The Effects of Dollar Inflation (Part 2)

April 5, 2009



Very sadly, this week a gentleman who posted under the handle of Scarab has passed on. Mark was a wonderful human being who always seemed to have a firm grasp on the reality of the present. To give you a brief glimpse of the man, I'll let Scarab's thoughts from 2007 ring out to you.

"Most of the general populace have yet to buy their first one ounce coin. In a time where the potential for disruption is so very high, on so many fronts. Perfection is priced in to the SM. Or something close to that. One of the things to note about the SM rally is the disconnect with truth. Note how little reason or fact effects the nature of the markets that tells you something about its current nature. There is a conscious or unconscious denial going on, the PTB and the public are in consensus in America on that much, no one really wants to face the facts, and so both invest and trade as if they didn't exist. It's so fascinating, so instructive as to the nature of humanity. And so I imagine what mindless gold buying will look like when it happens. We can only imagine until it happens. For one thing, I am sure it will eclipse anything seen before in the 70's."


In Part 1, we reviewed our take on the "Inflation Versus Deflation" question. We started to challenge the way that charts might be viewed when comparing a period of Dollar Inflation to a period of Dollar Deflation. In doing so we introduced the concept that "price" and "value" diverge in a period of Dollar Inflation. We also touched on the fact that in a period of time when many countries are inflating their currencies, a period of Global Competitive Currency Devaluations, the fiat pricing scheme called the Dollar Index becomes practically useless as a measure of Dollar value. These things are vitally important for an investor to consider in order for him to truly understand the current investing environment. You can find Part 1 at the link, below.

Today, we will continue our discussion of Part 1. We want to develop a much larger picture of the current investing environment- one that is much deeper and more 3-dimensional than what is generally discussed. For one to invest successfully, one must understand the environment he is investing in since markets do not operate in a vacuum. The current backdrop for the markets is one of massive deflationary forces as is usually seen in a K-Winter. Yet as far as we know for the first time in history, the Fed is trying to inflate our way out against the massive deflationary forces of a K-Winter. Thus, we believe that the massive Dollar Inflation being created in the face of the massive deflationary backdrop is the "driver" of the markets that must be considered. That Dollar Inflation is creating a market environment very similar to the 1970s, rather than one like the last K-Winter period of the 1929 era.

As we have shown with the charts of the Dow, our studies show that most investment sectors are closely following the cycle of the 70's in price and in time if considered at proper Elliot Wave Degree. Not only do the "fractal relationships" compare favorably in comparing one sector to itself in the 70s and the current period, but all of the sectors we have considered compare favorably to each other. Thus, all of the relationships of the different sectors compare favorably to each other in a fractal form that compares very well to the 70s time period. As long as the Fed continues to inflate the Dollar as the primary weapon against the deflationary backdrop, we see no reason for the close relationships to end. This is all very important to investors in the Precious Metals sector as we will eventually get to after we develop some of these different concepts.


Bonds are the means of financing corporate and government debt. This vital function of the Bond market is the motivation for protecting that market to the very end. In our last writing we suggested that it is about time to see the Bond market face a "mark down in price" to meet the deterioration in "value" as we saw happen to the Dow in the "deflation scare." That deflation scare provided one final rise for government debt as investors sought out a safe haven.

First, let's take a look at a chart of the Dow with both "price" and "value" plotted together. As a reminder the "value chart" is one where the effects of Dollar Inflation has been factored out, showing the real value of the Dow to a US investor. In the chart, below, the "price chart" of the Dow is in red while the "value chart" of the Dow is in green. We can see that the price chart of the Dow rose to a "false high" into 2007 mostly due to the falling value of the US Dollar as the denominator of the fraction which creates price. The "value chart" of the Dow in green constantly fell in a waterfall decline since around 2000. This relationship means that although the Dow was rising in "price", and investor was losing his buying power due to losses in the underlying currency- the US Dollar. Starting in late 2007 all the way through 2008, the "price chart" took a real dive during the deflation scare as "price" was marked down to approximate "value." We discussed in Part 1 why the "value chart" with the effect of the falling value of the Dollar stripped out, was the appropriate comparison to the Dollar Deflation environment of the 1929 era. We also suggested that with a fall in value of approximately 86% to date in the Dow value chart, we expect we might be in a window for a final low for the Dow price chart. We might still have one final wave down in this coming window of time. This concept matches what played out with the Dow in the Dollar Inflation period of the 70's.

Now, let's take a look at a price chart of the US Bond. We can see that the price of the US Bond has risen through the whole decade. In fact, the price spiked higher during the deflation scare when the Dow price was marked down aggressively since investors moved into US debt as a safe haven.

Next, let's take a look at the chart of the "value of the Dow" in red plotted against the chart of the "value of the US Bond" in blue. We see that the charts are very similar waterfall declines since around 2000. In fact, an investor in the US Bond has lost around 70% of the value of his investment since around 2000 if he has not hedged against the falling Dollar. We expect to see the "price" of the US Bond to shortly see the same type of mark down in price as the Dow went through in the deflation scare. The large gap in "price" and "value" cannot continue to exist. We are seeing a bunch of fancy names tossed about in terms of the Fed's second leg of Dollar Inflation. Yet, monetization of debt through "bail-outs", and monetization of debt through "Quantitative Easing" are just two forms of Dollar Inflation. In fact, both forms of Dollar Inflation are actually forms of the US directly defaulting on its debt. Defaulting on one's debt is not "Bond friendly."

The next chart is the "price of the US Bond" charted against the "value of the US Bond." This shows how the price of the US Bond has been bid constantly higher while the average US Bond investor has lost about 70% of his buying power to the falling Dollar. The charts are almost exactly the same for the 10 Year Treasury Instruments. We don't think the large gap between USB value and price can continue much longer.

Return On Principal Versus Return Of Principal

Richard Russell has often written on this issue. In fact, everybody should subscribe to Richard Russell for some period of time to read how he creates a framework for sound investing. Richard says that in an investing climate like today, it is less how much of a return on your investment that you receive, as it is one of getting your investment back whole. He also has said that "He who loses the least is the winner in this type of investment climate."

I think Richard is right, but when the charts of the Dow and of the USB are considered in terms of both "price" and "value", I think that exercising his advice can be rather difficult for most investors. A Dow investor probably felt pretty good being invested in the Dow between 2002 and 2007, yet the "value chart of the Dow" shows that from around 2000 to 2007, the Dow investor lost around 75% of the value of his investment. This is the kind of "dissonance" that fiat currencies can cause during a period of currency inflation when the currency is losing value. Thus, "up big" can really be "down big."

The US Dollar Index- A Fiat Pricing Scheme

In Part 1, we introduced how the Dollar Index can only be considered a fiat pricing scheme since it cannot reflect the value of the Dollar. Value can only be determined against a constant reference point- certainly not against a basket of items that are constantly changing. This is particularly true during a time period when most currencies are being devalued like the time period we are now entering. This is because a group of currencies that are all falling in value, if priced against each other, will leave the currency falling the least looking as if it has risen. Down is then up. This will become very important as the cycle continues to play out since the move to Global Competitive Currency Devaluations is growing. Investors relying on the Dollar Index as a "value" for the US Dollar will be in for a treat.

We will show, sometime later, how currency "price" indices might soon be relegated to the role of oscillators with little reflection of value, but for now let's try to use an analogy of how defective the US Index as measured against a basket of variable-priced currencies might be. This is especially true since the Euro is heavily weighted in the basket. To show the ridiculous notion of measuring "price" against something of constantly changing value, let's look at some charts. What if we had "priced" one Dow component against another during the sharp drop of the Dow during the deflation scare? The first chart will be the chart of IBM. We can see in the chart that IBM fell from around $130 in 2008, down to around $70, and has now bounced back to around $100 per share.

Now, let's look what the price chart for IBM might look like if it was "priced" against a basket of Dow stocks that was heavily weighted with Citigroup. This might be analogous to the Dollar pricing via a basket of other currencies, though we have picked and extreme example to make our point.

Wow! Instead of the price of IBM being down about 23% off the 2008 high, this pricing scheme shows that IBM might have recently been up by about 6,000% against a basket of Dow stocks, heavily weighted with C. (BTW, if you ever see this type of break-out of a falling wedge, you might want to buy it with some kind of stop in place.) This example shows how an item measured against a variably priced item can look like it is way "up" when it is actually "down." In the coming time period investors will need to take the Dollar Index with a grain of salt as all paper currencies are aggressively devalued against Real Money Gold since the currency pricing schemes against each other fail in a period of global currency inflation.


There is a real tug of war going on in the collective thoughts of investors concerning whether we will see a general environment of inflation or one of deflation going forward. This is an extremely important investing issue for the next several years so we certainly take it seriously. If we are to see an environment of outright Deflation over the next several years, then investors need to be moving into Dollars or into physical Gold. If we are to see an inflationary environment going forward, then investors need to be positioning themselves in "real things"- things with an intrinsic value. Such "real things" would include physical Gold, physical Silver, the Precious Metals Mining Companies that hold reserves of Gold and Silver, metals and commodities of all types, and investors might want to be considering when the General Stock Markets will be bottoming in the interim period if such a bottom is not recently in place.

Though the inflation/ deflation debate is a recent occurrence, we have been trying to stay ahead of the curve in considering this issue for a long-time. Over the past several years we have covered this issue in great detail. Thus, in the past we have posted our expectations of how the Dollar Inflation response to the massive deflationary backdrop might look. Those items have generally played out very much as we had anticipated. We showed how the Dow in this period would likely look much like the Dow of the 70s- another period of Dollar inflation. We had shown the cycle playing out in the LT chart of Gold where the 70's period very closely matches the current period to this day. We have discussed the chart of the US Dollar and the close similarities to the current period. We have also touched on the chart of the commodities and their general similar price movements to the 70s. In considering all of the above we anticipated the timing for the sharp fall for the general stock markets and the PM sector back as far as 2007, anticipating a sharp fall into the 4th quarter of 2008 which we labeled a "Deflation Scare" for lack of a better term.

With many investors expecting deflation going forward much like the 1929 era, we are now showing how the look of the charts change dramatically in a period of Dollar Inflation, though if the effect of the Dollar Inflation is stripped out of the charts- the charts would look very similar to the 1929 Dollar Deflation era. The current period is similar to the 1929 era in terms of the massive deflationary backdrop of debt in both time periods, but this time period is very different than the 1929 era due to the massive Dollar Inflation being provided as an antidote. The driving force for the markets for the first leg from 2000 until the Deflation Scare was Dollar Inflation. That first leg of Dollar Inflation was created mostly through the fractional reserve banking system. The Deflation Scare popped up at the "seam" between rounds of Dollar Inflation when the Fed "ran out of balance sheet", but it did so at precisely the point in the cycle where it was expected on the charts. Almost immediately at the bottom of the Deflation Scare momentum low in the 4th quarter of 2008, the Fed started another more massive inflationary effort as it started monetizing debt with the bail-outs, then extended that effort recently by starting to monetize our Treasury debt. We see no reason why the Dollar Inflation campaign will not continue.

To date, the similarities between the charts of Gold and the PM stocks to the 70s are uncanny. So are the similarities in the charts of the Dollar and the Dow. At the same time the price and time relationships for the Dow match the 1929 period if the effect of Dollar Inflation is factored out, and the Pi relationship suggests that a bottom in the Dow might be close at hand. Thus, we see no reason to expect anything but a continued Dollar Inflation program going forward with resultant chart movements that continue to mimic the late 70s markets. In future editorials we will show what we think that will likely mean for our favorite choice of investments going forward- Physical Gold, Physical Silver, and the PM Mining Companies that have good quality reserves of each.

Now, let's look at the potential importance of the fall in the "value chart" of the Bonds that we developed, above- something that we expect to lead shortly to the start of a "mark down" in the price in the US Bond charts.

A long-time ago, Jim Sinclair posted what he called "The Five Golden Pillars" of a Gold Bull market. Let's take a look at that picture.

Of those 5 Pillars, only the "Recognized Top In The US Long Bond" remains to be satisfied. Thus, our analysis of the wide differential between the Long Bond value and price is the last key to the Gold Bull. The only other Pillar that one might question would be "Bullish General Commodity Markets", but that can only be questioned if one ignores the relevance of the massive second leg of Dollar Inflation due to debt monetization, and if one is willing to stretch out on a limb in picking a top in the face of the second leg Dollar Inflation. Let's look at the chart of the original CRB Index.

Though this chart of the original CRB Index has corrected after a massive rise, there is no reason to believe it has topped in our opinion. The RSI and the MACD indicators have come off deeply oversold, the 2nd leg of Dollar Inflation has just started after the deflation scare, and in the late 70s the CRB index also showed a healthy retracement at the similar point in the cycle. Thus, confirmation of the Historic Gold Bull simply lies in the Bond market at this time in our opinion.


As a last item to finish up on, let's take a look at one comparison that might give us some kind of idea on how high Gold might rise in a Dollar Inflation environment like the 70's. We know that the ratio of Gold to the Dow regularly returns to an approximate 1:1 ratio on a regular cyclical pattern. Many who use this concept in trying to decipher a level that Gold might rise to, generally try to estimate a potential low in the Dow to compare to. Yet, if one looks back to the charts of the 70's Dollar Inflationary period, Gold topped at the start of 1980. It was at that point where the Gold to Dow ratio bottomed at around 1:1. By that point in the inflationary 70s the Dow had already bottom and risen back to around its "old top." Let's look at a chart of the 70s Dow, again, to confirm that. Look at the Dow at the beginning of 1980.

This chart of the Dow in the 70s suggests that if Gold and the Dow return to a 1:1 ratio in a similar way as the 70s, then we'll see Gold rise to a price somewhere North of $10,000 an ounce- maybe to as high as $12,000 an ounce. I find this little factoid to be interesting. Yet, we expect to see Gold rise in Dollars to whatever point it takes for Gold to balance the budget of the US. That will be determined to a large extent by the further amount of monetization of debt and of US spending into the future of the cycle. Recently, Jim Sinclair suggested that Gold would need to rise to around $17,000 to balance the US Budget at this time.


With some work and responsibilities out of the way, we expect to be moving to a subscription newsletter or investment site. It looks like I will have a friend as a partner. Anyone interested in receiving information when our site is up, feel free to send a note to the e-mail contact, below. Anybody who contacted us last year will have an e-mail notification sent to them.

Editorials like this one are meant to help define, or to "frame up" the investing climate we are in. Along with different "forward-looking" price projections, this framework is only the starting point of our investment strategy. The real nuts and bolts of investing will always lie in the work an investor does with each individual investment choice- both fundamental and technical chart-related. That includes some regular method of limiting risk, and there are many techniques to do so. Still, we feel that working hard to get a good feel for the coming investment climate, comparing the fractal considerations to past similar investment periods, and then instituting a sound and specific investment technique; will greatly increase our reward to risk probabilities. Minimizing risk while optimizing the potential for reward is about as good as it gets because "nobody knows for sure."

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For the moment…………..Goldrunner.

Again, I'd like to thank all of the posters at the Gold-Eagle Forum for their daily input. Special thanks go to Dr. Vronsky and Westerman for creating the Gold-Eagle site and for editing my work. A very special "Congratulations" go out to Dr. Vronsky and Westerman after Gold-Eagle saw its hit counter ring up to 327 million this last week.

Here is the link to a site I use to research the warrants of Precious Metals stocks. I will be discussing some aspects of the leveraged use of warrants later in this editorial series.

Another very good site that is dedicated to investments in Silver belongs to David Morgan, and his site can be found here…………….

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