The tsunami of deflation gets closer
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Could this be the moment I have long been waiting for? In the past two days, Dow has lost 500 points and US 30-yr T-Bonds have lost over 4 big points. Yes, stocks and bonds are declining together. That is my holy grail – which I have been waiting for over many months. This combined lock-step decline tells me the next tsunami of deflation is heading our way – and markets will not like it (unless you are short, of course).
And it will be a fair size, make no mistake.
I have previously related the reasons why I believe we are heading for huge declines in asset prices over the next year or two, but basically the fundamental problem is too much debt. By creating and encouraging crazy levels of debt, central banks have recklessly destroyed the open freedom of many of our financial markets in a chronically misguided attempt to prevent the forces of deflation from sending banks and companies into bankruptcy (China is a leading light in this area) following the Credit Crunch.
And with interest rates (and bond yields) now on the rise (see my blog of 19 July when I made a case for this), much debt will be un-payable and un-serviceable. Ominously, US corporate defaults are in the rise again even at the rock-bottom rates prevailing this summer.
The coordinated central banks’ actions have created huge bubbles in bonds and stocks many of which have been elevated by the record buy-backs over the recent months.
In addition, stock markets have been supported by the ‘Yellen Put’, thereby putting an (imaginary) floor under shares. I have a feeling many money managers will be testing the effectiveness of this put from now on.
Yesterday morning as the Dow was at the leading edge of its 400 point collapse, I sent members of my VIP Traders Club this chart with the Dow trading at 18,440:
I counted a nice five up from the June low with a strong wave 3. Wave 5 only just exceeded the high of wave 3, but that is enough to validate my count – and create a huge momentum divergence. I called that rally purple wave 1. And from that wave 1, the most common form of a second wave down is an a-b-c pattern. I already had my wave a down to my lower blue tramline and wave b up to last week’s highs.
This is what I wrote in Friday morning’s Trade Alert to members: “Now in an a-b-c correction in purple wave 2 that should break lower blue tramline setting off a pile of sell stops. Not sure where it could turn, but when it does it will rally again in purple wave 3. Odds are good that the c wave could end much lower by a few hundred pips given the sentiment picture.”
And that forecast panned out beautifully. This is how the chart looks at the close
The ‘c wave could end much lower by a few hundred pips’ forecast was realised by the close in no uncertain terms. Ominously, the market closed yesterday at bottom tick, which is quite unusual. Normally, after a solid day either up or down, there is some book-squaring at the close which brings the market off the extreme towards the middle. But not yesterday. This may be a bearish sign for Monday’s open (or rather, Sunday night).
That is what often occurs when bullish sentiment by the ‘insiders’ gets lop-sided. DSI readings have been at or near record highs this summer and VIX Fear Index has been at record levels of complacency – but not now!
Yesterday, it rocketed up from the somnolent 12 reading on Thursday to the short-crushing 17.5 level – a seismic shift of almost 50% in one day. That was one wake-up call for the stock bulls.
And here is the T-Bond yield chart (inverse to price)
Note that the low of 2.1% was made in July when made a case that the low was in. Since then, the market has been in a lovely contracting wedge girding its loins and on Thursday moved strongly above the 50-day MA in a bullish show of strength.
Yesterday, it reached 2.6%. That doesn’t sound much, but is in fact a huge gain of 23% in yield off the low. The next serious resistance lies at the 200-day MA at 2.6%.
VIP Traders Club members are short T-Bonds from July near the high (in price) at 176 and are holding a terrific gain of about 10 full points.
This bearish action last week does not necessarily mean my Dow target of 19,000 can be thrown out. The wave patterns in the above charts are part of a bigger picture. Watch this space.
So what is the outlook for the dollar?
I have been generally bullish the dollar and with last week;s developments, I believe demand for the dollar will only increase as bond yields rise. Most global debt is denominated in US dollars and debtors will need to find more dollars to make coupon payments than they expected when yields were much lower. In fact because of the overall bearish sentiment towards the dollar, the rush towards it will be a mad scramble as shorts are mightily squeezed.
We are at the start of a very large fifth and final wave up (to my long-standing target around 120 or possibly higher) and counting the smaller waves, also at the start of a third of a third of a third.
These are the most powerful setups on the board, so I expect a very rapid run-up to the upper blue tramline. Also, the pattern off the wave 4 low is turning out to be a five-wave continuation (see text, pp 38 – 39, 144 – 145) and heralding a move up.
As I said at the start of last week, with US traders back at their screens after the Labor Day end to summer, I expected a severe rise in volatility. Little did I know within a week, markets would become quite so alive!
Trading now will become much more exciting as we emerge from the summer doldrums. If you are a serious trader, I invite you to join my VIP Traders Club. Full details here.