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 Paul@investfortomorrow.com.

Until next time…


Paul Schatz


Heritage Capital LLC


http://www.investfortomorrow.com/

DEFLATION: The REAL Boogeyman to Fear

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

Over the past year, there has been so much talk about the coming inflationary problem. Some have even speculated that we would see hyper-inflation, like Zimbabwe, Argentina or the Weimar Republic post World War I, where we would need a wheelbarrow full of money just to go grocery shopping. I have not been in that camp. Rather, I am MUCH more concerned about the opposite of inflation, and that is deflation.

In the grand scheme of things, there is a very long-term cycle at play around the globe. If we start with inflation (prices going up and increasing) that leads to disinflation (prices going up at a slower pace). We then move to deflation (prices going down sharply) and finally reflation (prices going down at a slower pace). Our economies and markets tend to function best with mild inflation or disinflation.

At the most basic level, inflation involves too many dollars chasing too few goods, which causes prices to rise. Deflation, however, is too few dollars chasing too many goods. It’s a simple supply/demand analysis. Since late 1998, our economy has struggled with periodic bouts of deflation that really began with the explosion of the Internet. Think about it for a minute. Besides the convenience of shopping from your home or office, why do most people use the Internet? Because it’s cheaper for the exact same product! The Internet has actually caused many goods and services to decline, which is deflationary.

Look at computers, for example. I remember paying $2500 for laptop in the mid 1990s that wasn’t even 1/1000 as powerful as the one I am using right now for less money. Technology is actually a deflationary force that benefits the economy.

If I had to grade it, that sort of deflation would be considered mild or acceptable deflation. The problem we are facing now is much more serious. Every month the government releases a figure called Hourly Workweeks for Production and Non- supervisory Workers, which lets us know the average number of hours worked each week. During economic expansions, that figure tends to rise as companies have more demand and need to produce more so workers work more. It’s fairly simple.

Today, the average workweek is down to roughly 33 hours, which continues to make new lows month after month. Couple that with a dramatic decline in hourly earnings and the U.S. economy is left with wages at 1982 levels. Think about that. The average worker is making the same money as he/she did two decades ago! Since we already know that too few dollars chasing too many goods is deflation, this is not and has not been good news for years.

I have heard all the arguments that the Federal Reserve has printed TRILLIONS of new dollars and that is certainly inflationary. But that doesn’t accurately tell the story. I agree 100% that Helicopter Ben Bernanke & Co. are trying to print their way out of this mess. But they’re not even close. The credit market used to represent more than $50 trillion dollars. Yes, you read that right. $52T. That entire market has essentially been vaporized by the financial crisis. It really doesn’t exist anymore. The alphabet soup of products like CLOs, CMOs, SIVs, CDOs. POOF! Gone. May they rest in peace.

So if the global financial system lost $52T and our Fed, along with the European Central Bank and Bank of Japan printed roughly $10T, that’s still $42T that’s been removed the system, like a giant sucking sound! Try to fathom the global economy losing $42T of spending power. It’s not a pleasant thought! With the banks realizing trillions of dollars in credit write downs and the urgency to raise immediate capital for solvency, that doesn’t support too many dollars (inflation) in the system.

Going a step further, banks have reigned in lending (reducing credit), thereby hampering the economy from a “real” recovery by preventing money from freely flowing. Again, too few dollars in the system is deflationary. I guess this column wouldn’t be complete without mentioning housing, but that really is part of the whole credit market collapse. If the average person’s single largest asset is their house, and prices have been falling for several years, it only adds to the already worrisome deflationary condition.

Deflation is much more difficult to cure than inflation. It’s referred to as a spiral or black hole since once you get into it, gravity pulls you deeper and deeper in. There have only been two examples of this, the Great Depression and Japan for the past 20 years. World War II was the final fix for the Great Depression, but Japan has yet to find a way out. Non-Main Street experts have warned that Japan could actually remilitarize to try to solve their mess.

The most common medicine for deflation is abnormally low interest rates for long periods, coupled with running the printing presses 24/7 and enormously high government spending. In other words, exactly what’s been going on here for the past year. HOPE is one of the worst words to use when it comes to the financial markets or economy. But let’s all do it to make sure that the U.S. isn’t slipping into a deflationary spiral.

Next week: I’ll go to the other side of the spectrum and spend some time talking about inflation and what it really looks like.