Saturday, January 10, 2009

Deflationary bear market

The deflation versus inflation debate rages on, but the market has spoken. We are in a deflationary bear market. This will not suddenly morph into a hyperinflation anytime soon. This has many investment implications. The first is that cash is king. The value of the U.S. Dollar will fluctuate, as will all currencies in our current fiat disaster, but it will hold up until this cyclical bear market is over. In other words, cash will be able to buy more stocks, real estate, commodities and bonds later than now.

This comparative value is important because value is relative when currencies, or money, are unstable instruments. In other words, the U.S. Dollar Index could fall but still gain in value relative to other things. If those other things are what you desire, then you have become wealthier. The easiest examples to perceive this in everyday life are food, consumer goods, and real estate.

If you have the same amount of money as at the beginning of the bear market because you went to cash, you have more cash than someone who stayed in stocks, real estate, or commodities through the fall crash. This means you are wealthier in both a relative and an absolute sense because not only do you have a greater nominal amount of currency value assigned to your investment account(s), but you can buy more food, consumer goods and real estate because these things have fallen in value.

The reason I bring this up is due to the confusion regarding the value of gold. People think that in a severe deflationary bear market, gold will be a lousy asset to own. This is false. Even recent data shows this to be true. If an investor picked the very top of the stock market on 10-11-07 to buy gold or go to cash, the day the stock bull market ended and the day before the current deflationary bear market began, here are the returns for cash and gold for a U.S. investor denominated in U.S. dollars:

The assumptions I used to generate these figures are as follows: I assume the person bought at the highs for the day on 10-11-07 using the continuous futures contract price for gold and the U.S. Dollar Index for cash and used the closing price at the end of the day 1-09-09 for these, and I gave the investor in cash a total of 6% simple interest over the 15 month period to determine how much $100 would turn into.

Some believe that gold only does well in an deflationary environment when it is pegged to the currency, as occurred during the so called first great depression (the second one has started, by the way, in case no one has told you yet). In an early deflationary period, it is true that paper money/cash may outperform gold, but as the deflation intensifies (i.e. what's actually going to happen next in the real world), gold becomes a more sought after haven than fiat currency/paper cash.

There are several reasons for this, but they all boil down to trust. Keep in mind that the government and our central bankstas are trying to create inflation. They are in fact doing everything in their power to create inflation. Short-term government set interest rates are essentially at zero and fiscal "stimulus" (i.e. government debt creation to offest the slowing in private debt creation) is accelerating at a reckless pace. In other words, the government and our central bank are fighting the trend of having a strong currency!

As a believer in free markets and a non-believer in the magic wands of bureaucrats, I trust the ongoing storm of deflationary market forces will trump the action of elected officials. If you believe otherwise, why didn't these people see what was coming and prevent it from happening in the first place? Anyhoo, as deflation intensifies, the government is going to pull some pretty crazy crap and try to defy reality. It will expand debt aggressively in the name of trying to do something to get re-elected and placate the masses.

In this deflationary environment we are in, credit contraction is occurring / credit is becoming scarce. As examples of this undisputable fact, 103% loan to value mortgages have essentially disappeared and the commercial paper market had to be "stabilized" by the Fed to prevent an implosion. Well, there is even a limit to how much government debt can be created. The leash on government spending is market revulsion toward long-term government bonds/debt when the debt load becomes too high relative to the government's income and/or people's desire to hold this debt. If you look at a 30 year U.S. bond price chart, we are clearly approaching this point. Perhaps anticipation of a second massive round of Obamanation stimulation (notice the first is being put together before he even takes office?), once the first fails to do anything but waste money, will tip the scales.

When the long bond price plunges, the interest rate goes up and government ability to borrow more drops. If market intervention by the Fed attempts to prop up the long bond, then the currency will devalue in response. The important thing to remember is that every piece of paper money is backed by the U.S. government ultimately, which is where it derives its value from. Dollar notes are debt instruments and when the credit rating of the person/company/entity standing behind any piece of paper/debt note decreases, so does the value of the promise implied by the piece of paper/debt note.

All major world currencies right now are paper promises by the governments that stand behind them and all are debt instruments. We all know how reliable the promises of governments are in times of trouble. This is why gold is the ultimate currency. It is no one's liability and is accepted as valuable around the world, even if it can't be spent directly at WalMart. As deflation intensifies and one after another government promises a bailout, stimulus, stabilizing measure or whatever other crazy-ass bullshit they come up with to try to improve our economies, currency fluctuations will become more unpredictable and violent.

People will swing from one currency to another based on relative debt loads incurred as debt is suspect during deflation. Gold has no debt. With cash now yielding close to 0%, interest payments are no longer a valid argument for preferring paper money over gold. Bank holidays don't affect holders of physical metal. No confidence smokescreen is needed to assure gold's value - a few thousand years of collective human experience and wisdom have already created it and no modern government can replace it by issuing a decree. Not that they won't try...

Gold is not a way to get rich (that's what gold stocks are for!), but it is a protector of wealth and should be a bedrock of your portfolio in the current environment. Physical gold in your possession has no counter-party risk and no risk of having its value destroyed by the reckless whims of ignorant government apparatchiks. When the dust settles, there is no doubt that gold will have survived the deflationary storm intact and will be able to purchase much more real estate, food, consumer goods, stocks, bonds or whatever else your heart desires. Though cash will do the same, the built in free insurance policy gold provides against potential future currency dislocations is no longer a trivial bonus.

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