Deflation Debate Rages as Fed Ponders QE2

Editor's Note: This is a post covering two days - Monday and Tuesday, August 2 and 3 - due to my summer schedule, which includes a late afternoon round of golf on Mondays. The market stats are for Tuesday.

For conspiracy theorists, the constant droning about deflation which began on Friday with St. Louis Fed President James Bullard appearing on "Squawk Box" in the aftermath of his paper, Seven Faces of “"The Peril”", seems ominous enough to conclude that the new master plan is to plunge the economy into a deflationary depression.

While that may or may not be so, there are some views that make future prospects - even with the deflation element added in - not quite so frightening, such as Jim Rickards' thought-provoking response to Paul Krugman that deflation can actually benefit the economy, though Gary North's Economic Warnings From Niall Ferguson and Nassim Taleb and the Golden Jackass (Jim Wilie CB) Kindergarten Double Dip Recession Economics offer less-rosy scenarios.

Of course, here at Money Daily, my position has been consistent - that we've been deflating since August of 2007 - running diametrically-opposed to the views of Puru Saxena, who boldly penned, Debunking the Mainstream Economists Deflation Myths, while neither establishing economic realities as "myths" nor debunking any deflationary tendencies.

For whatever it's worth, the view here is that deflation is a soluble way out of the financial conundrum and relatively painless for regular people who would like their dollars to stretch a little further. For those invested in non-liquid assets with malleable price structures, the result of prolonged deflation might not be so pretty, and could actually be quite messy, ending up in bankruptcy court, where, indeed, many of the mal-investments of the past 20 years belong.

Since the non-stop talking heads on CNBC can't seem to leave the topic alone, it's probably a good sign that deflation is well underway. Either that, or they're purposely trying to scare investors, for whatever nefarious purpose they or their corporate masterminds may have concocted. It wouldn't be the first time that the on-air talent at CNBC was so far behind the curve that it appeared as a straight line, nor will it be the last. One only has to recall the archives from the Fall of '08 for some fresh views of the then-shocked and dismayed countenances witnessing the market meltdown in unanticipated awe.

If deflation truly takes hold and begins a spiral downward - something oil certainly seems not to want to do - day-to-day changes in stock or market indices will become more and more irrelevant over the near term, as will the generally feeble attempts by the Fed to do anything about any part of the economy, except, that is, to make it worse.

A paragraph from Jim Wilie's latest article (linked above) sums up the current catastrophe nicely:

The chain of ignominy includes gaping blind spots, blatantly wrong forecasts, minimized ignitions that spread crisis, misguided focus on goofy indicators, outright removal of important indicators, sloppy deception of monetization efforts (see last week's article), clumsy justification of Wall Street welfare, backwards perception of Too Big To Fail banks, and lying before the USCongress. The nation is dominated by fools who profess the lasting benefits of 'Hand to Mouth' approaches like tax rebates, purchase credits, jobless insurance extensions, and helicopter drops. Their worst investments are their biggest investments, like Fannie Mae and AIG nationalizations travesties. Harken back only to last winter, when economists were talking about a second half recovery, running all the red lights and stop signs. Then they shifted the klapptrapp to claims of a jobless recovery, which should evoke laughter from its impossibility. The economic counsel has forgotten what capital formation means, while they prepare for their next tourniquet to be applied to hemorrhages. The objective of monetary policy and banking policy is not recovery, but instead very clearly to retain power.

What seems clear is the Fed's desire to re-inflate via Quantitative Easing once again, a plan that has largely failed once and continues to do so, with what has become known as QE2. Should the Fed decide to expand its purchases of Treasuries, agency and mortgage slush, the result will be more of the same: banks will hoard cash, consumers won't spend and the dollar will be reduced in value against other currencies, which, naturally, may be the Fed's plan in a nutshell.

Debasing the greenback may (probably) not stimulate the US economy, but it will have the effect of improving our trade balance if only by making exports cheaper. That benefit accrues mostly to multi-national corporations, the very same ones that have been reporting stellar second quarter results while the real world wallows in a sea of debt, fear and uncertainty.

They'll probably do it, and it will probably fail, deflation will rule, and the brainy folks who call themselves economists can all go scratch their collective heads. While inflation, according to Milton Friedman, is always a "monetary event," deflation will prov to be a global fiscal event with long-lasting implications.

On Monday, traders sent stocks soaring like the Yankees had just won the World Series, based upon some very suspect ISM numbers, which actually fell from the previous month and were only buoyed by the artificial stimulus of public sector (government) spending.

Tuesday saw no visible follow-through, a hint that the massive Monday rally was only a trading ploy, designed to maximize profits from shorting into Friday's non-farm payroll report. Stocks plummeted right off the open and spent the rest of the day underwater, partially recovering.

Dow 10,636.38, -38.00 (0.36%)
NASDAQ 2,283.52, -11.84 (0.52%)
S&P 500 1,120.46, -5.40 (0.48%)
NYSE Composite 7,146.99, -27.91 (0.39%)

Decliners led advancers, 4000-2430; new highs lead new lows, 361-73. Volume was downright pathetic, even for August.

NASDAQ Volume 2,011,883,125
NYSE Volume 4,551,798,500

Oil continued to confound, gaining $1.21, to $82.55, an overshoot of dramatic proportions. Gold gained $1.80, to $1,185.20, while silver was unchanged, at $18.41.

Limited Market Reaction to 2Q GDP

Released an hour prior to the opening of the markets on Friday, the Bureau of Economic Analysis, U.S. Department of Commerce said second quarter GDP in the US was running at a 2.4% annual growth rate.

That was unsurprising. What did raise some eyeballs was the revision, by an entire percentage point, from +2.7% to +3.7%, of first quarter GDP. The large increase was likely due to the annual three-year revision the BEA undertakes each July. Since 2007, 2008 and 2009 were mostly revised downwardly, that made the first quarter of 2010 look better than it actually was, since the increase was based from lower overall figures.

It's a nice accounting trick, though in real terms, it means that the first half of the current year was hardly worthwhile. Real, unadjusted growth was likely negligible once one wades through the various modeling and statistical fudging done to the numbers.

Oddly enough, the whiz kids on Wall Street didn't quite know what to make of it all, settling instead to just churn stocks around the flat line after rebounding from a nearly 1% loss at the open. Being the final trading day of July, it was a little too neat to take seriously. The best that could be said is that nobody was in a mood to panic, at least not just yet.

Dow 10,465.94, -1.22 (0.01%)
NASDAQ 2,254.70, +3.01 (0.13%)
S&P 500 1,101.60, +0.07 (0.01%)
NYSE Composite 6,998.99, +4.42 (0.06%)

Market internal were a whole other matter, as advancers clocked past decliners, 3708-2708, and new highs were once again well ahead of new lows, 280-90. Volume was just a touch under average for mid-summer.

NASDAQ Volume 2,168,665,750
NYSE Volume 4,697,753,000

Oil finished another 59 cents higher, at $78.95, for the September contract. Gold added $12.20, to $1,183.40, and silver tacked on 38 cents to close at an even $18.00 in New York.

For all the emphasis put on the first GDP estimate for the second quarter, the resulting trade was anything but exciting. The Dow traded in a range of 160 points top to bottom, but mostly in a tight pattern which deviated less than 30 points in either direction off the previous close.

One can safely assume that markets will experience more volatility come Monday and in ensuing sessions, as current market conditions remain quite unsettled.

The "D" Word

Geez, the cat is finally out of the bag.

No sooner does Federal Reserve Bank of St. Louis President James Bullard utter the word "deflation," then the whole market gets all quivery and queasy. It's as though nobody wants lower prices or even a temporary restraint on runaway excess credit expansion.

Well, here's the news: We've been experiencing deflation - depending on how loosely you wish to interpret the definition - since about August of 2007.

Really? You ask, stunned by not being aware of current financial conditions. Yes, really, since August, 2007, like three years, when stocks began to deflate (or, go down). And real estate prices deflated. Remember when they called residential real estate prices a bubble? What happens when you prick a bubble? It deflates. If there's any indication of deflation, just ask homeowners in vast areas of California, Michigan, Florida or Nevada, where home prices have fallen by as much as 60% or more.

Technically speaking, there are two definitions of deflation, though since economics is more art than science, the two are often blended into one, such as this definition from Investopedia: "A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending."

Over on Wikipedia, deflation is described as. "a decrease in the general price level of goods and services." Pretty simple, and correct, though some economics adherents will insist that deflation is a decrease in the supply of money.

There are very good discussions on both of the above linked references, and each of them makes salient points which overlap and intersect in such a way as to make my argument - that we've been in deflation since August, 2007 - pretty darn accurate.

So, let's take a look at conditions since the summer of 2007, and see how we Americans are doing on the deflation scale. First, we know that houses aren't as expensive as they were back then, so the residential housing market is definitely deflated.

How about other assets, like stocks? Well, the Dow Jones Industrials were tickling the 14,000 mark back then, and are barely able to maintain a level over 10,000 today. Sounds like about a 30% deflation there.

Here's one nobody gets: wages, which haven't generally risen since 2002 and even before that were pretty stagnant. So, if you're an employer, you like deflation - or, at least stagnation - in the price of labor.

As for money supply, it may have been increasing, though according to these charts from Shadowstats.com, the rate of growth of the various popular money supply definitions (M1, M2, etc.) seems to have been slowing, so that would qualify, technically, as "disinflation," not deflation. Hey, I can't be 100% right all the time, no?

And, lest we forget, the Spring and Summer of 2008, when gasoline prices hit upwards of $3 and $4, so, since everything doesn't all go down at once, and some prices actually have gone up (like gold, or silver), I believe it's safe to say that deflation has been the dominant economic theme for the better part of past three years.

If you're unconvinced, just try raising prices on consumer goods and see how quickly your customers will become those of your competitors. Deflation, while it isn't an evil thing (in fact, it's probably preferable to inflation), is not regarded as generally good for businesses, especially the kind whose stocks are traded on Wall Street, who have to keep increasing their profits every quarter, which, when you think about it, is a pretty absurd concept. Most people who own small businesses are fairly happy just making the same profit over and over and never becoming billionaires, just "comfortable."

Deflation really scares the bejesus out of Wall Street types and with god reason. The companies they hype will die in a prolonged deflationary environment.

As for how the markets responded to the dreaded "D" word, the response was rather muted. Being fairly bright people, many traders already know that deflation has already been in effect for some time, and they also don't jump the shark and sell everything on the word of one Fed President, so the markets did a little dip, then rose, then sold off at the close, producing a chart probably more closely related to fears of what the second quarter GDP estimate will be tomorrow morning than anything else.

Dow 10,467.16, -30.72 (0.29%)
NASDAQ 2,251.69, -12.87 (0.57%)
S&P 500 1,101.53, -4.60 (0.42%)
NYSE Composite 6,994.57, -4.61 (0.07%)

Advancing issues barely beat decliners on the day, 3296-3093, and new highs continued to dominate new lows, 280-85. Volume was better than average.

NASDAQ Volume 2,332,617,500
NYSE Volume 5,247,904,500

The forces of deflation seemed to have little effect on commodities. Oil surged $1.37, to $78.36 per barrel. Gold was up $8.10, to $1,170.50 per ounce, with silver gaining 18 cents, to $17.62.

Initial unemployment claims came in slightly lower than the previous week, though still unacceptably high, at 457,000.

The first estimate of second quarter GDP will be announced at 8:30 am on Friday.

Trend is Lower for US Equities

Stocks gave back some of the outsize gains of the past two weeks in another sign that the summer rally is at an end. Earnings reports are dwindling down, though a few key companies are still releasing figures. For the most part, however, investors are looking beyond the earnings numbers and taking closer inspection of overall economic data, like this morning's June Durable Goods report showing a 1.0% decline after a downwardly-revised 0.8% drop in May.

That report put a pall over the markets and stocks struggled throughout the session. Most of the losses came after the release of the Fed's beige book at 2:00 pm, which confirmed what many already knew: the US economy is slowing down, though not yet experiencing negative growth. With this weighing on the minds of investors, some were quick to take profits, though there still seem to be plenty of buyers keeping stocks at elevated levels.

Dow 10,497.88, -39.81 (0.38%)
NASDAQ 2,264.56, -23.69 (1.04%)
S&P 500 1,106.13, -7.71 (0.69%)
NYSE Composite 6,999.18, -45.81 (0.65%)

Declining issues held their edge over advancers for the second straight session, 4357-2048 (2:1), though new highs continued their advantage over new lows, 203-68. The divergence, not only in the high-lows vs. the A-D line, but also in the relative out-performance of the Dow over the NASDAQ, signals a good deal of confusion in the markets, and the markets generally don't appreciate confusion. Tops on the list of confusing issues is the decoupling of listed companies from the US economy. Companies have shown strong performance in their most recent earnings reports, but all of the US economic news has been on the sorry side. This is emblematic of US-based companies actually deriving major portions of their revenue offshore, particularly in Asia and Latin America, two areas which are on the opposite side of the Euro-Us debt collapse.

NASDAQ Volume 1,865,542,625
NYSE Volume 4,554,030,500

Adding to market woes was the announcement - late in the day - by California Governor Arnold Schwarzenegger that the the Golden State was now in an official "state of emergency" triggering an executive order which calls for state employees to begin mandatory 3 day per month furloughs without pay starting in August.

The issue is the state's $19 billion budget shortfall, and the legislature's unwillingness to bring spending and revenue into equilibrium. With states across the country gearing up for fall semesters of schooling and teacher unions refusing to budge on key wage and benefit issues, California has effectively fired a warning shot across the collective bows of state capitols, many of which are facing serious budget shortfalls and intransigent government worker unions.

The commodity space was unsettled as well, with oil down again, by 51 cents, to $76.99. Gold gained a paltry $2.40, to $1,160.40, while silver declined 20 cents, to $17.42.

Market inconsistency should come to a head by Friday, when the government releases its first estimate of second quarter GDP prior to the opening bell. Thursday's initial unemployment claims will also be closely watched.

Dull Summer Session May mark End of Rally

With the passing of the Tuesday session, it appears that the recent rally in stocks has pretty much run its course. More than 75% of the S&P 500 companies having already reported, there are fewer opportunities for quick scores on earnings rises and investors are now looking seriously forward to Friday's initial estimate of 2nd quarter GDP due to be released prior to the opening bell.

Now that the European credit crisis has been put down for at least a nap, the market has been able to focus on earnings for much of the past two weeks, and the results are obvious. All of the major indices have experienced significant bounces since the start of the month, with gains in the range of 7-9% overall.

In particular, the Dow is up a whopping 850 points since its interim bottom on July 2nd (9686.48), though it is still some distance from the most recent high of 11,250 in late April. While the major averages have all found comfort zones above their respective 200-day moving averages, chartists will note that criss-crossing the 50 and 200-day MAs are not uncommon circumstances, especially in periods of economic uncertainty, like the current markets conditions.

Thus, it's unsurprising that many analysts are taking a rather dim view of the currently-stalling rally, seeing it as transitory and temporary. After all, markets became severely oversold by the end of June, and perceptually, stocks were cheap, even if they remain well above traditional norms.

Projections for what the government will report 2nd quarter GDP as are all in the range of 2.3 to 3.5% annualized growth, which would be a slowdown for the second straight quarter, and therefore, not helpful in alleviating stresses over a return to recession. With just about anyone who matters already resolved on slower growth for the remainder of 2010, it's difficult to imagine stocks breaking to new highs any time soon. The rational bet is for the major averages to continue trading in the same ranges that have prevailed since last October, though risk is skewed to the downside quite prominently.

Dow 10,537.69, +12.26 (0.12%)
NASDAQ 2,288.25, -8.18 (0.36%)
S&P 500 1,113.84, -1.17 (0.10%)
NYSE Composite 7,044.99, -1.01 (0.01%)

Declining issues held sway over advancers, 3618-2812, but new highs ramped far ahead of new lows, 401-63. Volume was slim.

NASDAQ Volume 1,940,649,125
NYSE Volume 5,330,884,000

Part of the reason for Tuesday's lackluster performance can be tied to consumer confidence, which fell again in July, to 50.4, from an upwardly revised 54.3 in June. The dour outlook by consumers is keeping a lid on prices and profits.

Commodities seemed to have been struck with liquidity issues on the day. Crude oil for September delivery fell $1.48, to $77.50, but continue to be range-bound, between $70 and $80 per barrel.

Gold was zapped lower by $25.00, to $1,158.00, it's lowest price in three months. In concert, silver dropped 57 cents, to $17.62.

Companies reporting strong earnings included DuPont (DD) and Cummins (CMI), both of which beat earnings and revenue forecasts.

The prolonged slump in residential housing and employment continue to weigh on the minds of consumers and investors alike.