Inflate or Die!

Enrico Orlandini
Lasco Report
29 August, 2005

I borrowed the title from Richard Russell; I hope he doesn't mind. I like it because it sounds dramatic and I think it fits the moment. In short, it's appropriate for our discussion. Why? It's important to understand that there are opposing economic forces at work in the United States in particular, and the world in general, and they're on the verge of causing serious problems. These opposing groups can be lumped into three camps: the inflationists, the deflationists, and the stagflationists.

Those who point to inflation usually site the rising cost of education, insurance, health care, and gasoline prices and say "See, that's inflation!" and they're right. It is inflation, but it's not the whole story. In fact I believe it is a small part of a much larger picture, but more on this later. The deflationists point to declining corn, soy bean, coffee, cotton, cattle, and lumber prices and say "See, that's deflationary!" and they're right too. So as you can see, we have a dilemma here and I would like to use the space below to work through it and see if I can arrive at some sort of solution.

Let's begin with oil. I believe oil should be treated separately from any other commodity or service (just like gold) when discussing the outcome of any increase/decrease in inflation. When I was doing my graduate work in economics, back when dinosaurs roamed the earth, I was taught that oil/petroleum account for 30% of the price affect on a typical basket of goods. That's a pretty hefty weighting and it's easy to see how a 200% increase in oil prices over the last two years could be considered inflationary. Or is it?

I believe that a rise in the price of oil is not inflationary. At best, it's neutral, and quite possibly deflationary. How do I arrive at such a radical conclusion? Actually, it's not so difficult when you stop to consider that oil is used for, and in, just about everything. An increase in the price of oil eventually must be passed on to the consumer in the form of higher prices (inflationary) and that leads to a decrease in consumption (deflationary). That decrease in consumption will eventually affect the bottom line of all the companies that produce the goods we consume. What's more, an increase in the price of oil leads to an increase in gasoline prices and that makes the consumer hesitant to even go out and shop, much less buy. This hesitancy is evident in the price action of the DOW 30 stocks which have been lagging the overall market for some time now.

There might have been a time when a rise in oil prices was purely inflationary; maybe back in the early 70's when the U.S. still produced something. Maybe it was even inflationary this time around when we jumped from $17/barrill to $35/barrill, but at some point it reversed and became a drag on the consumer specifically, and on the economy generally. And that's where we're at today. Take a look at the following chart:

This is a Daily Chart of the Retail Index and it clearly shows a downturn. Once the top was in, we began a move down highlighted by a lower high and then a lower low. Now I don't claim to know if this is the top or not, but I suspect it is. Why? Take a look at the following chart of Wal-Mart (WMT):

To put this chart of Wal-Mart into proper perspective, it's always good to remind ourselves that Wal-Mart represents 1.5% of the U.S. economy. It's clear that the breakdown in WMT began long before the top was in on the Retail Index. Also note that WMT is now trading well below its 50 and 200 day moving averages whereas the Retail Index is only now trading below the 50 day moving average. In short, the Retail Index is lagging WMT but I have little doubt that the path will be the same.

That's from the consumer side. What about the commodity side? Honestly, it doesn't look any better. The following are daily charts of soy beans, cotton, lumber, coffee, and live cattle respectively:

As you can plainly see, they are almost carbon copies of each other, but I didn't choose them for that reason. I chose these particular commodities because I can identify a demand for each and every one of them in almost every corner of the world. Take coffee for instance, it's almost a religion in Italy and most Latin countries and I can't imagine the average American without his/her morning cup of coffee. Going back to the charts, we can see they all have two things in common, they all put in a top several months ago and they all have made a series of lower highs and lower lows. Some charts, like soy beans for example, only tell part of the story. Due to the fact that these are all six-month charts, you only see the decline in beans from $7.60, but what you don't see is the fall from the $11.00 high put in less than a year ago. That's a 50% haircut in less than twelve months! What happened to all the Chinese demand that was supposed to take beans up to $20.00/bushel?

Just as a point of reference, I didn't choose these particular commodities because they "fit" my needs. I could just as easily have chosen silver, wheat, corn, or sugar, but my particular choices seemed a bit more representative with respect to worldwide demand. [Just a note on lumber, it has broken down even further than when I covered it in the July Newsletter and that is quite portentous when taking into consideration the housing bubble.]

Now that I've got all that out of the way, I want to focus on the real sources of inflation and deflation. Inflation is really quite simple: any and all sources of inflation begin and end with the Federal Reserve Bank of the United States. This has been the case since the bank's creation back in 1913 and has grown worse with the passing of time. In an effort to give you a clear idea of just what the Fed has done to every American man, woman, and child, I will quote directly from an August 23rd article by Richard Russell:

"When I left the army in 1945 the American Institute for Economic Research's dollar index stood at 100. In other words, a dollar bough a dollar's worth of goods. By 1960 the index was down to the point where the 1945 dollars that I'd been saving bought only 61.1 cents worth of goods. The erosion continued. By the time Alan Greenspan took over the Fed in 1983, the index bought only 18.0 cents worth of goods. By 2003 the index bought only 9.9 cents worth of goods."

Russell then goes on to say:

"The truth - the Federal Reserve doesn't just generate inflation. The FEDERAL RESERVE IS INFLATION. The Fed isn't being run for the American people, it isn't being run for America - it's being run for the benefit of America's bankers."

The Fed has managed to do this through the uncontrolled printing of dollars and it's gotten away with it, up until now, because the dollar has enjoyed the status as the world's reserve currency.

Normally, the printing press would have been enough, but 1999 saw the end of the greatest Bull Market ever in stocks as the stock bubble burst. The DJIA began a two year decline and this helped bring about a recession in the U.S. Under normal circumstances, you'd let these things run their course and you would even consider it nothing more than a healthy and much needed correction. Unfortunately, Mr. Greenspan didn't go that route. Instead, he decided to fight the Bear and began to drop interest rates to fifty year lows. Additionally, he made significant increases in the money supply. He had incredibly good luck in the perverse sense that the terrorist attack on New York provided all the justification one could want for such actions. The results were four fold:

1. The stock market bottomed in late 2002 and began a Bear Market rally that lasted until early 2005. It did so in spite of the fact that stocks never reached a reasonable value in order to justify the rally. In short, the bubble began to reinflate. ¹

2. The commodities market hit new highs and we had a new bubble as people began to search for something tangible to invest in (versus a devaluating dollar).

3. We see a significant bond rally (another bubble?) against all projections, and

4. Finally, the combination of extremely low interest rates and access liquidity produced the biggest bubble of all, the real estate bubble!

The fact that we went to war in Iraq only served in increase the liquidity feast. In fact, I'll go even a step further and say that the only reason we went to war was to draw the average American's attention away from growing economic problems at home. It became a case of 'let's all rally around the flag'. And that's just what we did. Now we're mired in a situation (Iraq) that we can't get out of.

In conclusion, Greenspan decided that he didn't want any recessions, or worse yet, depressions on his watch so he took the initiative and tried to fend off the Bear. He decided to "inflate or die". This decision is directly responsible for the housing bubble which I believe has now burst. The only question is, can we deflate in a controlled manner or not? I seriously doubt it.

With respect to the other side of the coin, i.e., deflation, we have two sources that can be easily identified:

• China/Asia - The Chinese actually export wage and price deflation to the United States. They do so by producing cheap, good quality products using the latest technology combined with 90 cent-a-day labor, and
• Internet - The Internet allows you and I to find the absolute lowest price for any item your heart desires.

We import deflation from China and we'll continue to do so as long as we have the tremendous trade imbalances that currently exist. The U.S. no long produces much of value so our exports become less significant with each day that passes. In reality, our only true exports are the dollars we print. This situation will only become more dangerous as time passes and American investors continue to inject capital and the latest technology into China. With the latest technology and an intelligent, willing workforce that earns less than a dollar a day, I see more deflation in the pipeline, a lot more!

CONCLUSION

In the U.S., we have the largest debtor nation in the history of the world and a consumer with a zero saving rate. The only other time such a low saving rate existed was during the Great Depression. We also have a Federal Reserve System with an "inflate or die" attitude that has produced a series of bubbles, each one bigger than the one before, all in an effort to defeat the Bear. The end result is that the average consumer has no real liquidity and his only store of "wealth", and I use that word loosely, is his house. Real Estate is/was the last remaining bubble and I believe it will be the most dangerous. Why? Houses are notoriously illiquid in a declining market. That's a lesson I learned the hard way back in the late 70's. The inability to sell an asset when you need money will only be exacerbated by all the novel "no interest down, pay nothing until the day you die" financing being thrown at people with marginal or bad credit.

Before I close, I want you to take a quick look at what may be a top in the real estate market. The following is a chart of the Dow Jones Real Estate Index:

And as you can see, there was a rather ominous drop-off in early August followed by a feeble rally. We've now completed a second rally with a lower high; not a good sign if you ask me. The Index has now broken below the 50 d.m.a. and I believe it will be difficult to move back above in anything other than a marginal break. Finally, note that the RSI did not confirm the top in the Index and that's bearish too.

To put some perspective on the above mentioned Index, I want to show you the following two charts of Beazer Homes (BZH) and Lennar Corp (LEN), two of the largest homebuilders in the business:

Note the similarities but with two exceptions: both topped several weeks before the Index and both saw a failure of not only the RSI to confirm the last top, but MACD also failed to confirm.

My own personal opinion is that we are looking at the top in the housing market, and that won't be a good thing. The previously mentioned pullback in the Retail Index ties in nicely with this. Throw in $66.00 oil, with an $83.00 price target, and you now you have the complete recipe for disaster. The DJIA is sensing this and that's why it's breaking down. Unlike other moments in history, there is no safety net this time around. The average American hasn't saved, is deeply in debt, his wages are declining in real terms, and won't be able to stand the pressure. He'll give the keys to his house and SUV back to the bank and go rent a smaller house or apartment and use mass transit. Unfortunately, bankruptcies will skyrocket and unemployment will rise dramatically. I see a Depression with one big difference when compared to 1930. In 1930, the bankers jumped out of windows of their own free will. This time around, I suspect that disgruntled Americans will be helping them out. That translates to social unrest and should lead to serious and much needed reforms on all levels.

¹ Try to remember that when you buy stocks, you are really trying to buy value. It's very hard to find anything of value in today's market.

Enrico Orlandini
For those of you interested in receiving information on the funds we manage, please feel free to e-mail us at ebo@dtanalysis.com and we will respond as soon as possible.

Recent Economy essays at 321gold: Nov 22 The Times, They Are A-Changin'  Casey Files 321gold    Nov 22 Deer In Headlights  HRA 321gold    Nov 17 Buy When There is Blood in the Streets!  David Chapman 321gold

321gold Inc