Timing the Bottom of Deflation

Stock prices will remain depress as long as deflationary threats linger. Oil prices fell from peak of US$140/barrel in mid 2008 to a recent low of US$36/barrel. If deflation lingers, it means falling corporate cashflow, falling wages, delay in consumption and debt default.

One way to track this is looking at behaviour of treasury inflation protected securities (TIPS). If we look at the yield differences between Treasuries and TIPS as an indicator, we note the implied deflation rates quite strongly in a year ahead, but it gradually eases off as we move ahead in times and ultimately the inflationary forces will start to kick on in year 2015. Any material change in this view of deflation would reduce the risk of holding equities and produce a significant rally. We would notice that when TIPS were rising, the S&P rebounded quite strongly in October 2002, suggesting that the subsidizing threat of deflation is a key driver for any rally in an equity bear market.

Another indicator to watch is the copper prices, which I find quite useful in confirming the bottom for equities in the two near deflationary recession of 1982 and 2002. This relationship can be traced back since at least 1921. The copper prices bottomed in October 2001 and this coincided with the bottom of the business cycle as proclaimed by the National Bureau of Economic Research (NBER). In an almost instantaneous reaction, the stock market leaded the economic recovery and even the earnings recovery.

With greater commitment to quantitative easing, I find it rather difficult to expect more debt deflation going forward. Also, I would argue that deposit insurance will reduce the risk of losing faith in the banking system. Unlike the collapse of the US banking system in 1929-32, depositors withdrew funds and this time around, I don’t see that being the feature of the 2008 crisis. The combination of the liquidity loop and the explicit guarantee of money market funds along with the existing deposit insurance guarantees, this has significantly reduce the prospect of banks run today compared to 1929-32.

There is evidence that more unorthodox approach is being deployed and the rapid expansion in the Fed’s balance sheet since the third week of September 2008, will provide a good base for current crisis.

To those investors that subscribing to this views, you may want to prepare to buy equities today, given that deflation is much less likely that markets believe. Recent stability seen in prices of TIPS, and copper is an encouraging sign that it may be turning positive in the near future, perhaps.