* I concluded yesterday's blog with the conclusion that economic factors are not likely to cause any amount of inflation. In fact, the deflationary factors at work are large enough to swamp even the most heroic government efforts to re-flate the economy. If it wasn't for massive deficit spending by the government, the current signs of a nascent economic recovery would not be visible at all. Many economists and market prognosticators have glommed onto the indicators which show that "things" are stabilizing. These know-it-alls extrapolate the economic indicators, which are now declining at a slower pace, or increasing at a modest pace, to conclude that the economy and the fortunes of many companies are about to launch into a new economic revival.

My main counter argument to this bullishness is to consider the effects of the government on the fortunes and fate of our economy. If the government keeps spending enough money, then it will appear that the economy is in OK shape. The theory behind government deficit spending is that the government is needed to prime the economic pumps, and from there, natural forces of economic growth will catch on and feed itself. To this I have a couple of things to say:

1>    The forces of deflation are going to provide a significant head-wind against the government's deficit spending programs.

2>    The minute the government tries to act fiscally responsible will be the day that these deflationary forces will win out. This might happen in 2011, after the democrats lose their majority lock in both houses. However, I do not think it will take that long for the economy to turn south.

3>    It is possible that the government can run trillion dollar deficits as far as the eye can see, without any adverse consequences. 2009's deficit was achieved to a large part because of the Fed's massive securities purchase programs, which took over $7 trillion of duration years out of the market. What is up for 2010? 

Japan, which has been running deficits for the last 18 years, is a case study on what might happen if the government runs chronic deficits to counter deflation. Japan, whose cumulative deficit which is now approaching two times its GDP, funds itself with the savings of its society. In fact, Japanese government bond yields are half the rate as seen in the US. To me, that is the best indicator that Japan is able to run these deficits with few immediate consequences. In fact, I have been reading much about how many hedge funds lost money in the 1990s by betting that Japanese rates would rise. 

In contrast, the US relies on foreigners to fund approximately half our deficits. Eventually, something has to give. A lot will have to do with how far our creditors allow us to go. On the one hand, they have no choice. They are so deep into our debt, that I do not see how they will get out of this predicament. Instead, I see some form of a gradual strategy by our foreign creditors to diversify away from the dollar. We are starting to see some of the signs of this in the precious metals markets, as Central Banks have begun ease into the gold market. Most notably, Russia and India have begun buying gold in billion dollar increments. While China will not own up to buying gold in the open market, they have managed to increase their gold reserves by more than 100% over the past few years, (which was announced in 2009), by quietly accumulating gold from domestic producers. More visibly however, China is on a mad dash to accumulate natural resource properties, but there is no way they will be able to spend their $2 trillion stockpile of dollars.

To conclude this part of the conversation, I see the consequences of the current course of "things" as a continuation of the "uneasy balance" I spent considerable time talking about in December. Eventually something has to give, just the timing remains a mystery.

* Stocks - This leaves us with having to figure out how far the investment flows will push the various markets which have been in a rally mode since March. I have been wrong about a stock market top since this fall, and I will be the first to admit that the current rally has gone further than I would have thought. By my charts, I have a pile of resistance levels in the low 1100's. Yet it is possible for the market to stretch higher and longer than I believe possible. One thing I have learned is that markets can do anything, especially the unexpected, and can stay irrational longer than a trader (who doesn't cut his losses) can remain solvent.

On the topic of reasons why stocks are rallying, a reader sends in this explanation from Bob Chapman, of the The International Forecaster:

"The massive stock-market rally in the past nine months is mostly due to secret government buying of stock-index futures, a respected stock-market analyst said Tuesday. Charles Biderman, chief executive of TrimTabs Investment Research, is the latest and most credible person to charge that the Federal Reserve and the Treasury (in league with top Wall Street firms) is rigging the stock market on a daily basis. In a special report released Tuesday, Biderman said the $6 trillion increase in U.S. stock-market capitalization since March can't be explained by the usual sources of fundsflowing into the market -- such as mutual funds, direct retail investment, pension funds, hedge funds or foreign purchases. Read more about Biderman's theory. The only logical explanation for the extent of the rally, he suggested, is secret buying by a government committee known colloquially as the Plunge Protection Team. It's like the dark matter that astrophysicists conjecture must be there, even if we can't detect it."

The reason why I am presenting this piece is because I am often asked about such government originated stock market buying. I do not believe this is happening. Oftentimes you do not need to follow the money to explain a change in the market. There has been such a proliferation of derivatives, which have the ability to influence markets by the trillions, with no money down, that following the money is no longer the only method to explain market movements. If you go back to March, the markets were so oversold, and sentiment was so bearish, that a change was in trend was inevitable.

Just as markets were decisively bearish last March, the markets appear to be getting stretched thin to the upside. As I survey the opinion of prognosticators, it appears that there is a universal call for a 10% to 20% rally in stocks, and for significantly higher rates. In fact, the calls are so similar and one sided, that I am especially on the alert for a reversal in both these markets. While I do not subscribe to the services which put out this information, recent readings of bearish opinion numbers (in stocks) is at a low of 16%. In addition, Put/Call ratios are also at a very bearish reading, around 66%, showing that speculators are buying calls versus puts in a ratio of 3 to 2.  Additionally, VIX, or the volatility of stock market options is down to its lowest level since the financial crisis began in September of 2008, another indicator that fear has left the market. While none of these indicators by themselves can be used to call a turning point, they are all warning flags of an impending shift in trend.

* Gold - the reason why I like gold is because I am concerned about the efforts of our government to rescue our economy will undermine the value of the dollar.  The government is clearly spending and printing lots of money as well. In addition, most governments around the world are engaged in an effort to prevent their currencies from appreciating versus the dollar. This is what has been called "the race to the bottom". While I admit that if the deflationary forces take hold, then it is likely that gold will get dragged down with everything else. I am also skeptical about gold right here from a trading perspective. As the attached chart shows, gold is bumping against resistance which runs from 1140 to 1160.

Tomorrow's unemployment report could be the catalyst for a trend shift lower in gold, stocks, and other risk assets. I will be purchasing put options on both gold and stocks in the trading account today, which is made cheaper since volatility has been dropping. I will hold off adding fixed income duration until next weeks refunding of 10s and long bonds.