The Fog Is Clearing

A few things are starting to become clear. First of all, the collapse will be deflationary. Central banks around the world are failing in their attempts to re-ignite inflation in their economies, and while outright deflation is only just starting to appear (in Europe for example) the trend is now well established. To me, hyperinflation has been the central risk but it would have taken runaway government deficit spending to create it – the Latin America syndrome – and that simply has not happened in the developed world.

Secondly, QE does have effects other than creating asset bubbles. Despite what Hussman says, bubbles in countries that haven’t messed with bank accounting have had knock-on effects in terms of confidence in the real economy. And so that confidence has given credibility to the illusion of recovery. It looks to me that we’re about done with that, though, for this bubble.

We’re probably pretty close to a top in the stock market, which is currently about 100% over-valued – from a fair value based on average historical returns. When over-valuation returns to mean, it doesn’t stop at fair value, however, or at least it never has in the past. In general, it heads for between 50-60% undervaluation (or 40-50% of fair value). So we’re looking at a swing low somewhere in the 400s on the S&P 500, most likely.

Since the collapse is going to be deflationary, we can expect Treasuries to perform well as the Japanese model provides a guide. I’m guessing we’ll see 30-year rates between 1.5 and 1.8%.

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