Sunday, August 23, 2009

Japan during the deflationary 90's

I'm going to take a look at the Nikkei during the extreme deflationary period following the collapse of the Japanese real estate and stock market bubble. Why? Because the US is in a very similar situation. We are also trying the exact same “fix” of propping up the failed banking system that Japan opted for, which failed miserably BTW.
What we see is a decade of explosive cyclical bull markets driven by nothing other than monetary expansion. Since this strategy never really cured the underlying fundamental problems every single one of these rallies eventually topped out and was followed by a long slow decline to new lows. At which point more stimulus was applied with the same result, another explosive rally and another grueling decline to lower lows.

The argument today is that we are in a deflationary environment and no amount of money creation is going to be able to keep up with the deflationary forces caused by the implosion of history’s largest credit bubble. I’ll point out that Japan experienced massive deflation during this period yet monetary stimulus was able to spawn multiple cyclical bull markets. I’m not sure we should assume that simply because we are in a deflationary environment the stock market won’t be able to rise. The Japanese model seems to suggest that a determined central bank can create asset inflation even in a deflationary environment.

Since we are doing the same thing that Japan did there is probably a decent chance we will experience a similar result.

A great many investors and money managers have been surprised by the stock market's relentless march higher. But as you look at the charts of the Nikkei we see that’s exactly what happened in Japan. Every rally unfolded in under a year. Almost every decline took much longer. For the impatient trader you were better off playing the long side because the gains came much faster than the losses.

There’s probably a pretty good chance that something similar is in our future for the next decade or two. This is going to be a market timers nightmare. History has already shown that the majority of market timers don’t make much if any lasting long term gains in the market. Add in extreme volatility and ever greater government intervention and you end up with a market that’s going to be next to impossible to trade effectively. Sure a few may get lucky from time to time but over the next 10-20 years I dare say almost no one is going to make any lasting money trying to guess the markets volatile gyrations as it gets pulled back and forth by the deflationary forces and the governments attempts to thwart them. Traders are probably going to be running up a mountain of sand for years to come.

So far we’ve seen the COT fail. We’ve seen most trend lines and patterns fail. The cycles have started to perform poorly. Sentiment has become for the most part meaningless. Overbought and oversold levels have been useless. 75 years of Lowry’s data went down the drain. All in all this market has managed to take away just about every tool that investors use to get an edge in the market.

Take a close look at all four of those cyclical rallies. Not only were the rallies extremely violent with all but one showing no inclination to test the bottom but the topping process was normally extended and the retreats were slow grinding affairs with multiple volatile reversals. Like I said a market timers nightmare.

I'm starting to lean in this direction as it is beginning to appear that the Fed may have aborted the current left translated 4 year cycle with a avalanche of liquidity, similar to Japan.