The deflationist view, which makes some compelling and elegant arguments, maintains that the credit losses in the U.S. financial system far surpass the size of the government’s monetary and fiscal stimulus. All those trillions in bad loans – plus the yanking of credit from consumers and businesses – overwhelm new money creation. The Fed, in other words, is trying to fill a swimming pool with a Dixie cup. This might take a while.

Therefore, this reasoning goes, the greater risk is that asset prices continue to fall. This is the classic debt-deflation point of view. I don’t dismiss these arguments lightly. I’ve spent some time going over the arguments of some of deflation’s most persuasive and sophisticated advocates – like the successful Treasury bond investor, Van Hoisington and the insightful economist, David Rosenberg.

Still, I think the endgame is for inflation — which is when paper currencies buy less. Given the choice of holding U.S. dollars or real assets (such as gold or iron ore or land), I’ll take real assets.

Over the weekend, Thomas Donlan at Barron’s presented a good analogy for it all. He asked what you would rather own as store of value, bananas or corn? The obvious answer is corn, because you can store it for months. Corn lasts longer than bananas. Fruit rots. You can also use corn for a lot of different things — corn flour, animal feed, etc. You can also arrange to sell corn into the future, say, by arranging to deliver corn so many days from today.

Corn can lose value, obviously, as can any real asset. But it is a better choice than holding the bananas.

Donlan likens paper money to bananas and natural resources to corn. “In the modern economy,” he writes, “a barrel of oil is much like a bag of corn… Paper money and bank balances are more like the bag of bananas.” When currency rots, we call that inflation.

The problem with the deflation arguments long term, it seems to me, is that you are betting against a government’s ability to destroy its own currency. Governments are seldom good at anything, but one thing they are undeniably good at is destroying their own currencies. The dollar has lost 95% or so of its value since 1913, the year the United States established the Federal Reserve. Enough said.

Long-term, betting that a government will safeguard its currency seems like a very bad bet. Deflation – or at least symptoms of deflation – may prevail today, but the real question is for how long. My own crystal ball is frustratingly cloudy on the issue. But the great rewards in investing are always with the out-of-consensus view.

The upside from holding Treasuries seems hardly worth the risk of being wrong, for instance. On the other hand, if we are right about currency rot, then we’ll make multiples of our money on natural resource stocks.

The downside on many commodities seems low, because the prices have already corrected. In several instances, as with oil and natural gas and iron ore, we are already below the marginal cost of production for much of the industry. So unless we don’t need these things at all anymore, the simple economics of the businesses involved help support a certain price structure.

And anyway, as far as the case for gold is concerned, I’ve been arguing that it is less about inflation or deflation than it is about creditworthiness in general. Gold does well during times of credit troubles. It did well in the 1930s, for instance, even though that was largely a deflationary era. Banking troubles made investors turn to gold.

On that front, we’ve got plenty of banking troubles on the way. Yesterday’s Wall Street Journal headline, buried in the middle of the paper, hints at what’s to come: “Pick-a-Pay Loans: Worse Than Subprime.” The piece begins:

“For the third straight month, option adjustable-rate mortgages are generating proportionately more delinquencies and foreclosures than subprime mortgages, the scourge of the U.S.”

These loans require only partial-interest payments each month. So the loan balances on many of these loans have actually gone up while housing prices have tumbled. Bad combination. As of April, 36% of these loans were at least 60 days past due.

These troubled loans will mean more large losses for banks — in particular for Wells Fargo, J.P. Morgan Chase and others who were active in these markets. Wells Fargo, the WSJ points out, has a mountain of this stuff — $115 billion of it.

So as long as we have banking troubles, we have the potential for fear to return in a big way. And that is when gold does well…with or without inflation. But I’m not counting inflation out just yet.

I’d use the market weakness in the gold price and in gold shares to pick up your favorite gold miners.

Source: Gold…If Not Now, When

A few days ago, billionaire hedge-fund manager, John Paulson, spent $1.28 billion to buy a piece of AngloGold Ashanti (AU: NYSE), the large South African gold miner. Paulson paid $32 a share for an 11.3% stake in the company. The following day, Fed Chairman Ben Bernanke delivered the shocking news that the U.S. Federal Reserve would buy up to $1.2 trillion of U.S. Treasury debt. And just like that, the price of gold soared, as did the price of AngloGold – handing Paulson a prompt $240 million profit.

But we’re guessing Paulson will hang around for awhile longer. We’re guessing the savvy investor is looking for a double on this investment, at least.

“Apparently, Mr. Paulson sees a solid-gold opportunity,” observes Byron King, the man who urged the subscribers of Outstanding Investment to buy AngloGold three weeks before Paulson made his high-profile purchase. “And Paulson, you may know, has pretty good eyesight, investment-wise. He’s the hedge-fund manager who made $10 billion in 2007 and 2008 betting that the subprime mortgage market would implode.

“Mr. Paulson’s purchase of AngloGold Ashanti is, in essence, a $1.3 billion bet that the U.S. government is pursuing a long-term policy to debase the dollar,” Byron continues. “Seems like a winning bet to us.”

AngloGold is not Paulson’s only wager on the yellow metal. He also owns 4.1% of Kinross Gold. Likewise, David Einhorn, the hedge fund manager famous for predicting the demise of Lehman Bros., is accumulating gold-focused investments (as we reported in the February 23, 2009 edition of the Rude Awakening, “Buy Gold…We Really Mean it This Time.”)

“Dollar debasement will doubtless trigger inflation,” Byron insists. “Over time, this will cause a flight from paper currencies to gold. I’ve already predicted gold at $3,000 within 30 months. I’ve heard other gold analysts forecasting gold at $4,500 within three years. So there’s a lot of room on the up-side.”

It’s true; the bullish case for gold has rarely seemed more compelling. But every investor has cause to wonder whether the bullish case for gold is also timely. Sure, gold could soar to $3,000 an ounce. But will it drop to $600 an ounce first…and stay there a while?

No one knows the answer, of course. Not even Byron King, an experienced geologist and student of financial history. Nor does John Paulson, a guy who knows how to make a few billion dollars by betting against the crowd. Nor does David Einhorn, an investor with an eye for profiting from adversity. But we’re inclined to trust the instincts of all three gentlemen. We are also inclined to trust the “instincts” of the market itself.

Six times during the last six years, gold stocks charged out ahead of gold bullion, signaling an imminent gold rally. Veteran observers of the gold market understand that major rallies usually BEGIN with gold stocks; not with the metal itself.

The chart above illustrates this phenomenon. In August of 2007, gold stocks advanced nearly 20% in three weeks, while the gold price barely budged. But during the next three months, gold soared from $650 an ounce to a new 17-year high of $825 an ounce.

A similar divergence has unfolded during the last few trading days. Gold stocks have jumped 30% – or double the gain of the S&P 500 Index – while gold, itself, has advanced only 4%.

Are gold stocks – like Lassie – trying to tell us something? We aren’t certain. But if we understand what the gold market is trying to say, either Timmy fell into a well or Ben Bernanke has incited the greatest inflationary episode in America since the 1970s.

Source:  Silver and Gold

There has been a lot of talk lately about the gold-to-oil and gold-to-silver ratios. This is understandable, as both ratios are further out of whack than they have been for a long time.

The gold-to-oil ratio, for one, is now at ten-year highs.

The gold-to-silver ratio is similarly extended, though not by nearly as much as gold-to-oil.

For gold-to-silver, the 200-month moving average is 57 and the current value (as of this writing) is a touch above 69 – meaning a single ounce of gold is worth 69 ounces of silver.

The 200-month simple moving average tells us that 57 is closer to the norm. So that puts a better than 20% premium on the price of gold versus silver (based on U.S. exchange-traded futures contracts).

Analysts have looked at these relationships and come to some interesting conclusions. Some feel strongly that it’s time to buy oil (or silver). Others feel – quite foolishly in my opinion – that it’s time to short gold.

Let me expand on a few key points here so you can come to your own conclusions.

First of all, many investors and traders have gotten into the habit of throwing gold, oil and silver all into the same bucket – the “inflation expectations” bucket. Reason being, when inflation comes roaring back, all this stuff should come roaring back too (as the value of paper currencies plunges).

That’s the basic theory. But it’s also a bit simplistic. We need to remember that all three of these commodities lead “double lives,” so to speak. There is more to the equation than just inflation expectations.

Oil’s Industrial Role

Oil, remember, is an industrial good. We use it to power nearly everything that moves (and a lot of stuff that sits still).

During oil’s run-up to $147 a barrel, the world was barreling ahead (no pun intended) at full steam. A global economic boom was under way, and the supply/demand balance for oil was very tight.

When the global economy fell into recession, though, global oil demand fell too. That slip in demand at the margins was enough to send oil prices crashing through the floor.

Remember that the demand for commodities (and most everything come to think of it) is determined at the margins. The price is set by the most desperate buyer (or anxious seller).

So when there was very little daylight between supply and demand, the price of crude just kept marching higher. But it didn’t take much of a drop-off in demand before, suddenly, the world had excess oil on its hands, as we were no longer burning up every last drop of the 86.4 million barrels being pumped out each day.

When the price of oil went into freefall, sharp-eyed traders saw a chance to store the stuff in tankers and wait for higher prices to return. But eventually most of the storage facilities filled up, and the stuff just kept coming. And so crude continued to fall.

Peak oil is still in effect, mind you. It’s just a long-term type phenomenon that needs a rising global demand trend to really have effect.

When the global economy gets back on track, oil demand will relentlessly tick back up. Think of long-term oil demand as the needle on a dial: At some point growth will take us back to 86 million barrels per day… 86.5 million… 87 million and beyond…

When those days come back, oil will be expensive again as we run headlong into a production ceiling. For now, though, oil is cheap.

The Golden Thermometer

Gold has a “double life” too. Or maybe two double lives, if you count jewelry and ceremonial demand. The double life we’re going to talk about here is gold’s role as a general anxiety barometer – a sort of thermometer for how the world is doing.

Gold is the ultimate safe haven asset. It’s the thing you buy when nothing else can be trusted.

Furthermore, gold has earned its safe haven reputation over a history of thousands of years, whereas the present-day fiat currency experiment is less than 40 years old (dating back to Nixon’s shutting of the gold window in 1971). Four decades versus multiple millennia… hmm, is there any wonder people are flocking to gold in this time of great upheaval?

The other wild thing about gold is the supply/demand picture. We just talked about the ugly supply picture for crude oil right now – how the stuff is overflowing because the world isn’t burning it.

With gold the opposite is true. There just isn’t enough gold in the world to even begin to satisfy total demand right now.

Consider that the total dollar value of all the gold ever mined, at present prices, is something like 4 trillion to 4.5 trillion dollars.

Four trillion bucks is a drop in the bucket. Foreign central banks already hold at least $3 trillion worth of U.S. Treasury securities, with trillions more set to be issued in 2009. The Federal Reserve alone has nearly 2 trillion dollars on its balance sheet – one entity with paper assets and obligations totaling close to half the worth of all the gold in the world!

Central banks around the globe would probably love to own lots more gold. But they know that they can’t buy it in size, because if they tried to they would run the price into the stratosphere.

That’s why, even now, countries like China, India, Russia and Japan have 3% or less of their total reserve holdings in gold. If they made a concerted effort to ditch dollar-denominated assets and up that total, the price of gold would explode.

Supply, Demand and Anxiety

In light of this information, the extreme highs of the gold-to-oil ratio make perfect sense.

Oil is in a deep funk right now due to the supply/demand situation and the prospect for a continued slump in global economic activity. While there is reason to be long-term bullish crude, there is little reason to expect a higher oil price until global demand trends show signs of returning to form.

Gold, on the other hand, is in high demand right now as a safety blanket – a salve for the general anxieties brought on by flailing governments, out-of-control printing presses, and mass “stimulus” schemes that get bigger by the day. There is not enough gold to go around right now. Hunger for the yellow metal is waxing, not waning.

As for the gold-to-silver ratio, gold’s 20% premium isn’t hard to understand there either. While silver is a bona fide “precious” metal, it is also an industrial metal… and silver has less psychological traction as an anxiety barometer.

There will come a day when the price of silver could explode, and perhaps even rocket past gold like it was standing still in percentage performance terms. But we will need to enter a mania phase for that to happen, and we are far from seeing that just yet. People are buying precious metals more out of a safety motive than a speculative one at this point, and so silver waits.

A Word on Economic Revival

There is another point that is important to address. Some pundits in the “sell” camp argue that gold will be ripe for a fall when economic recovery starts to take hold. When the sun begins to shine again, they reason, investors will come back to traditional equities and hoary old gold will go back in the closet.

I don’t think so, and here is why – the U.S. Fed and Treasury would consider the return of serious inflation a “win” at this point. Right now, Ben Bernanke and his global counterparts are doing everything they can to fight a deflationary death spiral. Inflation is a mosquito bite in comparison.

And so, in a dangerously deflationary world – the one we inhabit at this present moment – noticeable and persistent inflation pressures must take hold in order for us to have clear assurance that the Fed and Treasury’s rescue policies have worked.

And because mass stimulation is a highly inexact science, we won’t get to choose the amount of inflation we get. When you dynamite the deflationary dam, so to speak, you don’t get a say in whether it’s a trickle or a flood that results. The same goes for the Fed’s reflation efforts.

This leads to the odd conclusion that, in the event we see signs of recovery accompanied by signs of inflation, gold’s upside movement could actually accelerate.

But it’s really not so odd, when you think about it, because the price of gold is anticipating a future outburst of inflation here. Either that, or the debasement of all paper currencies into oblivion. One’s as good as the other as far as gold bulls are concerned.

Runaway Train?

In conclusion, I would argue that the extraordinary nature of the gold-to-oil ratio at this point is merely a reflection of extraordinary times.

We have seen a global deflationary bust knock down the price of oil, even as general anxiety and currency debasement fears have sent the price of gold rocketing higher. We are also seeing a marked divergence in the supply/demand picture, with plenty of oil to go round but not nearly enough of the yellow stuff.

I am chomping at the bit to go long oil and gas at some point in the coming year, but not as a currency debasement play. I’ll wait for global demand to show signs of life before getting on that train.

As for the gold train… if the $900 level holds, we could see another blast of upside movement soon as all the “wait for a pullback” folks get nervous and pile in.

And silver, which is still very much playing second fiddle at this point, will likely start going nuts once we hit the true “mania” phase – which we are nowhere near as of yet.

Source: The Gold-to-Oil and Gold-to-Silver Ratios – What are they saying?

John Mack, CEO of Morgan Stanley, warmed the hearts of many this week in predicting that the worst of the crunch is over. The subprime crisis is in “the bottom of the eighth or top of the ninth,” he said. As head of a bulge bracket firm, Mr. Mack has ample reason to hope his words are true. The question is whether or not evidence bears him out.

The IMF thinks the full cost of the credit crunch could be $945 billion… just a shade under a trillion bucks. With $232 billion written off by Wall Street so far, that would mean about $700 billion more to go.

What’s more, the consumer effects of the housing bust are still in early days. Bankruptcies jumped 30% in March, with the sharpest rise in uber-bubble states like California, Nevada and Florida. In Orange Country, as many as six out of ten new buyers could be “upside down,” meaning the size of the mortgage exceeds the value of the house. Time magazine talks of the first “Starbucks recession,” in which belts are being tightened enough to pass up that $4 cup of joe. Starbucks CEO Howard Schultz reports that, “For the first time in our history as a company, we have negative traffic this year vs. last.”

In many respects, too, the mortgage troubles are global. The housing news is ugly not just in the U.S., but in other countries like Britain, Ireland and Spain. (Recent Economist headline: “Britain’s property boom turns to bust: prepare for a hard landing.”) This means the flood of printing press stimulus will also grow more global, as we saw with the Bank of England slashing rates this week. Bad news for paper currencies; good news for gold.

Enjoy your weekend,

JL