Taylor On The Markets
Inflation Acceleration Enhances Deflationary Threat
The chart on the left represents the official consumer-price increases as compiled and published by the U.S. Department of Labor. Most everyone who has thought about price increases as reported by our government believes it is much higher than these monthly numbers indicate. For starters, the chart on your left ignores the cost of food and energy! And we know the cost of new houses are excluded and all manner of games are played with "hedonic" pricing strategies, all of which serve to promote the big lie that price inflation is no problem. But in fact, it is a much greater problem than you would think for most Americans, on the basis of the official values.
The Fed has recently revealed a growing concern about rising prices and has indicated it would continue to "tighten" monetary conditions so as to "contain" inflation. What "tightening credit" really means is that it won't grow at the torrid pace it had been growing after the most stimulative monetary period in American history following Ben "Helicopter" Bernanke's promise to use unconventional means to inflate away the growing deflationary threat that the Fed openly talked about back then.
Richard Russell says the Fed has, since the stock market peaked in 2000, been in an "inflate or die" mode. I would state it a bit differently. I would say the Fed might believe they have the alternative-to inflate or die-but in fact, ultimately they don't have that option. The option they are faced with is inflate and die!
I say that because the use of "printing press" money can no more reduce deflation in the long run than taking heroin can keep a human being alive forever. Like taking heroin or other drugs, easy money policies become addictive such that reducing the dosage of money becomes extremely painful the longer the process is allowed to run.
The whole world has become addicted to the easy U.S. monetary policy. The reason I say that is because an easy monetary policy that induces artificially low interest rates is keeping natural market forces from enabling the American economy to correct our excessive debt, which feels oh so good! And as Stephen Roach said last week, when he speaks to the Chinese people, the only thing they want to know is, "How are the American consumers doing?" The economies of China and Asia in general live (and die) by the actions of the American consumers, because the people in those
countries, for a host of reasons, are simply not spending their money for consumption.
But like heroin addiction, monetary addiction sows the seeds of its own destruction. With the easy money, Americans are getting themselves into debt even as average real wages are shrinking in America and as commodity prices are rising, in no small part because of artificially low interest rates. An essay a few days ago in the Financial Times, written by Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, pointed out the fact that a very strong correlation exists between negative real rates and commodity inflation. Rising commodity prices, rising debt service charges, even with interest rates remaining negative or well below
normal real levels, and declining wages, suggest the current drunken party is headed for a dose of sobering reality. And lest you think Mr. Bernanke can simply fire up his helicopter from which he will shower more money on the American economy in order to divert that dreaded "D" word, please revisit the reality of exactly what our so-called money is constructed of. Our fiat money system is a debt-laden money system, so that whenever Mr. Bernanke prints more money, he is injecting more debt ("heroin") into the veins and arteries and capillaries of the American economy. Folks, that is pathological and as such it will end in deflationary tears stemming from
massive corporate and personal bankruptcies and huge levels of unemployment and underemployment.
And as noted above, Asia is so dependent on the American consumer continuing his addictive pattern of spending beyond his means. This is one reason why the coming Kondratieff winter bust will be global. And the more I think and read about conditions as they are taking shape, the more convinced I am that we are heading over a deflationary cliff. This fate is, according to Bob Hoye, quite predictable, because the credit bubble that has been created in the U.S. rivals five other major credit bubbles of global scope since the late 1700s. Bob has studied these bubbles and their
aftermath, when they were characterized by currencies both with and without a gold standard, and he is quite positive that the end result will be (a) a stronger senior currency (in this case the U.S. dollar), and (b) an even stronger gold price. What Bob says we need to see to indicate we may be heading over the deflationary abyss is a steepening of the yield curve after the flattening process has been complete. This steeping would indicate a panic move for liquidity as credit quality begins to
disintegrate. And we are beginning to see some signs of credit quality declines by credit spreads between treasuries and junk bonds, though these spreads still remain historically narrow.
Our Inflation/Deflation Index Points Toward "Deflation"
As of this weekend, our Inflation/Deflation Index, which we constructed on
January 31, turned negative at the end of this week with a reading of 99.22. A Reading above 100 is considered "inflationary" and a reading below that base index number is considered "deflationary." (For a description of the various components to this index and the rational for their inclusion, see our hotline message of April 23rd.) Contributing to the decline this week was a sharp drop in commodity prices, a sharp increase in the long bond, a sharp decline in the price of silver, a rise in the Gold/Rogers ratio, Gold/U.S. Dollar Index, and a sharp increase in the Gold/Silver
ratio. Actually, since the Rogers Raw Materials Index value is always reported a day late, and because oil prices declined so sharply on Friday, I expect the Index will drop even more when I plug in the Friday value for the Rogers Raw Materials Fund. Also, it should be noted that a late rally in the stock market on Friday caused several other components to our Index, like the S&P 500, the Housing Index, the Real Estate Index, Toyota Shares, and the China Index, to all improve on Friday.
But it seems clear to me that the deflationary undertow is driving values of commodities, lower grade bonds, and speculative stocks down very hard. It is the beginning signs of this liquidity crunch that I think have been wreaking havoc on our junior gold shares, not to mention our energy and essential technology stocks. Last week I pointed out how damaging the decline in the gold shares has been to our Model Portfolio. This week was even more destructive to our Model Portfolios as displayed on page 9. Yet I remain confident that our gold share sector will ultimately be one of the few equity market sectors (if not the only) that will do well during the impending market decline. If gold bullion were stalling out, I would have second thoughts, but as the chart below shows, the powerful bull market that began back in 2002 is alive and well. At the end of April, the average daily price of gold was $429.57. The 20-month average was $408.81, and the 40-month average was $367.93.
As for gold mining shares in general and the junior gold mining sector in particular, what we see are some very exciting exploration results with companies on our list, and I know of two or three other juniors that I feel have home run potential on the basis of their exploration discoveries. I hope to tell you about those companies in the next couple of weeks.
Unlike the peak in the first leg up in the junior mining sector, we are seeing some very solid exploration results that strengthen the fundamentals for these little companies. These fundamentals, combined with strength in the gold bullion markets, and an exceptional amount of pessimism among gold share investors suggest we should be near a bottom for the junior gold sector. I should say that is an opinion that Bob Hoye holds as well. Bob believes this gold bull market may well last for up to 20 years and that some of these outstanding juniors will be the companies to find millions of ounces of gold since major mining firms have basically laid off exploration talent during the long gold bear market. Indeed, we have known since we began publishing this letter in 1981, that it is the juniors not the majors that make most of the major gold discoveries. That is true for several reasons, but as Mr. Hoye points out, it is more true now than at some other times over the past 20 or 30 years.
I am quite sure that the junior gold stocks will generate great wealth over the next 5 to 10 years, which is why this sector will remain a major part of our Model Portfolio. At some point late in the bull market, the junior gold shares will become over priced, frothy issues that will be compared crazy Internet stocks in 2000. When that day arrives, we will know it is time to exit this sector. But at this time, the juniors are almost as psychologically out of favor as they were when this bull market began in
2002. It is difficult to get excited about a market when it is out of favor, but that is exactly when the largest profits are made. "Buy them when no one wants them" was the slogan of Bernard Baruch and many other value orientated successful investors over the years.
May 1, 2005
Jay Taylor, Editor of J Taylor's Gold & Technology Stocks
www.miningstocks.com
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