Great investors, and great traders, often ask the question, “What if I’m wrong?”
A trader might ask, “Where should I put my stop loss?”
While a great investor might ask, “How will my portfolio (60% stock 35% bond and 5% cash) perform if interest rates rise 1%, the S&P falls 20% or a recession occurs?” This is a way to test how robust a portfolio might be.
Over the past five years, most investors have forgotten to ask such questions, or even consider the fact that another recession, and bear market, might actually happen (Even though a bear market and recession have occurred every 56 months since 1932 and 5.5 years since the mid-1800’s, respectively.). One big potential risk to asset prices is the conditions that foster a deflationary environment. The king of deflation, and its implications is Elliott Wave International (EWI), and they’ve provided some color on what deflation would look like. Even if it never happens, the risk of it happening is ever present, and investors would be wise to ask the question, “How would my investments perform if deflation hits?”
After this lengthy Trader Skillset editor’s note enjoy the EWI post:
Deflation is a decline in the supply of money and credit relative to goods and services in an economy. History shows us that the most important deflationary episodes are invariably accompanied by comparable declines in equity, factory and retail prices.
The most pronounced deflations in U.S. history occurred during the Supercycle-degree declines that began in 1835 and 1929. The 2000-2002 stock market decline coincided with the steepest fall in year-over-year CPI since 1964. The 2007-2009 bear market featured outright negative readings in year-over-year CPI, the biggest contraction since 1949.
As we noted The Elliott Wave Financial Forecast last month, this time around, wholesale and consumer prices are already approaching outright declines; this weakness confirms the potential for a bear market that is bigger than that of 2007-2009.
With the major stock indexes still near their all-time highs, indicating that optimism is still the reigning attitude, pundits are proclaiming the potential benefits of deflation.
“It’s like we’ve had a big tax cut,” says an Oxford economist. The same economist coined the term “Joyflation” to “describe the combination of the oil-driven slowdown in inflation and accelerating economic growth.”
Another headline generated by a formerly bearish economist says low oil prices “Could Be Market ‘Nirvana.'”
Over the course of 2014, we charted this attitude’s emergence. These more recent headlines capture the progression nicely:
Deflation Hits The Eurozone
– BBC, January 7, 2015
Asia Staring At Deflation
– Bloomberg, January 13, 2015
The U.S. Welcomes the Good Kind of Deflation
– Business Week, January 22, 2015
With “employers showing more confidence than they have since the Great Recession,” the Associated Press concluded that the economy in 2015 is on track for “the fastest growth in a decade.”
Consumers are happy, too.
On January 28, the Conference Board’s Consumer Confidence Index rose “to its strongest level since mid-2007 due to falling gasoline prices.” The surge to 102.9 is the highest reading since August 2007, which was one month after the Dow Jones Composite index peaked that year and two months from the associated peak in the Dow Industrials. During the ensuing bear market wave of 2007-2009, consumer confidence fell with stocks to a 50-year low of just 25.3 in February 2009.
This article was syndicated by Elliott Wave International. EWI is the world’s largest market forecasting firm. Its staff of full-time analysts led by Chartered Market Technician Robert Prechter provides 24-hour-a-day market analysis to institutional and private investors around the world.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.