Lear Capital on Gold and Deflation

Now that all the fireworks are over . . . or are they?Today the markets opened with an explosion tantamount in spectacle to the 1000 grand finales that took place across the country on the night of the Fourth of July.

After losing for 9 out of the last 10 sessions, stocks were up big and the market cheerleader's pom poms were going 100 miles an hour.Now, many wonder, what changed over the long weekend.Answer?Nothing!!

In a recent interview with Nouriel Roubini, professor of Economics at New York University's Stern School of Business, Roubini says we have avoided a depression for now.He does not see a technical double dip recession for the second half of this year.However, he quickly points out that, deficits are getting larger, home prices are still falling, unemployment is still on the rise, debt is growing, GDP will shrink to 1.5% but technically that does not qualify for a double dip recession.

What happened to that saying, "If it looks like a duck, walks like a duck and quacks like a duck?"Here's a quote from former Treasury Secretary Robert Reich,

"The economy is still in the gravitational pull of the Great Recession . . . all the booster rockets for getting us beyond it are failing."If it's true we are not headed for a double dip, I hate to see what needs to take place in order to be an official technical double dip.I'm hoping having some gold coins will help me sit that one out.

So, if nothing has changed, why the rally in the markets?Maybe the explanation is as simple as, last week the Dow lost 457 points and some investors are trying to re-enter the market and buy low.If you're still bullish on the markets, why not take advantage of the dips?

Now let's look at gold.Today gold dipped below $1190 an ounce as deflation chatter increases.Hearing this, many investors jump to the conclusion, if inflation is good for gold then deflation must be bad.It is commonly believed during deflation cash is king as costs of goods generally falls.During deflation, why buy now when whatever it is you want to buy will be cheaper tomorrow?

This may also explain why bond prices are on the rise and yields are falling.If you attain yields of 3% while inflation runs at a 3% annual rate, you have gained nothing.If you attain the same yields in 3% deflation, your effective return is 6%.

Because cash is king in a deflationary environment, some say gold will lose because it is not a recognized currency.Then when the media attributes a falling gold price to coming deflation not inflation, many people just nod and sell.But before you sell, here's what Adam Brochert said in a very insightful article last May, 2009.

Gold is money. Gold is a form of cash just like a U.S. Treasury Bill is. I know you can't spend Gold at 7-11 but you can't spend a T-Bill at 7-11 either and yet they are both cash equivalents. The advantage Gold has over the U.S. Dollar is that Gold is not backed by debt and does not represent debt. Debt is bad thing to have hanging over your head during deflation as debt burdens become more and more oppressive as deflation grinds on. So, Gold is the only form of money on the planet (allow me to neglect other precious metals for now) available right now that is accepted world wide, is nobody's liability/promise/debt instrument and requires effort to produce so it is valued for its relative scarcity.

So while some see gold only as an inflation hedge, others see it as a deflationary hedge as well.Gold demand is bound to endure periods of volatility just like any other investment.It takes time for people to figure out what all the economic data really translates to, as it applies to their own investments.

Today's market moves may be the prime example.The markets started out hot, with the Dow up to 9858, then slid 199 points to 9659 then fought its way back up 58 points on the day.It's like everyone started the day hopeful and then reality sunk in.Maybe it took a few hours to realize that in a deflationary environment, revenues drop and profits fall exponentially faster.

Think of it this way.If a company's revenues fall 10%, profits have to fall at a much greater percentage as no company's profits ever equals revenues.Then as profits go, so go stock prices.Deflation is bad for stocks and while deflation seems to be good for bonds, bonds are still debt and you have to hope they can be repaid.According to Dr. Gary North in a December 2006 report,

There is nevermonetary deflation for as long as 12 consecutive months. A tight-moneypolicy produces recessions, which in turn threaten incumbents. So,we occasionally get a few months of monetary deflation. Then theFederal Reserve returns to the policy of inflation.

This means a bond play may be good for the short term but inflation always follows deflation and then bond appeal diminishes.

In conclusion, if Gold is the only cash equivalent not backed by debt, then gold may be the best deflation play and the only one that continues to do well in the inflationary environment that follows.