Rick's Picks
Monday, October 10, 2005
For investors who'd rather be smart than lucky
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Deflation's Revenge
On Illusory Wealth
Recently, I speculated here that a precipitous deflation could inhibit the price of gold from reaching stratospheric heights. This elicited a challenge from several readers, including Quentin L, who wrote as follows:
"First, as a gold bug, I would like to congratulate you on 'keeping it real.' I have followed your briefs on Goldseek and Kitco for about thee years now. After reading your article: "If the System Collapses Who Will Bid up Gold?" I was left scratching my head and had to read it three times, but I'm still confused. Are you saying that even with the record trade deficit, and countries in Asia losing faith in the dollar, that the dollar will rise? Wouldn't currencies that have some backing to Gold such as the Swiss franc do well? In this collapse wouldn't there be a gravitation towards, say, even the Saudi gold-backed e-dinar?
"And lastly, if the deflation scenario does pan out, what percentage of my savings should be in cash? In this scenario FDIC backing would be worthless, and because the system would be unable to bail us out, even our 100k CDs would be in danger.
"I think deflation is the unknown that scares gold bugs the most."
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Waking Up Broke
Gold bugs are unlikely to bear the brunt of a deflation. As I noted in Friday's commentary, they will be holding an asset that at worst will retain its purchasing power. But don't expect an ingot and a few doubloons to buy you a retirement in Lugano, should the global economy plummet into darkness. My reservations about gold are rooted in the fear that we will experience an actual plunge, rather than a gradual slide, into economic winter. I used the word "precipitous," and I meant it quite literally. To put it as bluntly as I can, I believe there is a more-than-negligible chance that we will awaken one morning to a financial cataclysm that has left us all flat broke - meaning, for one, bereft of liquid savings that could conceivably be exchanged for bullion.
It might take a few weeks to ascertain the ruinous extent of our penury, and many months or even years for securities markets to reflect it as an actuarial fact, but it will nonetheless be true. Financial markets will be frozen in place while the bean counters attempt to sort out the mess. Ultimately they will fail in this task, since re-sequencing debt maturities so that everyone gets paid in due time will be like trying to retrofit the lower floors of the Trade Towers while the buildings were ablaze.
What Bailout?
Although nearly everyone seems to think the Fed will effect some sort of bailout before a meltdown occurs, the fact is, there is no practical way to do so. An administered hyperinflation is most certainly not the answer, since it would destroy savers and lenders as a class, rendering the bond markets largely inoperable for a generation. Far more likely is that liquidations will simply be allowed to run their course, punishing sinners more or less in proportion to their sins.
A global financial panic would undoubtedly send hoards of cash scurrying into T-bonds and T-bills. But gold bugs may be deluding themselves to think that any subsequent disintermediation would favor gold assets above all others. In the first place, cash credit for the purchase of precious metals will have been reduced by liquidations to a tiny fraction of the amount currently available for investment and speculation. Secondly, what little will remain of the world's liquid savings will likely go not into bullion, but toward survival. Whether you are a firm or an individual, you're going to use every scarce dollar you can lay your hands on to keep the bill collectors at bay and a roof over your head. Well down the financially flattened household's list of budget priorities will be the need to purchase bullion in order to protect one's remaining, and presumably meager, assets from the ravages of inflation.
The Post-Mortem
When the workout teams tote up assets and liabilities, the post-mortem will show that America's economic engine had been running on fumes for years and that most of our supposed wealth was merely a credit-induced mirage. Hard to believe? Then ponder this: Debt instruments currently in play total $248 trillion, according to the most recent figures from the Bank of International Settlements. This compares with a global economy in real goods and services amounting to just under $40 trillion. It's not a case of the tail wagging the dog, but of the tail wagging an entire financial cosmos.
A look at the corporate microcosm is instructive, since it shows how we've been able to clone hundreds of trillions of dollars of metaphysical wealth from the seeds of debt. General Motors, a failing manufacturer with a market capitalization of about $16 billion, currently supports debt of more than $300 billion. Every penny of it sits on someone else's books as an asset. But make no mistake, the entire sum - and, no doubt, billions of dollars downstream of it - could vanish in an hour if there's a systemic meltdown.
In the event, gold can be counted on to hold its value relative to all else, and that's why physical bullion, if not necessarily shares, should be in every investor's portfolio. But $1,000 an ounce? That could be hoping for too much in a worldwide depression that has virtually wiped out savings and pushed Europe's, Asia's and America's middle class toward destitution.
No Time to Panic
Some would argue that plenty of smart guys will see it coming and that their ensuing scramble for gold will push quotes to exorbitant levels. Perhaps. But my fear is that the collapse will unfold so quickly that there will be no time to panic, much less secure one's assets against the unknowable. Under the circumstances, it's worth asking what kind of shape you'd be in if you were to awaken on Monday to news that the markets, because of some epic crisis, have shut down indefinitely. To be sure, you'll be no worse off for having a roll of Krugerrands stashed in a safe deposit box. But as for the rest of your assets, including your home, they may not be worth much in barter. You'd be living from paycheck to paycheck, assuming you were lucky enough to still have a job.
For now, though, deflation's overwhelming power will remain submerged until the dollar's climb begins to accelerate. When this happens, the burden of debt for all who owe dollars will increase commensurately. Few could want this outcome, but it is all but unavoidable - a manifestation of Murphy's Law in a world that cannot afford to pay back what it owes with dollars that come any dearer than they are now. Unfortunately, evidence that the dollar is primed to go the "wrong" way could not be more obvious. In the chart below, you can see that it has been in a mild uptrend for most of 2005. If you had known at the beginning of the year that America's budget would be subjected to the shock of two devastating hurricanes, a still-burgeoning trade deficit, a $350 billion war and a spectacular spending binge on Capitol Hill, you'd have thought the almighty buck was headed into a perfect storm.
Even before these factors emerged, however, Buffett, Soros and a few other Masters of the Universe were shorting the dollar in size. But, as the chart makes clear, they have all been on the wrong side of the trade - not because their logic was terribly flawed, but because they failed to understand that it is financial speculation that has been driving the dollar, not the relatively insignificant dynamics of the world's real economy. Despite being in egregious oversupply, the dollar is strengthening simply because it's where all the leveraged action is - the hottest game in a global casino that, even with an earthquake beginning to rumble beneath it, remains eager and able to extend virtually unlimited trillions in credit to the players.
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Rick Ackerman
October 10, 2005
Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in issues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers' initials will be used unless express written permission has been granted to the contrary. All Contents © 2004, Rick Ackerman. All Rights Reserved. www.rickackerman.com
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