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Commodities Are Sending Deflationary Warnings to Stock Market

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The deflationary action in commodities spells danger for other asset classes like stocks, currencies, and real estate.

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US stocks are still trading near all-time highs and they continue to defy deflationary forces in the broader economy and elsewhere. Does it spell trouble ahead?

John Makin, a resident scholar at the American Enterprise Institute, wrote the following in a November 2013 report titled, "Beware the Monetary Cliff":

"Unlike the US fiscal cliff, which was largely defused by congressional action, the US monetary cliff -- which will be reached if US inflation rates turn negative -- cannot be easily circumvented. Over the past two years, US, European, and Chinese inflation rates have drifted steadily lower, and Japan's 'end-deflation' initiatives have produced only modest relief from 15 years of negative inflation (deflation). Once an economy slips into deflation, the risk of falling into a self-reinforcing deflationary spiral rises."

The impact of deflation is certainly being felt firsthand with depressed commodities prices. Commodities, as a group, have crashed 59% since 2008. Is it a warning sign of deflation ahead for the rest of the stock market?



We'll use the iShares S&P GSCI Commodity Index Trust (NYSEARCA:GSG), which follows a broadly diversified basket of commodities futures contracts and the SPDR S&P 500 ETF (NYSEARCA:SPY), a proxy for US stocks. Our accompanying chart illustrates how the relative performance difference between SPY and GSG has soared a mind-boggling 54% over the past year alone.

For alert investors, the message is clear: The deflationary action in commodities spells danger for other asset classes like stocks, currencies, and real estate. With certain individual commodities like precious metals, the effect of deflation are even more severe. Silver has deflated around 47% from its 2011 peak.

Are outsized performance discrepancies between commodities and stocks a surefire buy or a sell signal? Not necessarily. But when analyzed in conjunction with other key indicators, a person can clearly understand the length of the current market cycle and on which side (bullish or bearish) the odds are in their favor.

Editor's note: This story by Ron DeLegge originally appeared on ETFguide.com.

To read more from ETFguide, see:

Is Now the Time to Buy China?

Beating Low Yields in a Low Rate Environment

The Dow Committee Again Gets It Wrong
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No positions in stocks mentioned.
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