Gold, Silver During Deflation: Sell the Metals Short

 |  Includes: DBP, GLD, SLV
by: Nikhil Raheja

The investment with the most potential in 2009 is precious metals. However, the opportunity is in selling short the metals. Gold and silver are much above their fundamental values. Precious metals have an inverse relationship with the currency, when the currency loses value, price for precious metals rises. Also, when the country sees high price inflation, people buy things that can hold their value, mostly precious metals. Sometimes, they overdo it.

During the last 6 months, credit in the country has decreased, as lenders have hoarded their money. Lenders, including banks and traders are not willing to lend, and as a result the interest rates in the country have gone up too much. An average 10 year junk bond yielded close to 23% in December. Even though the yield has fallen to 18%, it is still extremely high.

Historically, a junk bond has yielded close to 5% over the comparable treasury yield, while it now offers a premium of 15%. High yields mean fewer people can borrow and they borrow at high rates. This prevents a lot of people from opening businesses. Even though the Fed has added enough money over the last 1 year, the money will not be used until the yields fall to their historical average.

As the the debt rates are extremely high, lower money use causes prices to fall, and that demotivates people to spend their money, also people lower their credit balances since their incomes are much lower owing to the lower production.

As all this occurs, consumer prices fall, and the currency gains value, putting downward pressure on gold. Gold rallies occur during frenzies, where people are convinced consumer prices would continue to increase and their purchasing power would continue to decline; this is not that time.

Gold prices are close to their all time high of $1040 an ounce. They are likely to fall significantly over the next two years. Also, a lot of hedge funds and economists are predicting gold will go higher. Almost every person on the street has a relative or neighbor who is buying gold. This is a classic signal of a bubble. Masses can only become rich in a bubble - forex bubble, Nasdaq bubble, housing bubble - but these bubbles always end badly.

Gold will have its day once the deflationary phase is over. Then, the excess money supply would be used to make more producer and consumer loans leading to higher prices. That day, however, is a few years away.