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Gold Friendly Deflation Is Here-Get Used to It!
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Most people believe gold is a great hedge against inflation. What they don’t realize is that gold performs best during periods of deflation. Because of debt levels far greater than even those at peak 1930s level, prospects for the mother of all deflationary depressions is bearing in on us. We believe there is no asset better able to protect your wealth in this environment than gold. This is the first in a series of articles that attempts to warn of the case for deflation and for gold as protection against the potential harm it can ravage on unsuspecting citizens.
 It was only three or four months ago that policy makers were very, very concerned about inflation. Oil had risen to $140 per barrel and all manner of hard and soft commodity prices had hit new highs. Then came the Lehman failure, and prices of virtually everything plunged with the speed at which we simply could not have imagined. Our Inflation/Deflation Watch (IDW) shown on your left says it all. Overall our IDW had risen by approximately 45% since January 31, 2005, and then crashed back to the starting point, mostly since the Lehman failure. Since our IDW is largely comprised of leading indicators like stocks and commodities prices, we have always believed it would indicate prices in the overall economy at a later point in time. Well, it hasn’t taken long for a collapse in commodities prices to feed their way into the economy, and what we are seeing is downright scary. Not only have producer and consumer prices fallen, but also, the extent of their fall at this early stage should be a warning that the forces of deflation are astoundingly great. For example, U.S. producer prices fell by a record 2.8% in October. That’s not an annual rate. That’s 2.8% in one month. Multiply that over 12 months and you get a non-compounded decline of 33.6%! Prices for intermediate goods fell 3.9% in October. Prices for crude goods sank 18.6%. Crude food prices dropped 11.1% for the month alone.
These price declines in the production chain have now started to filter through to the consumer. On November 19, the U.S. CPI was reportedly down 1.0%, its biggest monthly decline in 61 years! The “core” inflation measure had its first fall for 25 years. This is inherent in credit market deflation. Consumers have to spend a larger and larger portion of their incomes to pay down debt, such that they have little purchasing power left to buy goods and services. Softness in demand for goods and services then results in even lower prices in a chain reaction process that continues a great unwind, until an equilibrium level is reached.
The chart on your left tells this story as it currently applies to America. America is broke and facing very, very hard times. Note the direction of the debt line (red line), which doesn’t even begin to add in the trillions of dollars now being borrowed to bail out crony capitalist friends of our Washington politicians. As of the end of 2007, total debt in the U.S. from all sectors (not including potential debt from derivative defaults, which could be much, much bigger) was $53 trillion. More important than the absolute amount of debt is the direction of the red line relative to the GDP (blue line). At some point, debt becomes so large that income is not capable of servicing it all. Initially, consumption of real goods and services gets squeezed, which is what is happening now. The economy then enters into a recession, as is now the case. That results in job losses, which in turn reduces demand still further. This process must take place until equilibrium is reached. No amount of government intervention can change that reality.
And this brings me to the chart below, which pictures the work of my good friend Ian Gordon. Ian has had this chart of the past four Kondratieff cycles posted. These cycles date back to just before the Revolutionary War—in other words, before the U.S. was born as a nation! I urge you to go to Ian’s Web site, (www.thelongwaveanalyst.com), where there are many, very valuable charts and information about the Kondratieff cycle also known as the Long Wave. Ian is a financier who has done very well, funding junior gold mining companies. But he is also a student of economic history, and I consider him to be one of my best friends. In 2007, Mrs. Taylor and I stayed at his beautiful home in British Columbia that looks out over the bay into the United States. I have a very high regard for Ian’s work and think it is highly credible. I say that as a person who has learned to know him well. He is a very honest person and has a high degree of integrity.
What you see above are actual data for stock prices, a proxy for gold prices when they were fixed, and commodity prices (PPI before 1949 and CRB after that). Also pictured are U.S. Treasury yields as well as AAA corporate bonds.
What we see from this historical data are long-term expansion and contractions of the global economy that had, until recently, lasted 50 to 60 years. The current cycle started in 1949 at the end of WWII, so it is already 59 years in duration.
Ian has divided a given K-cycle into the four seasons of our year. The first three seasons, spring, summer, and autumn, are marked by economic expansion. The economy is improving during spring, from a devastating end of the last cycle. It heats up during summer and the best of times are in the autumn. Each of these cycles has unique characteristics when certain kinds of investments are very desirable. For example, in the spring, which in this cycle started in 1949 and lasted until 1966, stocks are a good investment. In the summer, which lasted from 1966 through 1980 and is marked by rising levels of inflation, commodities and gold are a good investment. During the fall (1980-2000 in this cycle), stocks and bonds are great investments. But the winter, which is what we entered into in 2000, is a tough time, because it is marked by a massive unwinding of an overextension of credit. Excessive debt has to be wrung out of the system through massive bankruptcies and unemployment.
The important thing to note is that government is ultimately powerless to stop the dreaded K-winter. It can, as it is now doing and as it did in the last K-winter in the 1930s, intervene with monetary and fiscal policy. But that policy will be unsuccessful in restoring prosperity. Because their “remedies” are in fact the root of the problem in the first place (namely excessive debt), their actions make the problem worse and longer lasting than if they did nothing. The K-winter season always begins with a stock market peak, which in fact occurred in 2000. The great housing bubble, which was a totally false economy, delayed the great day of reckoning by doubling the total debt outstanding! And now with massive bailouts, total debt is skyrocketing to even higher and more unsustainable levels. The end may well be more horrendous than anything our grandparents experienced in the 1930s.
America is now a bankrupt country and the potential exists for something far worse even than what our parents and grandparents experienced in the 1930s. Indeed, people like Robert Prechter who has studied long-term cycles, think we could be heading toward a 500-year event. Interestingly, Dr. Robert McHugh, who writes The Technical Indicator newsletter, wrote the following on Saturday, November 22.
“We now find ourselves in a catastrophic Bear Market, Grand Supercycle degree Wave {IV} down, which is correcting a Bull Market from 1718, before the United States even started. We show this degree labeling in the big picture chart on page 13 in this weekend's newsletter to subscribers. How do we know this? Because the S&P 500 fell to 752 Thursday, below the closing low the market formed at the bottom of the Bear Market in 2002. It means that low in 2002 was primary degree wave (4), that prices have now fallen below that bottom, which means the rally from 2002 to 2007 is a completed primary degree wave (5), which is all that was needed to complete a series of larger degree wave fives, supercycle degree wave (V)'s top, and Cycle degree wave V's top. This is not good. It means there is a very high probability that we are going to see new lows far below Thursday's 752. This hurricane is not over, not by a long shot.
“However, the good news is we are about to enter a period of relative calm, the second phase - a rally/sideways phase - to this three phase Bear market. This Grand Supercycle wave {IV} down is correcting centuries of rally very fast, and furiously. Time-wise, it may be relatively short compared to other Grand Super cycle waves, but damage-wise, this Bear Market is going to change the world as we know it.”
Then on Monday, November 25, Dr. McHugh wrote the following:
“There is a good chance that wave (B) up started Friday, November 21st, that wave (A) down, the first phase of this three phase Bear Market ended precisely on our most recent phi mate turn date, Thursday, November 20th, 2008. This second phase will be a calm before the next major storm, so use it wisely to raise cash.
“This phase is a gift. The eye of the hurricane storm, which is a category 5 financial storm. A second chance to raise cash at higher prices. Because, once it completes, a world rattling catastrophic plunge is coming, one that will take prices far lower than anyone - even Bears - imagine, wave (C) down. Wave (C) down could be so bad as to usher in mergers of nations, where nations become states within new larger nations. This coming political solution to wave (C)'s calamity is good reason to accumulate Gold.”
From a completely different angle, but drawing a similar conclusion are the managers of the Bearing Fund, Kevin Duffy and Bill Laggner, who we interviewed in our November 2008 monthly issue. It should be noted that the Bearing Fund has increased the value of its investors by 143% since its inception in July 2002. That funds’ proprietary credit bubble model enabled them to position themselves for this first leg down in what has proven to be a devastating bear market in equities. The fund managers anticipate the potential for a very major event that could be worse than that of the 1930s along the lines of Dr. McHug’s vision as well.
In the next article in this series, I will talk about the size of the debt deflation problem and why it may simply be too big to fix. The important thing to realize is that in this environment, because the cost of production is in decline, gold mining profits margins are improving. Now that we are at the start of this deflationary trend, we think there are several emerging gold mining companies that should do very well for their investors even as the general equity markets are in a longer term decline. Such was the case in the 1930s when Homestake Mining rose by over 600% even as though the Dow had lost nearly 90% at one point in time. Go to www.miningstocks.com to subscribe to J Taylor’s Gold, Energy & Tech Stocks newsletter to learn of emerging gold producers not yet on the radar screens of institutional investors.
J. Taylor
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Jay Taylor is editor of J Taylor’s Gold, Energy & Tech Stocks weekly and monthly newsletter. Jay provides stock recommendations with a major focus on the mining and energy sectors and also provides strategies designed to profit from major trends. Visit (www.miningstocks.com) for more information and/or call Claudio Bassi in Jay’s office at 718 457-1426 Monday through Friday between 9:00AM and 4:00 PM Eastern time
To find out more about J Taylor’s Gold & Technology Stocks newsletter, please visit www.WeBeatTheStreet.com
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