately return global markets to the inflation trade…”

      I think the inflation trade relies largely on the China Story being intact. If their real estate bubble rolls over sometime in the next couple of years and their demand for resources moderates, the “risk-on” response to QE3 or QE4 or QE5 might be progressively more subdued.

      After each round of QE it will become more apparent how temporary the effect of the fix is, and just how profoundly deflationary the global environment is once you take the stimulus away.

      At the moment, you have China struggling to control inflation which provides a counterpoint to the deflationary forces in the West. If China slumps and inflation is brought under control there, you’ll need larger and larger stimulus hits in the USA to get any reaction from markets.

  2. Deutsche Bank: “Further, the OECD’s leading indicator points to solid growth continuing in coming months.

    …whereas the ECRI was doing the media a couple of weeks ago tipping a global slowdown in the second half.

    Deutsche Bank: “Banks look cheap and have limited near-term downgrade risk.

    I’m sure MB will want to store that little gem and revisit this prediction at the end of the year and through into 2012.

  3. ECRI have such a good record, their forecasts can’t be lightly discarded.

    I have sold nearly everything and therefore have a bias to call the market even lower! However, I think there are good reasons to expect the wheels to fall of the growth buggy.

    Growth in global industrial output certainly passed an inflection point in the first half and is now decelerating throughout the industrial economies.

    The origins of the surge in industrial output through 2010 lie first in the seldom-equaled severity of the collapse in 2008/9 and then in the magnitude of the revival measures that followed.

    The resuscitation applied at the scene of the emergency certainly worked to arrest the decline and inspire a rebound. But industrial expansion has run into a series of broadly negative forces: the limited extent and too-rapid withdrawal of fiscal support from the global economy, the indebtedness of consumers, the sudden and now prolonged loss of jobs, the frailty of the financial sector, the run-up in commodity prices, – especially but not only, energy costs – widespread excess capacity, beggar-thy-neighbour exchange rate policies, and the depleted fiscal capacity of most Governments.

    These things have meant that final demand has tended to be insufficient to carry industrial production (and employment) into a more energetic expansion.

    The result will be at best a lapse into stagnation and at worst renewed convulsions that may completely rupture the global economy.

    This crisis has its genesis in the creation of a vast, mostly unregulated, speculatively-focused shadow-banking sector (the Chinese financial sector should be included here), and in its evil twin: a pathological addiction to unsustainable fiscal policy by most of the world’s wealthiest economies.

    These abject failures of public policy have not yet been rectified and still carry the potential to precipitate renewed chaos.

    That’s why I sold my humble super portfolio.

  4. ECRI have such a good record, their forecasts can’t be lightly discarded.

    I have sold nearly everything and therefore have a bias to call the market even lower! However, I think there are good reasons to expect the wheels to fall of the growth train.

    Growth in global industrial output certainly passed an inflection point in the first half and is now decelerating throughout the industrial economies.

    The origins of the surge in industrial output through 2010 lie first in the seldom-equaled severity of the collapse in 2008/9 and then in the magnitude of the revival measures that followed.

    The resuscitation applied at the scene of the emergency certainly worked to arrest the decline and inspire a rebound. But industrial expansion has run into a series of broadly negative forces: the limited extent and too-rapid withdrawal of fiscal support from the global economy, the indebtedness of consumers, the sudden and now prolonged loss of jobs, the frailty of the financial sector, the run-up in commodity prices, – especially but not only, energy costs – widespread excess capacity, beggar-thy-neighbour exchange rate policies, and the depleted fiscal capacity of most Governments.

    These things have meant that final demand has tended to be insufficient to carry industrial production (and employment) into a more energetic expansion.

    The result will be at best a lapse into stagnation and at worst renewed convulsions that may completely rupture the global economy.

    This crisis has its genesis in the creation of a vast, mostly unregulated, speculatively-focused shadow-banking sector (the Chinese financial sector should be included here), and in its evil twin: a pathological addiction to unsustainable fiscal policy by most of the world’s wealthiest economies.

    These abject failures of public policy have not yet been rectified and still carry the potential to precipitate renewed chaos.

    That’s why I sold my humble super portfolio.

  5. I’m totally with H&H.

    Just about all the big players like PIMCO, and many more have lost faith in the FED, and Ben know nothing else other than to print money (or asset purchase if you prefer).

    While I believe QE2 +QE1 + QE Lite failed – I don’t believe the asset purchases that are converted to money on the FED’s balance sheet QE’ing don’t have the potential to effect the economy. The new base money is supposed to be lent by banks to companies, and some does find it’s way there, but more goes in equities (US P/E went from 13x to 23x).

    Russell Napier said this:
    “QEII fails – Sell US equities
    We have long argued that America would be the first major economy to
    reflate and US equities would be the key beneficiary. As belief in this
    reflation has grown, cyclically adjusted PE has risen from 13x to 23x.
    Inferences from history suggested that equities would keep rising until
    inflation reached about 4%. However, recent data imply that the US
    reflation is in trouble. QEII has boosted reserves but banks continue to
    reduce credit, while broad money has contracted. There is material
    downside risk to equity valuations.”

    Watch US equities, and I believe ASX start to fall off over the next 3-12 months. If there is a big change in US policy things could change, but who knows.

    • the ASX was near 5000 and its at 4550 now, we can see it falling already not in 3-12 months LOL

  6. After seeing the S&P chart on ZH that compares 2002 with 2011, I’s day we’re in for a rough ride ahead. China was not on the scene in 02 but given events that coming out of China such as the bailing of non-performing loans to government run enterprises suggests they might not be in a position to help regardless.

      • Thanks Prince, much appreciated. Does ZH read Macro? It’s a shame the MSM doesn’t pick up on analysis pieces like this but at least Macro’s had a few runs in the SMH – building up to something big?

  7. Buy rubies – not gold! Have a strong position in actual currency!

    Real and potentially devastating risks are posed in a world with a quadrillion dollar derivative market and a 15 trillion dollar real economy. These are the same risks that threatened the wipeout of the global derivative market in 2008. The real problem. All else seems chicken feed. If these markets crash, so does everything.

    A Business Insider interview with Jeff Gundlach.

    http://www.polycapitalist.com/2011/06/vide-jeff-gundlach-on-whats-better-than.html

    • Spot on, and Geithner knows it. On Wednesday he was pushing the European to align regulations on derivatives, but it’s too late. Why didn’t he see the problem in 2008. It’s much worse now.

      Not sure on the Rubies thing however …

      Central Banks are buying gold still, but they may also be buying Rubies :-))

      • Gundlach, pointing out one of the practical difficulties of the goldbug’s dream – the actual carrying of gold – it’s heavy. He joked you’re better to have $25million in rubies, you can put them in your shoe and still wear the shoe – try carrying around $25million in gold.

        His clientele clearly a tad wealthier than I – the choice between rubies and gold in those amounts – sadly a pleasure I am unlikely to experience.

        • Yeah I watched his vid. On gold if you have the right numismatic coins you can carry 25 million easily in gold.

          If we have a Armageddon event we’re all in a lot of trouble and I’m not sure what would work. I’d like to think we won’t get to that stage. But who knows, and Geithner is worried as everyone should be.

          If a singularity event occurs none of these guys will be held accountable.

        • IF gold comes into its own, then you wont need to measure gold in and currency, you will need to measure it in ounces.

          and not many people have 25 million, most people have nothing they live on credit.

        • And now he’s voicing concern because he really knows the problem!

          Think of the financial leadership in the US – each and every one of them there in 2008, some architects of financial deregulation that resulted in and exacerbated the crisis, oblivious to the oncoming GFC tsunami…and all still there, hands firmly on the levers of control.

  8. Perhaps some more ‘informed’ people could explain why Deflation is considered so bad?

    From my perspective the price increases of nearly everything over the last decade+ is ridiculous and my confidence to borrow/spend will not be restored until large falls occur. Dare I say I wouldn’t be alone.

  9. Quick question H&H, how far do death throws normally go? I have always wondered … (just kidding).

  10. Deflation is not an immediate problem if you have no debt. The real future value of your cash will go up even if you do nothing at all. But this is a problem for everyone else, because the cash-positive will tend to become hoarders.

    On the other hand, if you are in debt, deflation is likely to be a disaster. The sum owed may remain the same in nominal terms, but starts to increase in real terms, and most likely your ability to service it starts to decline. This is pretty much what is happening in the US housing market at the moment.

    Once a deflationary cycle commences, it is extremely difficult to arrest and as it intensifies, the burden on the indebted becomes ever more severe. If deflation becomes a generalized phenomenon, consumption, profits, employment and incomes will start to spiral down. General misery awaits.

    • Flip side being that those in debt are rewarded and those without debt are punished in an inflationary environment.

      I guess a zero inflation/deflation policy would be ideal.

      • Andy….

        The point is when there is modest inflation, savings can be rewarded with a positive rate of interest. In a deflationary environment, both borrowing and lending become highly problematic. Borrowing is discouraged because the real value of borrowings will increase even as they are paid off. And lending is discouraged because the marketability of collateral and the capacity to service debt both become difficult to appraise. The creation of debt becomes more risky for both the debtor and the creditor. Savings rates go up, and, even though interest rates fall, investment contracts. The credit-creation process stalls.

        A corollary of this is that businesses have to increase their reliance on equity to fund their operations. Equity is usually more difficult to obtain and is more expensive than debt, so the general rate of capital formation contracts.

        At an incipient level, we can now see this at work to some extent in the US. The banking system is replete with cash, but will not lend to small businesses, who in any case are reluctant to borrow. As a result, the volume of debt issued to SME’s has been declining.

        Likewise, very large non-financial corporations in the US hold vast amounts of cash – said to be approaching $2 trillion – and yet are slow to invest it. In a deflationary climate, it makes sense for individual firms and households to hang onto cash rather than invest it….and the result is a spiral into broad-acre stagnation…

        Let there be inflation…..just not too much!!

        • Except that inflation (expansion of the money supply, without suitable expansion of goods) tends to net reward those who get hold of the new money first – and results in net wealth transfer up that pyramid of new-money-holders: from the last to the first.

          Inflation is, in effect, a secret and insidious wealth transfer scheme.

          Intended? Probably not.

          In effect? Absolutely, regardless of all the clever machinations of all the clever people to make appear and be otherwise.

          Deflation is, IMHO, the less of evils – at least the prudent don’t suffer for their prudence. A system that rewards otherwise is a sick system indeed – it deserves to fail.

          My 2c

          • I don’t quite get the logic here, BurbWatcher….

            “inflation …. tends to net reward those who get hold of the new money first”

            This is certainly true in a deflationary context. If you have money, you will be inclined to never part with it because its value will go up even if you do nothing but wait. In fact, the longer you wait, the greater will be the increase.

            Think of an extreme case. Suppose prices are falling steeply. Nominal interest rates may fall to zero, but will still have a positive real value. The further prices fall, the higher the real rate of interest. As real rates rise, savings will also rise and consumption will fall, driving down business sales, production, profits and employment.

            As well, rising real interest rates will induce a decline in investment, compounding the decline in output.

            Systemic deflation will eventually result in semi-paralysis.

    • Also are there any good historic examples of deflationary environments like you mention, or is that just theory?

      Plenty of hyper inflation examples around I know of, with the only deflation example being the great depression – wtf else did people expect after the inflation/excess of the roaring 20’s?

      Thx for the input.

      • The 1930’s are the text-book example, and Keynes General Theory of Employment, Interest and Money is the best analysis of deflation – what causes it and how to respond to it….

        Post-bubble Japan (from the collapse in 1991) is also often cited…

    • id say deflation is less misery because the market will clean the stink out naturally….pumping things up will only destroy the currencies and cause more choas, looting, killing for food.

      Deflation is bad for banks, the governments and the debtors….the nobles of this world.

      • Deflation is a destroyer – most particularly it destroys jobs and prevents the creation of new ones, condemning people to the vise of poverty.

        We have not experienced prolonged mass unemployment in industrial economies since the 1930’s, but it is returning in some places – parts of the US, Ireland, Spain, Greece, Portugal, parts of the UK. This hardship is still relatively isolated.

        It is a very serious issue and looks like it will be made more intractable by the slowdown in global industrial production we are now observing. It is notable that in the US, where total output has now recovered to match its pre-recession peak, total employment has barely begun to recover from its recession-lows.

        We have this peculiar situation in the US, where the finance system is still caught in a solvency shock, and yet prices in the real economy have been rising. So we have not seen general deflation in the price of consumer staples, but nonetheless we have seen the attrition of household incomes and an absence of job creation.

        All other things being the same, you would have to suppose this will translate into renewed contraction at some point.

  11. Prince,

    The charts look even more bearish if you look at the 30 year chart for the DJIA.

    You will notice the near perfect head and shoulders pattern that seems to be forming. If this market cannot hold at the current levels then hold on.

  12. In the meantime, the refusal of Americans to properly finance their public institutions remains a fundamental cause of this crisis. The State of California is essentially broke….and yet the political players find they stand to gain more by opposing compromise than pursuing it. Completely destructive madness rules in Sacramento as elsewhere in the US….

    “From Bloomberg….California’s Senate Republicans blocked Governor Jerry Brown’s plan to erase a $10 billion deficit as closed-door talks remain snagged on his demand for higher taxes as a deadline to pass a budget looms.

    Republicans oppose the governor’s proposal …”

  13. SON,
    good summary of the 3 options. I put it at 10-80-10. However, the one certain thing in this life is change and the world is way to strung out to handle it IMO. So all that is needed is a grey swan and then everything tanks. I dont know how to factor that in.

  14. Quantitative easing= Swapping Frn’s for garbage written by banks- not some kind of intelligent policy. The test for this is if you could explain it to someone ten years ago without them fitting you with a tinfoil hat.
    Surely when we get to QE n+1 we may finally realise that none of this can be bullish for any asset class, inflation,stagflation, deflation even the new term of biflation none of the possible outcomes seem particularly enticing.
    The fact that we are debating the possibility of QE 3 means we are in a great deal of trouble.