This is deflation, a contraction of money and credit. Hardy anybody argues about that anymore. So what happens next? Will Obama and the bailout maniacs inflate a new bubble in green energy in their new, green deal? Maybe, but it would only be a limited bubble, not the worldwide craze in any and all non-dollar assets that we saw the last time around.

Don’t assume that any new bubbles at all will form for a long, long time. The mood has shifted from risk to hoarding. Now that people have been burned by everything from dot-coms to gold miners and are scared to death of losing their jobs, they are going to hang onto the one thing that still works: Washington Wallpaper, the little notes that promise, “I owe you nothing but more of these IOUs.

Deflation will rage, until it doesn’t. We are still early in this phase, since among the public there is still a healthy fear of the dollar and paper money in general. But over the next year, as commodities and foreign currencies slide still lower and consumer prices stay solidly and noticeably negative, people will forget about the deficit and the $100 trillion in debt at just the wrong time.

This is the rule of maximum pain for the maximum number. The dollar is not yet ready to fail because it is too feared and despised. But when people let their guard down and sell for $450 the Krugerrands that they are paying $900 for today, take all that they have, because then the real fun will begin.

Just as the public will get too complacent about holding I-owe-you-nothings (Doug Casey’s phrase), Congress and Obama will get too complacent about printing them up, and the whole debt-based money system will come crashing down. I don’t pretend to know how it will play out (hyperinflation or just plain-old, “sorry, we can’t pay” default), but it will be visibly ugly, and I am glad I’ll only be watching it on TV. This won’t be pretty anywhere, but the US is not a civilized country anymore, and it has a most uncivil government.

The 30-year yield closed at 3.91% today, in a massive compression of the yield curve, a movement that has a lot of room left to run. Way back on August 8th (day 4 of this blog), I wrote the following in “That crazy, crazy bond market: a call for sub-3% long bonds”:

I predict that the dollar rally will strengthen the compression of Treasury yields at all ends of the curb, as the market perceives a lower currency risk. This is a sign of deflation: an increasing preference for cash. With the banking system on the verge of a collapse worse than the ’30s, people will have no choice but to buy Treasuries. These promises of an insolvent and unrepentant debtor are safer than cash in the bank (because its not really in the bank!).

This flight to safety will send short-term yields back under 1% (as they were in March), and traders will move out the yield curve to get ahead of the compression, driving long bonds to historic lows, likely well under 3%. …

So it may seem crazy, but it is entirely possible (and given the banking crisis, likely) that long Treasury yields will fall to 60 year records in the face of horrible fundamentals. But once they get there, I expect them to turn up and keep going, as the government starts to default by Fed printing.

To all those who feel that the US debt just DESERVES to be shorted, I say wait. It will get more deserving.

That post is worth another look, if only for the charts of the last top in Treasuries, the 1940s, when long yields hovered under 3% while inflation breached 10%.

There has been a lot of talk of a widening yield curve lately, and more than a couple of people have mentioned to me that they were thinking of shorting TLT or buying a short Treasury ETF. This actually furthered my conviction that despite the HUGE deficits that the US gov’t has started to run, that bonds were still a buy, or at least not yet a short, as no market tops out in room full of bears. Well, the premature shorts had another rough day, as we all were reminded again that this is a deflationary panic, and that Treasuries are the only things that go up in these little episodes.

Markets don’t have to make fundamental sense. They only sometimes do, in the sense that a stopped clock is right twice a day.

From Globaldow.com:

The Global Dow is a 150-stock index of the most innovative, vibrant and influential corporations from around the world. Only leading blue-chip stocks are included in the index. Its components, like those of The Dow, are selected by editors of Dow Jones.

This is certainly a useful index that I will follow (it stands at 1444, from base of 1000 as of 1.1.2000), but the timing of its creation, a few months after Mr. Murdock acquired Dow Jones and with talk of a global central bank in the air, is suspicious. It is with moves like this that perceptions are slowly changed, so that when soveignty is lost, few notice or care.

That said, I suspect that it will be very difficult for bankers to succeed in such an effort, because rough times like these breed nationalism and heighten differences.

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PS — I have been relocating and traveling these past two weeks, hence the lack of posts.

Bloomberg columnist Jane Bryant Quinn reports that most financial planners still view stocks as the cornerstone of a retirement plan. An informal survey of planners showed overwhelming support for an equity allocation of 50-60%, although many have a new found respect for cash.

It still sounds as if most financial advisers are pretty worthless, just dishing up the same bad advice you could get from the New York Times:

Most of the planners are advising their clients to rebalance their portfolios, which effectively means putting money into stocks at current prices. They’re buying slowly, dollar-averaging into the market month by month. For taxable accounts, they’re also harvesting tax losses, to use against the capital gains that some mutual funds will be reporting, based on gains taken earlier this year. They also love municipal bonds.

Any adviser who had clients in more than a token amount of stocks by 2007 should be fired for incompetence. Same goes for those who still advise 50% or who like municipal bonds, which are an accident waiting to happen.

A good adviser doesn’t just deploy static formulas for asset allocation, but has the historical (100+ year) perspective required to identify periods of relative over- and under-valuation in various asset classes. Stocks were a time-bomb after about 1995. Commodities should have been avoided by early 2007. Real estate was on a crash course post-2004. Munis and corporates were also all risk an no reward after 2004.

This is pretty simple stuff, really. Just look at the relationships of various assets to one-another and to consumer prices, and don’t forget that metrics like PEs and yields can reflect overvaluations for so long that up begins to look like down.

As asset classes get way out of whack with historical averages, they should be sold or bought accordingly. People often forget that cash is an asset class, perhaps the most important one, and should be bought in spades when it is cheap and held until it is dear. It is still cheap.

“Even Hitler got whacked in gold stocks”

Lewrockwell.com has assembled a compendium of essays and other media on this Greater Depression from writers with an Austrian perspective. While you won’t find many even here who understand the mechanics of deflation, you won’t find so many smart, honest economic writers anywhere else:

There is No Such Thing as a Free House

Someone once remarked that the best indicator of a recession is the number of times “Mises” “Hayek” or “Austrian” appear in the newspapers. During the boom, no one wants to listen to the lessons of the Austrian economists. No one wants to hear that we need to live within our means – that the Federal Reserve does not have the power to print us into prosperity by artificially creating credit. So while the writers of LewRockwell.com were warning against the housing bubble and the inflationary nature of the Fed, the mainstream was touting the economic wisdom of Bernanke and Greenspan. When this recession hit, it seems everyone except the Austrians was caught off guard. Commentators, bureaucrats, and politicians began panicking, “Something must be done! This is Something…therefore it must be done!”

Instead of looking to the mainstream for answers to this crisis, why not look to those who saw it coming?

For those new to Austrian economics, this reader will offer an introduction to this unique school of thought. It is unlike any other school of economics you have likely come across. Instead of focusing on unrealistic mathematical models, the writers here build their thinking on human action and observations of how the economy actually runs.

What’s important is not necessarily the specific political opposition to this bailout, but rather educating people about the dangers of nationalization, central banking, and government regulation. Only when people recognize the dangers of the government’s “socialism for the rich” will we be able to get back on the road to prosperity. Unfortunately, a correction is necessary. There is no such thing as a free house. The more the government intervenes, the longer and more painful it will be. But this crisis gives the country a chance to rethink its previous assumptions about the economy and the government’s role in it. Hopefully, this reader will be a first step for many into an exciting, growing branch of economic thought.

The Bailout

• Don’t Trust the Brain Trust, Lew Rockwell, October 7, 2008.
• The Bailout of Abominations, Robert Higgs, October 6, 2008.
• The Political Class Crosses the Rubicon, James Ostrowski, October 6, 2008.
• Lipstick on a Bailout, Ron Paul, October 2, 2008.
• The (Near) Death of the State, Lew Rockwell, September 30, 2008.
• The Good News About the Bailout, Geoffrey Pike, October 8, 2008.
• Democracy’s Debunking, Becky Akers, September 20, 2008.
• Herbert Hoover’s Depression, Murray Rothbard.
• Dispossession by Decree, William Norman Grigg, September 20, 2008.
• Stop the Bailout, Lew Rockwell, September 11, 2008.
• The Government is Not Promoting Stability, Bob Murphy, September 22, 2008.
• Day of Reckoning, Pat Buchanan, September 27, 2008.
• Economic Depressions: Their Cause and Cure, Murray Rothbard.
• Notes on the Fannie Mae/Freddie Mac Bailout, Bob Higgs, July 17, 2008.
• Get Out of the Way, Anthony Gregory, July 18, 2008.
• The Mises Institute’s Bailout Reader

The Bubble

• Blame the Government, Murray Sabrin, October 10, 2008.
• The Month When Reality Invaded, Gary North, October 4, 2008.
• Blaming the Victim: The Free Market, Gary North, September 27, 2008.
• Looting the Responsible, Kevin Duffy, October 8, 2008.
• The Denouement, William Norman Grigg, September 18, 2008.
• Understanding the Crisis, Lew Rockwell, September 20, 2008.
• The Impending End of the Housing Bubble, Bill Bonner, September 19, 2006.
• Is the Housing Bubble Popping?, Mark Thornton, August 8, 2005.
• Pop Goes the Bubble, Gary North, August 23, 2003.
• The Land-Price Bubble, Doug French, June 10, 2003.

The Banks

• Could Your Bank Fail?, Bill Sardi, July 23, 2008.
• Anatomy of the Bank Run, Murray Rothbard.
• More Bank Failures, Doug French, August 25, 2008.
• Run for Your Money, Max Raskin, September 28, 2007.

The Fed

• What Hamilton Has Wrought, Thomas DiLorenzo, October 6, 2008.
• Financial Dictatorship Comes to America, Michael Rozeff, October 6, 2008.
• How to Avoid a Depression, Michael Rozeff, October 4, 2008.
• The Fed’s Failure, Michael Rozeff, September 17, 2008.
• War and Inflation, Lew Rockwell, June 9, 2008.
• Why Not Abolish the Fed, Jacob Hornberger, February 5, 2008.
• A Run on the State, Bill Huff, September 27, 2008.

Short Selling

• The SEC Short Sells Us Down the River, Art Carden & Bob Murphy, October 10, 2008.
• Don’t Sell Short Selling Short, Gary Galles, April 7, 2007.

Ron Paul and Austrian Economics

• The Austrian School and the Meltdown, Ron Paul, September 26, 2008.
• The Creation of the Second Great Depression, Ron Paul, September 25, 2008.
• Ron Paul Against the Bailout, Ron Paul, September 25, 2008.

We Told You So

• Fannie and Freddie, Ron Paul, September 10, 2003.
• ‘Bull’ Market?, Mark Thornton, February 9, 2004.
• We Told You So, Mark Thornton, March 24, 2007.
• Falling Oil Prices: Told You So, Dom Armentano, September 10, 2008.

Podcasts

• The Problem With Fiat Money, Guido Hulsmann, October 10, 2008.
• The Counterfeiting Federal Reserve, Joe Salerno, October 8, 2008.
• Thanks for the Inflationary Depression, Peter Schiff, October 6, 2008.
• Doug French on Fractional Reserve Banking, October 1, 2008.
• Guido Hulsmann on Hyperinflation, September 29, 2008.
• Ron Paul on the Panic of ’08, September 18, 2008.
• Lew Rockwell on the Michael Reagan Show, September 26, 2008.
• Robert Higgs on War and the Economy, September 25, 2008.
• Steve Berger on Financial Markets, July 31, 2008.
• Robert Higgs on the “Crisis,” September 24, 2008.
• Joe Salerno on the Broke Banks, July 23, 2008.

Books

• America’s Great Depression, by Murray Rothbard
• The Causes of the Economic Crisis, by Ludwig von Mises
• The Politically Incorrect Guide to Capitalism, by Robert Murphy
• Economics in One Lesson, by Henry Hazlitt
• Prices and Production, by F.A. Hayek
• The Mystery of Banking, by Murray Rothbard
• The Case Against the Fed, by Murray Rothbard
• How Capitalism Saved America, by Thomas DiLorenzo

I entered an order to buy GDX (a gold stock ETF) calls on Monday, but didn’t hit the buy button, since no matter the technicals, I’m never very comfortable going against my understanding of the forces at play, even just for a short-term trade. Turns out those contracts would be up by a factor of three by today. I’ll just wait out the rally and go short again if things get out of hand, as in $32 for GDX. I have a hard time believing that the bear market in commodities is finished after only 4-7 months, when the economy is crashing through the floor and credit remains extremely tight.

Here’s a visual of the bloodbath and bounce in gold stocks (three-month chart from bigcharts.com):

Click for sharper view.

I’m in no hurry to go long anything at all, since the unwinding of the credit bubble will take years. I don’t think that we have seen any bottoms, not in gold, oil, copper, wheat or any kind of equities or bonds.

The risk is all to the downside. The looming risk of currency failure is the lone caveat, so it behooves everyone to have some physical gold — more if you are a renter with no other hard assets, less if you are an oilman or farmer or own significant real estate, within the range of 5-20% of assets for now. I intend to bump up my own allocation to near 50% or even much higher over the next couple of years, hopefully at very favorable prices.

This intention is predicated on the expectation that the US and other governments will before long saturate the markets for their treasuries and follow up by saturating the markets for their fiat monies. This will create all manner of chaos and depress real asset prices yet further, even from the very low nominal prices that I expect in the interim.

The assets to buy in the nominal and continuing real deflation will be those that generate income, since anything spinning off cash two years from now will have proved its mettle. Those companies and properties will be the most likely to hold their value in currency mayhem, and could generate fantastic capital gains in the recovery as earnings and multiples expand from highly depressed levels.

That said, all of this will take longer than even I think. Buffett, sell-out that he has become, was once a great investor, and he has remarked that sitting in T-bills is one of the hardest things to do.

Michael Rozeff crunches historical CPI and the gold price in this essay on Lewrockwell.com. Right off the bat, let’s clear the air with this statement, with which I am in complete agreement:

“If the economic world of the dollar is going to end anytime in the next few years, then the difference between paying $735 for gold and paying $500 for gold will be irrelevant. I am making no comment about the likelihood of these scenarios, other than to say that they are more likely today, in my opinion, than ever before.”

My suspicion that gold could break $500 is not an argument to sell or not to buy, but reason to buy slowly and without the panic so often associated with this particular economic transaction.

Give the article a read. It is not an exhaustive discussion, but the bear case on gold is still rarely heard, especially from a market participant with a hard-core laisse faire perspective (Robert Prechter also comes to mind).

I was a bit surprised that Rozeff’s record of 1967 grocery prices from his family’s store actualy reflected a slightly lower rate of inflation than CPI.

Apple jelly was $0.40 and is now $2.48. Up by a factor of 6.2.

Red raspberry preserves were $0.55 and are now $3.00. Up by a factor of 5.5

Jif peanut butter was $0.60 and is now $2.37. Up by a factor of 4.

Skippy peanut butter was $0.61 and is now $2.71. Up by a factor of 4.4.

Mazola was $3.07 and is now $13.59. Up by a factor of 4.4.

Pompeiian olive oil was $0.49 and is now $4.08. Up by a factor of 8.3.

Crisco shortening was $0.95 and is now $5.18. Up by a factor of 5.5.

Carnation evaporated milk was $0.19 and is now $1.17. Up by a factor of 6.2.

Borden condensed milk was $0.42 and is now $3.04. Up by a factor of 7.2.

Nestle’s morsels were $0.55 and are now $3.21. Up by a factor of 5.8.

The average inflation factor of these items is 5.75.

The CPI calculator here shows that $1 in 1967 is $6.15 in 2007. …

Rounding, I take $550 to be an estimate of gold’s 2008 price that is consistent with the CPI index. This calculation is supported by the fact that the rather stable price of gold in 1994 grew from a stable price in 1977 and that the growth rate tracked the growth rate of the CPI index between 1977 and 1994. …

Another very simple approach that does not use the CPI at all is to find a linear or arithmetic trend between 1977 and 1994 and project that trend forward. Gold rose from $148 to $384 in those 17 years or $13.88 a year. Over the next 14 years, similar increases would add up to $194. That gives a projected 2008 price of $384 + $194 = $578.

The next approach I use is to relate gold’s price to the prices of base metals. Copper, zinc, nickel, aluminum, and lead all rose substantially along with gold between 2003–2005 and 2008. They were all part of the commodity price rise. Now all of these metals have fallen back sharply. They are either back to their 2003–2005 levels or getting quite close. If gold mimics their behavior, then gold will return to its 2003–2005 level. That level is about $400.

If we see more negative CPI figures in the coming months (raw August and September month-to-month figures were negative — pdf here for Sept), as I expect, the reality of deflation will start to set in, and consensus opinion on cash in general and the dollar in particular will complete a 180-degree turn from the the atmosphere of 2005 to 2008, when gold leapt out of trend.

I have built up a position in DIA Nov. 08 puts on rallies over the past couple of weeks, and with the Dow up 300 at 3:30 today, I couldn’t resist adding a few more than I would ordinarily be comfortable with. I intended to part with the extra contracts maybe tomorrow or the next day in the inevitable correction after such an awesome rally (1,208 points, 14.8%). As it turned out, the Dow proceeded to drop 473 points in about 15 minutes, and I unloaded the contracts at the close for the fastest money I’ve ever made (as regular readers know, I’m more fond of buying LEAPs to capture the big, multi-month moves).

From Bigcharts.com, here’s the 1-day chart (1 minute):

Click image for sharper view.

As I count the Elliott Waves, this pattern has the A-B-C shape characteristic of a countertrend move, so it doesn’t change my expectation for new index lows in the coming days or couple of weeks. The mini-crash at the close looks like waves 1, 2, 3 and 4 of an impulse wave, which would resolve with another drop below the wave 4 low near the open tomorrow. Impulse waves move in the direction of the one-larger degree trend, as opposed to A-B-C moves.

Today’s chart also illustrates another textbook pattern: the contracting zig-zag from 2:40 to 3:15 resolved in the direction of the previous trend — up, way up. The 1-month pattern is still a very large contracting zig-zag, which, should it stay true to form, would resolve downwards, perhaps to Dow 7000, though a push above the October 14th high first is also possible:

Click for sharper view.

All of this near-term wave counting and trading is really just a hobby for me. I don’t use big money in it, but just enough to keep my attention so that I learn something. My real money is in T-bills, gold and still a boatload of 2010 puts that I accumulated over the last 15 months (see disclaimer), though I have been paring that position in the crash. If I hadn’t been selling, it would be about 85% of my portfolio by now.

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Sorry for the paucity of posts lately. I’m in the middle of a trans-oceanic move, ditching a ridiculous Latin American country for a central European one known for staying sane while the rest of the world goes nuts.

A ratio of the gold price to the XAU gold stock index of greater than 4 is traditionally considered a buy signal for gold stocks, with 5 a strong buy. Today the ratio is an unheard-of (to my knowledge) 10.65.

Are gold stocks a screaming buy or could this mean that gold has much further to fall? Mining stocks and other metals are down from 50% to 80%, so gold bullion stands alone with roughly a 30% decline. It is money, so it should fall less than other assets in deflation, but these ratios may be a bit extreme.

I considered GDX calls today as a short-term trade but thought better of it. This deflation is powerful stuff, and I want to stay out of its way for now.