Friday, June 4, 2010

Is Inflation STILL Dead?

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

Last week, I talked about the Summer Rally Trying to Begin. The stock market was showing classic signs of being washed out of sellers with so many indicators reaching extreme levels, like pulling the rubber band and finally letting go to snap back in the opposite direction. Everything was set up for a rally to begin, unless of course, it was one of those once every 10 or 20 years where the system temporarily breaks and we see an elevator shaft mini crash. The odds heavily favored the rally.

Fast forward a week and the market is basically in the same spot. We saw two modest down days and one big up day, plus today (June 3) which is up slightly as I write this. Stocks are “supposed” to get in gear to the upside now, but they are certainly taking their sweet time. The longer it takes to really get going from an extreme oversold condition, the less powerful the rally usually is.

Since I stand by my year old forecast that the next rally is the last one before a major correction sets up, the market continues to live on borrowed time. As a bull, I would like to see the Dow Jones close above 10,500 to confirm the bottom has been hammered in and set the stage for a move towards 11,000. I reiterate my risk/reward comment from last week that it’s plus or minus 5% on the downside and 10-15% on the upside.

Although I’ve been very positive on gold since Gold Getting Ready for Another Assault in mid March, my position has not changed one bit in the past THREE YEARS that inflation is dead, kaput, dormant, asleep, etc. As I’ve mentioned before I am far from a gold bug, even though our firm has more assets in our two gold strategies than the other seven and rising gold has significant benefits here.

Research has shown that gold is not a good predictor of inflation nor is it the best protector against inflation. In industry jargon, you could say that gold is not highly correlated to the CPI, which is the consumer price index, a popular measure of inflation.

For a long while, I’ve struggled to figure out how I could be positive on gold, yet still believe that deflationary forces are the dominant player in our economy. Deflation, the general decline in the price of goods and services, is the exact opposite of inflation and was the topic here last year, DEFLATION: The REAL Boogeyman to Fear. During “normal” deflationary times (if you can even use such a cavalier word for this), which there are only two modern day examples, almost all assets decline in value. It’s often referred to a black hole or spiral as the gravitational pull sucks everything in and won’t let it out.

Anyway, during deflation, as we saw in the 1930s and Japan since 1990, gold declines along with other hard assets. As we saw in 2008, there is mass run to the safest currency, the U.S. dollar, along with other “safe” instruments like treasury bills, notes and bonds.

So, if I think deflation has more to play out, how can this foot with being positive gold?

My answer comes from looking across “the pond”. The Atlantic Ocean, that is. The only way I can see gold rallying during another bout of deflation is if we see a stampede away from paper currencies. We’re all watching the mini collapse of the Euro currency now as their problems continue to worsen. What if those problems spread to Asia and back to America later this year and into 2011 and 2012? Wouldn’t that cause the global governments to fire up the printing presses that would make 2008 look like a picnic? That’s the only way I can see gold rallying with deflation. It’s not a pretty picture and I pray the various Feds and governments wake up fast enough to head off that stampede.

Back to inflation (or the lack thereof) to finish this post. I never bought the idea when the Fed began printing money and creating all these cutting edge, outside the box programs that inflation would rear its ugly head. And when they went to Red Alert, their quantitative easing programs and began buying treasury bonds and mortgage backed securities, I knew Bernanke was in panic mode that a deflationary spiral was setting in.

I’ve said this for three years now. Ben Bernanke would light up a cigar, open the best bottle of wine he could find and do a victory dance if the Fed could somehow engineer a little inflation. With wage growth negative, capacity utilization modestly recovering from the abyss and money velocity tame, there is almost zero chance for problematic inflation until we overcome the deflationary pressures.

FYI: I will be on CNBC’s The Call on Mon., June 7 between 11:05am and 11:20am.

Feel free to email me with any questions or comments at

Until next time…

Paul Schatz

Heritage Capital LLC

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