The Deflationary Scenario

Today, the chairman of Elliott Wave international made headlines with Robert Prechter Warning Economic Depression and Financial Crisis Worse To Come. This is as good a time as any to review his ultra bearish, long term deflationary scenario. The excerpt below is from April 2009 but highlights the basic pillars of his projections. When his new work becomes public it will be posted.

Two important points between Inflation and Deflation:

1.) They are not mutually exclusive
2.) Purchasing power in terms of gold and silver will go down (even in deflation markets collapse further than precious metals)

Dent, Prechter and Other Experts Warn: Worst is Yet to Come

Robert R. Prechter Jr. is author of a number of books including “Elliott Wave Principle” (1978) in which he predicted the super bull market of the 1980s; “At the Crest of the Tidal Wave – A Forecast of the Great Bear Market” (1995) in which he predicted a slow motion economic earthquake, brought about by a great asset mania, that would register 11 on the financial Richter scale causing a collapse of historic proportions; and “Conquer the Crash: You can Survive and Prosper in a Deflationary Depression” (2002) in which he described the economic cataclysm that we are just beginning to experience and advised how to position one’s self financially during that period of time. Prechter also publishes two newsletters, the ‘Elliott Wave Theorist’ and the ‘Elliott Wave Financial Forecast’ both of which are paid subscription based. The Elliott Wave Theory takes a ‘socionomic’ approach to forecasting which contends that markets are driven by psychology and, while it is relatively easy to understand in concept, the interpretation and resultant application of the trends are difficult to implement consistently.

The above being said, there are no shortage of senior economists, analysts and financial industry executives who sing the praises of his work. Such words as “ignore Bob’s books at your peril”; “it could help you save your financial future”; “the closest thing to a crystal ball we could look for…it is a road map that no investor should be without”; “ignorance may not be bliss – it may mean bankruptcy. Ignore the message at your risk”; “knowing long term risks and opportunities in financial markets ahead of time is absolutely the key to consistent investment success”; “if you want to preserve your wealth (or what little is left of it) I urge you to follow Prechter’s advice. You will be grateful that you did”. There are more words of praise to be had but I’m sure you get the idea of what astute professionals think of Prechter’s work.

So what does Prechter have to say about the current situation and how we should deploy our assets? He is not as exact with free advice as Dent and Napier are but, as a result of his analyses, he has the following to say about the economic and financial environment (and I paraphrase):

A Deflationary Crash and Depression is Imminent
Deflation requires a precondition: a major societal buildup in the extension of credit and its flip side, the assumption of debt. Credit expansion continues as long as there are those willing to lend and borrow and there is the general ability of borrowers to pay interest and principal. These components depend upon whether both creditors and debtors think that debtors will be able to pay, and the trend of production, which makes it either easier or harder in actuality for debtors to pay. So long as confidence and productivity increase, the supply of credit tends to expand. The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. The supply of credit contracts as confidence and productivity decrease.

The social mood trend changes from optimism to pessimism when creditors, debtors, producers and consumers change their respective primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less. These behaviors reduce the ‘velocity’ of money, i.e. the speed with which it circulates to make purchases, thus putting downside pressure on prices.

At some point, a rising debt level requires so much energy to sustain – in terms of meeting interest payments…. chasing delinquent borrowers and writing off bad loans – that it slows overall economic performance. When this burden becomes too great for the economy to support the trend reverses causing reductions in lending, spending, and production which, in turn, cause debtors to earn less money with which to pay off their debts, so defaults rise.

Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward “spiral” begins, feeding on pessimism just as the previous boom fed optimism. The resulting cascade of debt liquidation is a deflationary crash. Debts are retired by paying them off, by “restructuring” or by default. In the first case, no value is lost; in the second, some value; in the third, all value. In desperately trying to raise cash to pay off loans, borrowers sell all kinds of assets to market – including stocks, bonds, commodities and real estate – causing their prices to plummet. (Sound familiar? It should because such behavior is unfolding as you read this very article!) The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

Editor’s note: Where are we at this point in time? Let’s take a look again at the various stages of decline to determine where we are:
Stage one
The major banks of the world major are concerned that any credit obligations that they were to enter into with other banks would not be honored because of the unknown extent of toxic assets (such as derivatives and sub-prime Mortgage Backed Securities) on their books – as was/is the case on their own books.
This, in turn, has caused them to go from an expansion mode to a conservation mode resulting in a credit crisis such as we currently are experiencing.
Stage two
The major banks’ refusal to lend money to business has caused, or is causing, business to go from an expansion mode to a conservative mode which has, in turn, adversely affected the trend of production.
This is evidenced by the 6.2% seasonally adjusted annualized decline in GDP during the 4th Qtr. of 2008 which was the worst decline since a 6.4% decrease in the 1st qtr of 1982. To make matters worse, economists don’t expect any relief in the current quarter, which ends March 31st, projecting a further -4.8% annualized rate which would be the first time since 1947 that the GDP has fallen by more than 4% for two quarters in a row.
Stage three
a) The reduction in production by business has, in turn, led to or is leading to, over-capacity which has increased employee layoffs.
Indeed, unemployment soared to 8.1% in February, the highest rate in over 25 years. The consensus of private forecasters is for the unemployment rate to get close to 9% in 2010 with some forecasters suggesting a 10% rate. The Federal Reserve, itself, doesn’t expect the unemployment rate to fall below 7% until 2011.
b) The increase in unemployment has, in turn, reduced the affected consumers’ ability to buy goods and services.
c) The consumers’ inability to buy goods and services has, in turn, reduced company sales and profits.
d) The reduction in company sales and profits has, in turn, caused the price of their stock to decline.
e) The lack of easy credit and/or loss of employment has meant that home “owners” (i.e. mortgagees in some degree of co-ownership with whichever financial institution holds their mortgage) have not been able, in increasing numbers, to re-finance and/or afford to re-finance their mortgages and, as such, have not been able to make their escalating monthly mortgage payments which have, in turn, led to a record high number of mortgage foreclosures.
Indeed, as of the end of 2008 12% of Americans with a mortgage were at least 1 month late or in foreclosure which was up from 8% a year earlier. Even worse, a stunning 48% of home “owners” who have sub-prime, adjustable-rate mortgages are currently behind in their payments or in foreclosure which, in turn, has resulted in ever more distressed house sales by the mortgagors and other neighborhood homeowners with, or without, a mortgage.
Stage four
The dire economic scene (fear of loss of job, loss of money invested in the stock market, reduced resale value of their house, etc.) has seen, in turn,
a) a major increase in savings (the personal savings rate rose by 5.0% in January, the highest rate since 1995)
b) a reduction in spending (it dropped 0.2% in December)
c) a reduction in the sale of goods and services
d) a decline in the price of such goods and services (as evidenced by the U.S. GDP Price Index which declined by 0.1% on a quarter-over-quarter annualized basis in the 4th Qtr of 2008 – the 1st decline since 1954 – and supporting the Fed’s obtuse view that “inflation pressures will remain subdued in coming quarters.” That tells us that deflation is imminent.
Stage five
We are going to see a self-reinforcing escalating vicious cycle of stage two, stage three and stage four over and over again. The downward “spiral’ is in progress.
So there you have it! We are in the early weeks of stage five. As such, it is fully understandable why the governments of the world are throwing money at the credit problem so excessively in an attempt to get the wheels of industry turning to stem the decline before it takes hold. It is an extremely dire situation with no end in sight at the moment.

Gold and Silver Beginning a Decline to Under $680 and $8.39 respectively
Gold and silver will fall into their final dollar price lows at the bottom of the deflation…after which time these metals should soar in price. Given the likely political inflationary forces following the period of deflation the rebound could be much stronger than anticipated so owning precious metals prior to the onset of the post-depression recovery is desirable.
Should you buy gold and silver now? If you are willing to accept the dollar value of the precious metals dropping another 30% ($680 gold represents a 26% decline from the early March 16, 2009 price of approximately $923) or more before they rise substantially….but are willing, nevertheless, to pay such a price for its current availability and for the ‘insurance’ of greater portfolio stability under an unexpected inflation scenario, then the answer is yes.
The above being said, it is probably not as good an idea to invest in gold stocks because in common stock bear markets stocks of gold mining companies usually go down with the overall market trend except in relatively rare 5 to 10- year periods of accelerating inflation. As such, in this early stage of deflation gold mines will enjoy no false advantage over any other companies. Their stocks will probably rally when the overall stock market rallies. Owning gold shares is fine at the top of the Kondratieff economic cycle when inflation is raging and political tensions are their most severe.

DJIA Should Fall Below 777
The Dow Jones Industrial Average will go down to at least 1000, most likely to below 777 which was the starting point of its mania back in August 1982, and quite likely drop below 400 at one or more times during the bear market.

Editor’s note: To Prechter’s credit he acknowledges that these aforementioned forecasts are considered to be impossible by virtually everyone. He is of the opinion that the price swings will be dramatic over the course of the decline – as evidenced by recent swings in the Dow 30 from 11,723 on Jan.14th, 2000 to 7286 on Oct.9th, 2002 (-37.8%); to 14,165 on Oct.9th, 2007 (+94.4%); to 6594 as of March 5th, 2009 (-53.4%) – providing phenomenal investment returns to the successful long term in-and-out investor. Even short term in-and-out investors can profit considerably from the current market volatility as the market swings up and down (October ’08 low of 7774 to a November ’08 high of 9654 (+24.2%), to a late November ‘08 low of 7449 (-22.8%), to a January ’09 high of 9088 (+22.0%): to an early March ’09 low of 6594 (-27.4%). Is another 20% to 25% increase about to occur in the very near future (i.e. to approx. 8250) followed by an even lower low of 25% to 30% (i.e. to 6000 or so)? Only time will tell but Prechter sees money to be made during such times for those astute and fortunate investors who choose not to park their money in some form of cash or just ‘buy and hold’ as so many financial/investment advisors are so prone to recommend.

U.S. Dollar Index to Continue to Rise
It is important to make a distinction between the dollar’s domestic and international values. In a deflation, the value of any currency – the U.S. dollar, in this case – rises domestically while the USD’s international value, as represented by the U.S. Dollar Index, can rise or fall relative to other currencies in a deflation. In a time of financial crisis, however, the U.S. dollar is considered to be a safe-haven currency. This time is no exception, particularly given that the Euro, a major component of the USD Index, is going through extremely trying times itself. As the deflationary depression proceeds over the next few years demand for U.S. dollars should increase even further. In such a deflationary environment, where a strong dollar still persists, you want to be in safe cash equivalents such as U.S. T-bills.

Treasury Bonds are in a Bear Market
The 10-year Treasury note yield has been in a sharp decline since the early ‘80s when it reached 15.84% at the height of inflation and is at a deflationary level of 2.89% as of March 13, 2009. The gargantuan government bond issuance to fund the U.S. debt bubble, however, may push yields, which move inversely to prices, steeply higher in the years ahead.

Prechter has been quoted as saying “The reason that I remain willing to express my unconventional view is that I believe that my ideas of finance and macroeconomics are correct and the conventional ones are wrong. True, wave analysts make mistakes, but they also make stunningly accurate long-term forecasts.” Updates to Prechter’s insights and predictions on all asset classes can be found at www.elliottwave.com. I encourage those readers who have found his above forecasts and investment advice to be informative to buy Prechter’s books for a more in-depth read and understanding of the basis for his making such projections of future events with such confidence.

READ FULL ARTICLE