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Deflation: As Good As Gold?

|Includes:SPDR Dow Jones Industrial Average ETF (DIA), FXE, GDX, GLD, IAU, QQQ, SPY, TLT, UUP

It has been a year since gold began its downward biased consolidation out of the acute phase of the Euro meltdown and resulting hysteria. In that time, the deflation case was released from the jail that had been a heightened public fear of inflation (the pinnacle of which was in spring of 2011, a time when bond king Bill Gross was very famously short long-term US Treasury bonds).

The most recent red arrow on the chart above came during this time when inflation expectations were threatening to break down the barn door. Gross was short the bond, people were upset about gas (and general commodity) prices and an austerity-focused mob with pitchforks was assembling for a march on the Fed, with Ben Bernanke's head its main goal.

Gold has now done enough time in the out house that its promoters can begin to beat the drum on its price again as its consolidation/correction does technically look like it is completing. Personally, I am much more comfortable with it now than I was last summer amid the euro hysterics and ridiculous upside targets.

It is not to say some of these targets (3500 on up) will not be realized one day, but it is to say that people obsessed with inflation - and in particular, hyper inflation - are barking up the wrong tree. The upward bias of the 'continuum' (the long-term uptrend in the long bond and/or the long-term downtrend in the yield) shown above tells us that deflation is the big picture condition. Inflation is what the managers of the Keynesian global economy periodically try to do to this natural economic condition that would cleanse the system (or clean its clock) if left to its own devices.

Since I began writing eight years ago, the big theme has been a deflationary need to correct vs. man-made policy trying to inflate. We use the continuum above to try to establish points at which the various adherents (inflationist and deflationist) will be tragically wrong. The most recent confirmed point was spring of 2011 when commodity crazed inflationists raised their dogma to a fever pitch just as the bond was about to ping off the lower limit and rise into the current deflationary backdrop.

Today, in part using the same chart, we have anticipated this summer's bullish reversal moving against the huddled masses in T bonds, against precious metal, commodity and stock market bears and against the deflation case. But it is that very same deflation case that must be respected at all times because the natural forces of the market will likely one day overwhelm the will and egos of mere mortal policy makers, QE3 or no QE3.

While I respect the Austrian viewpoint and the idea of von Mises' 'Crackup Boom' into an inflationary death spiral, I think a deflationary unwinding - intrinsically worthless US dollars and all - is at least as likely and probably more so.

Promoters of various and supposed 'inflation hedge' products like precious metals, commodities and in some cases stocks root for the Austrian view (at least up until the 'crack up' phase of the boom), as they would continue to be enriched by the process as the public seeks 'safety' from inflation. But most commodities (and many stocks) will see price erosion during economic contraction, which of course goes hand in hand with the deflationary impulse. No matter whether the end game is an inflationary spiral or a deflationary one, businesses and economies are going to suffer eventually.

In the event of deflation, economies will suffer from the withholding of expenditures as people build and save cash. If the event is intensely inflationary, people will spend cash and drive up speculations of all kinds - including and especially the prices of necessary things - making bottom line costs for most companies untenable. The result would be continued grinding economic deceleration and in my opinion, an eventual deflationary end.

After more than a decade of the inflationary play, which began with Alan Greenspan's willful decision to preempt deflation out of the 2000 bursting of the technology bubble the public has become very aware of inflation and policy makers have become very sensitive about perceptions. These are dangerous times because policy makers from Mario Draghi to Ben Bernanke are like wounded animals. The wounds would be inflicted on their reputations and their legacies.

Aside from the recent 'Huey, Dooey and Louie' (we need QE3 now!) stuff coming out of some Fed members seemingly playing the market expectations game, there is a growing theme from the more rational and well-spoken members like Richard Fisher. More inflation is going to get us in bigger trouble down the road. Policy makers know it; they are not stupid.

Yet sadly, it is not as if deflation can be a positive solution now. Before the system was perverted - first by Greenspan and then by the Wall Street and financial services industry machine pitching all manner of leveraged and worthless garbage - modern, developed financial systems are too far out on a ledge for the fallout to be anything but complete, and utterly destructive. This is THE case for 'QE to infinity' as it is called by some. But it is no done deal; not by a long shot.

As often happens when I get on this subject, I rambled away from the intended theme. Is deflation as good as gold? The answer is that for someone who prepares for it by always managing risk, deflation can be better than gold. While I have maintained from day one that gold is about value and capital preservation over the long run, it should not be a 'play' on inflation and people certainly should not be buying up the 'gold is silver is copper is oil is hogs is tin' inflation promotion the next time the 'continuum' chart above approaches a red arrow.

Gold is gold; a tool for monetary survival. It may go down in a deflation, but then again all those deflated dollars would not suddenly gain intrinsic value simply because more of them are being horded. The rush for cash that would result from a deflationary unwinding would provide an opportunity for properly positioned people to buy all kinds of things, on the cheap. Property, resources, equity in quality companies... you name it... if you like it now, you would absolutely love it if it goes on sale as a result of a final unwinding of the current system.

My opinion is that gold was a big time buy early last decade and that the general inflation play is only that, a play to be gamed when the chart above says the probabilities are in line. This can go on as long as the current system goes on. Meanwhile, whatever combination of cash and gold works for one's individual situation is the only recommendation I could make beyond the intermediate 'trades' that the continuum presents.

Meanwhile, dialing in to the here and now we remain on the most recent turning point as implied by the continuum. So it is back to swing trader mode and the various 'plays' that are being presented. Just remember that cash and gold are the long term plays until the system is resolved. I would absolutely love it if you would sign up for's free (and spam free) eLetter that will help you get to know my work in finer detail.

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