U.S. stocks are still trading near all-time highs and they continue to defy deflationary forces in the broader economy and elsewhere. Does it spell trouble ahead?
John Makin, a resident scholar at the American Enterprise Institute in a November 2013 report titled, "Beware the Monetary Cliff" wrote:
'Unlike the US fiscal cliff, which was largely defused by congressional action, the US monetary cliff - which will be reached if US inflation rates turn negative - cannot be easily circumvented. Over the past two years, US, European, and Chinese inflation rates have drifted steadily lower, and Japan's "end-deflation" initiatives have produced only modest relief from 15 years of negative inflation (deflation). Once an economy slips into deflation, the risk of falling into a self-reinforcing deflationary spiral rises.'
The impact of deflation is certainly being felt firsthand with depressed commodities prices. Commodities, as a group, have crashed 59% since 2008. Is it a warning sign of deflation ahead for the rest of the market?
We'll use the iShares S&P GSCI Commodity Index Trust (GSG - News), which follows a broadly diversified basket of commodities futures contracts and the SPDR S&P 500 ETF (SPY - News), a proxy for U.S. stocks. Our accompanying chart illustrates how the relative performance difference between SPY and GSG has soared a mindboggling 54% over the past year alone.
For alert investors, the message is clear: the deflationary action in commodities spells danger for other asset classes like stocks (VOO - News), currencies (FXE - News), and real estate (ICF - News). With certain individual commodities like precious metals (GLD - News), the effect of deflation are even more severe. Silver (SLV - News) has deflated around 47% from its 2011 peak.
Are outsized performance discrepancies between commodities and stocks a surefire buy or sell signal? Not necessarily. But when analyzed in conjunction with other key indicators, a person can clearly understand the length of the current market cycle and on which side (bullish or bearish) the odds are in their favor.
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- American Enterprise Institute