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Over
the past three or four years a strange phenomenon has developed in the global
investment markets. With some exceptions, many asset classes, in particular
domestic and foreign equities, commodities, and foreign currencies have
tended to move in the same direction on a day to day basis. The
mega-correlation has lasted so long that most now take it for granted. This
leaves investors with relatively simple choices: when to get in to the market
in general and when to park assets in cash and U.S. Treasuries.
However, few recall that this pattern is relatively new in the annals of
financial history. Fewer still realize the reason for the current anomaly.
From my perspective the most logical explanation is fear, which has become
global, pervasive, and persistent. Traditionally, when investors fear
inflation they buy stocks, commodities, gold, and foreign currencies, and
sell dollars and U.S. treasuries. When they fear deflation they sell
stocks, commodities, gold, and foreign currencies, and buy dollars and U.S.
treasuries. The problem is that right now, no one knows which one to fear.
Depending on the news the pendulum swings from one extreme to another on a
daily basis.
The natural consequence of an inflationary boom should be a deflationary
bust. We've had the boom, but so far we have avoided the lion's share of
the bust, or at least the deflationary part. If the government were
pursuing a sounder monetary policy, one that allowed markets to function
properly, the deflationary scenario would be playing out. While in the
long-run this is the correct approach, such a scenario would be very bearish
for stocks, commodities and many foreign currencies. If on the other
hand, the government fights the recession by putting the inflation pedal to
the metal (which is the course they have chosen) investors should look to
real assets and certain foreign currencies to protect their purchasing power.
But for the most part, that is not happening.
The foreign exchange markets seem to be the center point for this
inflation/deflation tug-of-war. After all, if asset prices are falling,
cash is king. Since the dollar is still the reserve currency, it is the
king of cash, and benefits most from the global deflation
scenario. When the dollar rises, treasuries go along for the
ride, as investors need a "safe" place to park them. But when
the U.S. government reveals yet another staggering deficit forecast, inflationary
fears come right back. Hence, a market without a clear direction.
Many look at this dynamic from the perspective of risk appetite rather than
fear. They claim that when investors seek risk, they buy risky assets,
such as stocks, but when they are risk adverse they seek the
safety. But those who fear inflation sell dollars and treasuries
not because they seek risk, but because they seek to avoid it.
Of course, if investors felt that the Fed would actually fight inflation with
aggressive rate hikes then higher inflation would be perceived as detrimental
to stock performance. However, just about everybody realizes that there
is virtually no inflation scenario virulent enough to encourage Ben Bernanke
and his cohorts to actually raise rates. In actuality, the most feared
probabilities are that inflation runs out of control, or that deflation
overwhelms the Fed's efforts to prevent it.
From this perspective regardless of the direction of the stock market, assets
are simply being re-priced to reflect one of two very unpleasant
outcomes. Those who look at rising stock prices as a harbinger of
economic growth are therefore mistaken. These moves more than likely reflect
investors growing fear that the U.S. debt levels will swamp the dollar.
Given the extent of the fundamental problems that underlie the American
economy, and degree to which government policies are making these problems
worse, there can be little conviction that our economy will return to
sustainable growth anytime soon. Therefore, attributing stock market strength
to inflation fears rather economic strength makes far more sense.
Also, if higher U.S. stock prices really did result from an improving U.S.
economy, the dollar would be rising in tandem with stocks. However,
every time stock prices rise the dollar falls. The best
explanation for this dichotomy is that it is inflation not growth that drives
both stocks and the dollar. So rising stock prices do not really
indicate a bull market in stocks, but a bear market in the dollar.
Those who cannot differentiate between the two will continue to misread the
market and the economy.
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Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
20271 Acacia Street, #200 Newport Beach, CA 92660
Toll-free: 888-377-3722 / Direct: 203-972-9300 Fax: 949-863-7100
www.europac.net
pschiff@europac.net
For a more in depth analysis of the
tenuous position of the American economy, the housing and mortgage markets,
and U.S. dollar denominated investments, read my new book : The Little Book of Bull Moves in Bear Markets" (Wiley,
2008).
More importantly take action to
protect your wealth and preserve your purchasing power before it’s too
late. Protect your wealth and preserve your purchasing power before
it’s too late. Discover the best way to buy gold at www.goldyoucanfold.com , download my free
research report on the powerful case for investing in foreign equities
available at www.researchreportone.com
, and subscribe to my free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp
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