Deflation Anxiety and Gold

The stock market did not have time to come back to its senses before the “R” word started to dominate the discussions (see What the Fear of Recession Brings to Gold). This can be credited to the weakest nonfarm payroll report in four years. The trouble is the employment report, being a lagging indicator, is in a downtrend and no one quite knows how bad things really are at the current moment. It cannot be ruled out that in a few months we will look back and discover that during September the economy entered a “R”ecession.

There now appears to be several different camps among the market analysts:

• One camp predicts that the crisis is far from over and that the most serious problems are yet to emerge. They are certain that “the other shoe” is going to drop and a credit/collateral deflationary crisis will reemerge prompting markets to turn downwards. Only then will the Fed, finding itself behind the curve, finally act decisively by cutting rates by as much as 200bp, to 3.25 percent.

• The second camp insists that the worst is almost over; the analysts in the camp express confidence in the Fed policy and say that the government bailout policies will pull the economy and the credit market out of the current mess. The excess money in the economy did not disappear overnight and the bursting of the housing bubble is likely to create another bubble somewhere else due to the central banks’ reflationary policy. Why should the Fed worry when the S&P 500, the Dow and many markets around the world are close to all time highs?

Besides the moderate viewpoints described above, there are two more camps who have taken a more permanent stance:

• One still believes that the economy is strong and that the Fed’s priority is to maintain an anti-inflationary stance.

• Another consists of perma-bears who believe that another Great Depression is on its way but who are still debating whether the coming crisis is going to be deflationary or inflationary.

There are strong arguments to all sides. Only time will tell who is right. The Fed does not know the answer either – fight inflation or deflation – and has stayed put for the past 15 months. But for the most part, investors are sure a rate cut is on its way after such a long waiting period. The market is watching the Fed while the Fed is watching the market.

The latest employment report opened the door for the Fed to cut rates and at the same time maintain its credibility. If the markets weaken significantly before the meeting, the Fed will have plenty of room to become a recession fighter and aggressively lower rates. However, if stocks continue to hold up well and gold continues to flash an inflation signal, the Fed will be more likely to show its tough side at the next meeting on September 18.

What scenario for the next 2-3 months do we expect to unfold? As tensions in the financial sector are building, indicated by the rising LIBOR, there is a high possibility that another dirty little secret could emerge from one of the banks or hedge funds and cause the markets to lose their nerve. Even if “the other shoe” does not drop, there is still a risk that the Fed may not match expectations of a 50 basis point cut in September. In either case stocks should retest their August lows.

As a result, deflation fears will emerge giving the Fed a green light to inflate without endangering its credibility.

It is difficult to believe that the Fed and its colleagues around the world will calmly watch as the stocks are breaking below August lows. Instead, as always, they will flood the world with cheap money causing a sharp rebound in stocks – highly bullish for gold. Another factor is the strong yen which is killing the main driver of the Japanese economy – the export sector. Japan will have no choice but to devalue its currency to support its economy. Such intervention can prompt another wave of the yen carry trade. Watch for the 110 level on the yen.

Our main conclusion is: as a result of the influx of liquidity due to the deflation anxiety, a significant breakdown below the August levels is doubtful.

The market sentiment conditions are extremely negative, which also supports our view. The NYSE and the NASDAQ Public Short Ratios are now extremely high – meaning the public is in record short positions while specialists are still reluctant to short. The Investor’s Intelligence Sentiment Survey bull ratio has fallen to a very low level. We do not see a single sentiment measure that does not show a highly negative if not an extreme reading.

A bearish sentiment level among the public at the same time when the price action has been rather mild (S&P 500 is only down 5% from its high) is a very positive divergence which should establish a floor for the coming correction.

If we turn out to be right then another stock market decline will temporarily hurt gold and silver stocks as well. True, there have been signs that the precious metals sectoer the last week was the beginning of a large inflow of funds into Barrick (ABX), Agnico-Eagle (AEr is starting to move independently of the broad market. The major change we have seen ovM), Newmont (NEM) and a few other majors. What’s happening here is that the smart money is starting to move to our side – making major reallocations into the gold mining sector. Not only is this happening to gold stocks but also to gold as well. Street Tracks Gold Shares ETF (GLD) added an unprecedented 34 tonnes in three days ending at 549.42 tonnes on Friday.

But a couple of days don’t make a trend. What can be reasonably expected is that during the coming retest of August levels, precious metals stocks will make a higher low. This should present one of the best buying opportunities, especially for the greatly undervalued junior mining companies. But for now we continue to believe that it is prudent to hold core holdings and wait for another wave of selling before aggressively adding to positions.