Which is it- Inflation or Deflation? Either Way Gold Will Win

By Roger Wiegand              March 23, 2006 www.tradertracks.com

Confusion Continues as for today we are getting a taste of both

Are we experiencing an abnormal increase in available currency and credit beyond the proportion of available goods, resulting in a sharp and continuing rise in price levels? Or, in the alternative, do we experience a reduction in general price levels brought on by a decrease in the amount of money in circulation or by a decrease in the total volume of spending? In Trader Tracks we explore this issue.

Cycles and Conditions

We have gone through cycles and timing studies numerous times to determine potential major turning points in global economic and political conditions and how they affect markets. Our methods of chart reading have us working from longest term to the shortest. This method can be similarly applied to psychological, economic and political timing. The advantage we have here is history. By observing herd behavior from previous panics and crashes in America, ideas can be formed for coming events. Wave theory suggests “the big one” was due in 1999 vs. the 1929 cycle. In our view, this occurred right on schedule with the smash of the Nasdaq stock market. While this event took just a little longer, consider the heroic savior work by our Fed to prolong happy times thus causing a delay. Computers have been highly valuable in this cycle extension effort by Mr. Greenspan as their application is quite helpful in gleaning mountains of information much faster, and then using that information to manipulate market propping. This is why I think the Nasdaq took a little longer to turn over instead of hitting the1999 date. It is very important to note the Nasdaq was only one market of many. We now have markets not even dreamed of in 1929. So if collective human behavior is going to smash one market, to confirm our theory, it should smash them all-at least the primary ones. Our work suggests market conditions today are quite comparative to completion of the first down leg and dead cat bounce correction occurring in the early 1930’s. Timing today for 2005-6 is roughly 18 to 24 months ahead of the identical circumstances observed in the early 1930’s depression. Market cheerleaders would have you believe the worst is over and that now is the time to buy stocks. We disagree. The worst is yet to come. Economic history buffs clearly remember the Great Depression was not over until America became heavily involved in the World War II effort which put millions of men and women finally back to work. If there had been no world war, that economically depressing episode could have continued for years. The last major 1930’s economy drop came late in the decade which in effect was a “Wave Relapse” or continuation of the bear markets. This is what is in front of us again. The years 2006, 2007 and 2008 will be the worst and hopefully the grand finality of this mess. The downside will be a big world war which follows in 2009 comparative to that time when Germany and Japan initiated hostilities in 1939. Gold and gold stocks will again follow the patterns of the 30’s. With each succeeding year as the depression wore on, gold rallied faster and faster rising to record heights. We see a repeat performance once again. We said the fall periods of 2006, 2007 and 2008 will produce magnificent precious metals rallies building fortunes for those that are in the game. Those on the other side of the trade could be economically crushed. Today, in late March 2006, bonds prepare to rally and stocks to sell with vigor. Gold and silver has more corrective market pricing and some selling, but by the end of May, the new precious metals rally will be underway once again.

Investing, trading and managing markets while contending with inflation-deflation dilemma

We have seen some very elegant counter arguments from several people I highly respect. It is not my position to argue with any of them but to simply produce some potential ideas and work on building a plan keeping Trader Tracks readers out of harm’s way while retaining and growing capital. In times like those of the 1930’s and today, the fear and anger levels are headed into extremes. This is part of mass behavior exhibited in response to the status quo being dumped over. Contrary to the Pollyana daily news, we have some very serious problems with more on the way. It is not the end of the world although it may feel that way to millions who have had wishes and hopes dashed or are enduring this process. People have a choice. They can recognize the issues and address them, or stick their heads in the sand and suffer the fallout. In times of upheaval, more money is made faster than can ever be hoped for in a solid bull market. Sellouts, slides, dumps and wasting of assets takes about 33% of the time a rally requires to begin and end. If you are on the right side of the trade when the stock selling hits and the herd is in a quandary, you can be a monumental winner. Further good news says you can enter the game not being rich. Folks who think gold is done are not addressing the fundamentals. Could we see a bigger gold correction? Yes we can, and I am expecting more selling before our next major rally unless something worse hits us in the interim. Cycles, seasons and history say this is true. This week however, charts are showing we should be nearing a gold and silver bottom within a few weeks The XAU needs more selling to base and support and gold the metal should do the same. Gold investors obviously dislike this selling in their favorite market. What is happening now is only normal and will provide new lower price entry opportunities for experienced gold investors and traders.

Inflation and deflation are both upon us now pulling ideas and action in opposite directions.

We often provide lists of commodity and futures markets showing price extremes. Most of these markets have provided major rallies with some corrective selling that followed. It’s not over yet. What happens next is more of the same; ever wilder price movement with intensity and volatility as we move through the next few years. Gold has been decoupling from the US Dollar and becoming a “currency” of its own. This morning we got news of more central banks potentially dumping gold. Who cares; it will not affect the eventual conclusion of the gold market. CEO’s of two large gold miners said there are a major shortages of gold on the horizon just as more folks are trying to buy it and hoard it for safety and security. We agree. Chinese, Asians and Indians are buying gold and silver like never before. Also, think about this one; Africa has historically supplied nearly 25% of the global gold mining production. We warned our readers to stay away from any investments in this region due to union problems, aging costly mines, and political robberies of mining companies with take-over violence from gangs of criminals and thugs. Further, the strong Rand currency would not help African gold production values. All of this came to pass so now you have that monster African gold production rapidly declining while new buyers enter the gold market by the hundreds of thousands all over the world. You can call gold an inflation indicator and it is, however it will become the “new money” and a storehouse of value, too. Silver will behave the same only the numbers might be even more attractive to the extreme. Consider the recent silver market excitement on news of a probable ETF offering. Soybeans and other grains will inflate as Asian consumers demand improved diets and droughts continue to interfere with production. Base metals like aluminum, zinc, lead, iron ore, nickel, steel scrap, etc. will enjoy more rallies as China buys them up or secures more sources through acquisition.

Gold Grows the Most

There are ways to trade and invest in all these markets, but we feel precious metals and energy are the dominating markets for best upside returns. You can buy stocks, bullion, crude oil, gold, silver, gas, coal or anything else in these main growing sectors for higher returns. Of course we need to be selective as to timing and entry price. I would add grain to the best sectors though many do not see it at this time in our markets. Without a doubt however, gold will witness the greatest rally run with ever tightening supply and accelerating purchases of the metal equities, futures and bullion.

So where is the deflation part of this scenario?

Deflation is alive and well right now. We are having an experience where inflation and deflation are on the markets together and have been for some time. What tends to confuse and fool us is the mixture of markets as they cross from one dominating the other. Deflation is in force today creating loss of pricing power. Car dealers must provide extraordinary premiums to move the iron. As one company gives more the others must do so too, or they can’t unload the inventory. My own grocer in his fine new store told me some prices are much higher while several have actually been reduced. Those reduced grocery products have lost pricing power. With China providing goods produced by employees earning $1.50 per hour, how can any western competitor paying $21.00 per hour even hope to compete? They have lost pricing power and this is deflation. Overriding all these things are the major disturbances in currency and bond markets that were hit, twisted and turned with several manipulated market aberrations and extremes beyond the norm. This creates anger and fear that is a common product of recessions, depressions and panics. Aberrant behavior becomes the norm instead of the exception and the results are chaos and an extreme investing gold opportunity.

When does Deflation overcome Inflation?

Somewhere in the next 18-24 months deflation will become a majority factor elbowing out inflation. For now, as stocks fail, investors run to bonds for safety and income. Further down the road, bonds will fail. Today, the spreads between “good bonds and risky bonds” are widening. Naked fear is not yet on the table but mark my words it is coming for sure. Quite frankly any kind of bonds scare me. I read this morning that pro investor David Dreman called bonds suicidal. However we can’t be afraid of all the paper out there or we could not even buy gold stocks. My one very big worry for bond investors is what happens during a derivative implosion? Do some bonds crash, or does fear run so deep the whole pile goes over the side? Panics and bank runs can start very innocently when somebody’s remarks are too commonly known or rumors induce agitation for investors. Historically they begin small and then spread like wild fire. This herd instinct can be compared to some fool yelling fire in a crowded theater. My own mother went through one of those when she was attending a children’s Christmas party in the early 1900’s in Calumet, Michigan. The party was held at an Italian social club on the second floor where about 150 people gathered, handing out little gifts to poor copper miners’ kids around the holiday. Somebody yelled fire or there was a small decorations fire (I’m not clear) and all those people ran for the stairs trying to get out down to the street below. Sadly, the entry doors would only swing in and many bodies piled up against those doors which could not be opened. My mother was held back upstairs and saved and her older sister was saved as a man grabbed her from behind preventing her decent into that staircase of hell. As I recall, over a 100 people died that day and none of them were burned but were crushed and smothered unable to escape. One of my last favorite photos of my mother was taken of her in front of the monument honoring the dead on the now vacant lot of that Italian hall.

I tell this story not to draw sympathy, but to warn our Trader Tracks readers that these things can happen without any warning and frequently those in the way are destroyed. Consider what happened recently in Indonesia with the tidal wave event. The best way to avoid this is don’t get in the way in the first place. I remember a wise old quote from Ralph Waldo Emerson (1803-1935) that said, “In skating over thin ice, our safety is in our speed.” The question then becomes can you skate faster than all those computers powering the markets when a major event hits the news? In that instance, only the trading pits might have a chance and then it could be only seconds not minutes or hours. Big funds have computer pricing alerts set at certain technical levels. These alerts can be preset by technicians to buy, sell, or hold. When a pricing blitz hits, those computers will trade so fast even their own managers will not be mentally able to keep up. In response to this possibility, we are already beginning to add to our gold stock option positions from fall 2006 through 2008. At this date, even with precious metals doing their normal annual correction, our recommended gold stock options and gold futures options are strongly in the green.

Inflation and deflation versus currencies and bonds

One of the most impressive and volatile arguments today is direction of the U.S. Dollar. At this point, I think without counting votes, the majority says the dollar will rally considerably and be an important location for capital as personal property, cars, trucks, real estate and stocks are sold off. This theory says the race to liquidity will cause this dollar rally and propel it to values not seen in a very long time. Even though we are in the tiny disagreeing minority we gain great comfort in the knowledge Warren Buffet still has billions invested against the dollar. I don’t care what anyone says, that’s even a huge bet for Warren. When George Soros said to bet big when you have the belief, Warren was listening. Actually, I think Warren’s anti-U.S. Dollar investments are also a product of not having a decent selection of stocks from which to choose. Warren’s in cash as it makes sense to do it. It’s just that he recognizes other people’s cash is much better than ours for now.

I did a little estimating to see how this could pay off for Berkshire shareholders and determined if the dollar was priced at .7650 his $21 billion could earn somewhere around +$2.4 billion on the shorts plus a corresponding amount if he was long. I doubt that huge trade has any leverage, but the entry was certainly put on at better prices. Probably, his cash is dispersed among two or three other currencies including the Canadian, Euro and Swiss. If he’s all in Euros I would respectfully suggest another look see. The Euro is headed down soon and should be selling more so as the Euro Land Constitutional fracas continues to erupt. Important note: The U.S. Dollar will not undergo a traumatized failure and cease to exist. It will merely be devalued more in response to massive dilution (printing) and its failure to hold value relative to other associated currency markets including bonds and gold. As in all things how far is down and how far is up? The worst estimate I have seen among intelligent serious people is a U.S. Dollar at .5500. That’s plenty scary enough as it’s another 1/3 or so knocked off value. The recent high was near 1.21 and a reduction to .5500 is more than half. Since our currency consists of 80% of the world’s reserves, what does that mean for the rest of the world? Many of the weak little sister countries out there are headed back to barter if in fact it becomes that bad.

As unemployment rises, homes devalue and are foreclosed and seized. Major corporations will go bankrupt or merged, inflation will abate and deflation expands in earnest. The more the hard times and fear hits consumers the faster they will buy gold and other precious metals. Meanwhile, they will dump all their toys, including unneeded real estate and failed stocks. One of the worst things many older people will face is cancelled health insurance and reduced or eliminated pension plans. The government fund that is supposed to back up and guarantee pension plans is effectively broke and overwhelmed with bad debts. This is going to create great hardship. Look for elderly and early retired folks to be moving back in with employed children or vice versa.

I disagree with those who say the dollar will have great value once again. I expect it to settle in the 60’s or 70’s and stay there for many years. Today the dollar is .8942 stuck in the higher range we previously forecast. In our view the dollar is dead money and getting deader. For trading and investing purposes the Canadian dollar can be bought, sold and traded in tandem with Canadian precious metals stocks. If the bigger gold companies are doing well in Canada, Canada’s dollar will be too. There is a positive correlation between gold stocks and the Canadian Dollar. We expect to be recommending this long trade later this year.

The more I look at shorting Treasury Bonds for now, the more nervous I become. In my view those bonds are going down in value and up in price for awhile, but the pivot reversal will take hold beginning in late August of 2006. Defaults are already underway with widening spreads working from the junk into the corporate de-rated group (new junk) on up to the supposedly higher grades. I expect the City of Detroit, Michigan to enter receivership late this year or early next, and the State of Michigan to do the same in 2006-2007. By this time next year, Michigan will be $500,000,000 in debt with no way to pay. Unlike the federal government which has no requirement to balance its books; states by law must do this. So what does Michigan do when they cannot balance? They will have to start massive layoffs and cutback many programs most of which they never needed anyway. If Michigan installed a hiring freeze for five years, encouraged early retirements and cut wages for all state employees by 10%, they might have a chance. This is too politically unpopular so they will do it the hard way. Detroit will go broke and turn itself into a third world country with massive homelessness, unemployment, crime waves, and a host of other problems. Surrounding counties and cities, unfortunately for them, rely on the Detroit Public Water Department to sell them fresh water (actually today it’s a cloudy cocktail of chemicals). I predict this water system will be seized and operated by the State and the employee water department payroll will be expanded with increased security officers. Suburban communities buying water from Detroit will be stuck with all the extra costs as they have no alternative source for fresh water. Bills will double or triple while quality remains marginal or worse. With auto companies shedding workers and large supplier contractors doing the same it’s not going to be very nice around Michigan any more.

Getting back to bonds

When the bond market tanks; villages, cities, counties and municipalities will lose their ability to raise cash for public works. Many of the smaller among them will be merged into larger neighbor political entities and disappear. Lifestyle in some of these cash strapped communities could go beyond unbearable. I think you could see homeowners with solid equity, walk away from homes after they are taxed out of them by desperate cash hungry cities and counties. This is another good reason to rent. If it all turns ugly you can just walk and move to a better place. Conservative trading and investing bond funds are proclaiming the bonds of these public entities to be “safe.” Don’t bet on this as many little towns went broke in the 1930’s and it will happen all over again. Orange County California was a recent example. The only bonds I would trust would be those of a cash rich Canadian gold mining company. But why would you want the cash limited upside of bonds when the stocks are going to the moon? If you think I’m nuts, think about the bonds and cash issued by Germany in the early 1920’s. They are gone.

Foreign nations slip into deflation before the United States

Martin Fackler, an essayist for the WSJ wrote of Japan once again slipping into deflation. In my opinion they never got out of it and have been in serious trouble since their stock market crashed in 1989. What is news is the public statement by the Japanese Central Bank that “the country’s economy will remain hobbled by a corrosive downward price spiral until 2007, backing away from an earlier forecast that prices would start rebounding this year.” The Bank of Japan has been pumping Yen into the local economy in prodigious amounts for the last four years and it has had no effect. They even went from very low interest rates to negative interest rates which I have never heard of ever. The blame was thrown on Japanese consumers who it is claimed are too cautious to spend more which is needed to sustain positive growth. Japan’s stock market was improving and has topped out for now. Talk of rate increases above zero is premature and not expected now until the first fiscal quarter of 2007. With the USA sliding into recession, we think those rates stay neutral.

Recently, Germany claimed unemployment dropped below five million. Official numbers were 12-13% and now they say 11.8%. The real reason for the drop is 20,000 people gave up on claiming unemployment payments as they cannot qualify under the new and stricter rules. Further, 79,000 fewer people applied for new claims. Like Japan the German economy which is third largest in the world after the USA and Japan has been stagnant for four years. This timing coincides with the cycles and waves of time we alluded to early on in this report. Do you see the patterns? The United States, Japan, and Germany are all tanking at the same time at almost the same speeds headed down the hill. These are the top three economies in the world. After the Euro Constitution is fully disrupted and recognized as such, the Netherlands, Belgians and French can all join this ghoulish deflationary party. We do not dispute the deflationist theories but rather have worked to determine how fast we get to the point when inflation is not even considered. I have said it before and will say it again. Most of the time, our forecasts are correct. However, sometimes we are just a little early. That is why in this inflation-deflation essay, I predict 18-24 months before inflationary pressures subside and deflation gets the primary grip. The WSJ is very good at reporting accurate business information. On Friday April 29, 2005, they had a sub headline announcing “Stagflation fear puts a chill into Blue Chips.” Considering the remarks in this report, how do the readers of Kitco and Trader Tracks feel about this subject? We would welcome e-mails with ideas and personal stories on this subject to share with all readers. And, as usual, we welcome your questions on gold investing, markets and trading.