This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Monday, September 21, 2009

Market poised for dive as deflation odds rise

Sometimes life is a waiting game, and such is certainly the case with the coming correction in the stock market. Day after day, week after week, this market continues higher in a trend built entirely on thin air.

With few fundamentals to support this market recovery, investor sentiment is nearing levels of bullishness, typically associated with bubbles. In the late 1990s, sentiment reached all-time highs for tech stocks, and surged late last year for 30-year Treasury bonds as investors fled stocks. The global real estate market saw unprecedented positive sentiment for years as the housing market boomed, finally coming to a peak about two years ago.

Investor sentiment essentially measures the popularity of a given investment. The higher it trends, the more likely the investment is near a major peak. Investments can’t go up forever; at some point, they simply have to correct. The further an investment gets away from rational levels, the more likely it is to snap back in the other direction. This is reflected in market sentiment.

Today, we can see this not just in most of the stock market, but also in several commodities, particularly precious metals. Gold, which we typically love, has lately enjoyed a run that is extremely overdone on the upside, and it is poised to see a major correction within the next two to six weeks.

Likewise, silver is also overpriced given current conditions. Unlike gold, silver is much more closely linked to manufacturing – that’s where it’s most commonly used — and the economy simply has not recovered sufficiently to support the current price.

While we have been on the path for high inflation for a long time — we still haven’t seen the consequences of the trillions of dollars created in government bailouts — the sad reality is that it is becoming increasingly likely that the United States may enter a deflationary environment in the near future.

Deflation hasn’t been a major issue since the Great Depression, but it is typically characterized by falling prices that result from the slowing of credit, a general deleveraging (e.g. American paying off debt) and, unfortunately, rising unemployment.

These characteristics describe the current situation in the United States frighteningly well. What that means is that Fed Chairman Ben Bernanke, the self-proclaimed expert on the Great Depression — and avoiding a repeat — is looking at the real possibility of a double-dip recession that would cause massive unemployment and nasty deflation.

The problem now, and the reason that deflation is becoming feasible, is even though the Fed, in conjunction with the Treasury, created trillions of dollars last year out of thin air, all that new money simply isn’t circulating because the economy is so terribly slow.

The challenge facing the Fed is how to get all of that new money, currently held by banks as excess reserves in the Federal Reserve System accumulating minute interest, into the hands of American citizens and companies for spending.

At this point, with banks fearing losses from defaults, most banking institutions are happy to leave all that bailout money in the Federal Reserve System earning interest — no matter how small — rather than take the risk of lending.

Just as significantly, there simply isn’t demand for loans on the part of American consumers. The Fed seems to be expecting the consumer to turn around and create demand for credit which will get all their new money circulating. Unfortunately, this is unlikely.

During the past year, the United States has seen a drastic increase in the savings rate, which indicates that most Americans are much more interested in saving as opposed to consuming, much less taking on debt in order to make major purchases.

For years this rate was negative, meaning that Americans borrowed more than they saved. Now, it seems that trend has changed, and with unemployment moving higher and no truly positive economic news to be found (less bad will not suffice), Americans are cutting back on spending and building up reserves of their own.

When it comes to consuming, at this point, companies are much more likely to have any kind of demand for credit. In fact, right now they’re sitting on record cash reserves that could be used to service such debt.

The government’s best course of action would be to offer corporations incentives to loosen their purse strings to invest in expansion projects. This would most likely be done through tax credits for corporations. The current political climate makes this highly unlikely.

Instead, with its outdated fixation on the U.S. consumer, the government is much more likely to try everything in its power to stimulate American citizens into taking on additional debt to make unnecessary purchases. This would most likely be achieved through the expansion of homebuyer tax credits as well as rebate programs like cash for clunkers.

What the government fails to realize is that at this point trying to stimulate American citizens to take on debt and buy things they don’t need is akin to beating a dead horse.

The balance sheets of most Americans have been decimated during the past two years and it should be abundantly clear that the demand for new debt simply does not exist. It’s time the Fed realized this, and looked for another way to rescue the American economy from the brink of disaster.

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