Jim Puplava: Stocks roared from the March lows of last year, and now we’ve seen a nice correction since the April high. Is it just an interim correction as the bulls would argue, or does something worse lie ahead? Joining us on the program is Bob Prechter, author and head of Elliott Wave International. Bob, I want to pick up from last September. Since then we’ve had several quarters of positive economic growth. Asset classes rose substantially, CPI turned positive, gold has hit a new record, oil is close to $80 a barrel. I guess a lot of our listeners would like to know, have these events altered your views on deflation?
Robert Prechter: No, because we forecasted these events, and we forecasted them at the bottom in March and April of 2009. On February 23 in the Elliott Wave Theorist, I said that we were almost at the bottom; that ideally the S&P should get down in the 600s before turning up; and that the Dow was going to rally from that low up to about 10,000. We put that target out a few days after the low. The main thing we said at the time was that it was going to be only a partial retracement, in other words a bear market rally. By the end of it, we said people would be bullish on the economy, there would be positive economic numbers, investors would think we have made the turn, the Fed would take credit for having saved the financial system, and there would be optimism across the board. All of this has happened. And going into April 2010, few people in the fundamentalist or technical camp were looking for a downturn.
The final thing I said was that Obama’s popularity would rise into that peak, and on that one I was wrong. His ratings couldn’t even bounce during that period, which I found very surprising. But both Obama and George Bush’s popularity trends followed the real value of stocks, not the inflated dollar price of the stock market, which I find interesting.
As far as inflation and deflation go, we had deflation during the down cycle in 2008. Commodities fell hard, the stock market fell hard and real estate fell hard. But the recovery that we were looking for in the first quarter of 2009 was expected to be a reflationary, and it was. You saw a decline in credit spreads. You saw a rise from the lows in commodity prices and stock prices. All of that is perfectly normal. These are just waves ebbing and flowing. But the long-term trend is still down, and as this cycle matures we are going to see more and more evidence of deflation.
JP: I want to come back to government spending, but first I want to move onto the stock market. In your last two Elliott Wave Theorist issues, you laid out a scenario that would put the Dow and S&P, which in your opinion may have peaked on April 26, as the top from here. You feel that this top is the biggest top formation of all time, a multi-century top and we could head straight down in a six-year collapse that would end in 2016 that could see a substantial portion of the S&P and the Dow wiped out in a similar way that we saw between 1929 and 1933. Let’s talk about that and the reasoning behind it.
RP: Yes, you’re exactly right. I did a lot of work on technical forms, cycle forms and Elliott wave forms in April and May and put them in a double issue. Let’s talk about the cycles first.
The 7¼-year cycle has been quite regular since the first bottom in 1980. The next bottom was at the crash in October 1987. The next one was November 1994, which is when the economy went through four years with lots of layoffs; it was a recessionary period throughout until that cycle bottomed. The next one was between September 2001, which was the 9/11 attack, and the October 2002 bottom. And the latest one was at the low in March 2009. All those periods are 7¼ years apart, so we are in the uptrend portion of the 7¼-year cycle.
However, notice for example that in 1987, the market went up until August of that year and then bottomed in October, just a couple of months later. So the decline occurred very, very late in the cycle. This time it occurred a little bit earlier in the cycle, topping in ‘07 and bottoming in ‘09. In the current cycle, prices should peak the earliest of all of them. It’s what we in the cycle prediction business call “left-hand translation.” The market’s already gone up for about a year, and I think that’s just about enough. I think we’re going to spend most of the cycle going down. But the important thing to note is that the next bottom is due in 2016. That means I think we’re going to have a repeat of what happened between 1930—which was the top of the rally following the 1929 crash—and the July 1932 low. Instead of taking two years, it’s going to take about six years.
It’s going to be a very long decline. It’s going to be interrupted by many, many rallies, just as the decline from 1930 to 1932 was. And every time it bottoms and rallies, people are going to say “OK, that’s enough; it’s over.” But it won’t be over. It’s just going to be a long, long process. I think you and I will probably be talking a few times during this period. One of the interesting aspects of this process is that optimism should actually remain dominant through the first three years of the cycle. That will carry us into 2012. Even though prices will be edging lower, most people are going to think it’s a buy, and you shouldn’t get out of your stocks, and recovery is just around the corner, probably for the next three years. And then, for the final half of the cycle, the final three years, that’s when you’ll get the capitulation phase when everyone finally gives up.
JP: I want to take two well-known investors who would take the opposing view of a declining market. One is Dr. Marc Faber, who believes the S&P low of 666 will stand and that the government will simply inflate, because its debt is denominated in its own currency, unlike let’s say what we saw in Mexico where Mexico experienced some problems as a result of devaluation, they saw an increase in their stock market from the lows in nominal terms. So Marc believes because the U.S. debt is denominated in its own currency, the government will simply print, print, print. To add to Marc’s views I want to take famed investor Felix Zulauf. In a recent interview in Barron’s he also said one day the world’s financial system will reach a financial reckoning day where the Fed’s balance sheet will expand not by just a trillion or two, but by multiples of that, five, six, seven trillion, which would negate the deflation scenario. How would you argue against Faber and Zulauf’s views?
RP: I don’t think I have to. These are political predictions that may or may not come true. In other words, why does it have to go that way? Someone else could say just as easily, “Well, it’s also possible that the voters will all become Tea Partiers, they’ll throw all these people out, and they’ll elect conservative guys who will balance the budget and eliminate the Fed.” How would you argue against that? You can’t. It’s just a scenario. It’s not an argument, just a possible scenario.
Still, I don’t think it’s likely because of what I already said. I think the change in social mood towards the negative is already showing results. Here we are in a positive rebound, yet you’re still seeing Tea Parties and you’re still seeing incumbents pushed out of office. I think by the time the trend really turns down again and breaks those 2009 lows, you’re going to see the public so angry at their representatives that they’re going to start forcing a difference in behavior. Congress is not going to be spending like it was before. They’ll probably be drawn and quartered if they try to bail out another giant bank or certainly if they try to bail out the European banks as they did in the AIG disaster. All of this spendthrift behavior people are cluing into, and it’s spreading on the Internet, and it’s spreading through word of mouth.
You have this scenario that politicians are just going to monetize and they’re going to go crazy. But it’s not a given. It requires that politicians are somehow untouchable by politics. But in a democracy, they’re very subject to politics. Even in Greece, the leaders of that country wanted nothing more than to keep spending and borrowing and spending and borrowing. The creditors finally came in and said, “Enough. You can’t continue or you’re going to be literally out of power and bankrupt tomorrow.” So they agreed to some austerity programs, some creditors came to the door; some European governments, for example, came to the door. It’s always the creditors who are in control—these bond vigilantes. Even Clinton was upset when he found out they existed. The U.S. government depends on these people for all of its borrowings. The Fed hardly has any U.S. Treasury bonds anymore; its portfolio is full of mortgages and all sorts of junk. The private market and other governments have sopped up all these Treasury bonds. The government could decide to “print, print, print,” but the only thing it can print are bonds. It can’t print Fed notes; it can only print bonds. If the creditors shut down and say we’re not taking any more of Treasury bonds, there’s going to be a real disaster. They’re going to have to raise interest rates to double digits, maybe 80 percent or 100 percent or some crazy amount. That’s going to suck money from every other corner of the earth, and the economy is going to crash one way or another.
A crashing economy is going to be deflationary, because it means the debt that exists won’t be paid off. It’s the collapse in existing debt that’s the problem. Now the Fed and the Treasury are trying to shore up some of this debt. The Treasury said, “Look, we’re going to guarantee Fannie Mae and Freddie Mac,” and the Fed gave money to help bail out Greece. The IMF did the same thing, which is mostly funded through the American taxpayer. But relative to the amount of outstanding credit, these are actually small moves, even though they’re unprecedentedly large. That’s because the amount of credit that has been building up for 70 years dwarfs the amount of money that we have in circulation. I think the problem is too big for them to solve. It’s too late. The only thing they have to offer is more credit, more credit, more credit. So far, they really haven’t offered much more money. Credit is the problem, so printing more bonds in my view is not going to solve the problem. The government has already been borrowing at a mad pace. Wouldn’t you agree that the last year or two has seen the greatest government borrowing ever? And yet you certainly don’t have runaway inflation according to the commodity indexes. What is it going to take to create inflation? It’s going to require that they create something like 100 trillion dollars worth of new money, and I don’t think Congress is going to be able to stand up to the people and do that.
These scenarios are matters of social analysis, political analysis and opinion. What I’m saying is, let’s look at present conditions in the U.S. We can also look at Japan, which had quantitative easing like crazy, and they still ended up deflating: Stock prices are down, and real estate prices are way down in Japan. And the same thing is going to happen here. And that’s the best scenario. The Japanese economy kept going because the rest of the world was still expanding. Now the whole world is basically on the edge of depression. Nobody’s going to be able to bail out the world, because we’re the only people in it.
I think it’s a one way road to the nearly complete collapse of outstanding credit. And if you count all the derivatives, all the domestic and foreign debt that exists, you’ve got about a quadrillion dollars worth of IOUs out there and already written. I just don’t think central banks can or will replace all of that debt with money. It would mean their own self-destruction. And not only that, there’s this thing called moral hazard. As I said in a recent issue, the Fed is not a moral institution; it does not care about morality. But if it were to announce that it was literally going to monetize all the bad debt that anybody can create, the first thing that would happen is everybody would be out there creating new debt as best as they possibly could and selling it to the Fed. The scenario is not realistic. It comes from people who think the Fed and the government are machines. They don’t realize that they’re run by people who are going to have to survive politically. I don’t think they’re going to be allowed to do it. But time will tell.
JP: I want to move on to the topic of gold. It’s gone up for ten consecutive years, including this year so far. I know at times you’ve recommended gold after severe pullbacks, but you’ve been generally bearish towards the metal. Has its relentless rise surprised you?
RP: Yes. It went higher than I originally thought. I actually put out a very bullish comment on gold the day of the bottom in February 2001. Barron’s had run an article that day showing that nobody was bullish; even the industry was bearish, and they were putting out hedges. I said this is a real good buy. But I only rode it up for about a year, year and a half, and it’s gone much higher than I originally thought. However, I also think that it’s very much a situation such as we had in the oil market, or in the real estate market, or in the stock market, or now in the muni market. It’s an area where people have focused particularly in the last two years at the expense of other areas. And that means it’s going to probably pay the price and have a serious correction. There are two things that make me feel that way. First are the non-confirmations against other metals and the gold stocks. The XAU topped in 2008, platinum topped in 2008, and silver topped in 2008, so gold has gone to new highs in the last two years all by itself. The second thing that I think is important is the fact that at a recent peak in gold we had a reading from the Daily Sentiment Index put out by MBH Commodities that showed 98% of futures traders in the gold market were bullish. That’s the same reading we had on the euro when it topped out and the dollar bottomed. It’s not a good time to be betting that gold is going to keep going up.
I’m very patient. I think we’re going to have a buying opportunity in gold sometime in the next few years. I certainly wouldn’t want to be overly leveraged in gold right now. It’s stretched about as far as it’s going to go. I also realize that I’ve said that a couple of times. We’ll just have to see how it turns out. I think people in gold stocks have been very disappointed for the last two years; they’ve actually lost money even though gold has made new highs. It’s definitely not a monolithic market. It’s the single market that’s doing well. I’ll also point out that most of the people who believe in hyperinflation do not talk about those other markets very much. They point to the gold markets, but they don’t point to the silver market, which is still 60 percent below where it was in 1980, or platinum, which is way under its old high. I think they’re being selective in pointing one finger, and it’s better to look not only at gold but also at these other precious metals, the gold stock index, and especially the CRB index of commodities, which includes oil and agricultural commodities and everything else.
In a hyperinflationary environment, such as Germany in the 1920s or Zimbabwe in the last decade, everything went up; prices were soaring all the time. And now, very few commodities are moving on the upside, most of them are very stagnant. They’re down 50 percent from their 2008 highs and don’t seem ready to go anywhere. That could change. But so far, I think people who are saying gold is making new highs because inflation is a threat aren’t looking at the rest of the indicators of inflation.
JP: If I were to summarize your views: The greatest part of the economic and market downturn lies ahead of us. On the economic side, you see an economic depression unfolding. From a stock market perspective, you see a near 90 percent downturn unfolding over a six-year period. And most bonds will fall in a major wave of deflation. Have I left anything out?
RP: You’ve nailed it.
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