The Case for Deflation
...if enough people tell you you're drunk, it's sometimes good to lay down and rethink your drink.
Editor's Note: The following is an instant message conversation between Professors Toddo, Scott Reamer and John Succo.
Reamer: What's up Todd?
Toddo: Scotto - Just spoke to Succo about this and he suggested we gather for a group noodle.
Toddo: I am interpreting the CRB break (if and when) of the trend line from 2002 as pretty bearish for equities (I put two legs in my bear costume with a stop above BKX 114). I have been pinged by reporters and very smart fund managers who don't understand what I'm talking about.
CRB Index, Monthly, 2001-Present
(Chart courtesy Thomson Financial)
Reamer: Well, it would confirm the larger deflation call yes. But at this stage, stocks need to confirm as well by peaking soon and falling hard (which probabilities say are very good). Laundry list is: Dollar and bonds rally, stocks and commodities fall hard.
Toddo: It seems like a fairly lucid stream of consciousness for me---from an 'asset class deflation' standpoint (the other side of dollar devaluation)--and from a straight liquidity standpoint.
Reamer: Corporate spreads would widen big. You can have deflationary CREDIT contraction and have the dollar rally. It's actually part and parcel of the same thing.
Toddo: A stronger dollar seems intuitive in this scenario.
Reamer: Yes, because CREDIT is being shunned...in favor of ACTUAL dollar
Toddo: You guys are much smarter than me--just wanted to make sure I'm not eating a silly sandwich with so many people punching holes in this assertion.
Reamer: Not credit in an account but actual currency.
Succo: It's the kind of thing that is not intuitive to most.
Reamer: No. They punch holes because they confuse credit with paper currency.
Reamer: They are two different things, people think they are the same, they are not.
Succo: Certain stocks see it first as insiders realize prospects of making money are going down (deflation), then it feeds on itself and all stocks begin to react.
Reamer: Weimar Republic had CURRENCY hyperinflation. They actually printed money to repay their allies. Sent them cash. The Fed uses CREDIT to reflate...and that's a whole different animal.
Succo: And that is weakness. The irony is that companies now only take credit to buy back stock, which is helping stocks for a while.
Toddo: Just seems like the crowd is lining up at the wrong teller.
Succo: They have little other use for cash, like always.
Toddo: Potential for an off-sides is there.
Succo: Which is the heart of Scott's work.
Reamer: John's right about buybacks, etc. using credit - inflated credit - to buy back stock while they cash in their holdings.
Toddo: John, what was the stat about the percentage of earnings due to cost cutting you told me last night?
Succo: Hard to get at that, but my guess is a lot, maybe 40%?
Toddo: And your read is that this stat is deflationary because it's not sustainable?
Reamer: Cost cutting is a symptom of deflation, not a cause, that they can't find anything to invest in and can't grow the top line is because of a massive inflationary overcapacity (think fiber optic lines in 1998-2000.) That overcapacity leads to deflation. So that's how the mechanics work: inflation leads to deflation. All credit induced.
Reamer: So the percent of EPS coming from cost cutting is indicative of too much capacity and CEOs' desire to keep EPS growth going so they can ameliorate shareholders (and enrich themselves of course). Like Weldon said...only a matter of time...can't sustain itself because the APPETITE has to change for the deck of cards to fall apart...that means it (credit from the fed) will always be there. It's the motive (appetite) that has to change.
Toddo: Well, thanks for the clarity---again, got hit up from alotta angles and if enough people tell you you're drunk, it's sometimes good to lay down and rethink your drink.
Succo: People have a hard time understanding and getting their hands around deflation because it doesn't happen often due to central banks providing liquidity over many years and it happens as a result of years of credit expansion.
Reamer: Bankruptcies, no wage growth, housing bubbles bursting, etc...all those things could precipitate the move...and could end the demand easily. Which is why vols are so cheap.
Toddo: It's a process, not a point, this we know.
Reamer: Compared to what they COULD be if any one thing ended the credit demand side and ushered in the deflationary credit contraction.
Toddo: But I got to think the CRB breaking a four year trend line (coinciding with a massive reflation effort) is a pretty major development. But, what do I know? (I know I'm grateful for having you guys in the community--thanks!)
Succo: Not only CRB, COF, LEND, housing stocks, CFC, drillers, gold falling, HD, all in down trends.
Toddo: Thanks fellas--you're the best.
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