The Perfect Storm - Print Version

There are but two ways of paying debt: Increase of industry in raising income, increase of thrift in laying out.
Thomas Carlyle1795-1881, Scottish Philosopher, Author

It's our turn to take our hand at a gloom, doom type scenario. Well at least a minor hand. I call it the perfect storm because we are in a true paradox situation. At the Tactical Investor we specialize in looking at things from a different set of eyes and locking onto new emerging trends long before the masses even get a whiff of them. Credit is given to Jim Puplava for being one of the first individuals to bring this topic to light.

We are witnessing something that has not been seen before. We have inflationary and deflationary forces coexisting together in almost perfect harmony. Let's expand.

Inflation has always been around. The nefarious Feds have been very busy beavers and have convinced the world to look at inflation in terms of rising prices. This way they had free reign to push the printing presses to the max and churn out trillions of dollars. They kept prices under control buy subsidizing everything under the sun and artificially holding down the prices of Gold and Silver. Let's move forward. The effects of inflation are now apparent in the energy and base material sectors. Oil prices have gone throw the roof simply because the supply cannot keep up with the demand. As China and India's economy keeps growing, they will keep consuming more oil. Unfortunately the rise of their economies is creating a disaster type situation. The price of oil has risen roughly 40% in the last 52 weeks. This in effect is very similar to that of rising interest rates, both have a dampening effect on the economy. Since we are in such a precarious recovery, rising oil prices could plunge back into a recession type scenario.

America has the third largest population or so and it consumes more oil then the two most populous nations in the world. Let's just imagine for one second that India and China's consumption levels rise to a point where they match the US. Combined they have 8 times more people then the US. Lets make it more interesting and say that the consumption of the combined two nations equals half that of the US. Well if this situation were to occur we would have an energy crunch that would have no comparison. The reality is that unless something is done to alleviate the current shortages, we will run into the above type scenario. There is a new growing middle class emerging in both those nations and these individuals now thirst for the same luxuries as we do back home. They all dream of driving a car, having a cellular phone, large screen TV's etc. But when one presses them, one finds out that their number one want is to own a car.

M3 is already at 349 million, which works out to an annualized rate of 10.2% a year. At this rate we will surpass the 1 trillion levels with ease. Now that is inflation on crack and cocaine and the energy sector is responding in kind. What is worse is that Japanese bought almost no T-bills in April, a very potentially troubling situation. The fed may have to monetize their own debt, which means printing more dollars. This will result in even further price increases in the energy sector. Higher energy prices will eventually be the trigger for higher Gold and Silver prices.

The above chart very clearly illustrates that Oil is in a strong Bull Market. Oil has adjusted itself so that it is now reacting to this over supply of dollars in a tit for tat scenario. Unlike Gold it is not taking off, only when the dollar plunges. But has been rising as the dollar rises. This means that oil and now Natural gas are both in true bull markets. In addition the effect of inflation can be seen as the prices of all common goods are rising, Milk, butter, vegetables, livestock, and all other agricultural products. Base materials such as Aluminum, steel, copper, nickel, zinc etc have also all taken off.

Now let's look at the deflation scenario. Deflation exists today for one reason only. That reason can be summed up in 5 letters "CHINA" It has virtually eliminated the manufacturing sector in every western country. The average factory worker in the US earns about 15 dollars an hour. The average Chinese worker earns 1 dollar a day. With money it takes to pay one worker for one hour in the US you can hire 15 workers for the day in China. There is no way the US worker can compete with the Chinese worker. Effectively China has sucked in all these manufactures. As a result of reducing their labor costs by as much as 80%, they can now pass these discounts onto the consumer. There is nothing any government can do to stop this flight of capital, as the savings in labor costs are simply astounding.

This is where the situation gets tricky. Since more goods are being manufactured in China, the demand for raw materials has surged to such a point, that demand is now outstripping supply. So prices start to rise. As prices rise, the companies that have not moved are forced into moving, because they have no pricing power. The only place they can cut costs significantly is in their labor dept. So they have to move or die. Remember these kinds of moves never just occur at the rate of 1 for 1. Individuals always get over exuberant and so always over build. So you have a situation where thousands of factories are being set up and then placing more strain on the supply of raw materials.

Now let's throw in some gasoline. Interest rates start to go up, so the consumer gets scared. He stops spending money he does not have on things he really does not need. Instead he decides that he is better of trying to pay of his debt. What happens, all those excess good sits on the shelves and the manufacturers panic. If he the dumb consumer does not buy, the economy is over. Have you ever heard such nonsense before in your life that it takes consumers to keep an economy alive? An economy that is kept alive by consumers, is a debt driven economy and the only way it can keep growing is for the consumer to take on even more debt. At some point in time, the consumer is simply not going to be able to borrow anymore and will look for ways to cut his debt. The manufacturers will trip over themselves and start dropping prices, in a bitter attempt to trick the consumer into spending. Most of these companies cannot afford to lower costs anymore. Increased energy costs and cost of raw materials are already cutting their margins to razor thin levels. Soon they will become so thin you will have to use an electron microscope to find the profits. This action will ultimately precipitate a plethora of bankruptcies. This will take several thousand workers out of the work force. These unemployed workers will reign in their spending, forcing price reductions again and adding more fuel to the deflationary scenario. By the way these are long-term views.

Have you noticed that almost every manufacturer is now offering significant rebates? (Cellular phone, computer, car manufacturers etc.)

So on one side you have effects of inflation due to rising energy and base material prices, on the other hand you have deflation because of China. Later you have problems because these companies have to keep lowering prices, while their expenses keep going up. At some point in time the cheaper labor costs won't be enough to keep them alive.

The end result is very hard to predict. We think the following is possible. It is not going to be the metals sector that is going to lead this commodity based bull market, but energy. In fact this situation is already transpiring as can be seen by oils recent gains. This will result in interest rates going up. The fear and not the reality of further increased rate hikes will push the consumer to start paying of his debt. This will create a vicious price war amongst manufactures. In the end almost any manufacturer that wants to say alive will have to leave the western hemisphere and move over to China or India. This will leave a significant segment of the population unemployed. This will then fuel further deflation in the manufacturing sector. The feds will attempt to try to save the economy by trying to monetize the debt as no sane nation is going to keep buying this toilet paper forever. By doing so they will keep driving energy prices higher. Why the energy sector has caught onto the wholesale inflation of the dollar and is now reacting in sync with the increase in the money supply. It's going to be interesting to see what happens 1 year from now, when we have printed a trillion more dollars.

This fear of the future and rising energy prices will be the catalyst to start the raging bull in the precious metals sector. Out of fear and desperation people will turn to Gold, as they wont know what to do. Try to imagine the chaos caused when people have to pay 5,6 or 8 dollars a gallon at the pump. A few years ago 3 dollars a gallon was unimaginable and now we are there in some parts of the country. We feel that the biggest part of the Gold, Silver bull will be due to fear. If you think people behave in an insane manner when they are greedy, then you are going to be in a state of shock when you see how they react when they panic. There is no stronger emotion in the universe than fear.

How long will deflation and inflation coexist? We really cannot say at this point in time. It is entirely possible that they could coexist until this whole situation blows up. Meaning that as people panic and start pouncing into Gold, the manufacturers will be forced to keep lowering prices to try to sell goods from their overstocked warehouses. In the end the name of the game will be staying alive and profits will be completely forgotten. If such a scenario were to unfold, then it will be truly terrible for those that are unprepared.

The silver lining here is we will be prepared for this situation when it transpires. All of you have some Gold or Silver bullion. All of you have some Precious metal shares. All of you have some natural gas and oil stocks, and all of you are hopefully cutting your debt levels down as fast as possible.

I will stress this principle again, make sure you are now living one standard below what you can afford and just to prepare yourself, try to live 2 standards below your means every now and then. Take the money you save by doing this and put in a fund to buy bullion again or to pay of your debt. In addition avoid buying that huge SUV or owning 2-3 cars. You will find that living with almost no debt can be a rather pleasant experience. For many it will feel like a new lease on life.

Credit buying is much like being drunk. The buzz happens immediately, and it gives you a lift. The hangover comes the day after.
Dr. Joyce Brothers1927-, American Psychologist, Television and Radio Personality

Sol Palha
info@tacticalinvestor.com
www.tacticalinvestor.com

Sol is struggling with the same analysis that I struggle with. From a bird's eye view, we have two massive secular forces at work. We have a hyperinflationary policy regime all over the world where governments and central banks are creating money at unprecedented rates. Why are they doing it? Because they recognize that we are in a secular deflationary economic environment and they believe that they must fight it at all costs. This deflationary environment is partially the result of bringing Third World populations into the global marketplace. These Third World populations dwarf the First World and have a much lower standard of living so that First World workers cannot compete in manufacturing or exportable services. Global economic free trade is the great equalizer. Third World populations will experience an increased standard of living, but First World workers will experience declines. First World governments cannot allow their citizens to experience declining living standards, but they are themselves partially responsible by encouraging outsourcing and free trade. This is an explosive situation, both economically and politically.

The Perfect Storm is an excellent analogy for the meeting of the two storm fronts of hyperinflationary policy and deflationary economics. Just like a weather system, the collision of these massive forces will lead to chaotic and unpredictable behavior in markets and economies. It is the acknowledgment of a chaotic economic environment that inspired Sol and I to write "A Day Late and a Dollar Short" where we envisioned a dollar short squeeze scenario. We believe that such a scenario is possible in this environment because of the extreme leverage in all parts of the system and the sheer number of risk factors. The extreme leverage creates feedback loops throughout the economy. Massive monetary expansion gets caught in these feedback loops and reinforces them until a tipping point is reached then they suddenly reverse. We see these devastating reversals all over the markets as huge gobs of money rushes in and out of asset classes, desperately seeking return. These massive market swings have profound and unpredictable economic consequences.

Many analysts endlessly argue the "Deflation vs. Inflation" debate without acknowledging that both are possible either simultaneously or sequentially in quick succession. We are currently experiencing both inflation and deflation simultaneously because many manufactured goods are still falling in price while commodities and other fundamental necessities of life are rising. I have to give credit to Mr. Jim Puplava for first describing the Perfect Storm scenario of simultaneous inflation/deflation. It seems to be unfolding as he described, but with the glaring exception of the hyperinflating real estate sector.

I believe that a sequential or cyclical inflation/deflation is also possible. A number of analysts have pointed out that an increase in energy and/or commodity prices can actually cause recession when there is insufficient growth in incomes. These price increases act like a tax increase to reduce discretionary spending. This seems to be the situation we currently have in the US. Will consumers continue to buy luxuries with abandon while they struggle to pay for necessities? Any pullback in consumer spending is likely to become self-reinforcing, creating a feedback loop that pulls down prices and economic growth. Government policy will almost certainly respond with more monetary inflation and deficit spending, but these remedies will take time to trickle down into the general economy. In the mean time prices could fall, albeit temporarily. This time lag between policy and response further aggravates the situation by creating deeper cycles and even more chaotic money flows.

Whichever way the Perfect Storm evolves, many people will get hurt. The antidote for economic chaos and complexity is personal simplicity. I totally agree with Sol's advice to live below your means. Please do this by choice. Otherwise, the effects of the global economy may take away your ability to live beyond your means in the future. I have been living below my means for some time now and I find it a very satisfying lifestyle. Getting off the borrow/spend/earn treadmill has probably put years on my life and allowed me to reconnect with family, friends, and Nature.

George J. Paulos is Editor/Publisher of Freebuck.com, a website devoted to wealth preservation and enhancement using alternative investing approaches including precious metals. He is also Associate Editor of The Gold Letter, a newsletter covering junior mining and natural resource stocks.