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Deflation and the Liquidity Crunch: Update 2001

August 31, 2001

Part III

Why Is Gold A Good Store of Value During Deflation?

Our most popular Special Report has been Gold In A Deflationary Economy, researching over four centuries of inflation and deflation cycles and the true function of gold as a long-term store of value, and forecasting 1998 and beyond the price and value of gold.

Contrary to popular thinking, gold is a better store of value during times of deflation than inflation. The report describes this concept in much detail, reviewing empirical evidence and extrapolating the 1975 Jastram Study published in the late Professor Roy Jastram's book, "The Golden Constant."

At the risk of oversimplification, the value of gold as a store of value-whether on or off the gold standard-is best understood by asking the question, how many ounces of gold does it take to buy a particular basket of goods or services. Using a bushel of wheat during a deflationary cycle as an example, if one were to compare the cost of wheat in year one with the cost in year five of a deflationary cycle, one can see how that same ounce of gold buys more wheat later in the deflationary cycle than when the cycle started. If an ounce of gold could buy 100 bushels of wheat in Year 1, and the price of wheat declined into year five, that same ounce of gold could buy perhaps 120 bushels of wheat.

During the economic crises of 1997/1998, gold illustrated its ability to remain a store of value even in the current fiat currency system (paper currency not backed by commodities and declared official currency by government fiat). The countries that fared the best during the collapse of the Pacific Rim and associated domino effect were those that did not run out of currency reserves. Those that did, such as South Korea, were in severe crisis due to their insolvency. South Korea asked its citizens to turn in gold, and its government obtained gold, to be used as collateral for International Monetary Fund (IMF) loans (more paper currency). Gold, then, emerged once again in the public eye as a true store of value. It will again emerge as an important instrument of currency when the deflationary pressures strain the global monetary system between 2001 and 2003/2004 when the defaulting debt spiral pressures the value of fiat currency downward relative to gold, much like that which occurred during the 1930s.

For more on Gold as a long-term indicator of investment market valuation, and on understanding what deflation is, continue on to the next page, the Dow/Gold Indicator: Reversal of Fortune. For a complete discussion on the subject of gold and its performance in cycles of inflation, deflation, war, peace, on and off the gold standard, see our timeless 1998 report, Gold In A Deflationary Economy.

Part IV

The Dow/Gold Ratio:
Signaling a Long-Term Reversal Of Fortune
For Two Investment Markets

As we indicated, our most popular Special Report has been Gold In A Deflationary Economy, researching over four centuries of inflation and deflation cycles and the true function of gold as a long-term store of value, and forecasting 1998 and beyond the price and value of gold.

In 1998, gold was falling to 18-year bear market lows and the U.S. equity market was still entrenched in one of the greatest speculative bubbles of all time. Now, the bubble has burst, and we can take a look at a reliable long-term indicator, the Gold/Dow ratio, for clues as to the risk/reward of two diverse asset classes: gold and equities.

According to the World Gold Council, gold carries the most negative correlation with the U.S. equity market of any investment class. With a -89% correlation to equities, gold is not only a great diversifier, but has been proven in other research studies that, as part of a diversified portfolio, goldcan help provide the balance needed for a true long-term portfolio-one that is properly diversified to handle the bull and bear cycles through which the various investment classes cycle approximately every thirty years. Professor of Finance of University of Massachusetts Thomas Schneeweis, for example, confirmed that an investor's tradition stock and bond portfolio's return-to-risk tradeoff can be improved if between 10% and 20% of overall assets are allocated to a percentage of alternative investments (see Alternative Investment Management Association).

Now, we can view the situation at yet another major investment cycle turning point-the end of the megabull market of the past twenty years in stocks and in gold. The chart blow is virtually self-explanatory:

Despite it's obvious picture, we will discuss it a bit here with respect to using gold as a diversifier and preserver of operational wealth. Considering the World Gold Council's finding that gold has a very negative correlation to equities and other asset classes, take a look at the major and minor turning points in the Dow/Gold ratio, reprinted with permission from .

Major bull markets have ended when the Dow to Gold ratio has reached extremes, and minor bull and bear phases have turned enough to further illustrate gold's negative correlation with stocks. Note that two major speculative bubbles of the past 100 years in gold ended with the ratio at 1.0, and three major stock market bubbles have ended with the ratio above 18, the most recent Year 2000 turning point at an incredible 31.8. This, along with gold's reputation as a diversifier, preserver of operational wealth, and the World Gold Council's research showing a correlation approaching -1.0, is one of the reasons we recommended in 1998 in our monthly market letter, The Global Market Strategist®, that investors begin to consider diversifying 5% to 10% of total investment assets in gold. When the risk/reward ratio in stocks became prohibitive after the Pacific Rim crisis of 1997/1998, the NYSE Advance/Decline Line peak of April 1998 illustrating the peak of the most equities, and gold headed for our projected 1998 bear market targets near $280 per ounce, we observed that it was time to begin to diversify portfolios.

The Dow/Gold ratio is also one illustration of the real question that should be asked when attempting to understand inflation and deflation, as we detail in this report in the Why Is Gold A Good Store of Value During Deflation section. The ratio attempts to estimate the answer to the question: how many ounces of gold does it take to buy one unit of the Dow Jones Industrial Average? To understand deflation and gold's store of value, one should ask the same type of question: how many ounces of gold does it take to buy a basket of goods and services?

Since the historic answer, as documented with centuries of research detailed in Gold In A Deflationary Economy, is that gold buys more goods at the end of a deflationary cycle than it did at the beginning, it is a much better question to ask when attempting to measure inflation and deflation than measuring in one's local currency.

The fiat currency system (paper declared official currency by government fiat, as of 1971 when the Gold Exchange Standard was dropped) typically sees the economies of countries caught in a deflationary spiral implode, bringing on the collapse of their currencies. To measure inflation and deflation in terms of currency values, then, is not only inaccurate, but is a relative to the country in which one resides and the associated currency one is using to measure the answer to the question regarding the purchase of goods and services. In Japan, for example, the rate of deflation is -9.5% from 1995 through 2000, yet the yen has been falling since its record strength against the U.S. dollar ended that year. Gold, then, is in a bull market against yen and against many other fiat currencies, and it takes more yen now to buy a basket of goods than in 1995, but less gold.

The chart below illustrates what happened to U.S. Producer Prices after the gold standard was dropped during the Upwave portion of the Kondratieff Cycle. During the 1930s, Europe led the way down in the deflationary collapse, not catching the U.S. until 1930 (but the U.S. registered a -1% rate of deflation in 1928, much like its 1998 rate of deflation. During the 1990s, deflation has been exported from the Pacific Rim.

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