Fin/Inv

Lets take a look at prices today via the last week's CPI:



My Take:

Although I still believe that inflation is the longer term risk down the road, the threat of deflation in the near term is starting to rise substantially.

The drop in CPI in June versus a year ago was the largest drop in prices in more in 60 years!

Anecdotally, I was out at a nice prime steakhouse last evening and they told me they are dropping their prices nationally. Many other restaurants are doing the same. Go check out an Applebees or Outback and take a look at a menu and you will see the same thing: Lower prices and fewer patrons.

I am seeing signs of a crashing consumer everywhere.

Baltimore was eerily quiet last night. It was restaurant week which is a week here in the city where all the restaurants in Baltimore run huge dinner specials for 7 days.

Every restaurant is usually packed as a result. Not this week! Every place I went into was dead as a doornail last night. Usually on a Saturday during restaurant week you can barely get inside restaurants as people take advantage on the incredible deals.

Even thehe cabby's were telling me how dead its been. The city had a depressionary feel it it. It was pretty spooky.

I saw further examples of this at Best Buy yesterday when I was forced to go out and buy a computer after my Dell blew up yesterday morning. I went in thinking that a new desktop would run me $700 or so. I was shocked to see how much computer prices have dropped. I was able to buy an Acer with AMD's fastest chip, speakers, and a keyboard for $360! This was a pleasant surprise but shocking nonetheless.

Prices are dropping because companies are realizing that they need to adjust to this new world where the consumer is pretty much dead.

They will die themselves if they don't drop prices. This deflation can get really ugly because as companies drop prices, consumers tend to hold out thinking that prices will continue to drop.

This is called a negative feedback loop and it can devastate an economy because no one consumes anything thinking a bigger bargain is right around the corner. This is why the Fed is obsessed with trying to prevent deflation!

Here is an example of how a negative feedback loop can develop:

I was speaking to a mortgage analyst about the tax credit for first time home buyers. The housing industry is trying to raise the credit from $8000 up to $16,000. The 8k rebate ends on October 1st. The housing industry is trying to use the cash for clunkers success as a way to increase the rebate.

This sounds great in theory, but it can also backfire. Let me explain:

The first tax credit last year before this year's 8k rebate was $7500 but you had to pay it back at the rate of $500 a year until it was paid off.

As housing continued to suffer, the government decided to sweeten the deal for '09. They decided to make the tax credit $8000 that didn't need to be paid back at all.

Great news right? Well for most people that is: How do you think the people that got in on the first tax credit felt after seeing the second tax credit a year later that never needed to be paid back.

If the government once again attempts to raise the stakes and rolls out a $16,000 tax credit next year, how are the $8k'ers from this year gonna feel about that? Ummm..Let me answer that nicely. They will feel like they got totally screwed!

This stimulative effect is very effective in the beginning, however if you keep upping the ante, it can have the opposite effect because people will start to believe that they will get a better deal next year if they hold out.

Before you know it, a nasty feedback loop is created where consumers permanantly sit on the sidelines thinking that a better deal is right around the corner.

The Bottom Line:

I am starting to get concerned about deflation in the short term. What scares me even more is how the Fed will react if deflation begins to really take hold.

What might they do to fight it? They could start devaluing the dollar in an attempt to inflate out of it. This will not end well as prices will soar on everything which will further pressure the consumer.

Both inflation and deflation are a risk at this point. If deflation takes hold, shorting stocks and holding US dollars will be your best bets. Metals could take a beating in this scenario as prices drop on everything including commodities.

If the dollar begins to plunge once again, you need to be concerned about inflation. Once this deflationary period ends I still believe that inflation will be the long term problem because our Fed is acting so reckless when it comes to monetary policy.

That being said, the data for now is saying that the Fed is losing its battle with deflation. Hedging your metals positions by buying PUTS on metal ETF's might not be a bad play here.

I spent the weekend looking over some of my sentiment model indicators and things look ugly for the bulls. First of all, the latest AAII survey of individual investors shows a spurt in bullishness, which is contrarian bearish.



Moreover, the latest Commitment of Traders report shows that large speculators (read: hedge funds) are now in a crowded long in the high-beta NASDAQ 100 and the net long position has started to decline, which is another bad sign for the bulls.



Shanghai Index breaks down
China has become the last hope of growth in a growth starved world but the Chinese stock market is rolling over. The chart below shows the Shanghai Stock Exchange Composite Index, which has fallen through an uptrend line that began in November 2008, as well as the 50-day moving average. Both of these are important signposts for technicians that point to an interruption of the rally.



Given some of my recent warnings about the equity market (see here and here), these additional data points are more indications of the precarious state of the US equity market.

There has been significant research in the past looking at the phenomenon of "home bias," or investing a larger portion of your wealth in a domestic market, despite the benefits of increasing international diversification. Less research has been done on how these home bias investors rebalance between domestic and foreign exposure. Previous research has also produced somewhat conflicting data regarding foreign equity turnover rates, ranking them from having only slightly faster levels of turnover, to foreign equity turnover rates 10 times greater domestic equity turnover rates - although in many cases the data samples were limited to just a handful of countries.

Recent research by Kalok Chan and Vicentiu Covrig examined portfolio rebalancing as measured by the churn rate of mutual funds from 29 different domestic countries - with investments across 48 foreign countries (see their paper, "What Determines Mutual Funds' Trading in Foreign Stocks?"). The results were based on annual holdings of stocks from the years 1999-2004, with churn rates based on changes of equity holdings in consecutive years. Based on past research, it was not surprising that their results found that the level of stock trading is more active for the stocks of companies in less developed countries. In fact, the trading of mutual funds in foreign stocks was higher than for domestic stocks in 24 out of 29 countries. When digging deeper to determine the reasons for the increased turnover rates, the authors found that the level of trading is higher for stocks in markets for which there are weaker investor protections, or for markets that have lower disclosure standards. In general, the churn rate was higher as the quality of information and level of familiarity decreased. The authors found these results to:

".... be consistent with the hypothesis that the investors rebalance more often the holdings of stocks about which they know less and are less familiar with."

As might also be expected, the churn rate was higher in a foreign market if the market had performed well, with the rate increasing as the level of familiarity decreases. Similar to other markets, it seems that investors are likely to take profits after a market has run-up, and are much more likely to do so if the market is foreign, less transparent, and has a lower level of familiarity.

The "Dumb Money" indicator continues to hit new extremes despite last week's slight down market. The Rydex market timers continue to be bullish and leveraged to the extreme. And to round out our sentiment analysis, selling by company insiders has hit extremes as well. It is the perfect trifecta. Whether the perfect trifecta becomes the perfect storm (again) for investors is yet to be determined.

The journey into uncharted territory for the year over year change in EMRATIO continues - this is the monthly series from the St. Louis Fed, the Civilian Population to Employment ratio - smoothed into a 3 month moving average (3 Mo MA) and then subtracting the previous year's monthly measure to get the delta...

Uuuuuuuuugly continues to be the name of the game, for the sixth consecutive month the YoY change has matched or exceeded the previous record from 1954 by an increasing amount each month.

In comparing to previous recessions, the two most recent prior to the current recession would seem to be the best analogs with respect to the structure of civilian employment (service vs. manufacturing in particular). If the duration of YoY declines is at all analogous, this is going to deteriorate for an extended period of time - the peak declines for the previous two recessions occurred 31% to 36% of the way through the decline in 3 Mo MA of EMRATIO - measuring from the start of the EMRATIO declines six months prior to the declared recession start date, there could be 46 to 58 more months of YoY declines in the 3 Mo MA of EMRATIO from July, 2009...


(N.B.: When reading the graph, anything below the black line represents deterioration - as we approach from below, things continue to decline only more slowly - actual gains do not occur until the value is above the black line)