There have been quite a few threads on Elitetrader on the related topics of gold / inflation / deflation. This post summarises my thoughts on these topics. Main influences: Chris Martenson http://www.chrismartenson.com/ http://www.youtube.com/user/ChrisMartensondotcom Author of the "Crash Course" which covers various obstacles that will face the earth's population now and in the next 20 years. These include an exponentially growing money supply in a finite world, human overpopulation, peak oil and overuse of the earth's natural resources. Marc Faber http://www.gloomboomdoom.com/ http://marcfaberblog.blogspot.com/ http://www.youtube.com/user/MarcFaberChannel Jim Rogers (My understanding is that he thinks Asian countries will do better than the US in the coming years) Michael Shedlock http://globaleconomicanalysis.blogspot.com/ (Strong believer in deflation) Where are we now? * Significant decline in equities from mid-2007 to March 2009. * S&P 500 rose by over 60% from the intraday low of 666 in early March 2009 to September 2009. Despite the recession, total US debt / GDP ratio still remains at levels that are (1) similar to that seen in 2007 and (2) higher than 1929. Why is US debt still at 2007 levels despite the recession? Despite reduced levels of debt for consumers and businesses (seen by either debt repayment and/or debt default), the US govt has increased their borrowings in order to keep the US economy afloat. Where to from here? (part 1) There are some commentators (look at articles on 321gold.com for example) who strongly believe that the US will experience high inflation or hyperinflation in order to print away this debt. Likewise there are some analysts (Mish Shedlock, Hugh Hendry) who believe that the US will experience deflation, and that the debt will be reduced mainly be defaults. To be overly simplistic, letâs assume that these are the only two possible outcomes. Evidence Inflationists will point to the rising US Dollar gold price, ultra-low Federal Funds rate and powerful people (Bernanke, Geithner) who will take extraordinary measures (and incur extraordinary amounts of US debt) in order to support failing businesses and support economic growth. Deflationists will point to: *declining high (and rising) unemployment / underemployment, *declining wages, *steady inflation expectations, *bond bull market, with a 10-year yield well below 3.50% and 2-year yield well below 1%, *money supply numbers declining, *insolvent banks, banks unwilling and/or unable to lend, *consumers / businesses unwilling to borrow and low money velocity. Mish and Hendry also argue that despite the best efforts of Bernanke and Geithner, their actions are insufficient to keep the economic growth party going. Where to from here? (part 2) In a hypothetical market free of government interference, I would readily side with the deflationist camp, because in the absence of the extraordinary actions taken to support failing businesses (mainly financial companies, but also companies in other industries), the US economy would be in much worse shape. So the question then turns to the effectiveness of the actions of Bernanke and Geithner. As mentioned previously, the actions of Bernanke and Geithner have reduced the severity of the recession. In this respect their actions have been effective. Although the stockmarketâs 60% plus rise since March has CNBC presenters frothing at the mouth and declaring this the start of a brand new bull market, most Treasuries yields formed a double top in June 2009 and August 2009 and have been declining steadily since then. It is important to remember that in 1930 the stockmarket experienced a similar 50% plus bounce before it hit new lows later in the year, and kept on falling in 1931 and 1932. It is important to remember that the Japanese stockmarket experienced a similar 50% plus bounce in the early 1990s, however the Nikkei is at about 10,000 today, still 75% below the peak seen in 1989. For these reasons, it is reasonable to expect that deflation will be the prevailing trend; that the actions of Bernanke and Geithner, while extreme, are not sufficient to beat the deflationary storm engulfing the US. Hugh Hendry, for example has stated that he believes that the US should be printing close to $10 trillion to buy various securities in order to fight deflationary forces. But wait, thereâs more Letâs assume Iâm right, and that the stockmarket resumes its secular bear market, and that the S&P 500 falls below 1000, below 900, below 800, below 700. Letâs also assume that a few mid-size banks (not considered too big to fail) go under, and economic contraction (ânegative growthâ) continues, and unemployment rises above 15%. In this type of situation itâs reasonable to expect at least a small possibility of Bernanke and Geithner implementing additional measures in an attempt to support the economy. Ultimately these measures would result in a higher US govt debt burden. This is essentially Marc Faberâs view (http://seekingalpha.com/article/163919-marc-faber-equities-safer-than-dollars). In the Bloomberg interview mentioned in this article, Faber argues that the US authorities will continue to print more and more money, and that in the coming decade the US Dollar will implode. Investment choices In a deflation scenario (absent additional government support), stocks will decline significantly, and gold will probably also decline, but probably by an amount less than equities. In a Marc Faber scenario (additional government support), stocks will continue to rise, and gold will do even better. Either way, my view is that you donât need to be right with regards to the inflation / deflation debate. All you need to know is that in the coming decade, gold (in US Dollars) will outperform US equities.
Important questions to ask before taking multi-month positions: Can financial markets remain irrational for longer than you can remain solvent? Yes. What have been the effects of Federal Reserve / US Govt actions on financial markets? The actions helped to prop up failing financial institutions. The actions helped to start a nice 60% bear market rally in the S&P 500. What have been the effects of Federal Reserve / US Govt actions on the "real economy" ? The actions have slowed the rate of the economic decline, however it is important to note that: > The rate of money supply growth has declined towards zero > The rate of bank credit growth has declined towards zero > Unemployment is higher than it was in March 2009 There has been a recent increase in media attention to the decline in the value of the US Dollar against both fiat currencies and gold. Does this mean inflation is certain? Although gold is sniffing out inflation in the coming years, it is important to note that the ten-year bond yield has declined over the past few months from about 4.00% to about 3.20%. Usually the bond market is more "intelligent" than other financial markets. ie., there could be a significant decline coming in the coming months for equities and gold (priced in US Dollars). However, as mentioned in my previous post, if such a decline occurred, and it was significant, then there could be additional Federal Reserve / US Govt actions that could halt that decline and send prices of equities / gold higher.
Good post. I know its fashionalbe to say the bond market is more "inteligent" than the stock market, but unless I see some empirical data proving this, I will take issue with that statement. What seems to be crystal clear is that bonds, gold, and equities cannot all continue to rally together for much longer. As we are now entering the quarterly financial engineering Olympics (otherwise known as earnings season), I don't see a catalyst for lower stocks prices in the near future.
I strongly agree. I strongly believe that equities and gold will continue to have a strong positive correlation, because of their perception (rightly or wrongly) as both being 'risk assets'. Therefore I see two possible scenarios: 1. Bond yields start to rise (particularly at the long end of the curve) and gold and equities continue to rise. 2. Stocks and gold fall. My hunch is that #2 will happen, but the govt and/or Fed will then prop things up again and #1 will happen, which should result in (long duration) bond yields finding a floor. However my core position is long gold / short equities so I am agnostic about bonds. I understand your point. That's why I tried to soften the statement by prefacing it with the word usually. The best empircal data that I can provide (of the top of my head) is that US bond yields peaked several months before the stockmarket in 2007.
I am also watching crude oil (interesting to see that it peaked in June and August at roughly the same time bond yields peaked) and GBP/USD (also formed a double top in June and August) for clues about future market direction.
Interesting article from Chris Martenson on the deflation versus inflation debate. http://www.zerohedge.com/article/gu...nd-clapping-what-deflationists-may-be-missing Specifically, he does a good job of addressing the question of why stocks are up so much in the face of a contraction in economic activity ("negative growth") / high and rising unemployment.
One of the bad things about writing a public journal is that you became reluctant to admit that some of your trades are wrong because you dont want to look like an jackass. Its something I have gotten better with but I still could improve more I just find that the upside of clearing your head, balacing pro and counter arguments for each trade and hearing constructive criticism is bigger than the downside. For instance I dont think I would have ever gotten the confidence to bet big on ZQ since 2008 had I not wrote down the arguments. Once I did it, I got the confidence to go for it
Thanks Daal. For what it's worth I am focusing less and less on individual companies, and more on individual asset classes. Why is that? With the Fed / US Govt changing the rules regularly, there is a lot of risk with shorting individual companies. I am very comfortable with my long gold / short equities position, with the gold/$SPX ratio approaching 1.00 again. If the ratio pulls back towards 0.92 I will look to add to the position. I am targetting at least 2.00 in the coming years, but history has shown (see the 1930s for gold/$DJIA and 1970s) that it can get as high as 5.00. Also for what it's worth I am a believer in peak oil. Although the economic contraction over the past couple of years has reduced demand for oil, particularly in 'western' countries, there is a strong chance that the world has passed the Flow Rate Peak. (see http://www.elitetrader.com/vb/showthread.php?s=&postid=2596953#post2596953 for more information on this) Therefore I believe that: (1) in the coming years, oil (in US Dollars) will outperform US equities, because the Flow Rate Peak has passed. (2) Eventually higher oil prices will result in reduced economic contraction, which is bad for equities and therefore (3) in the coming years, oil (in US Dollars) will outperform US equities, because it will be hard for US equities to rally significantly in the wake of low GDP growth / GDP contraction that results from higher oil prices.
FWIW: http://www.federalreserve.gov/fomc/fundsrate.htm from June 2004 to June 2006, the Fed raised rates from 1.00% to 5.25%. Despite these rate rises, gold raced up to 725 USD or so in mid-May 2006. From memory in May 2006 and June 2006 there were plenty of hawkish speeches from Fed officials, despite the rate rises ending on 29 June 2006. My thoughts: Talk is cheap. Although Bernanke and company may talk about rate rises, I will believe it when I see it. Even if and when they do raise rates, it's unlikely they will raise them by much.