Economist Gary Shilling, president of A. Gary Shilling & Co., believes that the feeble economy will get even weaker.

Moreover, he recently offered his view about the S&P 500.

Here’s an excerpt from the Edmonton Journal.

Economist and author Gary Shilling, a longtime columnist for Forbes magazine, is also in the bearish camp. He sees another global recession and stock market crash coming — one that will drive the S&P 500 down to the 800 level, or about 45 per cent below Friday’s [Jan. 11] close.

Click here to read the rest of the article.

Is the market rally since the low of November 16^th signaling better times ahead? We don’t think so. It seems to us that Wall Street is automatically assuming that the fiscal cliff will be settled by year-end, that the economy will subsequently recover at a stronger pace and that the market is significantly undervalued. We disagree on each count.

While we don’t know the outcome, the odds that we go over the fiscal cliff are greater than the market is discounting. Although Wall Street and Washington are only 250 miles apart, they speak different languages, and market experts have never been too good at interpreting political events. The investment community’s main interest is to find some solution that will help the market, while Washington’s main goal is to get incumbents re-elected.

The Street doesn’t understand Washington and, in turn, Washington doesn’t understand the Street. It is entirely conceivable that the White House and Congress cannot find common ground in time, simply because doing so could harm somebody’s chances at re-election. Getting to an agreement in time requires complex compromises leading to a delicate balance that ensures enough votes in both houses to ensure passage. We also note that something would have to be done about the debt limit that will be reached again sometime in February. If not, another crisis would be upon us early in the new year.

However, even an agreement on the fiscal cliff in time to keep from going over the edge would be a long way from ensuring smooth sailing for the economy and markets. While going over the cliff results in extreme austerity that everyone wants to avoid, a settlement would also result in austerity, although obviously not as severe. Since the goal of this exercise is to reduce the deficit, a solution would necessarily involve some combination tax increases and spending cuts, a portion of which would be applicable in 2013. This would create strong headwinds in an already fragile recovery.

Despite monthly ups and downs in the various economic releases, the economy has been softening in recent months, and will get no help from a settlement of the fiscal cliff. Real consumer disposable income has been trending down and wages are flat. This is a negative indicator for consumer spending, which has held up only because the savings rate has come down. Core new orders for durable goods has been declining for the past year, indicating a weak outlook for capital expenditures. A number of leading corporations have been reducing guidance for 2013 earnings. The Conference Board Leading Indicator Index has been flat for six months and the three-month moving average of the Chicago Fed’s National Activity Index, covering a wide swath of indicators, has been down for eight straight months.

At the same time the global economy has been slowing down with some areas in recession and others showing lower growth. The IMF has recently reduced its global growth forecast for both 2012 and 2013, and, according to RBC Capital Markets Chief Economist Tom Porcelli, the PMIs of two-thirds of the globe are in negative territory.

In sum, once the fiscal cliff crisis is past, we will be facing a faltering U.S. and global economy as well as significant downward earnings revisions, a situation that investors would find exceedingly disappointing.

Inflation in the U.S. has historically been a wartime phenomenon, including not only shooting wars but also the Cold War and the War on Poverty.  That’s when the federal government vastly overspends its income on top of a robust private economy—obviously not the case today when government stimulus isn’t even offsetting private sector weakness.  Deflation reigns in peacetime, and I think it is again, with the end of the Iraq engagement and as the unwinding of Afghanistan expenditures further reduce military spending.

Chronic Deflation

Few agree with my forecast of chronic deflation.  They’ve never seen anything but inflation in their business careers or lifetimes, so they think that’s the way God made the world.  Few can remember much about the 1930s, the last time deflation reigned.  Furthermore, we all tend to have inflation biases.  When we pay higher prices, it’s because of the inflation devil himself, but lower prices are a result of our smart shopping and bargaining skills.  Furthermore, we don’t calculate the quality-adjusted price declines that result from technological improvements in many big-ticket purchases.  This is especially true since many of those items, like TVs, are bought so infrequently that we have no idea what we paid for the last one.  But we sure remember the cost of gasoline on the last fill-up a week ago.

Doubts

Furthermore, many believe widespread deflation is impossible and that rampant inflation is assured in future years because of continuing high federal deficits, regardless of any long-run budget reform.  And annual deficits of over $1 trillion are likely to persist in the remaining five to seven years of deleveraging, as I explain in my recent book, The Age of Deleveraging.  The 2% annual real GDP growth I see persisting is well below the 3.3% needed to keep the unemployment rate stable.  So to prevent high and chronically rising unemployment, any Administration and Congress — left, right or center –will be forced to spend a lot of money to create a lot of jobs.

But big federal deficits are inflationary only when they come on top of fully-employed economies and create excess demand.  That’s obviously not true at present when large deficits are reactions to private sector weakness that has slashed tax revenues and encouraged deficit spending.  Indeed, the slack in the economy in the face of persistent trillion dollar-plus deficits measures the huge size and scope of the offsetting deleveraging in the private sector, as noted earlier.

The deleveraging, especially in the global financial sector and among U.S. consumers, will be completed in another five to seven years at the rate it is progressing.  At that point, the federal deficit should fade quickly, assuming a war or other cause of oversized government spending doesn’t intervene.  The resumption of meaningful economic growth will reduce the pressure for economic stimuli and rising incomes and corporate profits will spur revenues.  Serious work on the postwar baby-related bulge in Social Security and Medicare costs will also depress the deficit.

Good Deflation

A decade ago in my two Deflation books, I distinguished between two types of deflation—the Good Deflation of excess supply and the Bad Deflation of deficient demand.  Good Deflation is the result of important new technologies that spike productivity and output even as the economy grows rapidly.  Bad Deflation results from financial crises and deep recession, which hype unemployment and depress demand.

I’ve been forecasting chronic good deflation of excess supply because of today’s convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output.  Ditto for the globalization of production and the other deflationary forces I’ve been discussing since I wrote the two Deflation books and The Age of Deleveraging.  As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services.  The rapid productivity growth so far this decade is likely to persist.

While I’ve consistently predicted the good deflation of excess supply, I said clearly that the bad deflation of deficient demand could occur—due to severe and widespread financial crises or due to global protectionism.  Both are now clear threats.

My forecast is that the unfolding global slump will initiate worldwide chronic deflation.  A number of indicators point in that direction.  Sure, much of the recent weakness in the PPI and CPI has been due to falling energy and food prices.  Excluding these volatile items, prices are still rising but at slowing rates.  Consumer price inflation is also falling abroad in the U.K. and the eurozone.

After China’s huge stimulus program in 2009 in response to the global recession and nosedive in exports to U.S. consumers, the economy revived, but so did inflation.  Double-digit food price jumps were especially troublesome in a land where many live at subsistence levels.  So in response to the surge in inflation and the real estate bubble, Chinese leaders tightened economic policy, driving down CPI inflation to a 2.0% rise in August vs. a year earlier.  But, in conjunction with the weakening in export growth, that is pushing China toward a hard landing of 5% to 6% economic growth, well below the 7% to 8% needed to maintain stability.

Back in the States, inflationary expectations, as measured by the spread between 10-year Treasury yields and the yield on comparable Treasury Inflation-Protected Securities are narrowing.

Other Varieties

Besides rises or falls in general price levels, which most think about when they hear “inflation” or “deflation,” there are six other varieties, maybe more.

Commodity Inflation/Deflation.  In the late 1960s, the mushrooming costs of the Vietnam War and the Great Society programs in an already-robust economy created a tremendous gap between supply and demand in many areas.  The history of low inflation rates for goods and services, we’ll call it CPI inflation for short, in the late 1950s and early 1960s, apparently created a momentum of low price advances that kept CPI inflation from exploding until about 1973.  But by the early 1970s, commodity prices started to leap and spawned a self-feeding up surge.  Worried that they’d run out of critical materials in a robust economy, producers started to double and triple order supplies to insure adequate inventories.  That hyped demand, which squeezed supply, and prices spiked further.  That spawned even more frenzied buying as many expected shortages to last forever.

At the time, even before the 1973 oil embargo, I was lucky enough to realize that what was occurring was not perennial shortages but massive inventory-building.  I found a parallel in post-World War I when wartime price and wage controls were removed and wholesale prices skyrocketed about 30% in one year as double and triple ordering hyped inventories amid frenzied demand and fears of shortages.  Then all those inventories arrived and sired the 1920-1921 recession, the sharpest on record, and wholesale prices collapsed.  Armed with this history, I correctly forecast the 1973-1975 recession and said it would be the worst since the 1930s, which it proved to be.  Arriving inventories swamped production, especially in late 1974 and early 1975, so production nosedived.

Another Commodity Bubble

It’s probably no coincidence that China’s joining the World Trade Organization at the end of 2001 was followed by the commencement of another global commodity price bubble that started in early 2002.  And it has been a bubble, in my judgment, based on the conviction that China would continue to absorb huge shares of the world’s industrial and agricultural commodities.  The shift of global manufacturing toward China magnified her commodity usage as, for example, iron ore that previously was processed into steel in the U.S. or Europe was sent to China instead.

Peak Oil

Crude oil has been the darling of the commodity-shortage crowd, and when its price rose to $145 per barrel in July 2008, many became convinced that the world would soon run out of oil.

But they discounted the fact that reserves are often underestimated since oil fields produce more than original conservative estimates.  Nor did they expect conventional and shale natural gas, liquefied natural gas, the oil sands in Canada, heavy oil in Venezuela and elsewhere, oil shale, coal, hydroelectric power, nuclear energy, wind, geothermic, solar, tidal, ethanol and biomass energy, fuel cells, etc. to substitute significantly for petroleum.

Recent Weakness

The weakness in commodity prices, starting in early 2011, no doubt has been anticipating both a hard landing in China and a global recession.  In my view, the foundation of the decade-long commodity bubble is crumbling, and the unfolding of a hard landing in China and worldwide recession will depress commodity prices considerably, even from current levels, as disillusionment replaces investor enthusiasm.

Wage-Price Inflation/Deflation.  A second variety of inflation is a particularly virulent form, wage-price inflation in which wages push up prices, which then push up wages in a self-reinforcing cycle that can get deeply and stubbornly embedded in the economy.  This, too, was suffered in the 1970s and accompanied slow growth.  Hence the name, stagflation.  As with commodity inflation, it was spawned by excess aggregate demand resulting from huge spending and the Vietnam War and Great Society programs on top of a robust economy.

Back then, labor unions had considerable bargaining strength and membership.  Furthermore, American business was relatively paternalist, with many business leaders convinced they had a moral duty to keep their employees at least abreast of inflation.  Most didn’t realize that, as a result, inflation was very effectively transferring their profits to labor.  And also to government, which taxed underdepreciation and inventory profits.  The result was a collapse in corporate profits’ share of national income and a comparable rise in the share going to employee compensation from the mid-1960s until the early 1980s.

The Peak

The wage-price spiral peaked in the early 1980s as CPI inflation began a downtrend that has continued.  Voters rebelled against Washington, elected Ronald Reagan and initiated an era of government retrenchment.  The percentage of Americans who depend in a significant way on income from government rose from 28.7% in 1950 to 61.2% in 1980, but then fell to 53.7% in 2000.  Furthermore, the Fed, under then-Chairman Paul Volcker, blasted up interest rates, and negative real borrowing costs turned to very high positive levels.

As inflation receded, American business found itself naked as the proverbial jaybird with depressed profits and intense foreign competition.  In response, corporate leaders turned to restructuring with a will.  That included the end of paternalism towards employees as executives realized they were in a globalized atmosphere of excess supply of almost everything.  With operations and jobs moving to cheaper locations offshore and with the economy increasingly high tech and service oriented, union membership and power plummeted, especially in the private sector.

In today’s unfolding deflation, the wage-price spiral has been reversed.  Contrary to most forecaster expectations, but forecast in my two Deflation books, wages are actually being cut and involuntary furloughs instituted for the first time since the 1930s.  In inflation, oversized wages can be cut to size by simply avoiding pay hikes while inflation erodes real compensation to the proper level.  But with deflation, actual cuts in nominal pay are necessary.  Note that as wage cuts and furloughs become increasingly prevalent, the layoff and unemployment numbers will increasingly understate the reality of the declines in labor compensation.

Financial Asset Inflation/Deflation.  Perhaps the best recent example of financial asset inflation was the dot com blowoff in the late 1990s.  It culminated the long secular bull market that started in 1982 and was driven by the convergence of a number of stimulative factors.  CPI inflation peaked in 1980 and declined throughout the 1980s and 1990s.  That pushed down interest rates and pushed up P/Es.  American business restructured and productivity leaped.

A Secular Down Cycle

The robust economy upswing that drove the 1982-2000 secular bull market ended in 2000, as shown by basic measures of the economy’s health.  Stocks, which gauge economic health as well as fundamental sentiment, have been trending down since 2000 in real terms.  At the rate that deleveraging worldwide is progressing, it will take another five to seven years to be completed with equity prices continuing weak on balance during that time.  Employment also peaked out in 2000 even after accounting for lower although rising labor participation rates by older Americans.  Household net worth in relation to disposable (after-tax) income has also been weak for a decade.

The Federal Reserve’s Survey of Consumer Finances, just published for 2007-2010, reveals that median net worth of families fell 39% in those years from $126,400 to $77,300, largely due to the collapse in house prices.  Average household income fell 11% from $88,300 to $78,500 in those years with the middle-class hit the hardest.  The top 10% by net worth had a 1.4% drop in median income, the lowest quartile lost 3.7% but the second quartile was down 12.1% and the third quartile dropped 7.7%.

Households reacted to too much debt by reducing it.  In 2010, 75% of households had some debt, down from 77% in 2007, according to the Fed survey.  Those with credit card balances fell from 46.1% to 39.4% but late debt payments were reported by 10.8% of households, up from 7.1% in 2007.  With house prices collapsing, debt as a percentage of assets climbed to 16.4% in 2010 from 14.8% in 2007.  Financial strains reduced the percentage that saved in the preceding year from 56.4% in 2007 to 52% in 2010.

Nevertheless, the gigantic policy ease in Washington in response to the stock market collapse and 9/11 gave the illusion that all was well and that the growth trend had resumed.  The Fed rapidly cut its target rate from 6.5% to 1% and held it there for 12 months to provide more-than ample monetary stimulus.  Meanwhile, federal tax rebates and repeated tax cuts generated oceans of fiscal stimulus as did spending on homeland security, Afghanistan and then Iraq.

As a result, the speculative investment climate spawned by the dot com nonsense survived.  It simply shifted from stocks to commodities, foreign currencies, emerging market equities and debt, hedge funds, private equity—and especially to housing.  Homeownership additionally benefited from low mortgage rates, loose lending practices, securitization of mortgages, government programs to encourage home ownership and especially to the conviction that house prices would never fall.

Investors still believed they deserved double-digit returns each and every year, and if stocks no longer did the job, other investment vehicles would.  This prolongs what I have dubbed the Great Disconnect between the real world of goods and services and the speculative world of financial assets.

Treasurys

I hope you’ll recall my audacious forecast of 2.5% yields on 30-year Treasury bonds and 1.5% on 10-year Treasury notes, made at the end of last year when the 30-year yield was 3.0%.  Those levels were actually reached recently, and I now believe the yields will fall to 2.0% and 1.0%, respectively, for the same reasons that inspired my earlier forecasts.  The global recession will attract money to Treasurys as will deflation and their safe-haven status.  Sure, Treasurys were downgraded by Standard & Poor’s last year, but in the global setting, they’re the best of a bad lot.

The deflation in interest rates has spawned significant side effects.  It’s a zeal for yield that has pushed many individual and institutional investors further out on the risk spectrum than they may realize.  Witness the rush into junk bonds and emerging country debt.  Recently, investors have jumped into the government bonds of Eastern European countries such as Poland, Hungary and Turkey where yields are much higher than in developed lands.  The yield on 10-year notes in Turkish lira is about 8% compared to 1.4% in Germany and 1.6% in the U.S.

The inflows of foreign money has pushed up the value of those countries’ currencies, adding to foreign investor returns.  And some of these economies look solid relative to the troubled eurozone—Poland avoided recession in the 2008-2009 global financial crisis.  But the continuing eurozone financial woes and recession may well drag the zone’s Eastern European trading partners down.  And then, as foreign investors flee and their central banks cut rates, their currencies will nosedive much as occurred in Brazil.

Tangible Asset Inflation/Deflation.  Booms and busts in tangible asset prices are a fourth form of inflation/deflation.  The big inflation in commercial real estate in the early 1980s was spurred by very beneficial tax law changes earlier in the decade and by financial deregulation that allowed naïve savings and loans to make commercial real estate loans for the first time.  But deflation set in during the decade due to overbuilding and the 1986 tax law constrictions.  Bad loans mounted and the S&L industry, which had belatedly entered commercial real estate financing, went bust and had to be bailed out by taxpayers through the Resolution Trust Corp.

Nonresidential structures, along with other real estate, were hard hit by the Great Recession and remain weak as capacity remains ample and prices of commercial real estate generally persist well below the 2007 peak.  The two obvious exceptions are rental apartments and medical office buildings.  Returns on property investments recovered from the 2007-2009 collapse, but are now slipping.

Retail vacancy rates remain high due to cautious consumers and growing online sales.  Rents remain about flat.  Ditto for office vacancies due to weak employment and the tendency of employers to move in the partitions to pack more people into smaller office spaces.  The office vacancy rate in the second quarter was 17.2%, the same as the first quarter, down slightly from the post-financial crisis peak of 17.6% in the third quarter of 2010 but well above the 2007 boom level of 13.8%.  In the second quarter, office space occupancy rose just 0.12% from the previous quarter compared to 0.18% in the first quarter.

Housing Woes

House prices have been deflating for six years, with more to go.  The earlier housing boom was driven by ample loans and low interest rates, loose and almost non-existent lending standards, securitization of mortgages which passed seemingly creditworthy but in reality toxic assets on to often unsuspecting buyers, and most of all, by the conviction that house prices never decline.

I expect another 20% decline in single-family median house prices and, consequently, big problems in residential mortgages and related construction loans.  In making the case for continuing housing weakness, I’ve persistently hammered home the ongoing negative effect of excess inventories on house sales, prices, new construction and just about every other aspect of residential real estate.

Spreading Effects

That further drop would have devastating effects.  The average homeowner with a mortgage has already seen his equity drop from almost 50% in the early 1980s to 20.5% due to home equity withdrawal and falling prices.  Another 20% price decline would push homeowner equity into single digits with few mortgagors having any appreciable equity left.  It also would boost the percentage of mortgages that are under water, i.e., with mortgage principals that exceed the house’s value, from the current 24% to 40%, according to my calculations.  The negative effects on consumer spending would be substantial.  So would the negative effects on household net worth, which already, in relation to after-tax income, is lower than in the 1950s.

Currency inflation/deflation.  We all normally talk about currency devaluation or appreciation.  This is, however, another type of inflation/deflation and like all the others, it has widespread ramifications.  Relative currency values are influenced by differing monetary and fiscal policies, CPI inflation/deflation rates, interest rates, economic growth rates, import and export markets, safe haven attractiveness, capital and financial investment opportunities, attractiveness as trading currencies, and government interventions and jawboning, among other factors.  In recent years, Japan, South Korea, China and Switzerland have all acted to keep their currencies from rising to support their exports and limit imports.

The U.S. dollar has been strong of late, resulting from its safe haven status in the global financial crisis.  Furthermore, the U.S. economy, while slipping, is in better shape than almost any other—the best of the bunch.  I believe the global recession will persist and the greenback will continue to serve this role.  Furthermore, the greenback is likely to remain strong against other currencies for years as it continues to be the primary international trading and reserve currency.  The dollar should continue to meet at least five of my six criteria for being the dominant global currency:

1. After deleveraging is complete, the U.S. will return to rapid growth in the economy and in GDP per capita, driven by robust productivity.

2. The American economy is large and likely to remain the world’s biggest for decades.

3. The U.S. has deep and broad financial markets.

4. America has free and open financial markets and economy.

5. No likely substitute for the dollar on the global stage is in sight.

6. Credibility in the buck has been in decline since 1985, but may revive if long-run government deficits are addressed and consumer retrenchment and other factors shrink the foreign trade and current account deficits.

Inflation By Fiat.  Way back in 1977, I developed the Inflation by Fiat concept, which gained media attention in that era of high wage-price inflation.  This seventh form of inflation encompassed all those ways by which, with the stroke of a pen, Congress, the Administration and regulators raise prices.

The continual rises in the minimum wage is a case in point.  So, too, are high tariffs on imported Chinese tires.  Agricultural price supports keep prices above equilibrium.  As a result, the producer price of sugar in the U.S. is 28 cents per pound compared to the 19 cents world price.  Federal contractors are required to pay union wages, which almost always exceed nonunion pay, as noted earlier, another example of inflation by fiat.

Environmental protection regulations may improve the climate, but they increase costs that tend to be passed on in higher prices.  The Administration says its new fuel-economy standards of 54.5 miles per gallon by 2025 will cost $1,800 per vehicle but industry estimates put it at $3,000.  The cap and trade proposal to reduce carbon emissions is estimated to cost each American household $1,600 per year, according to the Congressional Budget Office.  Pay hikes for government workers must be paid in higher taxes sooner or later, and can spill over into private wage increases—although state and local government employee pay is moving back toward private levels, as discussed earlier.  Increases in Social Security taxes raise employer costs, which they try to pass on in higher selling prices.

There was some deflation by fiat in the 1980s and 1990s.  One of the biggest changes was requiring welfare recipients to work or be in job-training programs.  That reduced the welfare rolls from 4.7% of the population in 1980 to 2.1% in 2000, while the overall number that depended on government for meaningful income dropped from 61.2% to 53.7%.  But now, as an angry nation and left-leaning Congress and Administration react to the financial collapse, Wall Street misdeeds and the worst recession since the Great Depression, the increases in government regulation and involvement in the economy have been substantial.  And with them, more inflation by fiat—at least unless there is a major change of government control with the November elections.

(Excerpted from Gary Shilling’s INSIGHT newsletter.  For more information, visit www.agaryshilling.com)

Until 1933, a dollar was defined as a certain amount of gold. Even the Fed’s notes were convertible into gold. Money was stable.

From 1933 to 1971, the dollar was still at least partially an IOU for gold, because foreigners could collect gold—price-fixed by the government at $35 an ounce—from the Treasury in exchange for dollars. Charles de Gaulle of France realized how stupid the U.S. government was for holding gold below its real value and continually cashed in on the deal in the late 1960s. In 1971, the government finally reneged on its debts even to foreigners.

Since then, although each paper dollar issued by the Fed is labeled a note, it is not a note for anything. Today’s dollar is just scrip. Nevertheless, U.S. citizens are required by law to use the government’s scrip as a unit of account. This situation makes it easy for the government and its central bank to hide the financial and economic destruction their policies have wreaked. They do it by issuing more scrip and IOUs for scrip and more recently by also passing laws to shift the burden even of the largest private debts from wealthy, reckless creditors onto innocent savers and future earners known as “taxpayers.” This dual offensive (in two senses of the word) has lowered the value of each dollar and kept what would have been unpayable debts in the system.

Financial commentators believe that the Fed will be able to print enough of its scrip, and buy up enough IOUs for scrip, to ensure inflation or even runaway inflation. This outcome would be assured if the U.S. monetary system were like Zimbabwe’s and the government produced all the country’s money on a printing press. But the U.S. has a mature debt-money system, and investors in debt—including IOUs for scrip—can demand higher interest rates if they perceive inflationary destruction of the units of value they are owed. Every economist knows that the prevailing nominal interest rate is the real rate of interest plus the inflation rate. Investors were so attuned to inflationary pressures in the 1970s that they demanded the government pay 16% interest on its Treasury bills. If the Fed were creating massive net inflation, that’s what investors would be doing today. But the Fed so far has succeeded only in replacing bad debt with new money, keeping the sum of debt and debt-money down only slightly instead of a lot. That’s why interest rates on T-bills are at zero:

Demand for loans is nearly zero, pushing the real rate of interest to zero, and the inflation rate has been about zero since 2008, according to the total amount of dollar-denominated debts in the system. Many economists declare that the only reason rates are near zero is that the Fed is forcing them to that level. But the Fed cannot create magic in that way. The reason the interest rates on T-bills are at zero is that investors are content with that rate of interest.

In my view, they are content with it because the deflationary mindset—which leads to caution, conservatism, careful creditors and debt retirement—is more deeply in place today than it was in the heady years of 2006-2008.

If there is one message I receive daily, it is that I am blind for not seeing that the Fed will just print, print, print and that hyperinflation is inevitable. These messages increase in quantity and stridence whenever stocks or commodities rise, and they reach peak levels when the financial markets are also peaking. Rising markets convince people that the Fed is hyper-inflating. But in late 2008 and early 2009, nearly everyone abandoned this belief and started being afraid of deflation. They will abandon their belief again during the next market downturn. The only reason the Fed appears successful at inflating now is that in 2009, the trend of social mood turned back toward the positive at Primary degree. Don’t forget, EWT predicted in April 2009 that by the time the rally was over the economy would be expanding, the Fed would appear to have saved the monetary system, and optimism would return. This is exactly what has happened. It is another testimony to the predictive value of the socionomic hypothesis that it has happened. This positive trend in social mood has reduced fear, induced investors to speculate and prompted business people to stop contracting their businesses and begin making more optimistic bets.

This change has let the Fed get away with appearing to be in charge of the trend. We also showed, in April 2010, that the 7.25-year cycle turned up in 2009, and it is still up. It is due to roll over in late 2012, but as EWT has said several times, prices are likely to turn down well ahead of the center of the cycle. They probably already did peak, in April 2011. The next big downturn will erase everything the Fed and the government have done in attempting to keep the system liquid.

The Fed is truly powerful in having monopoly powers to issue unlimited free credit, but borrowers take advantage of that credit only when their mood is positive. The Fed also has substantial ability to take on other people’s debts, but this policy will succeed only as long as the debts it takes on retain their full value. And the only reason the Fed has been able to take on all the debts it has is that the federal government has guaranteed them. But it will not guarantee everyone’s debt; voters are fed up with bailouts and the fat cats who benefit from them. That’s one reason why Ron Paul is showing better than pundits expected in the Republican primary race. When the next downturn occurs, debtors will start defaulting, today’s good debts will become riskier, and the Fed will almost surely cease buying so many IOUs. Even if I turn out to be wrong about these things, if at any time the Fed were to try to generate net hyperinflation, investors would demand higher interest rates and choke off the attempt. I still don’t see any way out but a deflationary crash.

In the first five months of 2012, there were twenty times as many Google searches on “inflation” as there were on “deflation.” This is down from a ratio of fifty times in June 2008. If any theme has been overdone over the past six years, it is the theme of inevitable inflation if not hyperinflation.

Inflation reigned for 75 years, from 1933 to 2008. People are so used to it that they cannot imagine the opposite monetary environment. Bullish economists have been calling for recovery, which means more inflation, and bearish advisors have been calling for a crash in the dollar, which means hyperinflation. No wonder those are the terms on which most people have been searching.

But only one word allows you to make sense of what’s going on in the world, and inflation is not it. The secret word is deflation.

Understanding Deflation

Deflation explains:

1) Why interest rates on highly rated bonds are at their lowest levels in the history of the country;

2) Why the velocity of money is the lowest since the 1930s;

3) Why huge sectors among investment markets are down over 40%;

4) Why the Consumer Price Index (CPI)  just had its biggest down month since 2008;

5) Why Europe is in turmoil.

That’s right: Ten-year Treasury notes pay out less than 1.5% annually, their lowest rate since the founding of the Republic. Treasury bills yield essentially zero, their lowest level ever. The velocity of money failed to rise during the past three years of partial economic recovery, and it recently made new lows. Real estate prices have fallen 45% in the past six years. Commodity prices — as measured by the CRB Index — are down 45% in just four years. This group includes oil and silver, two of the most hyped investments of the past decade. Remember in March when articles quoted analysts calling for $5, $6 and $8-per-gallon gasoline? In just three months since then, gas prices have fallen 13%, knocking the CPI into negative territory.

Deflation also explains why European loans are at risk, why Germany is tapped out, why Greeks are protesting in the streets and why U.S. corporations’ overseas profits are down. Deflation lets you make sense of the world.

What is deflation? Economists define it three different ways, but I find only one definition useful: Deflation is a contraction in the overall supply of money and credit. Milton Friedman said, “inflation is always and everywhere a monetary phenomenon,” and the same goes for deflation.

Why must deflation occur? Answer: There is too much unpayable debt in the world.

An Unstoppable Force

As I argued in my book Conquer the Crash, it ultimately does not matter what the authorities do; they can’t stop deflation. And look: Since 2007, the Fed has monetized $2 trillion worth of debt; the government has borrowed another $7 trillion; and it has pumped out $1 trillion worth of student-loan credit. Yet real estate and commodities slumped 40%-plus anyway.

These drunken-sailor-type policies have indeed succeeded in nearly maintaining the overall volume of money and credit. But in the long run you can’t fight a systemic debt overload by piling on more debt. The Fed and the government are shifting the burden of trillions of dollars’ worth of debt obligations from reckless creditors onto innocent savers and hapless taxpayers. The ploy might work if the public’s resources were infinite, but they aren’t. Perhaps this policy temporarily prevented a series of big institutional disasters, but it was only at the ultimate price of a gigantic public disaster.

Such actions have become politically less palatable. Some observers realize that the student-loan program of lending at below-market rates is exactly the model the government used for housing loans, which ended in a spectacular bust. Others know that the government cannot continue to borrow at the current pace and expect to stay solvent. Politicians on both sides of the aisle are tired of the Fed’s massive bailing out of highly leveraged financial-speculation institutions. But whether these policies continue or are curtailed is irrelevant to the outcome. If the government slows its borrowing, the overall value of debt will fall. If the government maintains or increases its present pace of borrowing, interest rates will eventually turn up, and the overall value of debt will fall. There is no escape from deflation.

Cash Is King

Ironically, investors in the past decade have been doing exactly the opposite of preparing for deflation. Convinced of perpetually rising prices, they have bought every major investment. They chased real estate up to a peak in 2006. They bought blue chip stocks into the high of 2007. They pushed commodities up to a peak in 2008. They chased gold and silver up to highs in 2011. And through spring 2012, they continued to buy stocks and commodities on any rumor that promised inflation: European bank bailouts, Operation Twist, the Greek election, Group-of-8 summits, Fed meetings, Bernanke press conferences, improved economic numbers, predictions of QE3, central-bank interest rate cuts, you name it. Meanwhile, the U.S. Dollar Index hasn’t made a new low for four years. During deflationary times, cash is king, and investors have chosen to own anything but cash.

It May Already Be Too Late

Deflation is still not obvious to the majority. Even now, most economists expect continued recovery, mild inflation and a rising stock market. But the experts on our site are 180 degrees apart from conventional thinking. It may be too late for you to get out at the top, but there’s still time to learn how to sidestep the worst of the crunch.

People will be using the secret “d” word much more often over the next five years. By the end of that time, they will also be using its cousin “d” word, depression. But that’s a discussion for another time.

This article was originally published on July 12, 2012 in Comstock Partners Market Commentary. 

Long before it became headline news, we were talking about the corrosive effect of deflation deleveraging,excessive debt, the softening U.S. and global economy, the “fiscal cliff”, the implausibility of a European solution, the probability of a hard landing in China and the prospect that corporate earnings estimates were far too high. Now these negative stories are carried in the Wall Street Journal every day and the word “deflation” is now being used by almost all market commentators. When we first brought up this word to warn our viewers about the damaging effect of the deleveraging associated with it, Microsoft Word did not recognized the word. We were asked if we meant “inflation.” This week alone carried articles on downward earnings revisions at major corporations, Brazil’s sputtering growth, the worsening slowdown in China, new austerity measures in Spain and Italy, the continuing disappointment in U.S. economic indicators and more worries about the fiscal cliff. As if that were not enough, the news has been full of reports on the fixing of Libor rates, the fraud at Peregrine Financial, and the J.P. Morgan losses.

In the face of the now-obvious negative outlook, the question we get most often is why the market has declined so little, and why it seems so resistant to bad news. In our view, the reluctance of the market to give up much ground is typical of many past market declines and reflects a state of denial by investors as they grasp at reasons to remain bullish. Currently, the reasons cited most often are that the market is cheap, corporate earnings are strong and the Fed, as well as other central banks, will provide all the liquidity that’s needed to avert a serious economic downturn. We believe that each of those evaluations is flawed.

The current earnings estimates for 2012 are unlikely to hold up and the market is not undervalued. The consensus estimate for S&P 500 operating earnings (even though we believe “reported earnings” is the more relevent) is about $104 for 2012 and $118 for 2013. The bulls simply multiply the 2012 estimate by 15 and come up with a prospective S&P of 1560 (usually something between 1500 and 1600). Various studies, however, indicate that the more relevant method is to use a trendline estimate of reported (GAAP) trailing earnings. Our estimate of trendline earnings is currently about $75, and, on this basis, the market is overvalued rather than undervalued. The problem is that estimates of forward operating earnings are almost always wrong by a wide margin, most often on the high side. In May 2008, for instance, the estimate for 2009 was $110, and eventually came in at $57. In this regard, it is noteworthy that although the second quarter earnings report season has barely started, 42 major corporations have already guided their estimates down. (For more detail on this topic, please see our comment of April 5, 2012, “Why Valuation Doesn’t Insure Against a Severe Market Decline” in our archives).

In a similar vein, we believe that investors’ faith in the ability of central banks, including the Fed, to avert a serious downturn is ill advised. In 1999 and early 2000 we had the so-called “Greenspan put”, which referred to the supposed ability of the Fed to avert a recession. Despite the fact that it didn’t work, investors still had great faith in the so-called “Bernanke put” in 2007, and we now know how that worked out. Despite the disastrous outcome in those instances, investors now seem to have great confidence in a global central bank put. In our view, global debt deleveraging and deflation will overwhelm any central bank attempts to prevent a serious downturn, particularly when we take into account that central banks have already used their best ammunition and have to rely on unconventional and untried measures with questionable chances of success.

In the last four major bear markets the decline started very slowly from the peak, and was interrupted by numerous rallies, but continued to gather steam, ending only after a scary waterfall decline toward the end. We suspect that the same pattern may happen this time around.