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Will Inflation or Deflation Win?

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It's not about who is right; it's about where you're standing as the arguments unfold.

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Approaching the interaction among asset classes is a bit like discovering puzzle pieces in a box and trying to fit them together without really knowing what the finished product is supposed to look like.

There are essentially two camps expecting the following:

1. A dollar decline, lower bond prices, higher stock prices (at least temporarily as a function of currency debasement) and sharply higher commodities, including gold.

2. Dollar rise (as a function of de-leveraging and debt destruction), higher bond prices, lower stock prices and lower commodities, including gold, as a function of a collapse in global demand.

Virtually all analysts and theorists present some version of these scenarios. They're the orthodoxy, the conventional wisdom. Some believe number one is occurring right now. Some believe number one has essentially already occurred and that this is the last gasp before number two prevails. Some believe number two will inevitably be followed by number one, and so on, and so on. But almost all market participants fall somewhere within the two camps noted above.

Of course, it's worrisome when there seems to be such uniformity of agreement, even if the agreement is between opposing camps certain who the group on the other side of their trade is. Essentially, these sides form a boundary of extremism; on one side are the hyperinflationary collapse forecasters, on the other are the deflationary depression forecasters. The reality is likely to fall somewhere in between, which is the primary topic of "Five Things" coming later this afternoon.

Meanwhile, one reason the market feels so strange here may be related to the fact that there are disagreements among various time frames.

This can be clearly shown on the CRB Index, for example. The monthly chart of the CRB Index shows three important things when viewed through the lens of DeMark studies:

CLICK TO ENLARGE



1. The solid red line indicates a qualified break of a TDST Down level, which means when probabilities are enhanced we proceed to a full countdown 13, which eventually means lower prices.

2. The TD buy setup that recorded in April was imperfect (in other words, the low of either bar eight or nine didn't exceed the low of bars six and seven). These imperfected setups are often perfected at a later date, which eventually means lower prices.

3. We're getting late in a TD sell setup (bar six this month). If the sell setup continues to completion, then we'll need to see closes in November (possible bar seven) above 257.45, December (bar eight) above 253.68, and January (bar nine) above 259.39, which also eventually means lower prices but illustrates that the upside is still unfinished.

File that information away for a moment while we look at the daily chart.

CLICK TO ENLARGE



This chart shows two important things as well:

1. The solid green line at 262.04 indicates a TDST Up level was broken in a qualified manner, which means the recent sell setup nine that recorded yesterday will likely proceed to a full countdown 13, which means short-term higher prices.

2. The jagged green TD Propulsion Up Momentum level at 263.99 was also broken and qualified, with the TD Propulsion Up target at the light blue jagged line, 281.25, which also means short-term higher prices.

Combining this with the longer-term time frame, we have a monthly floor for the CRB Index of 253.68 on a closing basis, and a short-term upside target of 281.25.

However, the larger monthly time frame ultimately shows a high probability of being resolved at much lower prices -- below 200 at least. So contextually we need to understand that the CRB Index, reflecting a basket of commodities prices, is involved in a short-term move up that is counter to the primary trend, which this DeMark study tells us is down. When prices are rising, it's helpful to know that the context of that rise is counter to the primary trend.

This information, along with the upside exhaustion signals accumulating across multiple time frames for gold and silver and the downside exhaustion signals for the dollar that still need a move below 70 to fulfill, suggest we're in a window where the counter-trend forces of reflation are temporarily prevailing. In my mind, that's important information that helps with short-term decision making and provides a context for short-term trades.

The task we now face is allowing the market path to unfold in its due time. We've known for most of this year, for example, that this quarter and the first quarter of 2010 are going to be very influential in the future path of markets because long-term quarterly DeMark indicators will, over the next three to six months, reach a point where an either/or question is answered; for example, either a long-term buy setup will record on the S&P 500 (and many other global indices), or it won't.

How these long-term patterns resolve themselves will influence how I choose to allocate long-term capital over the next few years. It will also influence which of the two camps described above has the upper hand. but let's be careful when we consider even the term "upper hand."

I couldn't care less which camp is "right," though I've tried to make the case that the second camp is the one that's about to emerge with some leverage -- sorry about the pun.

Markets unfold throughout time with no end, so it's imperative to understand that neither of the two camps will actually "win" anything because there's no termination point, no award ceremony, nothing to win. They will be passed through and then newer cycles will reveal themselves over time. Thus, the toggle between the two is where there's money to be made.

It's not about who's right; it's about where you're standing as the arguments unfold.

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No positions in stocks mentioned.

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