Deflating all asset classes

October 23, 2006 06:58 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 in Barron’s back in May 2004 provides a straight-forward explanation.

We described a striking similarity between a number of financial markets that traditionally are not correlated: 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.”

In late April and early May 2006, a concentrated reversal hit the precious metals, the CRB and many stock indexes. Markets that had turned earlier, such as junk bonds, housing stocks and credit spreads, made lower highs. Some of the few remaining hot areas of real estate speculation also turned down then. By July, losses ranged from 8% in the Dow to 67% in the Dubai index. Oil ended its run on July 14, the same day that gold made its secondary high.

The blue-chip U.S. stock averages have surpassed their May peaks, but the small-caps indexes, the Dow Transports and the property and commodity markets that were running higher with stocks through the last four years have not. If financial assets continue to act as if they are “all one market” as we expect, the blue chips will not be able to maintain their latest advance. As the turning tide reaches full force, all markets should begin accelerating downward together.

Economists quoted in the media most frequently cite “fear of inflation” as the cause of down days in the stock market. Our view, which is far from 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. As inflation retreats, all these markets should go down. As asset prices fall across the board, the sea change in behavior will spell deflation, and few are prepared.

How do you 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. This advantage will continue. For seasoned speculators, futures offer a great vehicle for short positions. Traders should keep in mind that although financial markets overall should fall, they may not do so simultaneously. Some will lead and others lag, and then laggards will play catch up. Nimble tacticians should be able to take advantage of both groups.

Our outlook also means that some traditional hedges will not perform as expected and may take on greater risk rather than reduce risk.

Pete Kendall is co-editor of The Elliott Wave Financial Forecast. Robert Prechter is author of Conquer the Crash. They can be reached at www.elliottwave.com.

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