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Trading in a new depression

Created:

9 February 2010

Written by:

Dominic Picarda

Be afraid - very afraid. That's the message of Robert Prechter, the world's foremost authority on the Elliott Wave Principle, who addressed the UK Society of Technical Analysts (STA) in London this week. Mr Prechter believes that risky assets could be on the verge of a collapse in the markets that will probably exceed that of the Great Depression.

Having correctly called the credit crunch, Mr Prechter's market timing has been pretty much spot-on ever since. In February last year - when bearishness reigned supreme and the Dow languished around 7000, Mr Prechter called for "a scary and sharp correction," perhaps to as high as 10,000. His advice for traders to cover their short positions came just a couple of weeks before the markets bottomed.

"Today, we're facing the most intense collapse in stock prices in 300 years," Mr Prechter told STA members. He compares the rally of the last 12 months to that of 1930. Then, as now, the market sold off sharply from its 1929 highs, only to rally 50 per cent thereafter - see chart. Investors convinced themselves the worst was over, whereupon the market collapsed catastrophically to new lows.

In this environment, Mr Prechter warns that there will be no refuge in either emerging markets or commodities. "Emerging markets are at risk of a mass withdrawal of developed-market money. Commodities have been driven higher by the same forces behind stocks. Gold in particular will fall a lot more than people are expecting, with a potential bottom occurring in 2014."

Although he is predicting sustained deflation, Mr Prechter is not especially keen on long-term government bonds. "The question for me is whether governments have taken on so much private debt that they too are now at risk of getting downgraded, along with the corporate sector." His preferred option is to hold the shortest-dated government paper, like Treasury Bills. Or better still, just plain old cash.

If Mr Prechter is even half right about the outlook for stocks, commodities and other risky assets, buy-and-hold investing could be a financially ruinous strategy over the coming years. Having a trading account in order to short-sell the markets would appear to be one way of making better returns than simply staying in cash and government paper.

But derivatives - which would include many of today's favourite retail trading products - come with a health-warning from Mr Prechter. "The financial sophistication of today's world is a symptom of the bullish mindset of recent decades. Previous bubbles also saw derivatives proliferate, all accompanied by lots of laws to ensure they paid out. But they didn't."