By Endre Dobozy

Everything in life seems to come down to a matter of perspective; It seems that the truth can be obscured and even completely covered up simply by putting a positive spin on current events. The market activity and the media take on it last month is a prime example. For the week ending July 9th the big news of the weekend was how the S&P 500 had just had its best weekly rally in a year and the DOW had its biggest weekly gain since July 2009.

So, looking at this could lead investors to conclude that the major indices are still going up. However, if you take a slightly longer term view, you would see that an investor who began their investing career in 1998 is no better off today than when they started 12 years ago and that’s only if you totally disregard the impact of inflation and the cost of lost opportunities. Take this into account and the investor would be far worse off.

This does not augur well for the devotees of the buy and hope strategy (Yes, I know, it’s buy and hold but to me you need hope to believe this will work) which in reality does nothing more than give most financial advisors an excuse to hide behind, when their clients receive extended periods of negative performance. Don’t get me wrong, there is no investment strategy that always goes up and even the best investments will experience periods of negative performance, but 12 years seems a little excessive.

Even if you take a short term view and look at the performance of the DOW for the year to date, it’s still down 0.58% and if you take it from the April high then it’s down 7.91%. So, in this respect, you can be thankful for last week’s 5.3% gain.

However, my take on this is that it was nothing more than a relief rally because the market was so oversold. It’s kind of like a pressure cooker left on the boil: eventually the pressure builds up and it pops the lid to let off steam. This is what led to the 274 point rally on the DOW. The next few days of market rally following this were more likely short covering. This is when investors who took out short positions expecting the market to fall, need to cover their short positions as the market rallies and goes against them. The necessity of buying into the market to cover shorts increases buying pressure and adds fuel to the rally which, in turn, results in more short covering and the rally keeps going till all the shorts are covered, by which time you have also sucked in more money from retail investors who see this as confirmation that stocks always go up in the long run.

I know there is a lot of conflicting information out there right now and, depending on who you listen to, it seems that we are either on the cusp of a new bull market or about to fall into depression. In all honesty, both arguments have their merits and it’s easy to make a case for both sides unless you are willing to dig a little deeper and look beyond the superficial market chatter.

The trouble is that most economic advisors, politicians and policy makers have grown up with seven and a half decades of rising markets. This has led them to become complacent and draw the false conclusion that markets always go up and that inflation is the only threat that needs to be taken seriously. The prospect of deflation is relegated to the realm of the Easter Bunny and Tooth Fairy.

In 2002 the chairman of the Carnegie Mellon Business School called the notion of deflation “utter nonsense”, another economist put the potential of deflation at 1000: 1 while yet another stated that deflation was 57th on his list of worries right after his fear of being eaten by piranhas. Granted, these examples are a few years old but deflation is still viewed in a similar light.

Even investors and economists that see the likelihood of a protracted bear market believe we will get inflation instead of deflation or worse still, hyperinflation, which is basically inflation on steroids. The definitions used by the media to categorise hyperinflation can vary from a cumulative inflation rate over three years, approaching 100% to inflation exceeding 50% a month. Whichever way you look at it, hyperinflation is bad but, fortunately, I don’t think it’s anything investors will need to worry about.

If you look at the US, it’s easy to conclude that increasing the monetary supply will lead to inflation. However, this can only be true if the value of assets don’t fall. Under normal circumstances, the more money chasing goods leads to inflation; as there is more money, retailers can increase their asking price, in which case goods become more expensive.

Reprinted with kind permission of H.S Dent

So, if all you do is look at the chart above then the assumption about inflation is correct. However, that’s only one side of the story.

The graph below is the velocity of money, which basically means the amount of time it takes for money to change hands. In a booming economy money is spent quickly and the velocity is quite high. The reason I have included this graph is because the velocity of money is one of the variables used to calculate inflation.

There seems to be a global preoccupation with inflation and economists and the media seem totally focused on one side of the equation. While I was in the US, I couldn’t believe the number of infomercials and ads on TV about how you need to protect yourself from the coming inflationary collapse by buying gold and gold coins. There was even one featuring Steve the bouncer from the Jerry Springer show. Mind you, when I see ads for barbershops in Manhattan willing to buy gold it makes me believe we are close to a top in gold.

The good news is that the forecasts of inflation are likely to be wrong. The bad news is that investors that structure portfolios to capitalise on inflation are going to lose money, worse still is that deflation is the only likely outcome.

Continued tomorrow…