I view gold as the preeminent wealth hedge in either inflationary or deflationary times, one reason for which is that it does well in either eventuality. Most hedges will do well in only one or the other situation, inflation say or deflation say.....But, I can't really think of a better overall hedge that captures benefits in both inflation or deflation better than gold....or even if there exists another wealth hedge vehicle that will do what gold does ... essentially covering both sides of the hedges... in inflation or deflation.. can you think of any other vehicle that can do that???

Really, gold languishes mainly in good economic times...but I don't think that in the next 3 to 5 years we will have good economic times; we will either see inflationary or deflationary problems becoming prevalent....

With yield so hard to find today, being at virtually zero real rates world wide....that tells us that the world simply does not see good times ahead, or anything really worthwhile sinking capital into. But if this is true, why is it that the gold community is so biased to the inflation side of the debate, since for inflation to really streak up, a relatively vital and strong world economy is a requirement?

Aren't low yields worldwide telling us this is NOT the case? Even though Asia is growing rapidly, low yields everywhere appear to be telling a different story.....

Now, of course oil is costly and inflation is present, but is that all there is to this picture? And isn't that really just a snapshot of the present, and not necessarily taking into account what a downturn in the world economy would have on inflationary pressures? Rather, there are massive deflationary forces lurking out there, waiting to manifest themselves, not the least of which is an impending real estate boom going bust.

And there are other huge deflationary forces as well, like massive government debt, as in the case of Japan, which tried unsuccessfully for ten years to stimulate itself out of a deflationary environment post the early 1990's stock and real estate collapse, and subsequent banking crisis...and racked up huge public debts... severely reducing any further possibilities of stimulation should they wish to the next time they need it. The US is in a similar situation, as far as public debt.

Now, much of the gold community is talking about the present inflationary forces, such as oil...as being the main thing to focus on, and then are extrapolating this to a future of massive inflationary pressures.... completely dismissing the deflationary arguments... and basically taking the inflation side of the inflation/deflation debate.

Even today, the US inflation figures appear to be heading up, and gold is reacting accordingly...

As of Wed, Aug 17, overnight gold dropped about 4 bucks to about 441...after shooting up Monday to the mid 440's.... but then upon the release of the US PPI, producer prices, by 1 pct in July, quickly started to retrace the overnight decline by almost half sending gold back to 443+.... but then declines to 442.. rapidly.

And so on... Of course some of gold's giveback is due to profit taking and of course the speculator volatility.... but Oil and Inflation pressures appear to be the gold news at the forefront as of this week.

However.........

As a counter argument, the rise of gold this past week was not really accompanied by a weakening US dollar, but rather one that is strengthening....Additionally, US Ten year yields are persistently low, with them at about 4.24 right now.....I wrote to my subscribers on Monday that, for these two reasons, I don't really see gold screaming ahead right now... and all the talk of 500 gold coming soon is premature...

Now of course, the news is inflationary and we have the gold community talking about that incessantly, as the gold community is biased somewhat toward the inflation side of the inflation/deflation debate. That is fine, but that is NOT the whole picture.

I believe what we are seeing here is the manifestation of the final economic growth that precedes a bubble collapse, say, in this case in real estate... that there are just gigantic deflationary forces all cocked and ready to manifest should there be any significant economic downturn in any major economy, China, the US, Europe or Japan....with the doubt being on the US most of all.

Also, I haven't even mentioned the potential effects of a derivatives crisis, should that ever get going akin to the LTCM situation... but with about 5 times the total size of that market....today at roughly 250 trillion in notional amounts....... and many entities who are supposed to track this new rats nest are observing little problems such as contracts not being completed in a timely manner, and the actual positions of the holders of these trillions of derivatives not clear whatsoever... the whole derivatives market is really like a black box... with the majority being illiquid OTC's..... and on and on and on...

The potential deflationary effects of trillions of lost dollars in a real derivatives crisis are astounding... and this new market is, as I said, really a true black box, with many of the entities holding them not even sure of their positions.. because the instruments are so arcane...

Now I ask you.... with these kinds of issues potentially leading us into a deflationary depression, why is all the focus on the inflation side of the debate only, whereas all this inflation data is really only recent and quite possibly temporary???? Of course oil is going to continue to increase in price, but is that all there is to the present inflationary arguments???? Basically, I see the oil situation as the primary driver in the inflation data today. Oil alone, as significant as it is, is not enough to overshadow the potential pullback of the US consumer, for example, should he pause or retract. In fact the Oil price situation is really quite deflationary anyway since it acts like a tax on all productive activity..... and on the consumer as well....

So I wouldn't get all carried away by the recent inflation stats, since they are so heavily OIL related, unless we see real widespread inflationary forces, such as wage growth and other things, but not just primarily oil related inflation.

Now then, since the recent gold action is not being accompanied by a declining USD, and 10- Year Bond yields are still staying low, at about 4.24 or what they were in DEC 2004....and there is not any yield to be had worldwide that is even close to inflation driven.....levels...... what is the rationale for gold to be getting to 500 bucks so soon????

My hunch is this: We really are one depression away from gold's massive explosion in price akin to the kind of situation we saw in the 1970's. Although there is some inflation, it is not even close to the levels of the 70's, interest rates are half what they were then,... yields are at zero real rates.....

This is JUST NOT the 1970's situation. Too many deviations from that scenario. Too much deflation on the horizon. Too many downside risks (in a deflationary sense) to the world economy such as a derivatives collapse and impending real estate bubble decline.

Chris Laird
Editor-in-chief,
PrudentSquirrel Newsletter
www.prudentsquirrel.com

August 17, 2005