Many seasoned and saavy Wall Streeters are perplexed by the apparent conundrum of a strong bond market that seems to be telegraphing deflation and recession and a stock market that seemingly proposes a very different scenario has it levitates with no apparent rhyme nor reason.
This public post (open to non-subscribers) outlines my thoughts on the dollars role as the answer to this conundrum. I’ll follow this post up in the next few days with additional thoughts on the inflation/deflation cycle and how it fits into our timing model(s). Those posts will be for subscribers only.
The answer to the conumdrum is that I think bonds and stocks are both accurately reflecting aspects of the current financial climate.
Bonds are accurately reflecting that market’s position late in the deflation cycle. This is self-explanatory and needs no exposition here.
Stocks are accurately reflecting currency uncertainty and future dollar irrelevancy that is the natural by-product of the trillions injected via QE following the 2008 crash.
A phrase I first coined in the 1990s and have repeated ad nauseum since is;
“If the dollar goes to zero, stocks will go to infinity and investors will be broke anyways.”
A bit of hyperbole, obviously, but it makes the point.
World equity markets are inflated by trashing the dollar. If the dollar is allowed to rise, then we see equity markets become unstable and begin to fall. That’s been the tendency since 2008.
click chart to enlarge
The chart above shows the link between the dollar and stock trends over the past two years. The 2008 stock crash occurred during a massive dollar rally. The dollar fell briefly in late 2008 at which point stocks quickly stabilized. The dollar rally resumed in early 2009 as did the stock collapse. The stock low in March 2009 was coincident with the dollar top (point #1). The falling dollar in 2009 went hand-in-hand with the stock market rally. Eventually, the dollar began to correct upwards while the stock rallied maintained its upward momentum. But when the dollar rally’s momentum accelerated at point #2 on the chart, stocks began to head south. The momentum low in stocks in the second quarter was coincident with the dollar high. Stocks’ price low occurred shortly thereafter. Stocks have been rallying since against a back drop of a dollar that is once again falling sharply.
click chart to enlarge
This second chart shows the stark contrast of the S&P 500 prices in dollars versus priced in gold. The question about the massive disconnect between the bond and stock markets is answered simply here.
The bottom clip of stocks priced in gold is exactly what one would expect given the current state of the bond market and its deflationary expectations.
The answer to the pain of deflation is a falling currency. In a deflationary world, the weakest currencies feel the least deflationary pain. Ergo – the falling dollar enables U.S. stock holders to escape the deflation pain. U.S. stock holders think they’ve recouped much of their 2008 losses. But the pain has just been kicked into the future to that point in time when the longwave inflation/deflation cycle flips to the inflation side. Then, the weak currencies will feel the maximum pain and the strong currencies will reap the rewards. I’m sure we can expect the Chinese to let the yuan float higher when that day comes.