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Two Precursors of What Deflation Might Look Like
The past few weeks have provided plenty of fireworks and sideshows on Wall Street, culminating yesterday with the news that the Fed served as the lender of last resort to Bear Stearns by financing JPMorgan Chase's purchase of the crippled securities firm. The Fed followed up today, March 18, by dropping its benchmark interest rate 3/4 of a percentage point to 2.25 percent. And the Dow shot up 420 points. But while these fireworks were going off, the sideshow of bond insurers, Ambac and MBIA, kept playing on. Bob Prechter sees an important story in the shape of the price charts of these two companies. In his latest Elliott Wave Theorist, he discusses how the action of their stocks offers a broad hint of what may come for many stocks as inflation gives way to a steep and rapid deflation. To learn how, read the excerpt below.
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Excerpted from The Elliott Wave Theorist, March 14, 2008, by Bob Prechter
A Portent of How Coming Price Adjustments Will Occur
According to lore, the stock market is supposed to be a “discounting” mechanism, meaning that it anticipates future events and moves ahead of them. This notion is fatally flawed, as explained briefly in The Wave Principle of Human Social Behavior (pp.331-332) and more fully in Pioneering Studies (pp. 379-384). The market does move ahead of events, but the reason is that it records the changes in social mood that motivate social actions, which manifest as events.
Lately, however, markets have failed to turn quietly and slowly ahead of events, as they usually do. The sub-prime mortgage meltdown provides a case in point. The Elliott Wave Financial Forecast described the market’s change in July 2007 from fully valuing these mortgages to considering them nearly worthless as being so swift that it was as if someone “flipped a switch.” Conquer the Crash came out in March 2002. So five years before the “switch” was flipped, someone studying the situation could see the tremendous risk in weak debt. Moreover, the housing market topped in 2005, so two years before that change, anyone attuned to the implications of the end of a record housing bubble could have made the decision to bail out of sub-prime mortgages. But the market did not budge. Optimism remained entrenched. It was not until some lone, unknown seller offered up one of these mortgages for sale in July 2007 that the market suddenly acted as if the mortgages were toxic.
We have just had another such event. Conquer the Crash covered the structural weaknesses in debt and insurance companies and expressed the utter certainty that rating services would be behind the curve. So, of all things, insurance companies that insured debt, thereby jacking up the bonds’ ratings, would have to be one of the most dangerous of all investments. Yet investors’ optimism was so persistent and blinding that they bid up shares of the two biggest debt insurers, MBIA and AMBAC, in 2003…2004…2005…2006…and even into 2007! AMBAC peaked on May 18, just shy of two years after housing prices topped nationwide. We were stunned at the complacency. Then, in a blinding fury, these two stocks fell 93 percent on average, in a matter of months….
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Do not assume, though, that the stocks in [the chart above] are “reacting” to events. The crashes in these two stocks are still way ahead of events and most people’s stated opinions. If you can believe it, the two major rating services are still confirming their AAA ratings of these two companies. But the market has spoken: These ratings will go the way of the dinosaur, and these companies will go under. These events have yet to happen, so once again the market is ahead of events.
I had long thought that the great bear market in stocks might be swift, because over the past 300 years the bigger the investment mania, the faster has been the ensuing collapse. The peaks of 1968 and 1835 led to deep bear markets of six and seven years, respectively. The wilder Roaring ’Twenties, capping an 87-year rise, led to a deeper bear market, yet it was faster, lasting less than three years. The even more dramatic South Sea Bubble, which peaked in 1720, led to a still deeper bear market, yet it was even faster, lasting only two years.
So given that the past 10 years of topping has produced the craziest overvaluation, the largest number of bubbles and the most persistent period of market-related optimism ever, by a huge margin, I am more than ever expecting a swift resolution. It would also make sense from a political perspective: The coming deflation needs to be swift enough to out-run the actions of the Fed and Congress. If it happens fast, they won’t be able to act quickly enough to turn the credit deflation into a currency inflation before the former trend has run its course.
Take a good, long look at [the chart]. This might turn out to be the profile of the stock averages when the big capitulation hits….