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A contrarian view on inflation prospects

Saturday, May 15, 2004 | 07:22 AM

One of the most thought provoking books I have read in the past few years has been Precheter's Perspectives. While I do not buy into the Elliot Wave School, Prechter nonetheless lays out an intriguing vision of the cycles that dominate Human activity. Indeed, he is fascinating for his view of the entire history of mankind -- past and future -- on the basis of rising and falling global sentiment.

To call his work mere "cycles" is too much of an oversimplification, but if you read Isaac Asimov's Foundation trilogy, you have an idea what his methodology can be likened to.

Prechter (and his ElliotWave colleague Peter Kendall) have an article in Barron's this week, laying out their vision for the coming deflation (yes, DE-flation).

Here's an excerpt:

"Hedgers, gloom-and-doomers, fund managers and now even conservative investors have embraced the idea of investing in "things."

The new believers in runaway inflation are being spurred by memories of the 1970s, which are echoed in current headlines such as "Skyrocketing Lumber Prices" and "Corn, Wheat and Soybeans Surge."

Is it dj vu all over again? Yes, but not in the way people believe. In our view, recent market turns portend not runaway inflation, but deflation. There is an important difference between now and periods of accelerating inflation such as the 1970s and its predecessor, the 1910s.

In those periods, the trends in hard assets and financial assets went opposite ways. Precious metals -- except gold, when its price was fixed -- and commodities soared while stocks languished and bonds collapsed, a typical response to accelerating inflation.

In the current environment, however, stocks and junk bonds have recovered right along with gold, silver and commodities."

We've previously discussed how many commodity speculators -- including the Barron's Big Money Poll -- are so late to the CRB party. So on that point, Prechter is definitely correct. Even the concept of coupled markets rising together as only possible in a disinflationary world makes some sense:

Rising liquidity in a disinflationary environment is not only fuel for a rise in inflation-hedge investments, but also the lifeblood of the stock market, property investment and the economy. A recovering economy, in turn, supports the issuers of junk bonds and maintains investor optimism.

Such a confluence of effects, as we have argued over the last several years, can occur only in a disinflationary world.

Many observers say that these classes of markets will soon decouple: Either inflation will accelerate, pushing up gold and commodities, or inflation will remain moderate, benefiting the stock market and junk bonds.

We disagree. Liquidity is everything now, and it is driving the prices of all investment classes. These markets have been going up together, and we think that when liquidity contracts, they will go down together.

This outcome happens only at rare times in history when a society-wide credit expansion reaches its zenith and social psychology changes from expansive to defensive.

A change in financial market trends from up to down signals the transition -- exactly the situation we face today."

It wouldn't be a Prechter article if there wasn't some prediction of doom to tie it all up: "The resolution of all this is likely to be a credit contraction followed by a deflationary drop in most asset classes. Cash and safe cash equivalents like Treasury bonds will provide a welcome refuge from the storm."

My problem with Prechter -- intelligently persuasive thought he may be -- is his perma Bear stance. He has missed much of the 90's rally, turning bearish a decade or so too early. What's striking about him is the fact that he has won numerous trading contests! That's right, he has been able to correctly time shorter term stock movements, despite being mostly wrong about the larger picture.

I suggest reading the full article, as well as the book Precheter's Perspectives, for more intellectual stimulation than market timing.

For a more tradable set of advice for trading agaisnt the crowd, I'd suggest Ned Davis: The Triumph of Contrarian Investing. It has the added benefit of being rather short, and filled with graphics . . .

Sources:
In Synch to Sink
Liquidity matters: A contrarian view on inflation prospects
By ROBERT PRECHTER and PETER KENDALL
Barron's, Monday, May 17, 2004
http://online.wsj.com/barrons/article/0,,SB108439366506809726,00.html

Robert R. Prechter Jr.: Prechter's Perspective