The global economy continues its march toward deflation. Policymakers continue to offer band-aid solutions for an intractable debt crisis and we move ever closer to a meltdown. Is it any wonder that investors are nervous? Even while the economy in the U.S. showed some improvement this fall, Europe careened from one crisis to another. Seemingly, there are no workable solutions to Europe’s problems, at least none that the political leaders are able to agree on. They propose one plan after another, but none really address the full issue. Furthermore, time appears to be running out on these leaders. No sooner do they reach agreement to deal with one country’s debt problems and another country’s debt issues take center stage. Countries with no margin for error are facing rising rates, contracting economic activity and severe budget austerity. On top of that, the European Central Bank continues to pursue a tight monetary policy. This policy combination is a formula that will guarantee disaster in Euroland. If Europe blows up, the global economy will as well.

Wall Street is correctly focused on Europe. Investors understand that global markets and the global financial system are all interconnected, and that there is tremendous counter-party risk involved. The world is perched on the doorstep of deflation. As I have said many times, deflation is not just a price decline. Deflation will involve a near-collapse of much of the world’s financial system. Many of our largest financial institutions are likely to fail this time around. Unlike 2008, there is no consensus for putting together the kind of aid to the banks and brokers that we had in 2008. In fact, the message being delivered by the public now is “do not bail out Wall Street again under any circumstances.” Our political leaders have gotten the message and show absolutely no inclination to do another TARP. I suspect Main Street is going to get its wish in 2012 and some of our largest financial institutions are going to fail. All I can say is be careful what you wish for. Next year has the potential to be the worst economic and market environment since the Great Depression.

Europe will likely be the catalyst, but the impact will be global and severe. The result will be a deflationary meltdown. Economies and markets around the world will tumble in a swift and dramatic fashion. For decades, economies across the globe have used leverage to enhance growth. Unfortunately, in the past two decades the use of debt went parabolic.  In 2008, we began to pay a big price for that excessive leverage. The policymakers were forced to intervene to ensure that the system remain intact. Financial institutions, both here and abroad, were bailed out and the monetary authorities pumped liquidity into the system at an unprecedented rate. These actions, and others, stabilized the system and allowed the economy to regain its footing. For the past two years the economy has grown, but in a sub par fashion. It is now beginning to sputter. Euroland appears to be re-entering recession, while the U.S. continues to grow, albeit at an anemic rate. Excess leverage is now acting as a drag on the economy. Policymakers are trying to manage the situation, attempting to prevent an orderly deleveraging process from becoming an involuntary liquidation crisis. Often times, debt is just being moved around from one entity to another, with the result being that the debt burden is not being significantly reduced. This is like rearranging the deck chairs on the Titanic. Policymakers may have postponed the day of reckoning with their efforts, but they have done little to repair the situation. With some of Europe’s economies now entering recession and with spreads widening, it is apparent that time is running out. The probabilities are high that the world will be dealing with a significant deflationary crisis in 2012.

This is the elephant in the room, the big picture that overhangs all investment decisions. It is the reason that this strategist has consistently said that we’ve been in a cyclical bull market the past couple of years, but that it was in the context of a secular bear market. I believe the next leg of the secular bear market will be even more severe than the 2008/2009 downleg that took the S&P to 666. My downside target for this next leg is 500 and it could even penetrate that. Similarly, I expect the Dow to fall to 5000 or lower. Despite this negative picture, I am not ruling out a robust year-end rally. In fact, my technical work is pointing to a rally that could push the S&P through the resistance at the 200-day moving average and up toward 1350. Investor sentiment is quite negative. Many hedge funds are positioned aggressively for the downside. If the market moves up here, many of these managers may feel pressured into committing cash and covering shorts. Given how late in the year it is, managers can’t afford to ignore a rally and suffer the performance consequences.  We could see a buying panic of sorts that could even push the market to new cycle highs. If we do get this rally, it should be looked at as a last hurrah to the upside, rather than any kind of sustainable move. Investors can create a rally by looking at the glass as half full, but they cannot eliminate the reality that the world’s economies are massively over-leveraged and moving ever closer to a deflationary meltdown. I expect the commodity producers, technology, oil service, industrials and financials to be among the best performers during the rally.

The Treasury market has had a nice run. From its low in February to its high in September, the thirty-year bond was up nearly twenty-five percent. TLT, the etf that tracks the Twenty Year Treasury Bond Index was up forty percent this year, trough to peak. I would expect a ten to fifteen percent correction near-term, before Treasury bonds resume their uptrend. Regular readers of this letter know that I have long been forecasting that the thirty year would ultimately trade up to a two percent yield and the ten year a one percent yield, as deflation takes hold and investors scramble for safety. Until recently, this forecast was viewed with much skepticism, if not outright derision. While most investors still find Treasuries unattractive at current rates, they are not nearly as bearish as they were earlier this year. If and when the year-end stock market rally runs its course, Treasury bonds will once again be an attractive refuge from the storm. If my scenario proves correct, the stock market is likely to decline by more than sixty percent from its peak, while Treasury bonds could provide a twenty to twenty-five percent return and TLT, potentially even more than that. There will be a huge delineation between winners and losers during the upcoming deflationary meltdown. It will not pay to trade down the risk curve either. Spreads off of Treasuries are going to widen dramatically during the bust. This is not a time to reach for yield. There will be a high premium paid for the guarantee of the U.S. Treasury.

I remain a bull on the dollar for the intermediate term. I continue to believe that the dollar index will trade up to 95 in the first half of 2012. Near-term, however, I expect the dollar to retrace most if not all of its gains of the last month. Just as with Treasury bonds, the dollar is likely to be seen as a place of refuge during the deflationary bust.  Even though the U.S. will be experiencing its worst economic contraction since the Great Depression, and even though our financial system will be under tremendous duress, the dollar will still be viewed by investors as a safer, more secure alternative to most other currencies. The Euro is clearly in trouble. It could trade up in the near-term, particularly if the leaders in Europe can convince investors that they are coming together on a workable plan. Ultimately, I do not expect to see a plan that will be large enough to contain the contagion in Europe. I doubt seriously that European leaders can move anywhere near fast enough to head off what I see as an inevitable meltdown. So while the Euro could trade a bit higher in the near-term, I fully expect it to be trading at parity with the U.S. dollar at some point in the first half of 2012. The commodity currencies of Australia and Canada are likely to trade stronger against the U.S. dollar in the next month or two but then I expect them to be hit quite hard in response to very weak commodity prices next year. The Japanese Yen continues to exhibit surprising resiliency, but I suspect it will come under much pressure during the global meltdown. There will not be many places to hide in 2012.

If my year-end rally scenario proves correct, commodities are likely to lead the rally. Having undergone healthy corrections, I think gold, silver and copper prices will all show strength in their prices in the next month or two. Copper could move back to $3.80-$4, while silver could trade up to $38. In neither case do I see prices approaching the highs of last spring and summer but good rebounds nonetheless. As for gold, I think it very likely will trade back to its high around $1900, and very well could push through to new highs. As with the stock market, I am viewing any rally as a last hurrah, with sharp reversals coming during the deflationary meltdown. I often hear pundits talk about gold as a refuge during times of deflation. I completely disagree with that notion and expect gold to come under a good deal of pressure during the meltdown. My 2012 downside target for gold is $1000. My target for silver is the mid to high teens and for copper it is $1-$1.50. I understand why investors might be skeptical regarding such dramatic projections, but given my economic forecast one can easily see how demand might fall sharply and lead to these kind of price declines. Oil is a bit tougher call given the influence of geopolitics on the price, but I wouldn’t be surprised to see it dip below $40/barrel in 2012. Needless to say, I believe commodity investors are in for a really rough ride in 2012.

Conclusion

Conditions are ripe for one last, sharp rally in stocks before deflation takes center stage in 2012, and we begin the next leg of the secular bear market. The November sell-off has caused investor sentiment to turn quite negative. As a contrarian, I see this negative sentiment as potential fuel for a rally. Given that we are approaching year-end, there is the possibility that if the market begins to rally it could draw a good deal of hedge fund money into the market as managers scramble to make their returns before year-end. In other words, we could see some sort of melt-up that could propel the S&P through the 1280 resistance area and toward the 1350-1400 levels. What factors might cause investors to become more bullish here? Certainly, a QE3 announcement is one possibility. A few Fed officials seem to be signaling that they are more open to this potential change in policy. Any further signs that Europe is coming together on a plan could also bring investors in from the sidelines. Any indications from China that policymakers there are reversing course and moving more in the direction of ease would undoubtedly spur buying over here as well. And of course, market momentum will beget more buying. So a healthy year-end rally seems quite likely. Investors should enjoy it while it lasts because I don’t think it will have legs much beyond the end of this year.

Regardless of what happens in December, I believe 2012 will be the year of the global deflationary bust. Policymakers, both here and in Europe, have been in reactionary mode throughout this debt crisis and I don’t see that changing. Everyone from Trichet to Draghi to Bernanke to Merkel to Sarkozy to Obama and beyond has been behind the curve from the beginning. No one has shown a sense of urgency. Even if Germany or the ECB were to announce a reversal in their position and agree to an aggressive printing of Euros, I’m not sure it would do much to change things. It would likely be too little too late. In this analyst’s opinion, the only thing that can potentially prevent the deflationary bust from occurring would be massive monetary stimulus on the part of all the world’s central banks. There is no one calling for that. It isn’t even on their radar screen. We are on deflation’s doorstep, yet most policymakers and a large majority of those on Wall Street remain fixated on the inflationary implications of any quantitative ease program. I am quite certain we will see a massive coordinated monetary expansion, but only in reaction to a deflationary meltdown that brings the world’s financial system to its knees. By then, the policymakers won’t have a choice. It will be the only tool at their disposal. Not since the thirties have we made such a misstep in monetary policy. History is about to repeat itself.

David A. Hunter, CFA

Chief Market Strategist

KCCI, Ltd.

(888) 267-9101

dhunter@kccidirect.com

November 30th, 2011