The First to Turn Down
By Ryan J. Puplava CMT, June 21, 2007
As the economy shifts from expansion to contraction in a normal cyclical economy with moderate inflation, typically the first market to turn down is the bond market. Martin Pring talks about the business cycle's effect on the stock market in this article: http://www.pring.com/articles/article8.htm.
The bond market tends to fall before the economic expansion peaks because of inflationary fears that pressure interest rates higher. During this time stocks and commodities are still rising because there is still growth in the business community, and inflation causes commodity prices to rise. I have reasons to believe that we are in the 4th stage that Martin Pring identified in his article above. These reasons are based off of a falling dollar, rising commodity prices, subprime mortgage meltdown, and most importantly: rising interest rates.
For commodities to rise, and thus inflation to rise, we need an increase in the money supply to cause our dollar to fall. Our dollar can also fall based on foreign money moving out of our currency and into another substitute, let's say maybe the new Euro. Even U.S. investors have done this as they've begun investing in overseas stock funds in recent years. Our dollar has certainly fallen in the last five years.
Rising Commodity Prices
As the dollar falls, commodity prices and inflation rise. Jim Puplava has been touting the "Next Big Thing" since his article in 2002 about the shift from paper assets to hard assets. He has been a faithful investor in precious metals and energy through one of the biggest bull markets this decade. If you're a deflationist and you continue to point out a low core rate of inflation as reported by the government, well then I guess the stuff we normally use such as gas, food, houses, and cars that keep going up in price shouldn't count as inflation.
There have been a plethora of articles on www.financialsense.com already which have pointed towards the nuclear fallout caused by the meltdown in sub-prime mortgage lending and so I won't need to linger on the subject much. Basically, the meltdown in sub-prime mortgages is shrinking up liquidity in the credit market, and its effect is reverberating through higher tiers of credit. This has caused rates to increase as lenders lockdown on restricting credit and easy lending. Interest rate increases then make it difficult for borrowers to reset their adjustable rate mortgages at the same rate they locked in a few years ago; in-turn, higher interest rates cause foreclosures and an increase in properties on the market for sale.
Interest Rates are Rising
It takes a rising interest rate environment for bond prices to fall. The fallout in subprime mortgages this year, on top of inflationary fears, have caused interest rates to rise. Finally, we have a normal, rising yield curve. A normal yield curve is a chart of short-term to long-term maturity yields that show a rising yield as bond maturities rise. This happens as investors expect higher inflation in the future because the economy is growing. The uncertainty of higher inflation causes lenders to require a higher risk premium.
It is my belief that we are in the 4th stage of an economic cycle as described by Martin Pring. In this stage, bond prices are falling while stocks and commodities continue to rise. What's the next market to go? Stocks should fall with commodities close behind. Currently, I see a possible double top formation in the Dow Jones Industrial Average with a break below 13250 by 1-3%.
Dow Jones Industrial Average - 13,545.84, up 56.42
S&P 500 - 1,552.19, up 9.35
NASDAQ - 2,616.96, up 17.00
Russell 2000 - 839.81, up 3.63
© 2007 Ryan Puplava