The Economic Collapse Cycle - Where We Are Now and How to Invest Accordingly

Includes: HL, SLV, WPM
by: Galt's Gulch

Recently, the hyperinflation-deflation debate has flared up again. What readers need to understand is that this question is really a distracter – the issue is not either/or hyperinflation/deflation – the key issue is where we are in the collapse cycle’s chain of events shown below.

*One key caveat – this cycle is a general theory – war, economic events, and other factors can impact it significantly.

So, where are we today in the cycle? This author believes that we are at the end of the “rising inflation” stage, with the recent announcement that the BRICS are further denominating trade between them in local currencies instead of the USD. Thus, deflationists can be forgiven for believing that we are in the previous stage, as housing prices continue to fall. However, the hyperinflationists remain right - the key point to remember is that deflation LEADS TO hyperinflation.

The reason why the deflationists are no longer correct is straightforward. Deflation is a step in the collapse process in two ways: 1) by hurting the confidence of individuals in the government and 2) by forcing government to “do something,” which usually means entitlement expansion. Since entitlements usually don’t shrink in a democracy, after a few repetitions of this inflation/deflation short cycle, the entitlement spending and the public’s frustration grow to the point where the people start wondering how much of what they thought they earned was “real.” At this point – if the government is too indebted and won’t change, the cycle moves to the hyperinflation track. The more financially-savvy buy “real goods.” As a group, they tilt the economy into net inflation (as their money velocity goes up). This time, inflation is DIFFERENT from before. Confidence is gone, leading to growing inflation and goods-stockpiling, which reinforces itself into hyperinflation.

The chart has one caveat – each box DOES NOT represent a periods of total inflation/deflation. It only shows which element is in the “driver’s seat.” There will ALWAYS be elements of both in inflation and deflation in ANY time period. So, deflationists who note housing is falling are correct. But - deflationists miss the impact that rising money velocity has. In other words – there is always enough money to spark hyperinflation. The only condition for hyperinflation is a loss of confidence that increases money velocity - once that happens, people start withdrawing money from banks to spend, forcing the central banks to print physical fiat currency to respond to “the demand for money” which is caused by an oversupply of credit – if they can’t turn credit into cash on demand, they’ll crash people’s confidence in ALL credit, which is even worse than printing money.

Deflationists ask “where does the money come from to cause hyperinflation?” Many hyperinflationists are technically wrong when they say “that the Fed printed TARP money ” – the Fed printed credit, and deflationists understand that credit is NOT money. However, deflationists must understand that this doesn’t mean credit cannot BECOME money either.

Let’s take the following example. Imagine that you own only $1000 - 10% ($100) at home, 90% ($900) in a bank. At the collapse checkpoint, you believe that the government can’t handle its finances. You take out another $100 “just in case.” Your $200 is now double what you held IN CASH before – if everyone acted like you, the money supply would have to be doubled. Then higher inflation comes, but your savings account only gives you 0.50% interest. You think “why am I holding money at a bank that pays no interest?” You realize that to pay bills, you need some money in the bank, but you pull the rest out. Out of your $900 in the bank, let’s say you take $500 out to speculate (leaving $400 in the bank).

Now there are 2 cases: 1) You gamble and double your money ($1000 in the speculative account). Your assets are now: $200 at home, $400 in the bank, and $1000 in the trading account. You then might think “maybe I should take money out of the trading account” and take $100 in cash from your trading account (which now has $900). In this case, you now have $300 on hand – triple your original amount OF CASH. 2) However, let’s take a step back and say you LOST money when speculating – out of $500, you lost half ($250). You give up on stocks and say “It’s not working for me – I’ll just hold cash.” You convert your $250 in the trading account into cash – bringing your total cash to $200+$250 = $450 – or 4.5x the original amount of cash you held before. Either way, from the Fed’s perspective, your personal money supply increased 3-4.5x what it was before.

The key points here are that 1) most people hold a surprisingly small amount of physical cash, and any hit to confidence will increase that preference for cash. 2) Credit makes this problem worse, because the more credit people have, the more they will want to convert to cash when they “get it.” 3) This leads to the ultimate catch-22 – to avoid a systemic bank run, the Fed MUST print physical cash – but the more cash they print, the more they increase the chance of bank runs. At this stage, for the United States – hyperinflation is already inevitable barring extreme changes.

What to do about it: It's well known that precious metals are the inflation hedge of choice - of these, gold and silver are the metals that usually stand out. Based on the longer-term gold-silver ratio of 1:16, which has held on average over the last few centuries, silver is extremely undervalued vs. gold at its current ratio of 34. Furthermore, official stockpiles of silver (such as the USG horde) have been fully depleted - meaning that for the 1:16 ratio to be re-established, silver must be priced lower than 1:16 for years to come before the supply can be re-established.

There's also much less silver compared to the industrial demand than for any other metal - and industrial demand for silver is much more price-inelastic than for most inputs. Finally, there's the popular and probable manipulation case stating that certain bullion banks are short enormous amounts of paper silver and are being forced to cover, resulting in a skyrocketing price. As an ounce of silver is currently only 1/34 of the price, it's a much more affordable bulk item than gold and appears to be the better buy.

After establishing a core position in physical silver, any money dedicated to stocks should be positioned in solid silver mining stocks. Current suggestions include well-known, relatively safe companies such as SLW, which has the best business model with few personnel, fixed payments, and unhedged silver inflows, while being an institutional favorite. SLW is also priced at far less than its year high, while silver is making a 30 year high, so it is poised to benefit from high silver prices that should flow to the bottom line.

HL is one of the most levered "big players" in the US in silver and should be viewed as a relatively tame "risk play" that is still safer than junior miners by far. The company's stock has been hit on news of a cave-in that has either trapped or killed a miner, and management has responded (rightly) by shutting production down at the mine in question to focus on rescue operations.

The overall thesis for both mining company plays is that in high inflation/hyperinflation, these stocks must rise significantly from: 1) the value of their debt eroding over time to nothing, 2) their production of real goods (silver) to sell at market – meaning their income includes the “hyperinflation premium”, and 3) their fixed real (not nominal) costs, so with increasing revenue and fixed costs, net income increases by multiples, making the stocks much more valuable. It is this author’s opinion that while physical silver provides the peace of mind and a high return, the right mining stocks could produce 5-10x the already enormous return on physical silver.

A future article will dive further into the silver mining sector to find the ultimate "risk capital" plays. It will focus on finding the WORST-OFF junior mining companies already producing (mostly) unhedged silver that can survive. Stay tuned, and keep buying.

Disclosure: I do own GLD puts and physical silver.