Trading The Prepper Mindset: Guns, Gold And Hyperinflation

Includes: AOBC, DGZ, GLD, GLL, RGR
by: Larry Trefz

Over the last few years, both gold prices and gun stock prices have seen rapid appreciation due to massive demand. This demand has come in the same time period during which the broader economy has been buffeted by bouts of deflation as the bursting of the housing bubble led to a world-wide credit crisis and subsequent deleveraging.

Chart forSturm, Ruger & Co. Inc. (NYSE:<a href='' title='Sturm, Ruger & Company Inc.'>RGR</a>)
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Ruger SR-556:

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The prices of gold and guns (and gun stocks) are linked, not only by the general time period of their price run-up, but also by concerns that many consumers of both gold and guns share regarding the potential collapse of civilization. Many see the aggressive monetary easing actions (currently $85 billion per month) of the Federal Reserve as resulting in hyperinflation, which they see as potentially causing a more devastating financial collapse than 2008-2009 and leading to the total melt-down of civilization.

As the Fed has continued to fight the deflationary cycle that was kicked off with the housing bubble bursting in 2005-2009 through massive monetary stimulus, a popular movement has grown which believes that their U.S. currency will soon be worthless. This movement has grown so large that there is a reality TV show called "Doomsday Preppers" on the National Geographic Channel. While there are many scenarios covered in the television reality show, a very popular theme is the concern of societal collapse, triggered by hyperinflation.

Hyperinflation is defined as:

Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless. --Investopedia

One of the most noted cases of hyperinflation happened in Germany's Weimar Republic after WWI. In 1919 inflation was already rapidly rising but the government was drowning in war debt so they continued to print money in an attempt to avoid default.

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Source: Takeshi Yashima Blog

This hyperinflation in the Wiemar Republic resulted in the famous situation of a wheelbarrow full of money being needed to buy one loaf of bread.

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Source: "Great hyperinflation episodes in history - and what they tell us about the Fed" --Washington Post

There are some significant differences between what happened in the Weimar Republic and the current situation in the United States that involves central bank monetary easing. The most important difference in my view is the advance in technology that has allowed money to take digital form versus being linked to a commodity.

Back when currency was linked to gold, money supplies could not be expanded easily to combat deflation due to the simple fact that there is only so much gold in existence.

Hyperinflation, as illustrated by the situation in the Weimar Republic, posed the opposite problem. The currency was paper, once it was printed and in circulation is was impossible to recall it at a sufficiently effective rate to reduce the monetary supply for the purposes of fighting inflation. The result of the lack of control over the money supply led to the collapse of the currency and made it necessary to reissue a currency so that commerce could resume in a more normal fashion.

The primary purpose of money is to facilitate the exchange of goods and services in the most efficient manner possible. Thus, the stability (and perceived future stability) of a currency over time is really what gives a currency value.

In modern times, currency is largely digital and the monetary supply can be expanded and contracted with a keystroke. Paper money is a relatively small part of the overall pool of currency. This important difference should be noted when referring to past episodes of hyperinflation.

The Federal Reserve has been given a dual mandate by Congress:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." --Chicago Fed

Price stability is primarily measured by the Consumer Price Index or CPI. The inflation target of the Fed is 2%, which is the rate that they believe keeps the economy growing at the most productive pace.

Historical Data Chart
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As we can see by the chart below the inflation rate is quite tame at present.

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Conclusion: Given the facts, it is not difficult to see that the dramatic increase in the price of both gold (and to a certain extent gun stocks) has been driven largely by concerns over potential hyperinflation rather than concrete evidence of it.

Contributing to the recent skyrocketing demand for guns, is the factor of potentially further restrictive gun laws. This has added greatly to the volume of sales beyond just the prepper mindset and concerns over hyperinflation. The allocation of funds from the average gun buyer to fuel the recent boom in sales is not likely sustainable in the long run but it has caused a massive run-up in the price of gun stocks.

Those consumers heavily involved in the gold and/or firearms market have experienced such a dramatic increase in prices that the concept of inflation has in some cases become a self-fulfilling prophecy as these products have been bid up and the result has been that the dollar has far less purchasing power in reference to gold, guns or ammunition than it did even a few months or years previously. This has led many to point to the prices of precious metals or firearms as evidence of the beginnings of hyperinflation.

Should it be recognized by the majority of the consumers of precious metals and firearms that the rise in prices is not sustainable due to a lack of the presence of an inflationary or hyperinflationary environment, the sales of these products is likely to slow dramatically which could cause a rapid fall in the prices of both gold and gun stocks.

The start of a significant drop in gold prices may already be underway as February 2013 saw record outflows from the GLD ETF.

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I would look seriously at shorting gold should inflation remain under control and broad-market uncertainties remain in check. ETFs that can be used in trading gold include: GLD, (NYSEARCA:GLL) and (NYSEARCA:DGZ).

I would look at firearms stocks (RGR) and (SWHC) in a similar light to the price action of gold, with the added ingredient of the potential for legislative action to restrict ownership of certain guns. The parabolic rise in sales of firearms is unlikely to continue at the same or greater pace than it has over the last couple of quarters as we have seen panic buying due to concerns over bans on certain types of firearms. I would watch earnings releases carefully for a blow-out quarter of sales.

The gun stocks do not appear over-valued using P/E or EBITDA measurements relative to the S&P index. However, the nature of a bubble generally contains another element, which is what we could call the positive feed-back loop. In a euphoric buying situation where the price of the products is being bid up at a parabolic pace, the earnings of the company will rise along with, and generally ahead of the stock price. Thus, the stock appears relatively cheap.

But there is a flaw in this situation, the P/E and EBITDA have been affected by a positive feedback loop of euphoric product buying as a greater percentage of the buyer's income has been directed toward these products than is normal or sustainable. This is the error that will eventually be exposed when the buying mania exhausts itself and the bubble bursts.

I would favor Sturm Ruger over Smith & Wesson Holding Company as a short for its price action and for the reason that Ruger manufactures firearms of a similar class to the AR-15, which has been in extremely high demand recently. If Ruger stock fails to break out above $60, a triple-top could be in place which creates a strong technical barrier. At the hint of any easing in the pace of sales, the stock could decline precipitously. I would watch carefully for a rollover in stock price around these levels. A short position in could be a profitable trade, I would look for a $35 price target in the near term and $20 in the longer run.

Chart forSturm, Ruger & Co. Inc.

Ruger SR-556 Carbine:

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Disclosure: I am short GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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