Deflation has Arrived

Good evening!

Interesting start to the week don't you think? There is much to talk about today. The sell off this week is not a surprise to me. I tried to warn everyone that the bounce was about done on Friday. I must admit its been on light volume so this must also be taken into consideration in terms of being a confirmation that we are abut sell off big time.

I am amazed at the power of denial that I am witnessing by the bulls.

It seems like the "bubble boys" need a reality slap of horrible data before they "get it" and sell. The stock market is filled with permabulls after the great run the market has had. This bullishness sentiment is fogging their ability to make smart fundamental decisions in a market that's about to be hit with a deflationary death spiral.

Many of these clowns will lose their fortunes just like they did during the tech wreck. The banks were punsihed today.

Lehman was a big story. I am going to put them back on the endangered species list(after losing a few bucks). The fact that they didn't sell their mortgage assets tells me that they can't afford to do it because their balance sheet is too damaged. The silence from Lehman today was deafening. The price action today tells me they are in trouble.

Deflation

So lets discuss deflation again today. The Telegraph had a disturbing article on the major contraction of the money supply(M3) in July. The graph below shows how sharply the M3 supply shrunk in July.



From the article:

"The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months.

Data compiled by Lombard Street Research shows that the M3 ''broad money" aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959.

"Monthly data for July show that the broad money growth has almost collapsed," said Gabriel Stein, the group's leading monetary economist.advertisement

Household income is now 131pc of disposable income, compared with 93pc at the top the dotcom bubble, 79pc in the property boom of the late-1980s, and 62pc at the end of the 1970s."

My Take:

This is another warning shot to the inflationists out there. The government is not trying to print out of this nightmare! In fact, they are doing the exact opposite. They are reducing the money supply. The drop off in July was the biggest 1 month drop in history!

I was happy to see this chart because going the hyper-inflationary route is much more painful, and usually ends up with governments being overthrown because no one can afford to live.

We seem to be taking the more prudent route out of this mess: Massive deflation similar to Japan. Guys, the writing is on the wall in terms of how the government plans to get out of this mess. They will shrink the money supply which will cause a massive deleveraging of the financial system which in turn causes massive deflation.

Deflation shrinks the value of all assets because there is less money in the system. Banks have forced to be more prudent with their lending because of losses and must deleverage and shore up their balance sheets in order to be viable companies that can make money in the future.

The only way they can do this is by letting deflation hit and allowing houses to become affordable again. When this happens, the ones that survive will be healed and they will have more demand for loans than they know what to do with.

Of course Wall St. hates deflation because it kills their earnings power. Deleveraging is not profitable! When Japan went through massive deflation their stock market went from 38,000 down to about 13,000 where is stands today twenty years later. I don't expect a 60% drop in equities, but we definitely have a ways to go on the downside.

Deflation has already started folks. I have discussed examples of deflation that I am already seeing here in the US.

Expect a lower standard of living in the US as we lick our wounds over the next several years. The good news is if your income holds up, living will become much more affordable and your standard of living may go up!

Other News

Fed president calls for Freddie/Fannie nationalization.

Aug. 19 (Bloomberg) -- Richmond Federal Reserve Bank President Jeffrey Lacker called for ``demonstrably'' privatizing Fannie Mae and Freddie Mac, becoming the first Fed official to publicly clash with the Bush administration's strategy of keeping them as federally backed firms.
``I would prefer to see them credibly and demonstrably privatized,'' Lacker said today in an interview with Bloomberg Television. He agreed with former Fed Chairman Alan Greenspan's view that the two largest U.S. mortgage finance firms ought to be nationalized, then split up and sold off.

Treasury Secretary Henry Paulson by contrast has tried to keep Fannie Mae and Freddie Mac in their current form as government-sponsored companies owned by shareholders. Lacker's remarks come as a slide in the firms' stocks and increase in their borrowing costs spur speculation the Treasury will intervene."

Inflation Soars to a 27 year high

"Aug. 19 (Bloomberg) -- Prices paid to U.S. producers rose twice as much as economists had forecast in July, reflecting the jump in energy and commodity costs that has since started to wane.

The 1.2 percent increase in the producer price index followed a 1.8 percent increase the prior month, the Labor Department said today in Washington. Costs were up the most in 27 years from a year before. So-called core prices that exclude fuel and food rose 0.7 percent after a 0.2 percent gain in June."

Final Take:

The inflation number may force the Fed to raise rates down the road if falling energy prices don't do the trick.

Remember, price inflation can happen in a deflationary environment. Many people don't understand that these are two different phenomenons. In fact, price inflation actually feeds deflation because people have less disposable income to buy assets like gold and houses because they are paying higher prices via inflation on goods like food and other necessities that are needed in order to live.

I would be nervous if I was an inflationary "gold bug" right now. The one way I do see gold rising is investors might take it higher based on fear when the equity market starts to fall further.

There is only one way the markets go as the money supply drops folks! Down, down, down. Please stay diversified and don't allow your portfolio to go down the deflationary drain!