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Expect Gold to Benefit as Re-inflation Efforts Fail

by: Greg Silberman posted on: March 20, 2007 | about stocks: GLD / IAU

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When everyone thinks the same, it means that no one is thinking. Here are some common (mis)perceptions out in the marketplace:

1. The current stock market correction was foreseen and necessary;
2. A consensus 10% correction is expected before we enter the next up leg in the
market;
3. Trouble in the mortgage market is well contained and will not cause any unforseen credit problems;
4. The recent sell off in gold along with the stock market confirms gold has passed its sell-by date and is ineffective as a counter-cyclical asset;
5. Oh yes, oil is bouncing from oversold conditions before it will plunge beneath $50 per barrel.

Contrarian investors should thank those who create the ‘market consensus’ because it regularly presents amazing investment opportunities.

Now is such a time.

Many indicators attest to the fact that the current stock market correction may be more than just a ‘routine’ pullback. The current correction may take much longer than the consensus expects to work out. Here are few indicators to suggest that a significant top has been put in place:

• The market was seriously over-bought after having moved up nearly 7-months without so much as a 2% correction.
• There had been continued internal deterioration (MACD and RSI) in the Dow Industrials even whilst the market moved higher week after week.
• The Nasdaq market (a leading indicator) made its high in December and has not been able to better that.
• Fundamentally the market is way overpriced with a P/E of 21 and dividend yield of 2.3%.
• Technically speaking, most corrections are not V-Shaped (down then up) but zig-zag affairs which probe the bottom and tops on a number of occasions – we have only seen an initial fall.

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Suffice to say, based on the technical damage, the Market may be trending lower for some time as it undergoes a mean reversion from previous Stellar performance.

The danger ofcourse is that prolonged weakness (or even a flat market) will be insufficient to service the debt burden underpinning asset prices. For example, sub-prime mortgages will continue to crater in the absence of a turnaround in Home prices.

The odds therefore favor a Fed induced re-inflation program to begin sooner rather than later in order to protect asset prices. And I’m wondering, just wondering, will the Fed really be able to reinflate?

To re-energize the economy, the Fed will cut interest rates and cause a flood of new money to enter the market. Nothing wrong with that, except that the Fed cannot direct where the new money will flow.

We see from the 2000 – 2002 bear market that the Fed was ineffective in reinflating the collapsing tech bubble and instead, new money found its way into real estate. By the same token, the Fed will fail to bolster real estate this time round.

So where will all the new money go?

My guess is it will find its way into government sponsored programs like infrastructure and defense. Nobody but federal, state and local governments will have the stomach to borrow and spend after the current real estate debacle.

It will also find its way into agricultural commodities where, for example, live cattle prices have recently broken to new highs (even whilst stocks are sagging).

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Source: futures.tradingcharts.com

The problem is that higher food prices and higher infrastructure / utility bills are strong warnings of rising price inflation. As inflationary expectations increase, market participants demand higher yields on bonds to compensate for the additional risk (even whilst short-term rates are falling).

And when consumers perceive inflation to be rising they will demand higher wages from employers to compensate for an obvious increase in the cost of living.

Higher wages and higher borrowing costs will have a negative effect on corporate profits, yanking the rug from under the stock market and creating a vicious circle of falling asset prices.

All the while making it necessary for the Fed to inject ever more fresh money to stimulate the economy.

None of this will be lost on gold which is a chief inflation indicator:

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When inflation protected bonds outperform unprotected bonds (the chart is falling) inflationary expectations are rising, gold (bottom) responds favorably.

Continued weakness in stocks or even just the failure to make new highs could trigger a significant monetary disturbance. Gold is poised to be the major beneficiary and, at current levels, is significantly undervalued.