The all-over rollover

September 22, 2006 06:19 AM

In mid-2006 there was a puzzling tailspin in a slew of disparate financial markets. Various pundits ascribe the drops to “inconsistent communication” from the Federal Reserve, “economic confusion” and/or an “all-time high in uncertainty.” But an alignment we dubbed the “all-the-same-market” phenomenon over two years ago (Barron’s, “In Synch to Sink,” May 2004) provides a straight-forward explanation.

In May 2004 we showed a striking likeness between a number of financial markets that traditionally do not move all in the same direction: the U.S. Dollar Index (inverted), real estate investment trusts (REITs), gold, silver, the S&P 500, junk bonds and the CRB index of commodities. We conjectured, “Liquidity is everything now, and it is driving the prices of all investment classes. These markets have been going up together, and we think that when liquidity contracts, they will go down together.”

It has taken longer than we thought, but the turn from up to down in traditional financial assets appears to be over. Major tops are typically diffuse, and this one has been no exception. As shown in the updated graph (“Weekly Trends, From Leaders to Laggards,” below), the EWI Junk Bond Index reversed in February 2004. The dollar bottomed, and most foreign currencies topped, in December 2004. The spread between yields on junk debt and U.S. Treasuries reversed to a widening trend in March 2005. This is an important turn because a developing contraction in credit is behind the entire multi-market reversal. A key housing-stock index shows that homebuilding shares peaked in July 2005 and are now down more than 45%.

The recent downturn in May 2006 was a concentrated reversal. On a daily closing basis, the Dow topped on May 10, the precious metals peaked on May 11, and the U.S. Dollar Index made a deep secondary low on May 12. Many commodities and other stock indexes around the world topped about the same time. Markets that had turned earlier—such as junk bonds, housing stocks and credit spreads—made lower highs. The few remaining hot areas of real estate speculation turned down then as well. By July, losses ranged from 8% in the Dow to 67% in the Dubai index. Oil, a late holdout, ended its run on July 14, the same day that gold made its secondary high.

Economists quoted in the media most frequently cite “fear of inflation” as the cause of down days in the stock market. Our view, which we admit is far from the mainstream, is that the inflationary fixation is a case of getting the causality backwards. Inflation is not starting; it’s ending. For more than two decades, while inflation (as properly measured by the money and credit supply) has continued, stocks, bonds, property and more recently commodities all rose with it. It is abundantly clear that for the past four years inflation has been bullish for all these investments. So a drop in inflation won’t be bullish. As inflation retreats, all these markets will go down, not up. Likewise, a drop in asset prices won’t be due to “fear of inflation.” As asset prices fall across the board, the sea change in behavior will spell deflation. Deflation is something that almost no one fears and for which few are prepared.

Across-the-board financial reversals are rare events that happen when a society-wide credit expansion reaches its zenith and the psychology of investors and consumers changes from expansive to defensive. Our forecast is based on what we see as emerging financial conservatism, which will lead to selling, which in turn will justify more conservatism. The developing downtrend should spread into seemingly unrelated areas as investors unload even the most secure financial assets to meet margin calls and make mortgage and other debt payments. We therefore view the subtle evidence of upside exhaustion in financial investments worldwide as just the beginning of a major downturn. If our overall thesis is correct, the summer rebound in investment prices has offered the last chance to sell into strength.

How does one prosper in this environment? For most investors, the easy answer, the non-traditional answer, is to hold safe cash equivalents. Cash has outperformed the S&P—including dividends—for more than six years. We think this relative performance will only improve. For seasoned speculators, futures offer a great vehicle for short positions.

Pete Kendall is co-editor of The Elliott Wave Financial Forecast.Robert Prechter is author of Conquer the Crash.

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