Most financial commentators, even the well-known and respected ones, just don't get it. They don't understand what's happening in macro-conditions because they fail to accept the understanding that sentiment, as measured by speculator betting practices in the various options markets populating the landscape, is the single most important driver of prices in our mature fiat currency based financial markets. What this means is no matter how much money and bailouts our bureaucracy sponsors, until the collect mind changes, as measured by rising open interest put / call ratios on the major US indexes, meaning the speculators are becoming more pessimistic, in general, prices will keep falling. Of course this can change, and corrections (higher at present) will occur, however if you are waiting for unbridled monetary and fiscal largesse to result in hyperinflation with declining numbers of bearish equity market speculators to squeeze, you are likely in for a disappointment.
Does this mean that deflationists like Mike Shedlock are right, and that we are in a formal state of deflation at the moment? No, as a matter of fact, it does not. As outlined in our opening statement it simply means that en mass equity speculators don't see a percentage in getting short the various markets at current levels because they see prices moving higher, no matter how much they fall. It in no way means money supply is contracting, which is the formal definition of deflation, and the only one that would matter if equity bulls were to turn bearish. (i.e. falling prices do not constitute deflation.) Easily the best example of this at the moment is found in crude oil (and commodities), considering the stock market appears to have turned higher in earnest now. Are we in a state of deflation because crude oil prices are falling?
Here, it's important to note stocks have turned higher due to selling exhaustion and seasonal influences, not because speculators have turned predominantly bearish, as measured in still low open interest put / call ratios (see attached above) on the major US indexes. What this means is if speculative betting practices in these markets do not fundamentally change as the bounce in stocks matures into next year, any strength witnessed between now and then will be exactly that, a bounce, destined to fail once negative cyclical / seasonal influences are in a position to exert themselves once again. You will remember from our previous studies on this subject matter, history suggests this likely bounce could last into April of next year at which time the secular bear market will reassert itself.
In getting back to our crude example now, where prices have not turned higher due to selling exhaustion just yet, making a discussion on this subject matter here more pertinent, again, as mentioned above, it's important to realize why oil prices remain subdued so that correspondingly, we will know what to look for on the way up as well. This is very important moving forward because even though commodity prices have crashed with the larger equity complex in 2008, this does not mean the prices of these commodities can't run all the way back up to the highs (and beyond) under the right conditions. Is such an outcome possible if the stock market is to turn lower on a secular basis again next year, implying the credit cycle is still contracting long-term?
You bet it's possible under the right conditions, which is a lesson in history. First and foremost, and the reason I spent so much time explaining it above, one must realize we are not in a state of deflation, which I admit is challenging with all the confusing talk out there. Naturally then, if this true, we must necessarily be in a state of inflation to some degree, with currency hyperinflation the most excited condition therein. We are of course not there right now, however it's possible we are could be at some point if the Fed decides to devalue the dollar ($). And here's the kicker in terms of why commodity prices could run right back to the highs, with crude oil the exemplar due to it's importance to us, pictured below. If a $ devaluation were to occur concurrent to speculators becoming convinced such an outcome is not possible, which is not a stretch considering the drubbing commodity prices have just undergone, then the fuel for a short squeeze would be in place (put / call ratios on the energies would rise), and the 'wall of worry' would do the rest. (See Figure 1)
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