Deflation

Ever since the 2000 stock market top, the natural deflationary cyclical forces have been bearing down on not only the stock market, but the underlying economy. It has been these natural deflationary cyclical forces in which the Money Masters have been fighting with their massive liquidity and intervention campaign. As a result of the unprecedented efforts to re-liquify the economy, the stock market has been the tool of choice to paint the illusion that everything is okay. As a result of the unprecedented efforts to re-inflate, this cycle has become the most extreme ever and as a result I believe the current market environment is the most dangerous since the inception of the Dow Jones Industrial Average in 1896.

As the market rallied out of the 2002 4-year cycle low, the liquidity infusion fueled the natural cyclical advance to new highs and ultimately resulted in the longest 4-year cycle advance in history as of that time. I warned all throughout that rally that the extension of this cycle was only making matters worse and that extension did, in fact, result in the worst financial disaster since The Great Depression. Then, as the market rally out of the 2009 4-year cycle low began, so did the most aggressive liquidity, intervention and propaganda campaign in history. As a result, this 4-year cycle advance has been stretched beyond any historical norm. Throwing money at a problem, does not always fix the problem. In fact, throwing money at the problem following the 2002 low and into the 2007 top only served to make matters worse. What we have seen since 2009, in my opinion, makes for an even worse financial disaster. Think about it. The fix for the problem that created the worst financial crisis since The Great Depression has been more of the same thing that created the worst financial crisis since The Great Depression. How logical is that? This massive liquidity, intervention and propaganda campaign has not fixed the underlying economic issues. Once again, it has only created a worse problem.

In reality and in spite of what every one thinks, the advance out of the 2002 and the 2009 low have occurred within a secular bear market and the rallies out of these lows have been extended and fueled to new highs only as a result of the massive liquidity and intervention and not as a result of a recovering economy or within the context of a secular bull market. I realize that this may sound crazy, but I have evidence to support this statement as well as examples of this having occurred in the past. People have been trained to think that a market at a new high has to be in a bull market. Not true! As an example, the Industrials actually moved to a new high in late 1972 and into January 1973 amidst the 1966 to 1974 secular bear market. Note on the chart below that the rally into the 1973 high was followed by a 46% decline into the final secular bear market low in late 1974.

In Technical Analysis of Stock Trends, Edwards and Magee write:

"Volume goes with the trend- Those words, which you may often hear spoken with ritual solemnity but little understanding, are the colloquial expression for the general truth that trading activity tends to expand as price moves in the direction of the prevailing Primary Trend. Thus, in a Bull Market, volume increases when prices rise and dwindles as prices decline; in Bear Markets, turnover increases when prices drop and dries up as they recover."

Now, I want to walk you through the chart below of the S&P 500 with volume bars at the bottom in blue. Starting back in 1982, look how volume expanded with price, per the green trend lines above the volume bars, as the secular bull market pushed into the 1987 top. As the 1987 price top was being made, there was a non-confirmation by volume, per the small red trend line above the volume bars, which lead to the decline into the 1987 low. As the advance out of the 1987 low began, volume was a little light, but by 1989 volume began expanding once again and it continued to do so all the way into mid-1999. There was a brief

non-confirmation in conjunction with the 1998 4-year cycle top, which again is noted in red. Nonetheless, this was bullish behavior and following the decline into the 1998 4-year cycle low, volume again expanded into mid-1999. Then, once again, as price moved into the 2000 top, the contraction in volume created another non-confirmation, noted in red, which lead to the 2000 secular bull market top.

I want to stress the point as to how the relatively short-term volume non-confirmations that were seen in conjunction with the 1987, 1998 and 2000 tops lead to the declines into the 4-year cycle lows that followed. Please also note that the volume characteristics from 1982 into the 2000 top were consistent with TRUE bull markets, per the Edwards and Magee quote above.

Now note how the volume behavior changed following the 2000 top, it clearly shifted from bullish, to bearish behavior. As price declined into the 2002 4-year cycle low, volume moved up in conjunction with that decline, as is noted by the green trend line above the volume bars. Then, note the further characteristic change in that the advance into the 2007 high occurred on decreased volume and that volume increased, per the green trend line, as price moved into the 2009 low. Remember what Edwards and Magee said about volume. ".....in Bear Markets, turnover increases when prices drop and dries up as they recover." But wait, it gets worse. Much worse. Look how the entire advance out of the 2009 low has occurred on increasingly less and less volume and the only expansions in volume, per the green trend lines, have occurred in conjunction with price declines.

Turning back to Edwards and Magee, they talk about the three phases of bull and bear markets and the related volume characteristics. In regard to bull markets they write, "Finally, comes the third phase when the market boils with activity as the 'public' flocks to the boardrooms. All the financial news is good, price advances are spectacular and frequently 'make the front page' of the daily papers, and new issues are brought out in increasing numbers. ..... In the last stages of this phase, with speculation rampant, volume continues to rise, but 'air pockets' appear with increasing frequency; the 'cats and dogs' (low-priced stocks of no investment value) are whirled up, but more and more of the top-grade issues refuse to follow." While the recent advance exhibited some of these characteristics, this quote is descriptive of the advance between 1997 and 2000. The key here is volume continues to rise. Obviously volume is not and has not been rising with the current price advance. There was an indisputable change in volume behavior from bullish to bearish in conjunction with the 2000 top. In spite of the fact that price moved to a new high in 2007 and now to yet another new high in conjunction with the longest 4-year cycle advance in stock market history, these rallies have absolutely NOT occurred within the context of a secular bull market.

Now I want to tie this in with a couple of other charts that have been discussed in various articles on the internet in the last few months. The first is the chart of the Velocity of M2, which can be found below. I feel this chart goes a long way in explaining our current economic woes as well as why the correlations and conclusions about specific levels cannot always be drawn. The velocity of money is basically the rate at which money is exchanged from one transaction to another. M2 is a category within the money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds. Let's start with the contraction in the late 1990's. The Velocity of M2 peaked in July 1997, which was followed by the 1998 4-year cycle top in equities. Now notice that the Velocity of M2 never moved above its 1997 high in association with the stock market's advance into the 2000 top. In other words, there was a non-confirmation if you will by M2. Then, as the contraction continued, the market moved down into the 2002 4-year cycle low. I downloaded the raw data so I could look at the details of this closely and the rebound in M2 Velocity that followed the 2002 low peaked in April 2007. In case you have forgotten, the last 4-year cycle top in equities occurred in October 2007. M2 Velocity continued to contract into July 2009, but then peaked again in July 2010. The ongoing contraction that has followed, combined with the underpinning of this stretched 4-year cycle, makes for a very dangerous setup.

When you stand back and look at this chart, it should be obvious that what the money masters have been fighting since 1997 is a contraction in the velocity of money and consequently a contracting economy. It should also be obvious that it is just not likely that we are operating within a secular bullish environment with such a contraction in the velocity of money.

Really! Stop and think about that a minute. It's just illogical and it defies basic common sense that you can have a secular bullish period on the back of such a contraction. Rather, this is telling us that the economy peaked out in the late 1990's to early 2000 period, just as the secular bull market in stocks did. It fits! This tells us that we have had a tightening economy ever since and the Money Makers have been trying to overcome this contraction with various stimulus methods. In the process, they managed to create the housing bubble that popped back in 2005, the commodity bubble that popped back in 2008 and now the stock bubble, all of which have occurred on the back of a bad underlying economy and a secular bear market. At the time, their efforts to reinflate following the 1998 top, made the decline following the 2000 top worse. I again said during the advance out of the 2002 low and into the 2007 top that the phony manufactured reinflation efforts would once again only make matters worse, which proved correct in association with the decline into the 2009 low. I fail to see why the even more desperate manufactured reinflation efforts, on the back of a continued contraction in the velocity of money, along with this extended cycle, all within the underlying secular bear market, should prove to be any different.

The next chart I have included here is of the Labor Force Participation rate. This chart peaked in early 2000, which is consistent with the peak in the velocity of money, what I believe was the 2000 secular bull market top and peak in the underlying economy. Does it really compute that we have a recovering economy with a contracting velocity of money and a contracting labor participation rate? Rather, these contractions, are consistent with the secular bearish characteristics seen in equities as well as the contraction in the Velocity of Money.

The talking heads, the economists, politicians and anyone else can try to ignore, gloss over or explain away these facts all they want. Ignoring the facts does not change the facts. The hard data discussed above cannot be disputed. When the rally out of the 2009 low began I said that this rally would continue until the DNA Markers associated with all other 4-cycle tops is seen. Once these pieces fall into place, all the King's Money Masters and King's men will not be able to put Humpty Dumpty back together again. There is a massive unwinding coming and we certainly have the ingredients for it to be the worst financial disaster ever. You have been warned! If you would like to know more about the DNA Markers and the assessment of the current market developments, that research is available in the monthly research letters at cyclesman.com.