Clif Droke
June 23, 2008
©2002 - 2008 Publishing Concepts

Inflation, deflation and channel busters

A reader asks, “I can’t seem to figure out exactly where the economy stands in America. Are we in an inflationary period? Crisis period? Both? Or are we still not sure? I just can't tell anymore -- what is you opinion?”

The best way I know to answer this question is to offer turn to the key long-term cycle that governs inflation and deflation. Every market has to have a long-term bubble and with the popping of the housing bubble it’s clear that oil is the new bubble. The question is asked why there have been so many bubbles in the last 10 years? In former times it was rare to see more than one major bubble every 10-20 years. Yet since the late ‘90s we’ve seen the Internet stock bubble, the housing and credit bubbles and now the oil bubble. Isn’t this a product of extreme inflation?

Actually, no it isn’t. On the contrary, it’s the work of the long-term deflationary cycle coming down and scheduled to bottom around 2014. I’m referring of course to the 120-year Kress Cycle along with its accompaniment, the 60-year K-wave.

The final years of the K-wave and the Kress Cycle always bring about runaway deflation. It might seem mutually exclusive to have inflationary bubbles within the context of long-term deflation but think of it this way: when an air mattress has developed a leak and begins deflating, it’s not uncommon for all the air to bunch up in one corner of the mattress while other areas are devoid of air. And if you go to the trouble of trying to re-inflate the leaking mattress without patching the hole, you’ll succeed for a time in creating a fairly uniform inflation throughout the mattress. In only a short time, however, the leak becomes apparent again and the air will tend to expand in certain pockets of the mattress, especially if you exert any pressure on it.

Using this air mattress analogy you can see how it’s possible to have inflationary pockets within the context of a major deflationary environment. Yet even with the temporary pockets of inflation that well up from time to time (as in stock, commodity and housing prices) you can clearly see the effects that deflation are exerting on the financial system. The most obvious deflationary impacts are seen currently in the U.S. real estate market.

Back in the late 1990s when the Kress 30-year cycle component of the 120-year cycle was peaking, the focus of the temporary inflation-within-deflation bubble was in Internet stocks. The broad market was lifted to abnormal extremes by the ebullience of this bubble and we all remember those heady days when the U.S. economy was white hot and stocks kept soaring to record highs on almost a daily basis.

Notice how many times the S&P 500 Index made an upside “channel buster” by breaking slightly above its upper channel boundary. In each instance, this would be followed by either a long period of lateral consolidation or else a sharp pullback to test the extreme lower channel boundary. The more times a channel buster was made in succession (as the triple channel buster in 1997, see following chart), the sharper was the eventual downward resolution. This was needed to work out and correct the excessive buyer optimism that was generated each and every time the price of the SPX exceeded its upper trend channel boundary.

We’ve already seen that crude oil today occupies much the same place that the SPX had in the affections of institutional fund managers in the ‘90s. Below is the latest chart showing the crude oil futures price (July contract). The crude price still trades within the boundaries of an intermediate uptrend channel. Notice that twice during the past month. As we’ve discussed in the past, upside channel busters are typically less reliable than downside channel busters since bull markets can be driven to speculative excesses by virtue of upside momentum. Downside momentum can stop on a dime, but upside momentum is more difficult to reverse. Clearly, oil is being driven primarily by institutional money at this time and with oil being practically the only game in town, that’s a lot of money fueling (no pun intended) the excesses in the oil price.

The second channel buster that occurred at the end of May was catalyzed by the fact that the oil price dipped briefly under the lower boundary of the uptrend channel (see squared area in the above chart). This set up a strong oversold recoil rally that produced the second trip above the uptrend channel at the end of May. Since then the oil price has pulled back somewhat but still hasn’t come down appreciably. Historical chart studies indicate that whenever this particular pattern is made with a double channel buster, you will normally see a meaningful reversal occur within 2-3 weeks following the second channel buster. This happened with the Amex Oil Index (XOI) back in September-October 2005 (see last Friday’s report).

Sometimes, though, the price extension above the uptrend channel can sometimes persist for longer periods in the event of a speculative blow-off. Whether or not this will prove to be the case for the crude oil price remains to be seen. This much we do know: the longer the oil price remains above the “channel buster” area, the more extreme will be the inevitable price decline when it finally begins.

--Clif Droke
clif@clifdroke.com

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