Sunday, January 10, 2010


I know many bears are expecting another market collapse. We are in a secular bear market after all. But the fact remains that you can't have a bear leg down (I'm talking recession) unless you have a catalyst. Let's face it the Fed is always going to be increasing money supply. As long as that holds constant there is just no way for a bear market to take hold unless there is a catalyst.

Invariably throughout recent history there has been a common denominator in every recession. The price of oil has spiked at least 100% within a year's time. A gradual rise in energy prices can be dealt with. The economy can slowly acclimatize to gradually increasing energy costs. However when an event occurs that dramatically spikes the price of oil it has always led to a recession.

Economies can't adjust to rapidly increasing energy costs. It crushes discretionary spending. And if you happen to add in a bursting credit, housing or tech bubble on top of it you can end up with a severe (more than 40% decline) bear market in stocks along with the economic recession.

I'm constantly seeing bloggers predicting the next leg down in the bear market, usually based on some meaningless trend line or pattern on a chart. Sheesh, are these guys serious?

Markets don't work that way. You don't get a bear market because a line on a chart hits a trend line. Bear markets aren't caused by technical analysis. Bear markets are caused by deteriorating fundamental conditions.

So if we are going to get another bear leg down I have to ask what is the fundamental change to get the ball rolling? Real estate has already crashed, the credit bubble has already burst, there is no tech bubble, and Bernanke isn't jacking up rates to halt runaway inflation. So what is going to send the economy back into a deflationary collapse as the deflationists are so direly predicting (and have been for the last 10 months)?

I'll tell you what's going to send the economy back into recession. The same thing that sent it or contributed to every recession since 1974... spiking energy prices.

The Fed, and every central bank in the world has printed oceans of money to support the failing financial system. That liquidity is, and has been, looking for a place to roost. Throughout history whenever governments debase their currency it has always led to inflation.

The price of oil has already spiked from $35 to $83 so I dare say the damage is already starting. But what's worse is that we still have all that money floating around out there. Central banks have made no attempt to drain this liquidity from the system, mainly because it hasn't cured any of our economic problems yet. Unemployment is still high. Until we see strong gains in employment it's going to be politically impossible for the Fed to drain liquidity.

But like I've pointed out in past posts no amount of money printing is going to lead to prosperity.

It's like trying to turn a giant ocean liner. You can't start to turn it 100 yards before you hit the iceberg. The same is true for inflation. You can't start to fight it after it's already begun, by then it's too late. Bernanke should have begun draining liquidity last March. But like I said, at that time it was politically impossible, and still is.

So now we are at the beginning of what I expect will be a colossal inflationary storm during the first half of this year. And that is the catalyst that will ultimately put an end to this liquidity driven rally in the stock market. As strange as it sounds spiking inflation will be the trigger for the next deflationary chapter of this secular bear market, just like it was last year.