World Deflation

Ignacio Merino 636
Santa Cruz
Miaflores, Peru

Phone: 001-51-56-973-5599
001-51-19-280-8796
Email: ebo@dtanalysis.com
Website: www.dowtheoryanalysis.com Worldwide Deflation
DAILY REPORT (9/08/08)

It appears that very few people realize that deflation is a worldwide phenomenon; the few that do believe deflation exists think it is confined to the United States. They are wrong. For years the US has had high inflation but offset it by importing deflation from places like China. China kept its currency abnormally low, or devalued it in terms of the US dollar, and that allowed the US to import cheaper goods. That is a deflationary pressure. China wasn’t the only country to play this game; most of Asia did the same thing. In the end though this pressure to produce and export finally drove the price of raw materials up into the clouds and everybody felt the sting. The US for their part did their best to keep the game going by blowing as many asset bubbles as they could: stocks, credit, housing, and finally commodities, all reached extreme valuations. No attempt was made to find equilibrium. In fact any attempt to find a meaningful balance was discouraged if not punished outright. The presence of a bubble was always denied until it had long since burst, and then meaningless commissions were formed to pass hollow laws that changed nothing. Then it was on to the next bubble du jour.



We have now reached a point where the United States is finally out of bubbles after a twenty year binge of spending until you drop. Literally trillions upon trillions of dollars were wasted on pointless consumption, pointless because it added absolutely nothing to the economy or society. The rest of the world took our wasted money and turned it into useful infrastructure in order to produce more efficiently and at lower prices. Sounds great for the rest of the world and not so good for the US, but things are often not what they seem. The key to keeping the whole mess afloat was the American consumer, and for him to consume, he needed lots and lots of credit. He



needed credit because the US didn’t produce much of anything and his real income was on the decline for years. Since the stock market had topped in 1999, the only real way to offer credit was through the financing and refinancing of homes. Enter the credit/housing bubble, bigger than tulips, and bigger than stocks. Down went interest rates along with restrictions for obtaining loans, and up went housing prices. If you needed more money, you simply bought another house, waited six months for the value to increase, and then refinanced and pocketed the difference. The more houses the better, and if you made eight dollars an hour at McDonald’s it didn’t matter.

Since rates were going down, all the way down to 1% thanks to the Fed, it seemed to make sense to use adjustable rate mortgages (ARM’s), so your cost could drop every three months or so. In fact, I seem to recall that the Fed, i.e. Greenspan, even encouraged it. After all, no one can see a bubble until it’s already upon you, so take advantage of the moment. Greenspan created a kind of financial carpe diem, and that is just what the American consumer did. Exit Greenspan and enter a credit crisis in July 2007. Housing topped, the Dow topped in October, and consumption topped one month later. Incentives were offered as rebate checks flew out across the country, interest rates were cut yet again, and the Fed injected another trillion dollars into the financial system. In short the Fed did what it had been doing for almost twenty-five years when a problem appeared, print your way out of it. A funny thing happened on the way to the recovery though, that liquidity never made it to the general public and the consumer has left the building. Probably for years! Enter deflation in the United States, a problem for which the Fed has no remedy.

So that’s the story in the US, but what about the rest of the world. They still have all the wonderful infrastructure and investment they made and that should be worth something, right? Not so fast! The consumption binge in the US led to a commodities bubble, and that in turn led countries like China, Brazil, and Russia to invest huge amounts in exploration and exploitation of raw materials. I look out over the bay here and I see a one billion dollar natural gas plant owned by the Brazilians, and I know of an even larger plant going up fifty kilometers away. On the other side of the bay I see four new five-star hotels under construction; all foreign owned and financed. If I go inland toward mining country, I can find Australians, Chinese, Canadians, Americans, Russians, and most major countries, all with a workable mine. The Chinese spent almost one billion dollars building two railroads, one in Chile and one in Brazil, just to get copper and soybeans respectively to port and on a boat to China. It should be mentioned that they own the mines and fields those products come from.

What I am trying to say is that foreign companies have spent ungodly amounts of money in order to ensure a reasonable uninterrupted supply of raw materials. It doesn’t stop here either. This foreign investment led to local companies sprouting up all over the place in an effort to serve these overseas clients, and you had a boom within a boom. As is often the case in a booming market, everybody began to project astronomical profits and assumed it would last forever. It never does. Countries that export raw materials, like Australia, Peru, Chile, Argentina, Bolivia, and China, went and bet on a sustained growth in income, borrowed against that future income, and are now totally and completely up a creek with no paddle. What’s more many wealthy individuals and companies borrowed huge sums of money and plowed that money into real estate as prices continued to the sky, even after the bottom fell out of the US housing market. Commodities had the bad taste to top at precisely the wrong moment, income fell hard, profits disappeared almost overnight, and reality walked in the door. Companies with huge overseas infrastructure and expense are forced to scramble for liquidity, or take on debt, while at home their illiquid investments lose money almost daily. That’s why I think it will be difficult for any foreign Commonwealth Fund to bail out Lehman Brothers, or any other American firm, unless it’s truly an exceptional value. A company like Lehman, that can’t even begin to calculate its losses, is not an exceptional value. [Just to throw a little wood on the fire, many Commonwealth Funds and foreign central banks still hold CDO’s and bonds from Fannie Mea/Freddie Mac at face value. It remains to be seen if that will be the case]

For a really clear picture of just what is going on in places like Asia and Brazil, take a look at the eight-year weekly chart of the Baltic Dry Index:



This index topped at 11,793 in May, about two months before commodities did, and much like the Dow did last year, i.e. with a slightly higher all-time high. This is important because the index was created by the Baltic Exchange in order to measure the change in the cost of shipping raw materials like grains, metals, and fossil fuels over the high seas. Since the top the Baltic has fallen and last week went off the cliff with a large gap down and loss of over 1,146 points to end the week at 5,662. That’s a long way from the May high and a great indication of how demand for these materials has fallen. This decline would seem to be confirmed by the CRB Index as



it broke below what was good support at 507.82 this week and closed on Friday at 489.24. Commodities topped in July after an almost non-stop run that began seven years ago. After such a long run, it would not surprise me to see a continued sell-off that could last as long as eighteen months. To date the CRB Index has retraced close

SUPPORT RESISTANCE

CRB INDEX 450.00 561.00
399.00 507.00
348.00

*All prices are based on the spot price for the cash CRB Index

to 32% of the 433 point rally. At the very least, I would look for a 38% correction down to 450.00, would expect a 50% down to 399.00, and would not be the least bit surprised to see a run all the way down to 348.00 before it’s all said and done. That would demoralize even the most bullish of investors. I know many are asking if the bull market in commodities is over, and the answer is no. This leg up is definitely done with, but the bull is alive and well, and will last another decade.

Just about every significant economic/financial problem in the world can be traced back to the US Federal Reserve bank and a small group of individuals like Greenspan, Paulson, and Greenberg who ran the country into the ground. Every economy in the world has experienced booms and busts, but somewhere along the line someone came up with the bright idea of eliminating the busts. Throughout the 90’s the world experienced a series of economic crisis in Asia, Mexico, Russia, and even in the US markets that would have been enough to cleanse the system and restore equilibrium. On each and every occasion the Fed met the problem head on with the printing press, so a full blown reaction was avoided thereby creating what I call a “distortion” in the financial system that would eventually have to be sanitized. What any normal country would have done after a capital injection is withdraw that capital once things got better, but the US never did that. They just kept right on printing much like a drug addict keeps increasing the dosage because the old amount has less and less affect. Unfortunately, like a drug addict the economy eventually dies from an overdose, and that’s where we are today.

A debt ridden US is deflating while being caught up in the middle of a worldwide deflationary scenario and no amount of fiat currency will solve the problem. Since most of the world is now scrambling to serve debt, some productive but most not, there is considerable upward pressure on the US dollar and that was not expected by many investors. Below I have posted a three-year weekly chart of the US Dollar Index:



As you can see the dollar recently broke up out of a downtrend that had been in place since 2001 and that cannot be ignored. In spite of the rally, one must not lose sight of the fact that this is a short term phenomenon. By short term, I mean six to nine months and then the greenback will head back down to make new lows. Never forget that the US dollar is a fiat currency, backed by nothing, and created out of thin air at the whim of whatever wizard is in favor at that moment. There can only be one real direction for the dollar and that is down to zero. In the meantime I see two possible tops for the rally that is already overbought; 79.05 and 83.15 although the old high at 80.39 could serve to stop the ascent. Good support is down at 76.18. On Friday the September US Dollar futures contract closed at 79.00 with an intraday high of 79.14 and I am guessing but I do not think the dollar will turn down at 79.05. I am looking for a high of 83.15 followed by a period of distribution. My reasoning is that the dollar bottomed in March and moved sideways building a base until mid-July. It did not spend four months building a base for a two month rally. I think we’ll rally to 83.15 by sometime in November. Time will tell.

With the Dow, I don’t think we’ll have to wait very long at all to understand the intended direction. I suspect there will be an announcement concerning the bail out of Fannie Mae and Freddie Mac, probably timed to Monday’s open and designed to produce another government sponsored rally, but I fail to see how a US $275 billion bailout of the good old boys can be bullish. The FHA, a government entity, taking over two failed quasi-government entities while under government supervision, does not elude confidence. I expect a one-day wonder followed by the continuation of the move down and here is why:



As you can see in the preceding daily chart, we had another leg down beginning in May and it ran until July 15th, taking out the previous lower low established in March at +/- 11,750. The July low was followed by a series of weak, narrow rallies that failed on three occasions to penetrate back above the 11,750 (green-red horizontal line) and in the process formed a head-and-shoulders top highlighted below (blue arrows):



Aside from that, you can clearly see that the Dow broke down from the trend established by the rally last Thursday and well below the neckline formed by the head-and-shoulders top. In short the Dow is now deflating once again, much like the US economy, and that is not good.



If we see a Fannie/Freddie induced rally, I would expect to see price back up to the 50-dma at 11,416 which also ties in well with decent Fibonacci resistance at 11,417. No upside reaction should last more than three sessions at this point in time and we should see a good test of critical support at 10,725 sooner rather than later. Although

SUPPORT RESISTANCE

DOW 11,146 11,263
11,091 11,328
10,725 11,417
11,449
*All prices based on the September Dow futures contract

we may see a bounce of no more than eight days once the test is made; I am convinced it will not hold. Ultimately I feel the Dow will fall down to a minimum of 9,913 and may go as low as 9,005 on this leg down. This is an important distinction to make, i.e. this is just one leg down and there will be more. Just because we stop at 9,913 doesn’t mean the bear market is over; far from it. There is a long way to go before we hit bottom both in terms of points as well as time. At this time next year, we’ll still be discussing the bear market we are in. All this daily questioning on CNN of whether we’ve seen the bottom demonstrates a complete ignorance as to what markets are all about. The bear is out of his cave, he’s hungry, and he’s not going to hibernate any time soon.

So other than US dollars over the short run and Swiss Francs over the long run, where can an investor park his money with relative safety? Like the US dollar, bonds may be okay for the moment but I think they’ve already priced in two, if not three rate cuts and are overpriced. Stocks have nowhere to go but down and should be shorted, although most investors mistakenly shy away from that thinking, there is too much risk. In my opinion there is only one place to go, and that place is gold. The yellow



metal is a great investment anytime a government makes bad decisions, and the United States made a series of bad decisions, not only economically but politically as well. So many bad decisions that they created a series of distortions that must be painfully purged from the economy. Gold has been sensing that for seven years and that is why it has rallied from US $250.00 up to Friday’s closing spot price of US $802.00, and traded as high as US $1,033.90 earlier this year. Like all financial products gold is subject to corrections and that is precisely what we have been experiencing. Unlike all other financial products we view gold as a port in the storm and a store of wealth, and we don’t like it when the waters get rough. Fear is a strong emotion, and when associated with gold, fear becomes stronger exponentially. This magnification almost always leads to an investor buying when he should be selling and selling when he should be buying, and that is what is occurring now.

The December gold futures contract fell from an intraday high of 1048.00 in March, all the way down to an intraday low of 777.00 in August, for a decline of 26%. This was almost identical to the 2006 decline that produced a similar seller’s panic. What’s more the decline stopped just above strong Fibonacci support at 773.10 and gold was as oversold as it had been in years. I know that questions abound and many claim the bull market in gold is done with, but I could not disagree more. Also, many assume that deflation will drive gold down as well, and it has over the short run as I said it would, but gold rallied hard in 1930 and will rally even harder in 2008 and 2009. Why is that? In 1930 the US was a creditor nation and had the resources to fight deflation whereas in 2008 the US is the largest debtor nation and does not have the resources. All we have is debt and shortly that will accelerate the rush to gold as everyone tries to preserve their wealth.

Since gold bottomed at 777.00 it has rallied modestly in the face of a rising US dollar and falling commodities. This last week both oil and copper broke crucial support at 110.00 and 322.00 respectively, and yet gold continues to hold up. On Friday the December gold finished down .50 at 802.30 and at almost par with the spot price. Each time someone steps in to sell it at this level, buyers appear. I do not ignore the possibility that gold could retest strong Fibonacci support at 773.10 and I know the possibility exists that it could even fall as low as 736.40. Everything is possible, but the probabilities say that December gold has bottomed and we’ll build a base and then rally. After the 2006 correction, gold rallied 92% and surprised just about everyone, and I am convinced we’ll see a repeat performance over the next six months. That means that silver will rally as well, since it is currently the cheapest thing around. Below I have posted the important Fibonacci numbers for both gold and silver:

SUPPORT RESISTANCE

GOLD 800.00 817.10
789.80 825.30
780.30 833.00
773.10

SILVER 12.28 12.55
11.76 12.98
13.29
*All prices are for the December gold and silver futures contract

I do believe the coming rally in gold and silver should surpass even my expectations, but it will be extremely volatile. In closing many of you want to know how far commodities can drop, so I have posted the Fibonacci numbers below for oil, copper, corn, and soybeans and I have highlighted with an * my choice for a bottom:

SUPPORT RESISTANCE

OIL 99.99 109.18
89.71* 128.65
79.97 138.39

COPPER 3.01 3.15
2.72 3.19
2.34* 3.37

CORN 542.9 556.8
488.9 591.3
437.7* 640.0

SOYBEANS 1092 1193
1002* 1284

Obviously I think the decline in commodity prices will cut deeper than most analysts, but I have been around long enough to know that the pendulum almost always swings to extremes. This time will be no exception.



ebo@dtanalysis.com
Dow Theory Analysis SAC
Sept. 06, 2008