BEST OF ROBERT PRECHTER

By Robert Prechter, Steve Hochberg and Pete Kendall

June 27, 2003

DEFLATION & THE ECONOMY

In 1930 as now, investors sang a song of cheer because the bear market had yet to break the back of the economy. The economy’s relative strength is evident in the 28% bounce the Dow Transports and a bounce in the 1-year rate of change in U.S. Industrial production. A similar upward bounce in the economic downturn took place in 1930 when January and April were the only months to stem an otherwise steep descent that had started in July 1929. The first hint of trouble in 1930 came on March 31, when the equivalent of the Dow Transports peaked 13 trading days ahead of the Industrials. This time, the Transports peaked 9 market days ahead of the Dow Industrials. This divergence is just the first hint of a wall of "cares and troubles" that investors, consumers and businesses are about to slam into. The Transports have completed an expanded flat upward correction from the October 2002 low that suggests that they should be tumbling to new lows soon. The economy lags the stock market, so production may expand for a few more weeks. After this late strength, however, the economic statistics should deteriorate with a speed that will stun economists.

Deflation Watch.

Talk about missing the forest for the trees! Economists breathed a collective sigh of relief when the CPI figure was unchanged in May. On the basis of a single month, many argued that deflation’s "Launch Has Been Scrubbed." Looked at historically, however, the figure actually supports the argument that deflation is taking hold. May’s figure followed a down April. It was the fourth time in less than two years that a declining CPI was followed by another flat to down month. This is the same number of times that this happened over the prior 35 years! The current persistence speaks to deflations gathering strength.

Evidence of deflation – that "impossible," "improbable," "unlikely" event – is flooding in. It runs the gamut from a 5% decline in May car registrations in Europe (after a 6.5% decline in April) to a 12% decline in frozen food sales at Heinz to Roadway trucking’s earnings, which on June 5 were reported to be half of what analysts were expecting. The company cited revenue shortfalls caused by slack demand and pricing pressure. Another sign is Chrysler’s targeting of suppliers that charge anything higher than the lowest price that can be found anywhere in the world. On June 16, the automaker told 132 suppliers to reduce prices retroactive to January 1, 2003! Then there’s the frenzy for cheap wine depicted in the following spot from CBS news:

‘Two Buck Chuck’ Wine Cult

It’s the California wine with the cult following. Charles Shaw is known in local circles as "Two Buck Chuck." Humble Two Buck Chuck. The $1.99 nectar of the gods is sinfully cheap and good. A full year after flooding the market largely on the west coast, wine lovers can’t get enough.

- June 2, 2003

The Fed’s powerlessness against deflation’s gathering momentum is apparent on the sliding stock market ahead of the Fed’s much-anticipated rate cut. Remember back in 2001 when the Fed started to cut rates? Stocks celebrated with a month-long rally. On the Fibonacci 13^th interest rate cut, the market couldn’t even hold up until the actual cut. The averages fell away from their highs as revelations about the "problems" that lower rates were likely to create circulated. Conquer the Crash said zero was the limit, but late last week, for instance, the Wall Street Journal reported, "too low a rate would imperil money-market mutual funds because they could no longer cover expenses and pay a return to investors. Why would a bank borrow in the money market when it can borrow from the Fed free of charge?" The Fed is powerless to cut rates further because it does not want to decimate America’s $2-trillion money fund industry. It has shot its last bullet. Another difficulty is that bankers have no intention of matching the rate cuts with lower interest rates on loans. Many have placed a floor on lending rates, and they won’t go lower because the risks of default are close to all-time highs. Here’s the headline that appeared in The Wall Street Journal a few hours before the once-invincible Fed took action:

Why A Rate Cut Might Hurt You

Action by the Fed Wouldn’t Lower Mortgages

or Credit Cards, but Savers Would Suffer

The holes in emergency measures such as the Fed’s plan to buy up U.S. Treasuries have also started to appear. The downside of the Fed’s plan to push rates down by purchasing Treasury notes and bonds was revealed when a Fed Vice President realized that the bonds would eventually have to be re-sold. The resulting flood would capsize the bond market. In other words, the bond market is keeping the Fed honest, just as Chapter 13 of Conquer the Crash ("Can the Fed Stop Deflation") said it would.

The official desperation is running so high that a senior economist at the Fed even suggested that the Fed could "conduct an open market purchase of real goods and services." One potential problem is that such a move would violate the law, but he advised getting around the restriction by making the purchases through other agencies of the U.S. government. "By coordinating with fiscal policy, the Fed could even implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter. Extreme times could require extreme measures." It could happen. If it does, it will be the deflationary equivalent of Nixon’s wage and price controls in 1973. But it won’t happen until deflation is much further along. As the Elliott Wave Theorist stated in 1994, "Government is always acting on the last trend." A good example of this principle is provided by the latest CPI report. According to one account, the "villains behind" a bigger than expected rise in the core CPI were "familiar ones: medical care and housing costs." These are the very sectors that are most protected from the competitive economy by the Federal government. Government programs always soar in cost until they fail. These aren’t really CPI elements, they are just measures of government inefficiency.

A House of Cards Exposed

In time, deflation will leech into these areas as well. The seepage is already apparent in the housing sector, where the government-backed mortgage pyramid, also known as Freddie Mac and Fannie Mae, is starting to collapse, just as Conquer the Crash predicted. As EWFF added in November 2002, One of the principle dynamics of a real estate bust is a reaction against the credit system that helped propel the boom in the first place." With the pressure building on Fannie and Freddie to raise lending standards and movement to revamp its status as a "government-sponsored enterprise" gaining steam on Capital Hill last fall, EWFF added, "As these and other ‘reforms’ crunch the availability and demand for credit in myriad ways, the latest government-sponsored real estate depression will begin." This month, Freddie Mac’s top three officers were fired, a criminal probe was launched and several analysts said Fannie Mae suffered a huge loss that it has yet to own up to. Today’s story is that a change in the treatment of Freddie’s derivatives exposure is likely to result in a $4.5 billion earnings restatement. These manifestations of a bear market that are now pressing hard on the instruments of the old bull market. As one headline from June 20 notes, "Signs Abound that Freddie Mac, Fannie Mae Could Lose Advantages as Legislative Tide Turns."

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