Reflection Series: Market Prediction by Garrett Jones

In the “The Sequence of Events in the Cycle," Garrett Jones explained his philosophy on market cycles:

In covering the sequence of events in the Long Wave cycle, we need a starting point. A logical point would be the absolute economic bottom that was the beginning of the cycle we are currently in. That would be 1933. At the bottom of the cycle, we slowly begin to rebuild a devastated economy. After the crash (1929 to 1932), debt is wiped out because most of it results in default. People are hungry and desperate -- so they are willing to work hard. There are no "slackers" because slackers don't get hired. The work that is produced is of the highest quality because there are few jobs available and only the best workers are hired. This philosophy permeates the society. If you want a job, you've got to work hard and produce a top quality product.

The process is slow, but once the economy begins to grow, debt creeps back into the picture. As businesses grow and seek expansion, the most logical and efficient method for acquiring capital is to get a loan. As the cycle progresses, business begins to boom and debt increases at a much faster rate to compensate for the demand (1960s). Demand translates into necessity. The necessity brings on inflation and the inflation begins to rise at an increasing rate (late 1970s). Inflation then peaks due to leverage, reduced returns and increased debt (1980). The peak in inflation is usually followed by a recession lasting a year or two. This is followed by the Plateau Period which is the period following the peak in inflation. I’m sure you have heard the term “necessity is the mother of invention” – the increased demand of the period leading into the peak in inflation brings about a new technology in the Plateau Period. The semi conductor boom of the late 60s led to the computer craze of the 1980s and 1990s – the New Technology.

This ushered in the Information Age at the expense of the Industrial Age. The Plateau Period is characterized by declining rates of inflation; declining interest rates; a psychological return to "normalcy" and a roaring bull market in paper assets. The plateau period is a period of disinflation -- initially, this is inflation where the rate of inflation is declining. This new technology enhances production and, ultimately, leads to overproduction. The high debt and overproduction set the stage for deflation after many years of disinflation during the Plateau Period. The breadth of the stock market peaks (1998) which ultimately predicts a peak in stock prices (2000). This sets up a crash in the stock market (2000 to 2002). At this point in the cycle the stock market is the market of choice and is the vehicle where the vast majority of investment funds reside. Later, this trend changes from disinflation to deflation.

When the stock market peaks and ultimately crashes, it puts extreme pressure on all other investments (2007). At this point, due to the high level of debt and unemployment, people are forced into liquidation -- initially liquidating their investments, but later their homes and other valued possessions. This ultimate liquidation in society brings us to the bottom and completes the cycle. As you can see, each separate phase of the cycle sets up the next. It is perfectly logical -- it should be, Mother Nature doesn't make many mistakes.

Now that we are familiar with the cycle, how do we utilize it? I have said from the very beginning the most important part of the cycle is knowing the sequence of events. The reason you want to know the sequence of events is so you can determine where you are in the cycle. If you know where you are, then you know what economic events should follow. If you know what is coming, you can plan for it and use it to your advantage rather than having it take advantage of you. It's really that simple.

Now that you have a comfortable idea of the cycle from this information, let's see if we can determine where we are in the cycle at this point in time. Once we determine where we are we will then be able to determine what economic events are likely to follow -- in other words, what are the implications of our current position in the overall cycle? Once we know the implications we can act accordingly i.e. we either seek protection or opportunity … or both. Note: For simplicity, the sequence of events in the cycle is listed in bullet points later in this communication.

We have already had the peak in inflation. That was in 1980 when gold hit $877/oz., silver was $50/oz.; Oil was over $40/bbl., CRB futures price index at 337.60, etc. There was a one to two year recession that followed in 1981-82. The stock market took off in 1982 and peaked in 2000. There has been a market crash that was primarily centered in the area of the “new technology”. This was an 83.5% peak-to-valley crash in the NASDAQ 100, the market of choice. That was “the first shoe dropping” i.e. the warning shot for mankind to “pay attention”. There is always a warning. In the prior cycle it was the real estate boom and bust in Florida in 1927. In fact, we have had the same warning this time – once again with Florida real estate.

This was followed by another inflationary run where both the Dow Jones Industrials and the S&P 500 went to an all time high in October 2007, but the institutional index peaked in 2000 and could only generate a 61.8% Fibonacci retracement – thus creating a major divergence with the all time highs of the major indices. Remember, it is the institutions that run the show. This is a very interesting and very major point that was missed by virtually all of Wall Street – but it was blatantly there for all to see.

Wall Street is aware that bear markets correct the bull markets that immediately precede them. The1982-2000 bull market was corrected by the 2000-2002 bear market. In a similar manner, the bull market of 1932-1937 was corrected by the bear market of 1938-1942 … and, the bull market of 1942-1966 was corrected by the bear market of 1966-1982 (with major lows in 1974 and 1982). Unfortunately, most people don’t realize that the larger cycles also have corrections. Markets are constantly in the process of going from one extreme to the other. Larger cycles (Long Wave cycles) comprise three bull markets and roughly cover the time span of an average lifetime. The current Long Wave cycle began with the stock market extreme low in

1932 and corresponds with the extreme economic low in 1933. It completed its ‘orthodox’ high in 2000 with the stock market top and “real value” peak in 1999 (the stock market peak in terms of real value). This was followed by the final thrust higher to the market’s all time peak in October 2007 (a higher market price, but divergence in real value). It is this advance (from the all time stock market low in 1932 to the all time high in 2007) that is now in the process of being corrected. Correcting an advance that spans 75 years is much more significant than merely correcting the advance of the most recent bull market. The chart below will give you an idea of the potential for what can happen when an entire cycle faces a correction. Note that in just the first wave down, the market has corrected almost the equivalent of the entire 2000-2002 bear market.

We live in a world that is defined by cycles. One of the best examples of this is the seasonal growing cycle. We can all readily relate to summer, autumn, winter and spring. Each season comes at the same time every year and has the same characteristics. The seasons can be intense or mild; extended (an Indian summer) or contracted (a short winter); but they happen in order and their characteristics remain the same. The growing season follows the same seasonal pattern and provides an example of why each individual season actually set up the season that follows. For example, in the spring, seeds germinate with the warming temperature and rain to nourish them. In the summer they flourish into mature plants. In the autumn, the plants are harvested. Finally, in the winter, the process rests by going dormant.

This process is classic action in a cycle. Once you have defined the cycle, it becomes quite logical and follows a defined process. As you can see in the seasonal growing cycle, each predecessor phase (season) augments the one that follows. This same process occurs in the economic cycle. By spending some time going over the sequence of events, you will soon see how logical this process is and how well it defines any particular phase of the cycle. It is an incredibly helpful tool in business and investment planning and it brings logic and explanation to difficult economic times that otherwise confuse economists and other economic observers.

THE SEQUENCE OF EVENTS IN THE CYCLE

• The Ultimate Economic Bottom (DEBT DEFAULT; BANKRUPTCIES; BANKS CLOSED; ETC.)

• Slow Rebuilding Process (LITTLE DEBT; QUALITY WORK; DEBT SLOWLY CREEPS BACK)

• Business Expands (LOANS ARE THE MOST EFFICIENT WAY TO FUEL THE GROWTH)

• Business Booms (DEBT EXPANDS AT MUCH GREATER RATE TO MEET DEMAND)

• Increasing Inflation (DEMAND becomes NECESSITY brings on INFLATION)

• Inflation Peak (SHORTAGES; LOWER RETURNS; LEVERAGE; INCREASED DEBT)

• Plateau Period (RECESSION; DECLINING INTEREST RATES; DECLINING RATE OF INFLATION; PSYCHOLOGICAL RETURN TO NORMALCY; ROARING BULL MARKET)

• New Technology (NECESSITY is the MOTHER of INVENTION-COMPUTERS-INFORMATION AGE)

• Overproduction (NEW TECHNOLOGY enhances production and, ultimately, OVERPRODUCTION)

• Stock Market Peak (FOLLOWS PEAK IN BREADTH)

• Stock Market Crash (PARTICULARLY IN THE AREA OF THE NEW TECHNOLOGY) THERE IS AN INITIAL CRASH IN THE FAVORED MARKET SECTOR FOLLOWED BY A RECOVERY IN STOCK PRICES. LATER THE SECOND DECLINE BEGINS WHERE THE REAL SHARE DEVASTATION OCCURS

• Disinflation becomes Deflation (PRICES OF ASSETS FALL)

• Bankruptcies and Liquidation (DUE TO DEFLATION, UNEMPLOYMENT & HIGH DEBT LEVEL)

• Debt Default (INDIVIDUALS AND CORPORATIONS BELLY UP ON DEBT)

• Stock Market Bottom (TOTAL CAPITULATION) AT THIS POINT PEOPLE LITERALLY HATE STOCKS AS THEY HAVE FALLEN TO AN EXTREME LEVEL OF UNDERVALUATION

• Economic Bottom (BANK CLOSINGS; DEBT RESTRUCTURING; REMONETIZATION; NEW CURRENCY)
  
  

NOTE: WAR IS A PART OF THIS PROCESS, AS WELL. PEAK WARS OCCUR DURING PERIODS OF STRONG ECONOMIC EXPANSION (VIETNAM); ARE A BURDEN ON THE ECONOMY; AND ARE UNPOPULAR. TROUGH WARS FOLLOW A DEPRESSION; HELP THE ECONOMY DUE TO UNEMPLOYMENT AND UNDERCAPACITY; AND ARE POPULAR (WORLD WAR II). TERRORISM AND OTHER SUCH ‘WILD CARDS’ ENTER THE CYCLE AT VARIOUS STAGES. THIS TIME AROUND IT BEGAN IN 1970 WHEN 3 ARAB TERRORISTS ATTEMPTED TO HIJACK AN EL AL BOEING 707 AT MUNICH AIRPORT IN GERMANY.

The Psychology of the Market:

It is important to tie the cyclical information in with the psychology of the market. The market is driven by two forces, fear and greed. It’s interesting to note that both are negative. It is also interesting to be aware that the stock market is unique when compared to other markets – particularly, on a psychological level. If you want to attract buyers in a retail market, you have a “sale” – the attraction is lower prices. In the stock market, you attract participants by raising prices. Go figure.

Anyway, when you analyze the psychology of the market and how it fits in with the sequence of events in the cycle, it is important to be aware of the nuances. I’ve put together two charts that deal with the phase of the market (and the economy) that are the most important. Interesting things occur throughout the cycle, but the real challenge, as one might expect, occurs at its conclusion. During the body of the cycle, the worst you have to deal with is recessions. Some of them have been quite serious, but they are recessions nonetheless. Further, after these recessions conclude, the market and economy have always moved on to new all time highs. This can lull one into complacency and cause one to assuming that you 1) never get anything worse than a recession, and 2) once the recession is over, the market will always rally to a new high. This is a reasonable assumption throughout the cycle … and a very dangerous assumption as you approach the end of a cycle.

It is psychology and emotion that drive markets – both up and down. The chart that follows shows the most basic of the emotions that have driven the market over the past 15 years. The chart tells a lot. First of all, you have had two bull cycles and two bear cycles. It is obvious that the strongest motivator is fear. Markets can move up quickly, but they fall much faster. For example, have you ever noticed that you can run faster when you are feeling fear than when you are feeling greed? The market reacts the same way.

The following chart shows essentially the same thing as the above chart, but it breaks down the emotions from basics to specifics. The distinctions are very important because the basics don’t do justice to the reality of the situation. The move from 1994 to the market top in 2000 was a mania, driven by technology stocks. It was a “new economy” and the pundits said the extreme valuations were justified because “it’s different this time” -- a comment made at every major market top in US stock market history. After the mania, the market had the initial collapse where the S&P fell by about 50%, but the real story was in the technology stocks where the decline was much larger. The NASDAQ 100 had a peak-to-valley collapse of 83.5%. That was the “first shoe dropping” and a serious warning to “smart money” investors.

In the stock market, “smart money” is not defined as educated people with money. As we have recently seen, these people have gotten hurt just as badly as those with less savvy and far less money. An argument can be made that the CEOs of Lehman, Bear Stearns, Wachovia, Merrill Lynch and others were the dumbest of all – and these are very smart people with an abundance of money. They are not “smart money”. Smart money is that rare investor who inherently has a feel for where we are in the cycle and acts on those feelings. These are people with “anticipatory intelligence”. Everyone else essentially “fights the last war” i.e. they assume what is happening will continue – therefore, any change will be a surprise.

Following the mania and the initial collapse is the denial phase. A snappy rally ensues and everyone is bullish again and expecting the worst is over. These feelings carry into a peak of hope where there is knowledge of serious problems such as debt, deficits, war, derivatives, lack of leadership and a myriad of other such negatives – however, they are digested and, essentially ignored. At the peak of the hope phase, some markets set new all-time highs (such as the Dow Jones Industrials and the S&P 500) and some don’t (such as the NASDAQ and the Institutional Index).

This is followed by the recognition phase – where the market crashes and creates a year like 2008 where you have the worst performing year for the stock market in 77 years (and 2009 beginning with the worst performing January in history). In the recognition phase, everyone realizes there are problems and that the problems are quite serious. There is general recognition that there is no quick fix.

The next phase is the reprieve phase. Here the market rallies because there is a belief that 1) the worst is over and, 2) the government’s actions will help to solve the problem(s). This is a dangerous phase because it gets everyone leaning in the wrong direction. When it becomes clear that the worst is nowhere near being over and the government’s actions have actually exacerbated the problem, it leads into the liquidation phase. This is where people sell their assets because they need the money to survive. This malaise continues and spreads throughout the society – it is accompanied by fear and anger. At the extreme of this phase, you enter the final phase – CAPITULATION. Markets are always in the process of moving from one extreme to the other. At this point, the market is at the opposite extreme of the bull market top – it is at its lowest ebb. It is a time where everyone hates the stock market – including those who are employed by it (in one form or another). People swear they will never buy another stock for the rest of their lives. The capitulation phase, by definition, is the best buying opportunity you will ever have – unfortunately, most will never benefit from it because the market psychology is so overwhelmingly negative that everyone will hate everything about the stock market at that point. In fact, at the point of capitulation people hate all forms of investing because everything they have ever believed in has been devastated.

In many ways, the recognition phase is the most critical phase of the cycle because there is recognition of the problem, but no one has any idea of what to do about it. There is no guarantee how long the reprieve phase will last, but you can count it will last long enough for most investor to believe “the worst is over”. This has been a very large and extended cycle – which means that the downside will almost assuredly be extreme – it already has been and it’s far from over. This is the final chance to prepare for the final two phases (liquidation and capitulation). It will be difficult to do because all the “professionals” who did so poorly in the recognition phase will make a comeback during the reprieve phase. These people who completely missed the top will now chime in and say the worst is over. They don’t understand the cycle; they didn’t see the fall coming; and they don’t understand what caused it, but they will be the biggest cheerleaders that the bear is dead. Ironically, most investors will remain with these people even though they have proven they have little to no ability in markets that go in a direction other than up. Now, at the most critical stage of the cycle, people will continue to trust their funds to people who have just proven their worth in turbulent markets. In addition, these questionable “professionals” have zero knowledge of the long wave cycle. They will parrot what the financial news media says and assure you that the worst is over. Most likely, they will be correct for awhile.

You now have the information in your hands to be your own best advisor, however, the “smart money” player realizes that knowledge is only one part of the equation for success. There are two other mandatory components. The first is discipline. Knowledge without discipline is like having money without a place to intelligently spend it. The third component is experience. You have a roadmap – one that took me decades to perfect. The combination of knowledge, discipline and experience will allow you to navigate the roadmap.


AUTHOR’S COMMENT: If you take the time to learn the sequence of events in the cycle, you will have a very valuable tool that will assist in business and investment planning and providing you with the knowledge and peace of mind in knowing where you are in the cycle. Knowing what is next to come in a cycle removes the element of surprise and replaces it with expectation. Expectation allows one to plan and take advantage of the situation as opposed to having the situation take advantage of you. In closing, the quotations by Marx, Twain, and Livermore on page 2 are interesting, but the focus should be on the content of the article. No one really knows if a quote from someone in the past is valid or not. At this phase in the cycle, it is absolutely imperative to be focused on where we are in the cycle and the extreme implications of being there. If you missed seeing the top in 2000 or the more recent top in October 2007 and were hurt by what followed, you now have no excuse to not be paying attention.

Important: Note that the charts are all updated to October 2009 with the exception of the chart on page 8 which was not updated. The purpose is so you can see what my expectation for the market was on February 24, 2009 when this report was initially written. If you compare the chart on page 8 with the chart below – the expectation became reality. That is the benefit of learning the sequence of events in the cycle. When you consider that bearishness and fear were extreme in February 2009, it was impressive to predict 1) the market going lower, and 2) then having a sharp rally into this time period. It is also important to be aware that my Special Alerts called the July 2007 top and the October 2007 top as indicated with the arrows below. Clearly, expecting that top would have saved one from losing a lot of money. In a similar manner, expecting the March bottom would have saved further loss and presented an opportunity. Without question, the study of the sequence of events in the cycle can be quite helpful to an investor or businessman.

The chart below shows the two “bubble” tops of this decade in the stock market. The 2000 top was the Tech Bubble and it resulted in an 83.5% peak-to-valley loss in the NASDAQ 100 (the leading market index at that time). The 2007 top was the Stocks Bubble and it resulted in the worst loss for the benchmark S&P 500 Index in 77 years – down 57.7%. These losses were absolutely devastating for most investors and money managers. In fact, the recent decade is the worst performing decade in US history.

I was interviewed by Dave Allman of Wall Street Uncut in June 1999 when the stock market and technology stocks in particular were in an explosive move to the upside – an extremely bullish time. I commented that I expected two more rallies and then expected the market to top – so the 2000 top was not a surprise either – it was an expectation. That is the significance of learning the sequence of events in the cycle – it provides a roadmap of sorts and helps to remove the surprises.

As you can see, the Reprieve rally began as expected. Bullish sentiment was 2% (an obvious extreme). The rally got everyone bullish – with bullish sentiment well over 90% at times. The belief is that “the worst if over” and we are in a new bull market. What you must not forget is that this is followed by the Liquidation phase of the cycle and, ultimately, Capitulation. The cycle suggests a depression with the potential to be worse than the Great Depression. This phase of the cycle separates almost everyone from their money – the rich and poor as well as the intelligent and the ignorant. It is an “Equal Opportunity Destroyer”-- it has already devastated a number of rich and intelligent people – yet another hint as to where we are in the cycle … but will anyone listen? Frankly, that is the whole reason for studying the Long Wave Cycle – to give you an advantage in knowing what to expect. The market’s job is to fool most of the people – particularly at critical points – and we are about to enter the most critical phase in the past 80 years.

Trader: The “January Barometer”

The S&P-500 Index lost 3.7% of its value in January, the biggest monthly setback in a year’s time, succumbing to heavy selling, especially after US President Barack Obama and his economic adviser Paul Volcker, shocked the markets, by calling for stricter limits on the “proprietary trading,” activities of Wall Street’s titans, - aiming to rein-in their ability to buy and sell commodities, derivatives, and equities for their own accounts.

The fear of Washington re-imposing the 1930’s-era Glass-Steagall laws, requiring the separation of commercial and investment banking, rattled the stock market bulls, and extended the S&P-500’s slide to a 6.7% retreat from its most recent high of 1150, set on January 19^th. It’s a worrisome sign for traders who see the first month of the year as a trendsetter for the next 11-months that follow. According to the so-called January Barometer, - as January goes, so goes the year.

Since 1950, there were only six-times when January got it wrong in a big way, giving it an accuracy rate of 90-percent. However, in 2009, the January Barometer went terribly awry, and its reputation was badly tarnished. Although the S&P-500 suffered an -8.5% loss in January 2009, portending another year of negative returns, quite the opposite occurred. The S&P-500 index finished the year with a 23.5% gain, following a spectacular 65% rebound from its bear market bottom.

The Nasdaq ended up 44%, and the Shanghai Composite Index rallied 80% for the year. The Euro- Stoxx 600 Index gained 28%, its biggest annual increase in a decade. Dollar inflows to Brazil totaled $28.7-billion in 2009, lifting the ballistic Brazilian Bovespa stock index up 81%, and the Brazilian real up 33% against the dollar. The CRB commodities index climbed about 24% last year, sealed its biggest annual gain since the 1973 oil crisis.

Unprecedented intervention by the Group-of-20 central banks and governments, including $13-trillion in bank guarantees, monetization of government debt, bailouts, and the alteration of FASB #157 in the United States, was deployed in a coordinated strategy, in order to overturn the bearish tide, and putting a big monkey wrench in the January barometer. A nine-month rally was underpinned by expectations that a global economic recovery, would spur capital spending for technology, and increase demand for energy, metals and other natural resources.

However, January 2010 got off to a rocky start, with commodity and stock markets tumbling worldwide, on signals that the politicians pulling the strings in the world’s two fastest growing economies - China and India, have given instructions to start withdrawing large dosages of monetary stimulus. News that Beijing is clamping down very hard on bank lending, and draining yuan through “Quantitative Tightening,” has sent shock waves from Asia, to London, to Wall Street, and Brazil, and convinced many speculators to dump over-extended long positions in key commodities, such as copper, crude oil, rubber, platinum, and soybeans.

The Reuters-Jefferies CRB Index, a basket of 19-exchange traded commodities, suffered a loss of 6% in January, led by the copper market - rudely interrupted with a sharp 9% decline, and crude oil fell 8%, all tracking losses on the Shanghai stock market, which surrendered 8.8% of its value. On Feb 1^st, Fan Gang, a top advisor to the People’s Bank of China’s (PBoC) monetary policy committee, said Beijing must address the problems caused by excessive liquidity, and that inflation and asset bubbles are the biggest worries for the Chinese central bank.

Selling pressure in commodities in January was extenuated by a stronger US-dollar - which knocked its top rival, the Euro, below $1.400 for the first time in more than six-months. Big speculators began to unwind the massive US-dollar carry trade that was utilized for risky bets in global stock markets. In a virtuous cycle, a stronger US-dollar makes commodities more costly for users of other monies, and helps to contain inflation. Ironically, it wasn’t the Federal Reserve that ignited the unwinding of US-dollar carry trades, but rather the central banks of China and India.

Chinese and Indian policymakers became alarmed by the sharp rebound in industrial commodities, particularly crude oil, which must be imported in large quantities, in order to fuel their manufacturing based economies. Higher food and energy costs feed heavily into the consumer price indexes of the emerging Asian giants, and adjustments of interest rates and other monetary tools are often utilized by their central banks to contain inflationary pressures.

Global demand for crude oil has been buoyed by a powerful rebound in global factory activity, led by the United States, where the ISM factory index rose to a reding of 58.4 in January from 54.9 in December, it’s highest level in six-years. India’s Purchasing Managers’ Index (PMI) rose to 57.7 in January, consistent with double-digit increases in industrial production. Overall, the global manufacturing PMI rose to 56.1 in January, up from 54.6 in December, which combines data from the United States, Japan, Germany, France, Britain, China, and Russia.

Over the past four-months, US light crude oil has mostly confined within OPEC’s target zone of $70-to-$80 /barrel. “We are satisfied with the market situation of $80 /barrel, said Libya’s oil chief Shokri Ghanem on Jan 13^th. “I don’t think an action will be taken to increase production, unless the price reaches $100,” he said. However, once crude oil prices surged above the upper limit of OPEC’s targeted range, Beijing acted to snuff-out the crude oil rally as it approached $84 /barrel.

On Jan 12^th, the PBoC shocked the global markets, with its first meaningful move to tighten liquidity in eighteen months. Armed with knowledge that China’s economy was growing at a 10.7% annualized rate in the fourth quarter and with its import bill in December soaring to an all-time high of $112-billion, the PBoC began draining liquidity, and clamped down on bank loans. Consequently, $12 /barrel of speculative fluff was wiped-off the crude oil market over the next two-weeks.

The Bank of India (RBI) followed suit on Jan 29^th, surprising commodity traders, by lifting cash reserve requirements for banks by more than expected 75-basis points to 5.75%, and warned of mounting inflation, suggesting its next move may be an interest rate hike. India’s closely watched wholesale price index (WPI) is closely correlated with the direction of commodities, and the RBI has bumped-up its forecast for the WPI to an 8.5% inflation rate by year’s end.

On Feb 1^st, India’s central bank chief Duvvuri Subbarao left no doubt about a tighter monetary policy in the months ahead. “It is the responsibility of the Reserve Bank to manage expectations about inflation and what we are going to do in the next few months is to target inflation,” he said. However, the resiliency of key commodities such as crude oil, buoyed by indications of expanding factory activity in the top industrialized nations, will make the task of containing inflation much harder for the PBoC and RBI. Therefore, traders can expect further Quantitative Tightening (QT) moves in Asian nations and hikes in interest rates in the months ahead.

“China might increase interest rates once consumer inflation exceeds the one-year benchmark deposit rate of 2.25%,” warned Ba Shusong, a prominent government adviser on Feb 1^st. Consumer prices rose +1.9% in the year to December, but inflation could accelerate at a 6% clip, without further tightening measures. Thus, the Shanghai red-chip market is likely to remain under selling pressure, which in turn, is bound to cause greater anxiety in world commodity markets.

China consumed 43% of the world’s base metal supply last year. Thus, Beijing is most anxious to engineer a speculative shakeout in the base metals markets, to help lower the cost of key raw material imports. Copper was a star performer in the commodity sector last year, nearly tripling in value, from its lowest levels in December 2008, to as high as $3.55 /lb in January 2010, riding the boom of a powerful revival of global demand, including massive Chinese stockpiling.

However, in reaction to Chinese and Indian central bank tightening, combined with the Euro’s descent below $1.400 due to Greece’s debt crisis, copper futures in New York tumbled 20% from their January high, to around $2.87 /lb today. Global factory activity might begin to decelerate as Asian governments withdraw high powered fiscal and monetary stimulus, to prevent inflation from overheating.

Beijing is also aiming to weaken the leverage of the big-3 global miners, BHP Billiton, Brazilian mining giant Vale, and Rio Tinto, which control a combined 70% of the world’s sea-borne iron-ore market, ahead of critical contract negotiations. China imported a total of 630-million tons of iron ore in 2009, up 42% year-on-year, as it produced a record 700-million tons of steel. China’s iron ore import dependency ratio has increased from 44% in 2002 to 69% last year.

In the first round of iron ore pricing negotiations between Rio Tinto is asking Japanese and Korean steel mills for a 40% price increase. However, since Beijing tightened its monetary policy on Jan 12^th, iron-ore prices have tumbled $10 /ton on the Chinese spot market to around $121 /ton today. Chinese steel mills might wait for iron ore prices to tumble further on the spot market, before agreeing to a 2010 contract price, especially if the PBoC plans to tighten its money supply further.

Gold weighed down by weaker Euro

Last year, China made great contributions to the world economy, as it was the first country to recover from the international financial crisis. As a result of its 4-trillion yuan stimulus spending, China’s debt to GDP ratio is expected to reach 31-percent this year, far less than the average government debt of OECD countries, which is projected to almost equal their total GDP this year, and exceed it in 2011.

In sharp contrast to the sound finances of China, backed by $2.4-trillion of foreign currency reserves, the newly elected government of Greece’s socialist Prime Minister George Papandreou faces massive pressure to get its fiscal house in order. Among the 16-nations within the Euro-zone struggling to cope with their budgetary imbalances, Greece faces the most difficult situation. With a budget deficit of 12.7% of GDP this year, and debt outstanding of €300-billion, Greece’s debt-to-GDP ratio is expected to top 120%. In the short term, Greece needs to borrow €53-billion before year’s end to refinance debt which is about to mature.

Over the course of the past two-months, the interest rate that Greece must pay in order to attract foreign capital for 10-years has risen by 175-basis points to 6.75% today. Amid growing doubts that Athens can repay its debt, the cost of insuring €10-million of Greek government bonds against default for five-years has soared to €370,000. That puts Greece among the top-four countries in the world that are most likely to default, behind Argentina, Ukraine, and Dubai.

On Jan 29^th, Greek Prime Minister George Papandreou complained that his country was being targeted as a weak link, by speculators with ulterior motives, and seeking to profit handsomely from the possible break-up of the single European currency. Already, amid the capital flight from Greek bonds, there’s been a simultaneous exodus fleeing the Euro currency, knocking it below the psychological $1.400 area, from around $1.500 just two months ago.

In an ironic twist, the “flight for safety” from the Greek bond market, isn’t finding a “safe haven” in the gold market. Instead, the yellow metal is enduring selling pressure, undermined by the weakening Euro. The US-dollar is getting stronger by default, largely due to the unwinding of “carry trades” in global stock markets. Furthermore, spike rallies in the gold market could meet resistance, as it becomes increasingly apparent, that China and India are still on course for further tightening of their money supply (QT) in the months ahead. Also, G-20 central banks allowed their foreign currency swap agreements to expire as of Feb 1^st, eliminating a huge source of global liquidity, which at its peak reached $586-billion.

In the event that Greece defaults on its loans, or if its interest rates climb too high, it could prompt a chain reaction for other weak links in Euro-zone bond markets, with devastating consequences for the entire Euro currency system. The most vulnerable to capital flight is Spain, where the jobless rate hit 18.8% in the fourth quarter of 2009 and the government said it could reach 20% this year.

Already, contagion sales from the troubled Greek bond market are starting to seep into the Spanish bond market. The credit default swap rate to insure 10-million euros of Spanish bonds has nearly doubled to 148,000-euros, and yields have climbed 40-basis points higher to 4.15% over the past two months. Spain, expects a fiscal deficit of 9.8% of gross domestic product in 2010, but said its ratio of public debt to GDP should peak at 74% of GDP in 2012, well below Greek levels.

Still, capital flight from the weakest links in the Euro-zone bond markets is triggering the unwinding of US$ and Japanese yen carry trades, which in turn, is rattling global commodity and stock markets, and precious metals. While it’s true that the January Barometer was far off the mark in 2009, one also should remember that it’s been accurate for 90% of the time over the past 60-years. Much will depend on the degree to which the G-20 central banks drain the global liquidity swamp, which led that the emergence of asset bubbles in 2009.

(from goldseek.com, February 4, 2010)