The possibility of a deflationary spiral and depression still seems to dominate  the Federal Reserve's list of worries. There has been some improvement in several economic indicators in the last couple of months or so, but this economic recovery from 2008 recession  still remains much weaker than any previous post World War II recovery . Real income growth for the average worker has been near 0 over the last 10 years.  The portion of long term unemployed as a percentage of all unemployed is double the normal ratio. The number of discouraged workers has increased, sharply lowering the labor market participation rate to 63.6 %. The Gold market mini-crash, seen by many as a bear raid by investment banks or even central banks, is on the face of it a deflationary event.
    By the standards of the terminology used prior to the Great Depression of the 1930's,  conditions that have prevailed for the last 5 1/2 years might very well have been labeled a depression. For that reason, I expect the Fed to continue with the QE and zero yield short term rates. As long as earnings can slowly increase the equation PV = FV/ (1 + r)^n.  will keep the stock market rising. PV= Present Value, FV = Future Value (future cash flow), r = annual interest rate, n= number of years of compounding. The ^ symbol is used on non-mathematical keyboards to indicate an exponent. "x^2" means "x squared". This formula is the reverse of the compound interest  formula and is thus derived from it.
   If interest rates are low, the value of r is less,  FV is being divided by a smaller number, and thus the formula's quotient yields a higher value for PV, which is the discounted Present Value of stocks (what they are selling for now). This is closely related to the idea that in a zero interest rate environment, there is no sacrifice of interest required to invest in stocks (there is no low risk, interest yielding alternative to stocks). If earnings decline, the FV part of the formula will decrease and thus the quotient  PV will diminish for that reason. If interest rates increase, the formula quotient PV will fall because FV is being divided by a larger number . That is why I say that a slow growth economy with gradually rising earnings and very low interest rates will cause the bull market to resume after the correction completes. If any of these factors changes significantly, the correction could easily develop into a bear market.
   I wrote in Geopolitics of  a Reserve Currency on April 1, 2013 that I thought that the countries under the umbrella of protection of the US military "understood" that a large part of the US deficit was caused by military spending and for this reason would not try to topple the Dollar as a Reserve currency. In other words part of the US deficit increase was incurred on their behalf so that it would not only be ungrateful, but foolish for them to undermine the Dollar.
    The agreement between the Saudi government and the Nixon administration in 1973 which stipulated the the US would indefinitely guarantee the protection of Saudi Arabia (and probably the other Persian Gulf States) in exchange for the Dollar being defined as the exclusive means of payment for Arabian oil.But this agreement requires that the US continue to maintain a powerful, state-of-the-art military. If the US engages in too much deficit spending for domestic purposes, and reduces military spending to pay for it, that behavior would constitute reneging on it's half of the agreement.
   The purchase of US Treasury notes and bonds by our allies is a vital part of this agreement. In lieu of compensating us directly for the protection we provide, they accept the Dollar as a reserve currency and purchase our Treasury instruments (debts) thereby financing defense (and domestic) spending. The benefit of receiving reserve currency status is so great that it is apparently considered superfluous to pay the US directly. The one exception that I know of was allied (especially Japanese) contributions to the cost of the first Gulf War, Operation Desert Storm.
      The economy is supposedly strengthening enough to cause the US Federal Reserve to reduce it's US Treasury and Fannie Mae and Freddie Mac bond purchases (QE 3). If this happens, how much will it upset the discounted present value equation described above? It will probably cause longer term rates to rise a little bit, but if the economy is growing stronger, earnings should increase a little faster. The net result under this scenario is that the divisor in the formula will increase a moderately, but the earnings being divided into will do likewise. The result is that discounted present values of corporations will continue to rise. Since the stock market has been rising faster than present values this year, it may well need to give up some it's recent gains for stock price valuations to return to a better alignment with fundamental valuations (PE ratios, book value, etc).
    But it is rather evident that the Fed will increase the pace of QE 3 again if the recent economic growth proves to be a flash in the pan. So the only force I see that could trigger a bear market is simply that investors will have grown too exuberant and pushed the market too far above reasonable valuation. In other words, as Richard Russell of Dow Theory Letters puts it, the buying will finally exhaust itself. The usual caveat, of course is that the world financial system does not tear itself apart at the seams before investors get a chance to exhaust themselves.

                         

1933 Video "Benefits of Inflation" & Banking Crisis Refuge

Here is a newsreel from 1933 that explains how inflation stimulates demand to get the economy moving again. I believe economist  Dr. Paul Krugman uses this film as one of the prime teaching videos in his macroeconomics classes. If nothing else, this YouTube video is an amazing window into the great economic and social crisis of 80 years ago and probably essentially represents what one major political party still believes is the solution to our economic malaise. It is really a  much more "hip" production than what contemporary people might expect from what we generally consider a "stodgy" era. You can become a time traveller by investing just 10 minutes in this video. Here is the link:  http://www.popmodal.com/video/2066/Vintage-pro-inflation-propaganda         Provided courtesy of TCM

I am also sending a link to a guest post by Ellen Brown on Barry Ritholtz's The Big Picture site on an alleged US-UK plan to take the bank savings deposits of savers (depositors) and use them to recapitalize the banks in the event of a financial crisis so great that it dwarfs the ability of the FDIC to cover insured bank deposits. The NCUA is the insurance entity for credit unions that does what the FDIC does for banks. I am not sure what it's ratio of capital to liabilities is, but it may not be much better than that of the FDIC (which is 5%). The Ellen Brown article has a short educational section on the actual legal staus of bank depositors under the fractional reserve banking system, which is unpleasantly different from what I thought it was. This has made me start thinking about where I could invest a large savings account that would give me the highest priority creditor status. This is an action that would have to be completed ahead of time because bank accounts would be frozen as they have been in Cyprus once such a calamity struck. This kind of event could be worse than the Banking Crisis of 1933 because the US Treasury has a much worse balance sheet than it carried in 1933 and the Federal Reserve has a vastly huger balance sheet (of which vulnerable mortgage-backed securities comprise a large part). In 1933 the US Government had the financial strength and credibility to back up the US banking system. That is quite questionable now. The FDIC has only 5% of the money it would need to pay off all insured depositors (up to $250k per depositor for each account class, that is: regular savings or IRA) if all the banks failed simultaneously. This admittedly is an unlikely event, but not an impossible one. The acquisition of gold/gold coins to keep as real money is so widely discussed at the site http://www.safehaven.com/  that it is unnecessary for me to repeat the extensive arguments made there.
    I am thinking that short term US Treasury notes and bills would be the safest thing to be in because the US Government must redeem these notes in order to be able to keep financing its operations. But the purchaser of Treasury instruments can no longer hold these directly, but must place them in custody of a dealer (like TD Ameritrade) who holds them in electronic custody. That raises the question of whether the Treasury is personally liable to you for your investment if the broker-dealer fails. I think the answer is that the US Treasury must be, or it's creditworthiness would be a sham. But I can't assert that assumption with absolute knowledge so I must research this crucial topic. Anyone else who has knowledge on this subject is invited to comment. I am going to post this letter on my blog at the Unraveller's Spool on Google Blog. This is the link to my blog if you are interested: unravellersspool.blogspot.com. Outlook express wouldn't turn the preceding web address into a clickable link so you will have to copy and paste it into your browser address line if you want to use it. However, what is much more important is that you read the Ellen Brown article at this link: http://www.ritholtz.com/blog/2013/03/bank-confiscation-scheme-for-us-and-uk-depositors/

                                                 The Unraveller

            The Geopolitics of a Reserve Currency

     My conclusion is that it makes no sense to cut one dollar from defense spending or to reduce our nuclear arsenal by one more warhead. In 1973, Nixon persuaded Saudi Arabia to exclusively accept dollars in payment for oil from any and all countries and to agree to buy US bonds with the money they received. In exchange they were to receive US military protection from any regional or global power.  By 1975, a year after the 6 month oil embargo ended, all members of OPEC agreed to do the same, effectively making the US dollar the world's reserve currency. I haven't calculated the numbers, but I wouldn't be surprised if the monetary benefit of being the world's reserve currency has been worth enough to pay for all US military spending since WWII. Whatever the figure is, it is monumental. And this privilege will only remain intact as long as the US possesses overwhelming world military superiority, including control of the seas ( as in "Britannia Rules the Waves").

    Wasn't it you who speculated that the US attacked Iraq in 2003 because Sadam Hussein threatened to stop accepting dollars in payment for oil? You will never see this discussed openly by any Western Government official because it is too explosive of an idea. It makes it clear that the US is a modern Roman Empire or a 19th Century British Empire. Nations never admit their real geopolitical/economic motives but always disguise their actions in lofty moral terms. But Realpolitick drives the world much more than the pursuit of idealism. Conversely, without economic and military power, it is impossible to pursue any altruistic policies and actions even if a nation does desire to do so.

     There is much anguish among various economists and writers that the USA's deficit spending will turn the dollar into a "banana republic" currency unwanted by other nations as a store of value and thus not of value to measure a unit of economic exchange. Of course that is a real danger if "money printing" is carried far enough. 
   But the allies and trading partners of the US know full well how expensive it is to maintain a top-flight military establishment, and they factor this in to their evaluations of our deficit spending. Just consider how empty France's posturing was during it's intervention in Libya. France has some excellent aircraft and military technology, but they couldn't even supply enough ordnance for their planes to last for more than a few bombing runs. The US had to supply them after about the first week or two. This analysis does not imply that I think the intervention in Libya was even a good idea. I believe it was ill-conceived right from the start for many reasons. However, that discussion deserves an article of it's own, which Stratfor.com has probably already written.
   I believe that Obama's desire to reduce our nuclear arsenal reveals a profound strategic incompetence (assuming he does not learn better).The amount of radioactive hazardous waste produced by the process of creating these warheads is a price this country will never be willing to pay again in the future if there appeared to be a necessity for building more warheads again. So the sensible thing is just to store the ones we have, not dismantle them. Even in the thoroughly unlikely eventuality that there is never again a serious threat to the Western world from a dangerous adversary, there are other hazards which may need to be countered by the use of nuclear warheads. The most obvious is the deflection of asteroids from paths that could lead to a collision with earth. In my thinking, this should be the next great priority for a NASA- Air Force project.

Public Pessimism and Professional Optimism

     First of all, I want to admit that my April 21, 2011 blog, a speculation about the possible formation of a cup and handle, obviously did not develop as I had hoped. In fact April 30 was the top of the market. The potential cup and handle was in reality a double top in the process of forming. Now I am going to venture to propose another potential bullish scenario evolving out of the recent market decline. This letter makes reference to William Schmidt's TigerSoft system as well as to the Dow Theory.
      Perhaps we can view the weakness in public buying as a contrary indicator, like new highs in the odd-lot short selling to purchases ratio. At bottoms, the public tends to be bearish and they don't become bullish until the uptrend is well under way. Under the Dow Theory, the first psychological phase of a bull market is where informed money in strong hands comes in to buy and the public is still afraid of the market. This corresponds to professional and insider buying in the TigerSoft system. In the second psychological phase the public joins the informed money (and professionals) in buying. Economic news tends to improve in the second phase. In the third, speculative phase, the public becomes the main driver of stock prices as professionals and informed money accumulate less and distribute more. If we are in the first phase of a mini-primary bull market, the TigerSoft Accumulation Index should grow stronger as insiders join the professionals.
     The weak link in my analogy is that while professionals are bullishly buying, the corporate insiders, as measured by the TigerSoft Accumulation Index, have not yet decisively done so. They correspond to the "informed money " under the Dow Theory. Of course, I really think that this is all taking place on a miniature scale; realistically the best we could expect would be an intermediate term rally coming out of a sharp correction which could be called a mini-primary bear market. My small cap mutual fund declined about 25%, which is over the 20% threshold that many analysts use to demarcate a bear market. But the sharpness of the decline as well as the terrible surrounding economic news has been enough to generate these "cyclical" psychological dynamics which the Dow theory describes and Tigersoft  indicators measure.
 

Cup and Handle Pattern

Most of the major indexes formed a potential cup and handle pattern from Feb. 22 2011, when the top of the left side of the cup was formed, to April 7 2011 when the top of the right side of the cup was formed. On the DJ Industrials, the left high side of the cup reading was 12,391 and on the right high side of the cup the number was 12,450. The low point of the handle came in at 12,200 on a closing basis. On April 20 The DJI rallied 187 points, after advancing 65 points on April 19. If the DJI can decisively move, on a closing basis, above today's closing peak of 12,453 with no more than a nominal loss intervening, it will have successfully broken out above the cup and handle pattern and be in technical condition to move significantly higher. According to the Stockcharts.com tutorial on the William O'Neill Co. (Investor's Bus. Daily, Daily Graphs) tool on the subject, the price target would be about 13,350 before another pattern needed to materialize. I haven't read the Investor's Business Daily for a few years, so they might have recently covered the current technical situation with a cup and handle analysis. You can find the StockCharts.com tutorial at this web address: http://stockcharts.com/help/doku.php?id=chart_school:chart_analysis:chart_patterns:cup_with_handle_cont. You can view the Dow Jones Industrial chart at Stockcharts.com on the Market Summary page.
    Volume on April 20 was above its 60-day exponential moving average. I consider this quite positive in view of the fact that this mini-bull has advanced on unimpressive volume since its inception on March 10, 2009. But it does need to break out decisively above the C & H pattern if we are to be spared another indefinite period of uncertainty with its attendant hand-wringing.

2000-2009 Secular Bear Market?

Letter to Richard Russell of Dow Theory Letters:

Richard:  I think it is clear that both the 2000-2002 and the 2007-2009 declines were primary bear markets. I think the important question is whether the period since 2000 has been a secular bull period or secular bear period. Remember, "secular" refers to whether PE's and valuations in general are increasing or decreasing, not just whether prices of stocks are rising or declining.
   You state that you now believe that the 2007-2009 bear market was just an exceptionally severe correction, not a primary bear market. The "mini-bull" market high of 2007 ended up at a lower PE by far than the PE at the bull market high of 2000. The "min-bear" market low of 2009 produced a lower PE than the the bear market low of 2002. Thus, even though the market averages at the 2007 highs topped out above the market highs of 2000, we can still call the 2000-2007 period a secular bear market because these are defined by PE, not price. The rise and fall of valuations is what the classical Dow Theory called a "primary" bull or bear market, but the Dow Theory seemed to assume that valuation highs would correspond to price highs and valuation lows would correspond to price lows. Thus the mechanical signals given by price movements were assumed to have no possible conflict with valuation readings.
     But we find at market extremes that there is some divergence between these two measurements, at least in terms of the cycle high and low points of each successive bull and bear market. Thus there is a need to distinguish between "primary" bull and bear price movements, and "secular" trends, which are based on PE ratios.
    It appears that future peak of this mini-bull cycle has a chance to exceed the maximum PE of the 2007 market highs. If that happens, it will reveal that the secular bear market ended at the March 2009 lows.
    I attempted to post the Case-Shiller S&P 500 PE Chart onto this blog but it would not fit. You can look at it at the following site: http://www.multpl.com/
                                                         

                                                       The Unraveller

                             

Market Indecision & China Comment

     I observe see that the Big Money Breadth Index compiled by Richard Russell  of Dow Theory Letters is showing great strength while the A-D line has been weakening by showing resistance to making new highs. New highs in the DJ Industrials and S and P 500 confirm that the blue chips are currently the predominant Indexes. Does this indicate that the next rally, assuming it comes before a major decline, will be one led by the blue chips with the majority of stocks lagging? In the past, this has been a formula for the creation of major market tops. One thing I have puzzled about is how the type of scenario described above comports with the observation that a major rally in "cats and dogs" also is the harbinger of a longer-term market peak. Can the "cats and dogs" experience an upside explosion while the A-D line is weakening?

     Of course it is quite possible that the A-D line, which has led the market up since the March 10, 2009 lows, is simply undergoing a much-deserved consolidation after which it will resume its strength. I hope that this is the case for it would portend a longer extension of this mini-bull market. This uptrend is drawing closer to equaling in length the 1970-1973 mini-bull advance, which has been a sort of longevity benchmark for me.

     Simply because it has such a large population, it is well to remember that China needs to surpass the US in absolute GDP just to raise its per capita income closer to that of the "developed" nations . Especially ironic for a "Communist" country, China has huge disparities in the distribution of wealth.