There is a simple fact that all Goldbugs miss: and that is the American economy, and most all others in the world, have just experienced a massive asset DEFLATION (still underway in some segments like commercial real estate). This deflation in America was about $15T over the past two years according to New York University’s Nouriel Roubini (from $40T to $25T). That asset deflation was completely psychological. One day American assets of all types were worth one value in dollars and just a little bit later, were worth quite a bit less. There was no massive physical destruction of assets as in a war (counter to the weak Weimar argument for hyperinfaltion), only economic.

The basis for my opinions on monetary reflation are derived from Hyman Minsky’s work. PIMCO’s Paul McCulley has written on “The Minsky Solution” many times the past two years. In early January, I featured one of McCulley’s articles in a post: http://wealth-ed.com/2009/01/reflation-economics-or-the-minsky-solution/

To deflate assets requires the value of the currency those assets are denominated in to increase as the quantity decreases (this might be counterintuivitive for most). In essence, $15T of dollars were destroyed or disappeared (not physically, but notionally with debt paper markdowns). Less dollar supply at a given demand = higher price / value. Central bankers everywhere understand this dynamic. So, in a coordinated way to restore stability to global assets, currencies are being expanded to replace those notionally destroyed through markdowns during 2008 (the paper that underpinned all those assets, CDOs, RMBS, etc).

The most intelligent dissertation I have seen on repairing a deflation was printed in Barrons last February. Ray Dalio, a rare Barrons contributor, was interviewed. I reference this interview on this blog: http://wealth-ed.com/2009/02/fixing-a-deflation-a-most-intelligent-analysis/

To recap what Dalio said, then, and most presciently: this CB driven monetary expansion is NOT inflationary to the extent that aggregate asset values are being returned to 2007 levels. “How can this be?”, say all the skeptics at this point.  My answer: by definition, the reduction of the value of $40T national assets to $25T assets is DEFLATIONARY. In America, $15T of the global reserve “currency” (almost all of it electronic bookkeeping and not “paper”) can be created to replace the “paper” that was lost in 2008, with mostly positive effects. There is no deleterious effect so long as the re-creation of the lost currency is done slowly enough as to not be disruptive to global currency flows (currency destruction in 2008 was disruptive enough, don’t we all agree?)

$80 Oil and $3 copper is probably in the area of “fair value” vs. the dollar given a mid 2007 USD reference. But $1100 Gold? Unlikely. Gold is now trading on speculative fear of inflation, not the reality of inflation itself. So far, the dollar has not even been expanded (reflated) sufficiently to move asset values back to mid-2007 (check local house prices). Monetary expansion is definitely not inflationary, in America, at this point in time. For gold to be worth $1100, let alone $1500, then global central banks must be unable to stop the expansion that has started in an effort to stabilize asset values. Maybe that is a reasonable speculation, and maybe not (and I own a prudent number of gold shares as a hedge, just in case it is). But like many others, as a more significant inflation hedge, I would rather take my chances with commodities that have fundamental industrial value, and not merely the psychic value of gold.  As is pointed out, gold is worth nothing unto itself. And worse, gold is not consumed, so supply forever increases. This ever-increasing supply dynamic is NOT the hallmark of a good investment.

Many people are very upset that the dollar has been declining the past few months.  The call is out for the Fed to raise interest rates (see Barrons headline, October 19, 2009). 

But there is a flip side to this argument.  Asset valuation (whether real estate, baseball cards or stock equities) is never about fact, but always a matter of opinion.  Facts, like the P/E ratio,  might support the opinion, but value is an attitude or belief, it is not an absolute truth.  Because valuation is an opinion, it is subject to psychology.  When people feel good about an object and can support that feeling with some fact, it has higher value.  When they feel poorly about the same object it has lower value.  But the object itself doesn’t physically change.  Value is psychic.

And what is the point of this observation? 

The same is true for currency of any kind, including the maligned dollar and revered Gold.  When people want it, the unit price is higher, when people don’t want it, the unit price is lower.  To turn what is obvious on its head, maybe it isn’t that house prices went down the past three years, but that the value of the dollars used to buy the house went up with demand from the world for a safe harbor. 

The American currency remains the safest form of wealth the world knows.  After all, contrary to its reputation, the price of gold declined during the worst of the panic.  It did so as the price of the dollar in the form of short term US Treasuries, increased to record levels (as interest rates went to zero). 

So, it was the currency ”safety trade” and a highly valued dollar that was a primary source of our real estate woes.  Put in this light, it makes much more sense that the Fed is working a policy to lower the value of the dollar back to where it was before the crash began.  By lowering the value of the dollar, all physical assets priced in dollars will increase in apparent value.  This will add to the wealth effect and eventually, business leaders will start hiring and consumers will start spending.  That is and always has been the sequence of economic events.

The easiest way to devalue the dollar and thereby reflate the economy is by creating a flood of currency liquidity.  The Fed has the power to do this and it is.  This action is right out of the anti-Great Depression playbook and was used in the 1930s to great effect until the Fed lost its nerve in 1937 and raised interest rates by shutting off liquidty (tightening money supply in other words); prematurely as history has proved. 

So what Andrew Bary in the Barrons piece is calling for, is really the recipe for a Double Dip Recession or perhaps even to tip the economy over into the Depression we just narrowly avoided.  To raise interest rates or reduce financial liquidity at this point would destroy the economic comeback, one which is unprecedented in its speed and amplitude. 

It is time to appreciate Ben Bernanke’s insight and command of monetary policy.  It is his (and the Treasury’s) knowledge and courage that have kept the global economy from capsizing.  We took on some water, but Bernanke and company kicked the bilge pumps into high gear and we are beginning to float high and unfurl the sails once again.  He should have no problem trimming those sails once the wind comes up.

Just six months ago, at the bottom of the financial crisis during the darkest days of October and November 2008, it was unclear whether the American banking industry would survive.  Fannie Mae, Freddie Mac and AIG had already been effectively nationalized (more than 80% of stock owned by the Feds) and Citigroup, Bank of America, Morgan Stanley and others appeared to be on the doorstep of investor-owned demise. 

Now, in May 2009, the world seems a much better place for bankers and the rest of us that use bank money.   I for one, don’t think banks will lead the market higher, but they need to at least regain their health and participate in the economy for growth to happen.  It seems they are on their way.  BAC, one of the sickest of the surviving banks, successfully sold over 1 billion shares after hours on Tuesday to close the gap on its capital needs according to the government “Stress Test”. 

Dick Bove, who has been a lone voice for the survival of the banking industry, sees a very bright future for BAC, at least as compared to now.  He came public Monday with a statement that he expects BAC earnings to normalize around $4 per share, even after dilution, within the next 2-3 years.  Applying a 10-12 multiple to earnings, this implies a $40-48 future share price as compared to the $12 today. See his comments towards the end of the embedded news clip.

A great way to play the banks over the next few years is UYG, the leveraged ETF of the financial index.  UYG is today comprised mainly of the superior banks such as JP Morgan, Goldman Sachs and Wells Fargo, but BAC also has a place on this index.  Barrons posted an article on options trading strategies for BAC stock that might provide some ideas to capitalize on the return of the banks:

http://online.barrons.com/article/SB124265990717130781.html

Regarding the commodity price discussion by Stephen Leeb in a recent newsletter, I think we can have it both ways, both the Barrons and WSJ positions. We are in the midst of a “short term” correction in commodity prices. Basically, the price increases got ahead of themselves at a time of weakening demand. The commodities markets are heavily influenced by speculative cash flows in today’s market. It has become a favorite play ground of hedge funds and hot money. The size of the commodities markets is relatively small compared to the amount of funds available to chase those commodities, so the prices are easily moved around by speculative money flows. I agree with the 30% correction forecast by Barrons, and we are just about half way there on gold with the price in the upper 800s.

But I also agree with the WSJ article which makes the case for supply constraints as the “long term” problem for commodities pricing. New supplies of natural resources and ag products are hard to bring on line. Demand will not create instant new supply like it might for financial products or electronics, which are very easy to ramp up in terms of production (all financial products require is a paper and pen). New mines or oil wells require land acquisition, permitting, support infrastructure (roads, power, etc), labor in places where it may not be already available (Northern Canada), large capital funding, plant design and engineering, etc. And as the most accessible resources are tapped out, the remaining resources are in harder and harder to develop locations (mining seems to go with mountainous terrain for example).

So, I think we can consider both arguments and invest accordingly. If you like to trade short term, like me, the trade now is to be short the commodities. But if you are more of a buy and hold investor, then the proper trade is long. And the new lower prices make this a decent entry point for gold, copper, iron, etc. Ag commodities will also be a good buy if they pull back a bit more.