I remember in the mid 2000s when the online calculators for calculating house price carrying costs did not include the option for prices to decline. They barely even let you put in zero price appreciation, let alone a negative number. We now know that this sort of thinking wasn’t limited to online calculators, but that billions of dollars of mortgage backed securities were priced with this same sort logic. There had never been a national decline in home prices, so there was no point putting that outcome in the distribution model. Of course, we all know had that ended.

This morning the trading community is having a good laugh at the results of the European bank stress test. Initially there was a little bit of surprise at the number of banks that passed. The market was definitely expecting more failures. But then as the details of the stress test came to light, the results were dismissed as yet another case of the ECB creating a test that would achieve the results they wanted.

The ECB stress test did not include the possibility of deflation. Let me repeat that – the ECB stress test did not include the possibility of deflation. Hello? Anybody in there? McFly?


If there is any economy that needs to incorporate the possibility of deflation it is the European Union. The inability of the EU member nations to agree on monetary policy in a world of increasing Central Bank monetary expansion makes the EU especially vulnerable.

The clear trend of disinflation is obvious even to mopes like me.


At this point, the European Union is flirting with deflation. The trend is firmly pointing towards the possibility of inflation actually heading negative in the months to come. Given the German’s reluctance to engage in QE it is preposterous to arbitrarily dismiss the notion that the EU might actually slip from disinflation to deflation. In fact not only is it ridiculous to close their eyes to that possibility, it is probably the most likely outcome.

The European Stress tests are pure theatre. The EU once again solved the equation backwards. They figured out the answer and then came up with the test that would achieve those results.

The Stress Test results are not bullish

I continue to be worried that the market has over estimated Draghi’s ability to expand the ECB’s balance sheet. Many of the fast money types are betting that Europe will follow the US Quantitative Easing playbook. Although I agree that this sort of policy is desperately needed, I made a similar mistake in late 2011 in Japan. I underestimated the inertia of the status quo. It takes a real crisis to get things moving. I kept saying to myself, “how much pain can the Japanese take? Don’t they know they need to devalue their currency before they collapse into a deflationary abyss?” Eventually the Japanese came around, but it took way longer than I would have ever imagined.

My guess is that the market is busy making the same mistake in Europe. Everyone knows that eventually Germany will have to relent and allow QE. But how long it takes before that happens is the real question.

In the mean time, I would be weary of getting too bearish on the Euro or too bullish on risk assets. The fact that the Stress Tests came in with better than expected results is risk negative not the other way round. Not dealing with the problems and continuing muddling along are signals that full blown QE is still a ways off.

Make some sales!

Last week the stock market rally continued like September’s swoon was a nothing more than an erroneous headline induced dip. And although right now it is easy to be bulled up by the “great action,” don’t forget the fear from last month. During that decline there was a shocking little amount of bids. It went down in a vacuum. This is not a normal market and the risks are way higher than most investors realize.

There is a saying that investors have the memories of goldfish. I think that is selling goldfish short. The ability of investors to completely abandon any long term analysis and simply chase the momentum of the last week makes goldfish look like dolphins.

Could the market run up to new highs? For sure. But given that most investors were busy puking into last month’s hole 140 S&P 500 handles lower, I think that this is not the time to be bullish.

I know it is hard because everyone around you is proclaiming that the coast is clear, but this is the time to make some sales – not the other way round. For goodness sake, don’t chase it both ways.