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There is one huge potential risk to the economy and to the stock market that is being completely overlooked. It is deflation and it is by far the biggest hurdle that the United States and global economies must get over. Otherwise, the global economy will sink into an extended depression. Even though deflation is the most significant risk facing the stock market and the economy, I cannot recall it ever being discussed by media pundits and analysts.

Deflation is not on the radar screen and its risk also has not been discounted into share prices for the simple reason that there are few that have ever lived in or experienced a deflationary environment. The last time that deflation was an issue for an extended period of time was between 1929 and 1933. Thus, for a current economist or analyst to have experienced deflation they would have to be a minimum of 21 years old in 1933, which means that they would be 97 years old today.

My grandfather, who was in his early 20s, and my grandmother, who was a teenager in 1929, both experienced deflation fully. I vividly remember my grandmother’s passion for clipping coupons every time I visited her in Chicago. She always had a pair of scissors in her hand, which she used to cut grocery coupons out of Chicago’s daily newspapers. Coupons in her hand and with me in tow, she would head out in her car to as many as five different grocery stores to do her grocery shopping. She was steadfast in refusing to buy anything unless it was on sale. I remember thinking to myself that she was a little nutty for wasting much of her time to shop at five different stores to purchase five different items. My grandfather refused to take his car to a mechanic or even to a body shop after he had a routine traffic accident. He fixed everything that he owned. He also refused to throw out anything and kept thousands of items in small jars in his basement. He even cut his own hair so that he would not have to pay a barber. I cannot remember even one occasion or a time in which my grandparents took me out to eat at a restaurant, and my grandfather lived for 102 years.

While there are few who are alive today that have actually experienced deflation, there are economists who have researched it fully. Among them is Ben Bernanke, the Chairman of the Federal Reserve Bank. In 2002, Bernanke gave a speech specifically about deflation at the National Economists Club in Washington, D.C. The title of the speech was, “Deflation: Making Sure “It” Doesn’t Happen Here”. Bernanke dedicated his speech to deflation because he knows that deflation is an economy’s biggest nightmare. The Federal Reserve Bank’s origin came out 1929 Great Depression, which was caused by the U.S.’s last serious bout of deflation

Deflation is reviled by all central bankers and economists. They consider deflation to be the evil twin brother of inflation. Left to his or her druthers, any sane economist or central banker would much rather deal with the problems caused by inflation over the problems caused by deflation on any day. William McDonough, the former president of the Federal Reserve Bank of New York, recalled his father taking him in the late 1930s to see breadlines and “people in jail, who were there for stealing food for their families.” In a speech that McDonough gave, he said, “The depression was a very real thing to the people who created the Federal Reserve’s mandate and they never wanted it to happen again.”

Deflation defined:
Deflation occurs when the value of hard assets, commodities and consumer prices begin to fall and continue to fall. This may seem like a great thing for consumers except that the cause for deflation is generally a long-term drop in demand. The drop in demand coincides with the beginning of a recession, which has its customary job losses, declining wages, ongoing declines in hard assets and financial assets. One the consequences of deflation are that businesses drop their prices in a desperate attempt to get consumers to buy their products.

The metric that measures inflation is the Consumer Price Index. The CPI does not measure stock which is what retirees use to fund their retirement and businesses use to raise capital. Because the CPI does not include house prices and only the equivalent rentals it often lags home price declines and therefore underestimates deflation.

Deflation is very similar to inflation, in that both are difficult to oust after they become entrenched. The reason why is because when consumers and businesses feel less wealthy, they spend less. This reduces demand even further and enables deflation to continue its downward spiral.

In an inflationary environment, banks make loans and companies borrow on the assumption that rising sales volume and prices will enable the debt to be repaid. In a deflationary environment its exactly the opposite. Banks do not want to make loans on hard assets which have been declining in value and businesses do not want to borrow funds to expand when the prices they receive for their products and services are consistently lower. This results in businesses and consumers delaying their purchases because they believe that prices and services will ultimately go lower.

In 1929 the Consumer Price Index (CPI) hit an all-time high of 17.1 and by 1933 it fell by 24% to 13.0. The index did not get above its 1929 high until 1943. The U.S. is now faced with a repeat of 1929 and this could result in a spiraling deflationary cycle that could last for years, especially since equities have now entered their first super or secular bear market since the 1966-1982 Super Bear market. For more information on the bear market I suggest that you read my December 2008 EQUITIES Magazine article, “A Super Bear is Upon Us.”

The 1930s demonstrated that deflation is most dangerous when debt burdens are heavy, as they were in the 1920s and in 2008. "When a deflation occurs ... without any great volume of debt, the resulting evils are much less," Yale University economist Irving Fisher wrote in 1933. "It is the combination of both ... which works the greatest havoc."

Based on the answers that Ben Bernanke gave in an August 2003 interview with CNBC’s Ron Insana, all indications are that the U.S. and other countries have now entered into a deflationary zone. Here is an excerpt from that interview:

Q. What signposts would lead you to believe that the U.S. economy has begun to enter a period of deflation that you would find problematic?

A. One would be, of course, that we start to see negative readings among the core measures of inflation. Second, if short-term interest rates were very close to the zero boundary. And third, that we're seeing a severe weakening of the macroeconomy and bad performance in asset markets. Seeing that would be the configuration of signs that the economy was entering a deflationary zone.

Bernanke interview by Insana, August 1, 2003
The lethal combination of the global credit crisis and declining hard and financial asset prices have allowed the seeds of deflation to be planted into the U.S. and global economies. There are now signals that deflation’s roots have taken hold and are now sprouting the buds of deflation:

• As of Nov. 25, 2008, there was not one mutual fund out of a total of 11,585 that had increased in value during 2008.
• Commodity prices have declined by more than 50% since hitting their peak in 2008.
• The major stock indices such as the Dow Jones and S&P 500 have declined by more than 40%.
• The Producer Price Index decreased by 2.8% and the Consumer Price Index (CPI) decreased by 1.0% in October. It was the largest monthly decline since the publication of the changes in the CPI began in February of 1947.
• An increasing number of homeowners believe that the value of their homes will decline in 2009.
• Consumer spending began to decline in August of 2008, which is before Lehman went bankrupt and the Global Financial Crisis became prolific.

There is ample evidence that Bernanke, his predecessors and many of world’s economists have been schooled in what causes deflation. However, it’s important to understand that there is not currently an economist or central banker that has any hands-on experience on how to deal with it. Here is an excerpt from Bernanke’s speech on “Deflation: Making Sure “It” Doesn’t Happen Here”:

“In the remainder of my talk I will discuss some possible options for stopping a deflation once it has gotten under way. I should emphasize that my comments on this topic are necessarily speculative, as the modern Federal Reserve has never faced this situation …”
Ben Bernanke, November 21, 2002

The Federal Reserve Bank and the U.S. Treasury have thrown in everything including the kitchen sink in a desperate attempt to prevent a long-term deflation trend from taking hold in the U.S. and Global economies. However, there are several problems, which I believe are insurmountable. The foremost one is that the problem is global. It would be easier to solve deflation if the U.S. was the only country suffering from this predicament. This is far from the case. To have any chance whatsoever of pulling out of this deflationary spiral, a majority of countries would have to attack the problem in unison. They would have to use the same weapons simultaneously. This, of course, assumes that the weapons including fiscal stimulus, zero central bank interest rates, and flooding the money supply would work and this is the second problem. I do not believe that any of the weapons are big enough to cause significant impact. To win the battle, the following are the major global economic events that need to happen simultaneously and as soon as possible:

• Global real estate prices would have to stabilize.
• Global stock prices would have to increase by 40% to levels that would give investors the confidence to keep their current investments in stocks and to make new investments in stocks.
• The interest rates on corporate bonds and for the sovereign debt of third world countries would have to fall precipitously to nominal interest rates. Without this, many corporations and countries will soon become insolvent.
• The immediate creation of approximately five to 10 million global jobs.

The problem is that there is not enough cash or credit in the world that would enable these four things to happen. Without all of the major economic events happening simultaneously, global consumers would not have the propensity to spend and that is the only thing that can prevent deflation from taking hold. Even if the governments of the world were able to miraculously orchestrate the events it would not guarantee that deflation would be whipped.

Now that its rather obvious that deflation is sprouting in the U.S., the Federal Reserve and U.S. Treasury will be focused on implementing remedies to cure deflation instead of preventive measures. These remedies will include the purchase of assets by the U.S. Treasury and the guarantees of bank issued debt securities by the Federal Reserve. The Fed is also manipulating interest rates and money supply. The Treasury department will also utilize a projected fiscal stimulus package of at least $1 Trillion, which will likely be passed by Congress after President-elect Obama has taken office. The package will likely include tax cuts for the middle class and a public works program to create jobs. Regardless of whatever action that the U.S. government takes, I believe the probability that they can successfully stem the tide of deflation is low because of the following reasons:

• It would take too much time to gear up for a public works or an infrastructure spending program. It will take some time even for the U.S. government to spend $1 Trillion quickly.
• Rising unemployment in the U.S. will result in even more declines in consumer spending. As each day goes by, more and more consumers will retrench and this will only exacerbate the deflationary spiral.
• I beg to differ with Bernanke’s statement that tax cuts “ought” to stimulate spending. Given the horrible news on job losses and the extremely negative environment, I predict that the consumer would be more likely to use tax cuts to pay off debt and credit cards instead of purchasing additional goods and services.
• The spread between U.S. BAA corporate bonds and U.S. government bonds is the widest since 1932. Corporate bond yields have gone up from 6.5% in 2007 to 9.20% in 2008. This is the most damaging to the Fed’s fight with deflation because companies have to borrow at higher rates to finance declining revenue.
• Many public companies will go out of business because over 50% of them generated negative free cash flow over their most recent 12 months. This will increase unemployment.
• There are many other countries, which have been hit by the two-headed flu bug of recession and deflation. There is nothing that the U.S. can do to save them. This will result in a downturn of global consumer spending.

One of the misnomers that everyone believes is that the result of the government’s intervention and bailouts is that inflation will soon rear its ugly head. I disagree. The main reason is that in a deflationary environment, investors seek out guaranteed debt investments because the value of most hard and financial assets including corporate bonds and a majority of stocks are in decline. Given a deflationary scenario, the security behind the credit of corporations and individuals is declining in value. Therefore, the most secure investment during a deflationary period would be U.S. Treasury debt securities. This is why the demand for U.S. Treasury bills and notes has driven their prices to all-time highs and their yields to all-time lows as of December 2008. Conservative and knowledgeable investors are putting their monies in U.S. government debt securities because they know that they are guaranteed to be repaid by the full faith and credit of the government. The U.S. government’s ability to levy taxes on its citizens enables it to enjoy the top credit rating in the world. On the other hand, the yield on corporate BAA rated bonds are up from 6.5% in 2007 to 9.2% and the spreads between them and government bonds are the highest since 1932. The fact that investors are shunning high rated corporate BAA bonds with yields at above 9% and instead investing in governments with yields at under 4%, confirms my argument that deflation and not inflation is the issue.

Should deflation clamp its jaws down on the U.S. and/or global economy it would be difficult for even the top blue chip corporations to pay their debts in full. This is because the value of their assets, including inventories and plant and equipment, would be depreciating along with lower revenues and profits. U.S. banks would also have a problem in paying off their depositors because the value of their collateralized loans would be depreciating faster than the repayment or amortization schedule of principal and interest payments.

The U.S.’s top-notch credit standing gives it the ability to borrow at will. It has been able to do so at increasingly lower interest rates or yields. Ultimately, the U.S.’ credit rating and its ability to borrow at will for its economic intervention programs and stimulus packages will come back to haunt it. Its shrinking taxpayer base due to bracket creep and the fact that 76 million U.S. baby boomers will enter retirement over the next 20 years will eventually result in a downturn in productivity. Eventually, the U.S. will have a smaller base of workers that will be strapped with a high tax burden in order to service the debt that the U.S. is taking on in its attempt to cheat deflation pressures.

There are two reasons why I am predicting that the major stock market indices including the Dow 30 Industrials and the S&P 500 will go to significant new lows in 2009. The first is because I believe that the odds are low that the Federal Reserve will be able to stop deflation in its tracks in 2009 or even by 2010. The second is that the devastating impact that deflation can have on consumers and businesses has not been fully discounted into the valuations of the vast majority of all public companies. The shares of many public companies will not be able to escape deflation’s wrath. Therefore, I am advising investors to maintain at least 80% of their liquidity in short-term U.S. government debt securities. The remaining 20% can be invested into the shares of those publicly traded companies, which reside in the online financial information sector. It is the only sector or industry out of the 216 that I cover that is benefiting from the global financial crisis. For more information on the online financial sector, go to www.onlinefinancialsector.com. For more information on the Super Bear market, go to www.bearmarketnavigator.com

Michael Markowski and/or his family members hold shares in each of the companies that he is recommending in this article and may buy or sell such shares at anytime.