The big question in finance is whether we are heading for deflation or inflation.

In order to become a better investor, one must occasionally push aside all the heat and noise of today’s financial markets and plot out alternate courses for the future. But before we push it away, let’s look at what the bond market is telling us. Today’s bond markets are definitely pricing in deflation which appears to be a safe bet if you look at the GDP numbers in the US.

Price source: http://www.bea.gov/national/xls/gdpchg.xls

Actual GDP growth in current dollars turned negative for the first time since 1949. Why is that important to the bond market? Because bond investors are paid in current dollars. The great fear of a bond buyer is that inflation will eat up returns and principal. US Treasury yields are below 3% (see Bloomberg chart) and almost any inflation above 2% would be detrimental to bondholders financial health. These investors are not writing editorials in the New York Times, they are risking real money.

Why are bond investors so confident now?

Because there is lots of money but no chasing. Milton Friedman and Anna Schwartz proposed that “Inflation is always and everywhere a monetary phenomenon.” In simple terms, inflation is caused by too much money chasing too few goods and services. The problem with Friedman’s dictum is that it has been mis-sold by Fed and Treasury officials of late. They sold the country on the idea that since inflation is a monetary phenomenon, one need only double the Fed Balance sheet (print money) and the threat of deflation will disappear with a few months lag.

So now there is too much money but still no inflation. Inflation is not kicking in because retail sales are telling us that there is certainly no chasing of goods or services going on in the United States. Consumption makes up almost 70% of GDP so one needn’t look too far for the answer. What about the Government stepping in? With all due respect to Nobel Prize economists like Paul Krugman, the Federal Government is good for a bit more than 20% of GDP and most of that is transfer payments (taking money from one group and giving it to another). However stimulus programs are packaged, the government will not get dollars to chase goods and services on its own.

The Road from Deflation to Inflation

So that is a wrap. The smart money in the bond market has figured out that all the noise coming out of Washington will not trump the bruised and battered consumer whose credit lines have been euthanized over the last two years.

But the road to inflation is not totally blocked. The money is still there. With corporates building cash piles, real estate mired in the foreclosure work out dumps, and some version of the Volker Rule likely to constrain the amount of money banks can punt in the markets, there are not many profitable places for a bank to turn. Once bank lobbyists have figured out how to gut the financial reform legislation, mailboxes should start filling up with credit card applications once again.

And once the credit taps are opened, we will see the excess money start to chase goods and services. Will the Fed step in to raise interest rates and preserve “sound money”? Perhaps when inflation gets into the high single digits but by then it will be too late. Current GDP will be growing at 10% or better, government coffers will be filling up as taxpayers are pushed into higher brackets and the Debt to GDP ratio will stabilize and then start to fall.

Who wins?

No one really. Bond investors are hit first and pay the most but inflation is a stealth tax on everybody and it tends to be a very regressive tax. The political will for cutting spending or raising taxes is almost non-existent so developed economy governments will fall back on inflation to get the job done quietly. Does that amount to a default? If one reads “This Time Is Different”, one might feel that way.

What should investors do?

Nothing today. With the weight of money on the deflation side of the trade, there are no points awarded for being early. This is a trade to watch out for and the indicators are retail sales and M2/M3. Once these turn, there are a number of funds and ETFs that can give you inverse exposure to bonds. But be careful about the tracking errors that can build with time. With inverse and leveraged products, it is easy to be right on the idea and get it wrong on the execution.

A simple way to hedge against inflation is to borrow as much as you can service at today’s low “deflation inspired” rates. A 30 year mortgage below 5% (check rates here) may not sound too sexy today but if inflation rises to 3-5% and hard assets start to appreciate, it could be a cocktail party bragging point for years to come.

As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).

Source: Bloomberg

Why is the yield curve so steep?

The short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.

Supply

On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.

Demand

Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.

An unpleasant task but it is important to step back and remember where we are in the greater cycle of investing.

Here are the three questions:

1. Are we in a Secular Bear Market?
2. What does a Secular Bear Market look like?
3. Why are we in a Secular Bear Market?

The third question will help us to see the signposts for the next Secular Bull Market. The signposts are both political and interest rate driven.

Are we in a Secular Bear Market?

The answer is Yes. Does that mean the market will go in a straight line down and there are no investment opportunities to be had? No…except, as we shall see, Japan. Just as certain asset classes surged and corrected during the Secular Bull Market of the 80’s and 90’s, certain asset classes will surge and correct during a Bear Market Phase as well.

What does a Secular Bear Market look like?

Here is the Dow and S&P500 which can be put together in a few minutes using Yahoo Finance and Excel. Charts and statistics can be manipulated to tell a particular story and these charts are no exception. We have used a logarithmic scale (so a 10% rise in the 1950’s looks like a 10% rise in the 1990’s) and have squeezed it to emphasize the long term time periods. On top of that, we have laid lines of our choosing to frame your thinking. Why bother describing this? Because it is important to think about the construction of any chart that might influence your investment process. Don’t be afraid to draw different lines and even conclusions.
Source: Yahoo Finance DJIA, SPX, Nikkei

The most interesting thing to note about the two US market charts is that a Secular Bear Market is not a smooth downward progression that the words imply. A Bear Market is generally defined as a 20% drop from the peak but that definition refers to a cyclical bear market. And, since many of those 20% drops happen quickly in otherwise Secular Bull Markets, one can see how the general perception of a Secular Bear Market is formed. However, the longer term beast that prowls the financial markets these days is a generally sideways affair. Generally, because one always has the example of Japan, which has gone to great efforts to make the last 20 years as dreary as possible.

Why are we in a Bear Market?

This is an important question because it will help us find the signposts for the next phase. Despite many sunny assurances that the Great Recession is behind us, the world does not feel like it is enjoying a strong recovery. A big part of the problem is the structure of the developed world’s economies. After a long period of globalization and attendant wealth creation, the demands for pensions, government programs, subsidies, worker protections and the like have finally taken a toll on the fiscal positions of many European and US states. The government’s share of GDP has grown dramatically, particularly in response to the Global Financial Crisis. Good growth is being crowded out by Government growth.

What should we look for? Dramatic action. The US and Europe did not break out of the malaise of the 70’s until dramatic actions were taken. Governments in the US and Europe will have to make some hard choices over the coming few years in order to set up for the next round of economic growth. What signs should one look for? Political reordering, sneaky pension cuts for public employees, a change in Social Security retirement age in the US and perhaps a government willing to stand up to public employee unions.

On the financial side of the equation, the big problem is that there is plenty of liquidity being created in the banking system but very little is being turned into money that businesses and individuals can use.

Courtesy of ShadowStats.com

Why isn’t money moving from the Federal Reserve to Main Street? Simply because it makes no sense for US banks to even look at making a loan.

This chart is presented in a fashion that one might not be familiar with because we are showing it from the bank’s perspective. To a bank with access to short term Fed Funds, the dramatically steep curve in US dollar rates means that the bank can make a bundle in the US by simply borrowing at next to nothing and lending it to the US Government for a few years. Compared to the complexities of a 30 fixed rate mortgage, this trade is the path of least resistance. Not only do you not need loan officers, you do not need an advanced degree to lay on the trade.
Data Source: Bloomberg

For now, it means that banks and other financial institutions around the world will continue to crawl over each other to get in on the trade. That means continued dollar strength (UUP) and weakness in the British Pound (FXB) and Euro (FXE) for the foreseeable future.

The signpost to look for is the flattening of the yield curve. When the long end comes down (because the FED appears determined to keep the short end anchored near zero) the loan officers will be out in force to recycle the profits that are being racked up today. Once that engine restarts, expect to see a huge surge in asset prices, economic activity and eventually, inflation.

What to do in the meantime?

As we pointed out in the beginning of the post, the next few years will be dominated by the Secular Bear Market. That means a general sideways drift with plenty of smaller bull and bear cycles along the way. To make money in rotational markets one must pay close attention to asset allocation and being ready to shift assets between classes. The old “Buy and Hold” formula which worked so well for almost two decades will only deliver very slim returns with lots of volatility. We continue to refine and test the Fund King System to meet the challenges of these markets.

Right now the System is telling us to stay in the following asset classes: Emerging Europe (TUR is back), High Yield, India, Tech, Reits, US Consumer, US Small Caps and Homebuilders. In our commodities only portfolio, only Gold (GLD) and Silver (SLV) look interesting.

For more information, go to our Portfolios Page. Gold members can see the most recent recommendations.

Disclosures: We eat our own cooking so you can safely assume that we own, have recently owned or are about to own the ETFs discussed here. In this particular post, we do not own GLD or SLV although we have owned both in the recent past.