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Much has been made about the death cross of late, the 50 day moving average crossing through the 200 day moving average, although I think and know it is a significant event it is nothing compared to something else I have noticed. We are all aware of the primary reason of the bull run over the past 12 months, massively oversold markets, combined with marginally better economic data and, most importantly, a weakening dollar. Why the dollar weakened is important to note, quantitative easing via the Federal Reserve’s asset purchases or the printing of money. Although we will not know the long-term implications of QE for some time to come it is safe to assume it accomplished its goal, weaken the dollar and boost the economic data through negative interest rates, essentially.

We all know the market action of late, a horrendous selloff which was only a surprise to the parade of bulls on CNBC and those who kept their heads buried in the sand, but those out in the real world knew it was coming. What was unexpected was the 4^th of July rally that took us back up some 7% on the backdrop of pretty bad economic data. Some of the bounce was because of a technical bounce and some of it was because of the expectations of stronger earnings which started last week. I fully expected 2Q10 earnings to be good, but I expected to see more top line misses and the outlook from CEO’s to be downgraded as well. So far, it is a mixed bag, but the outlook or guidance remains very bullish for many firms, however, a look back through prior earning announcements, particularly 2000 releases, as Mark forwarded to me, shows that Intel did not foresee a slowdown there either, so trust the economic data rather than CEO guidance going forward.

Back to what is going on in the equities market and why the dark cross is less important than the other ‘grey swan’ that is going on. First, everyone and their grandmother knows or knew about the dark cross, not that it takes away from its importance, but when everyone knows about it very rarely does the market deliver the results we are looking for. Except the market kind of did deliver, but stopped short and rallied all the way back to some important moving averages where it failed to break through, very bearish from my lens. At the same time we saw the selloff begin the dollar was moving towards the 89 mark on the DXY, but it stalled after a dramatic breakout and reversed course. Not only did the DXY reverse course, but it got crushed moving down from 89ish to about 82.5, not an insignificant move.

Exhibit 1-1 2 Month DXY Chart

Why is this a big deal? It is a big deal because stocks went up on a weak dollar trend which meant a better environment for U.S. companies to sell products abroad. Basically, a weaker dollar is better for U.S. exports and sales as we become more competitive in the world. It made sense for the markets to not like the move of the DXY from the low 70’s to 89, but to not like the move from 89 to 82.5, well, I am perplexed. The market should love this and we should be flying to at least 1,100 on the S&P 500, but we are not. This is a huge warning sign that stocks cannot rally on a weak dollar and it means more than the dark cross.

Exhibit 1-2 1 Year S&P 500 and DXY

The charts show the trends pretty clearly, lower dollar higher equity prices, higher dollar, lower equity prices, but over the past couple of months things have been out of whack. What else is going on during this time period? Treasury yields are collapsing to historic lows. We have the 2 year treasury under .60%, the 10 year under 3% and the 30 year under 4% which is a sign of 2 things, risk aversion and fear of deflation. My belief is deflation is the clear danger as of right now, it is fairly evident from my lens and the market is pricing it in as we speak. The credit markets have been pricing it in for some time and will continue to, I am bullish on debt securities, have been for some time now, but the equities markets, well, it has not priced in any real deflationary pressure at all.

Exhibit 1-3 Yield Curve

Granted, we have not seen total deflation yet, just the beginning sign of it, but the evidence is pointing towards it. Here is the rub, everyone says the Fed will do QE2, but they won’t do it. See my other posts as to why they will not do it, but from my lens they would be insane to even attempt QE2 at this point. The problems in the U.S. economy has nothing to do with what is happening in Europe, a little I suppose, but not directly related. My past posts about Europe relate directly to actual defaults by countries and to corporate earnings. I think anyone will find it hard to believe that the Jones’s are not buying that new car because they are worried about Hungary being kicked out of the IMF-EU rescue package. They are not buying a car because they are worried about their job and do not want to take on much debt or because their credit score is so lousy they cannot get financing, 25% of Americans have a credit score below 600 now. Instead the Jones’s are paying off debt and buying what they need, not what they want which is deflationary.

This trend will continue and so far only the credit markets are pricing this in, the equity markets are in La-La Land, still. The DXY – S&P cross is very bearish if the trend continues and will mean a big correction in the near future especially if commodities head lower as well. Commodities are not performing well and that is reflected in the Baltic Dry Index and combine that in with the above information and it is putting the explanation point on the whole theory. So far the only strategist I know for sure who is putting all of these pieces together, and has been ridiculed relentlessly by the bulls on CNBC and such, is David Rosenberg. All of the rest of the strategists are telling you to buy the dips even when they see everything I presented to you, they know what it means and, to top it off, they know the ECRI is rolling over and housing is going down the tubes. It is incredible to say the least. Be ready for some fireworks soon unless this trend breaks.

What works in a deflationary environment? Income and dividends, pure and simple. I like (and own) the following: CTL, MO, PM, WM, PFE, MRK, LLY, BPT, RYU, PEY, INB, DNH, CGO, VZ, high quality corporate bonds, strategic income bond funds, emerging market debt funds (PCY has been good to me), short and intermediate term treasury funds. Many of the above mentioned stocks have underperformed, which I like, and pay very nice dividend yields, which I love, but may not do well in an inflationary environment. This is why one has to hedge with precious metals or, at the very least, TIPS.

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