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Case for Deflation-Part 2
When I am doing my analysis for stocks, I like to use a combination of fundamental and technical analysis. I look at price charts a lot to determine my entry (and exit) from stock positions but only for stocks that I believe to be fundamentally sound. While I am a believer of technical analysis because I have observed how chart patterns, support and resistance levels, and even fibonacci retracements levels have worked, I would not be comfortable buying a stock that has a great looking chart but poor fundamentals like poor earnings or high debt. That was how I felt when I read forecasts of Deflation from people like Robert Prechter, who mainly does his forecasting using Elliot Waves, a type of technical analysis. I do not doubt that his method works as he has made many accurate market calls before but I still felt uncomfortable with using his forecast because I don’t really have a good understanding of Elliot Waves. My gut tells me that he is probably right. I never believed this rally would last as a lot of the “green shoots” was from government stimulus but I could not see anything that indicates a lasting recovery. I was looking for some fundamental analysis that supports Robert Prechter’s forecast and I found it in Harry S Dent’s book “The Great Depression Ahead”.
Before you switch off and say “oh no, not another dooms day book by a perma bear”, which was what Kingsley thought when I bought the book, Harry S Dent also wrote the book “The Great Boom Ahead” which was published in 1992 when he forecasted the unanticipated boom of the 1990s. Harry uses a number of forecasting tools but his primary tool is based on demographic trends. From his studies, people have a set spending pattern based on age as shown in the diagram below.
From the diagram, you can see how spending increases from age 20 to your late forties, and decreases after that. All of us who have families can relate to that. When we just look at spending just on accommodation alone, we start out renting a room for ourselves, buying a starter home in our 30s, and upgrading to a bigger home in our 40s as the kids get older. After our kids have grown up, we will probably downsize to a smaller home and eventually rent a room in a nursing home. When you apply the average spend in each age group over the population in each country, you can derive what he calls the “Spending Wave”. The biggest age group in the US and most developed countries are the baby boomers who were born between 1946 to 1964. The youngest boomer is now aged 45. In the last two decades, this group have been in the age group where spending increases but now most are past their peak spending years and are falling into the other side where spending decreases. As companies’ performance is fundamentally linked to earnings, increased consumer spending results in increased earnings and hence good stock market performance. Of course there are other factors that can affect stock market performance, but you would expect a high correlation between that market’s performance and the Spending Wave as shown in the chart below.
From the chart above, you can also see a sharp decline in spending from 2010 to 2020 which is the primary reason why Harry is forecasting a deflation in the US in the next decade. Spending increases after 2020s as the echo-boomers (children of baby boomers) increase their spending. He also forecasted the deflation in Japan in the 1990s using this tool as the Japan’s Spending Wave hit a peak about 10 years before the US. In Chapter 6 of his book, he discusses the changing global demographic trends and provides Spending Waves for individual countries, including Australia. I will discuss Australia in a separate post as obviously it is of most interest me and most of my target readers. The Spending Waves for countries with low birth rates and low immigration like Japan, Western Europe, and even China (after 2020) all show declines in spending well into the future. China will have to pay a big price for their one child policy. Astute demographers like Philip Longman have noted “China will grow old before it grows rich”. Countries that have strong net in-migration like the US, Australia and New Zealand will fare better in the future as immigrants will compensate for the falling birth rates. As the global Spending Wave charts are copyrighted, I am unable to reproduce them in this blog post but they are available for download (under the Free Download tab) if you register at Harry Dent’s website.
There is a lot more that is covered in Harry Dent’s book than just demographic trends. This book has helped me understand why certain things happen. I observed deflation in Japan since 1989 but did not understand the reason for it until I read this book. I have better insights on whether something like the housing collapse in the US is likely to apply to Australia, or not. If you would like to learn more about Harry Dent’s forecasts and his recommended investment strategies for the coming decade, you can buy the book at Borders for $32.99.
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Interesting stuff Christina,
Of course there are areas where spending will increase due to the aging boomers, healthcare for example.
This sits well with my flexible roadmap that the ultimate lows for this secular cycle will come between 2014 and 2018. I really wouldn’t want to be a buy and hold investors for the next 5-10 years, unfortunately that is what most people are via their managed funds and super accounts.
If you couple the demographics with the absolute need to revert to saving after the credit implosion it seems probable that there will be less spent in real terms in modern economies. However, I don’t see how that necessarily leads to deflation. Industrialised governments around the world need inflation to dig their way out of debt. The printing presses are running hot, commodities of all kinds will be become scarce as the 5 Billion don’t haves strive to become haves.
Hi Dean
Yeah, the book is an interesting read and goes into a lot more than I can cover in a blog post. I will try to cover some of the points you raised with what was in the book and some of my own thoughts:
1) Re deflation, to me it is the result of supply exceeding demand. The current manufacturing facilities were set up to anticipate increasing demand. When demand (spending) decreases instead, there is over production and to get sales, you have to reduce prices. Eventually some suppliers will go out of business and supply will equal demand and then prices can start to go up again. So deflation is temporary.
2) Re inflation. As you rightly pointed out, governments want inflation coz it makes it cheaper to pay their debts. They will print and create more M0 but total money supply is still contracting as people don’t want to borrow and banks are reluctant to lend. Private debt is going down faster than (govt debt + printing) is going up. That is why we are getting deflation instead of inflation.
3) Re commodities, there will not be much need for them in the short term when production is not going up. Initially, some people may buy them to stockpile because of the fear that dollars will become worthless (I was one of them) but commodities are not of much use if they just sit around and some commodities like oil is expensive to store. Eventually they have to sold cheap if supply exceed demand. Harry Dent also anticipates deflation of commodity prices. He also believes in a 30 year commodity cycle which is due to peak in 2010, but that is another story.
Prices will go up again once a new equilibrium in supply and demand has been reached. Deflation will happen in the shake out period and the deflationist investment plan is to stay in cash or cash equivalents until prices stop deflating and they will be in a strong position to buy at a bargain when that happens. A more aggressive plan would be to use your cash to buy inverse ETFs that can profit when the market goes down. I just open a position in SH which is the Proshares ETF that inversely tracks the S&P500. This was a recommendation by Harry Dent in his Sept 11 update which fits in with my investment strategy.
I was also more worried about inflation before but I think I am leaning towards the deflationist camp now but I am still holding a small stash in SLV just in case I am wrong. The deflationist plan of staying in cash will be disastrous if there is hyperinflation and dollars become worthless.
All the best in your investing in 2009-10, it will be a tricky year ahead.
If you look in the web at “tax history of the US”, “Tax history of Australia”, you will see that the previous recession in the Us was in the 30′s, the same as it was in Australia, but with the same cause – low top tax. Australia escaped from the recession – although I believe it was really a depression. by increasing the top tax to a level to restrain the greedy from grabbing excessive incomes ie our top tax was raised to 66.6%, which fixed the recession and it stayed there suscessfully for 20 years. The idiot treasurers since then, have progressively lowered the top tax again and a recession was achieved 3 times in the last 30 years. Choosing a treasurer is definitely not for a millionaire or lawyer, their greed or training does not cope with that type of expectation.