The answer is: yes.

The “hyper inflation is coming” people will tell you that the massive stimulus spending by the government is very inflationary, so a hyper inflation is inevitable.

The “deflation people” will tell you that, if we haven’t seen a hint of inflation after a few trillion dollars in government spending, it’s unlikely we ever will.

So who is correct? Before I give you my thoughts, let’s talk about what inflation means.

To the average person on the street, inflation means “prices are going up”. That may be the manifestation of inflation, but that’s not necessarily inflation. If I design a really cool new gadget, version 5.0, and I can charge more for it that the old 4.0 version, is that inflation? No, it’s just the price of something going up.

I define inflation as an increase in the money supply. Here’s a very simple example.

In the entire economy there are only ten pencils. In the entire economy there is only $10 in money in circulation. Since the only thing you can buy in this economy are pencils, the price of a pencil is $1.

Then, one day, the government decides to “stimulate” the economy by printing more money. The print $90 more dollars, and give those dollars to the citizens of this economy. There is now $100 of money in circulation. Of course printing money doesn’t actually create any products, or wealth, so the only thing you can still buy in this economy are pencils. Now there is $100 of money chasing ten pencils, so the value of a pencil rises to $10 each.

It would therefore appear that pencils have experienced price inflation, since their price has inflated from $1 to $10. However, the true value of each pencil has not changed; each pencil remains one tenth of the economy. What has changed is that the money supply has increased, and that’s what has caused inflation.

To summarize: inflation occurs when the money supply increases.

Based on that example, it would appear obvious that we are in a period of significant money supply inflation. There are now a lot more dollars chasing the same number of goods. So why are we not seeing inflation?

Good question.

Milton Friedman’s is known for his quote that “inflation is always and everywhere a monetary phenomenon”. I’m not as smart as Professor Friedman, so I will assume he’s correct: past inflations were caused, in large measure, by increases in monetary policy (or increases in the money supply). However, that doesn’t mean that an increase in the money supply automatically leads to inflation. How do I know that? Because we have had massive increases in the money supply in the last two years, but we have had no inflation. One obviously does not lead immediately to the other.

But again, why, with massive government spending, are we not seeing inflation? There are a number of reasons:

The main reason is that no-one has any money.

The government gives a billion dollars in bail out money to a bank. The bank uses that money to “shore up it’s balance sheet”, or to cover it’s loan losses. No new money is lent, so actual consumers, that make up three quarters of GDP, have no additional money to spend. No-one has any money because:

• consumer’s can’t borrow, because banks are not lending;
• household income is falling (due to the recession, high unemployment, and declining real wages); and
• people have no savings (we owe more than we have saved), which means, simply put, we have no real money. If we have no money, we have nothing to spend.

And that’s the point. We have no money; we have nothing to spend, so prices are not being “bid up.” Here’s our story, again:

In the entire economy there are only ten pencils. In the entire economy there is only $10 in money in circulation. Since the only thing you can buy in this economy are pencils, the price of a pencil is $1.

Then, one day, the government decides to “stimulate” the economy by printing more money. The print $90 more dollars, and give those dollars to the banks. There is now $100 of money in the economy, but there remains only $10 of money in circulation, so the actual price paid for a pencil doesn’t change.

As you can see from this example, a massive increase in the money supply does not automatically lead to price inflation; for prices of consumer goods to increase, there has to be demand.

Today, there is no demand. Unemployment is high, and despite all of the government happy talk, the man on the street knows the economy is still suffering. He knows that he could be unemployed at any time, or he is already out of a job. So how does he react? He starts to cut his expenses. He pays off debt. He tries to save money. Not surprisingly, if we are saving instead of spending, prices are not going up. If retailers can sell stuff to us, they have no choice but to lower prices to get us to buy.

Prices going down is not a sign of inflation.

Yes, it’s possible that the price we pay at the gas pump may go up. It’s also possible that the cost of imported food will also increase. But that doesn’t mean we have inflation. It means we may be spending more on gas and food, so we will have to cut back in other areas, since our resources are limited, and it’s no longer easy, or prudent, to borrow to consume.

So, for now, we are in a deflationary period. We may still get hyper inflation in the future, but for now, expect deflation, not inflation.

Investment Implications of Deflation

Reduced consumer spending is NOT a formula for stock market increases. In simple terms, stock prices increases when company profits are increasing. Company profits only increase if consumers are actually spending money. Since consumers are not spending money, companies will not increase profits, so stock prices will not increase.

But wait, you say, the stock market has increased! No, it is actually down year to date, but yes, I see your point; since the bottom of the crash the markets are higher. How can that be? There are two explanations:

First, the markets are wrong. Investors are assuming the recession is over, and they are pricing stocks based on the assumption of future profit growth.

Second, company profits have increased since the bottom. That’s true, but in most cases they have increased due to a reduction in expenses, not an increase in revenue. If Company ABC’s revenue remains flat, but they lay off 10% of their workforce, and cut 10% of their expenses, their profit will increase by 10%. The earnings per share goes up, so the stock price goes up.

Great! So if companies continue to cut their workforce by 10% per year, we will all be millionaires! Except for the fact, of course, that no-one will have a job, and if no-one is working, no-one is spending or consuming, and the depression gets worse. Again, that’s exactly where we are today. Official unemployment in the U.S. remains stubbornly in the 10% range, but the true unemployment number, when you add back discouraged and under-employed workers, is a lot closer to the the 25% levels that were reached during the last Great Depression in the 1930′s. That’s deflationary, and that’s not good for stocks.

Which is why I am largely in cash at the moment.

The Implications for Gold

If the stock market is poised for a drop, does that mean gold and gold stocks will also drop? That’s two separate questions. Yes, when the tide goes out, all boats fall, so if we have a significant stock market correction, all stocks, including gold stocks, will suffer.

However, gold is a store of value. We humans tend to think of gold in terms of “dollars per ounce”, which is the wrong way to think of gold. We should think of gold in terms of other products. Today, an ounce of gold, at $1,200, will buy you a good man’s suit. Back in the 1930′s, when gold was $35 per ounce, an ounce of gold would buy you a good man’s suit. The price of gold in dollars may change, but an ounce of gold, yesterday, today or tomorrow, will still buy you a good man’s suit.

That same ounce of gold will also buy other products. 20 ounces of gold will buy an inexpensive car, 200 ounces of gold will buy a nice house, and so on. As prices deflate, do I want to store my wealth in a product that is also deflating, or do I want my wealth in something that will hold it’s value?

Obviously I want to store my wealth in something that will hold it’s value. Gold is good for that. So, I will continue to hold gold, because I know that even in the future I will be able to trade in my one ounce gold coin for a nice man’s suit, or other commodities I need. The same can’t be said for fiat currency.

Of course I could also store my wealth in other commodities, like a good shovel for use in my garden, or a bicycle I can use for transportation, or some solar panels for my house. (I have yet to convince my wife to let me put solar panels on the house, since they are not yet cost effective, but I do have good garden tools, and two good bikes).

So to summarize: I expect stock markets to fall, but I plan to continue to hold gold, since in both periods of inflation and deflation, gold will hold it’s value.

As for the muddling markets, that was a nice little drop on Wednesday, if you think a 3% drop on the Nasdaq, and an almost 3% drop on the S&P 500 is a “nice little drop.” It allowed me to close out my September S&P 1020 puts, at a nice profit. I then took the money I originally invested (taking my profits off the table), and immediately bought some September S&P puts with a 990 strike price. Silly gamble? Probably, but most of my money is in cash, and I find if I play with a few dollars it keeps me interested, and prevents me from being silly with larger amounts of money.

The S&P 500 closed the week at 1,079, stuck right in the middle of it’s 1,000 to 1,200 trading range. Which way will it break? If I had to guess, I’d be betting on the lower end of the range, obviously. Of course I have no idea when it will break, so for now, I continue to ponder the impact of near term deflation, I continue to hold cash, and I sit, and I wait.

Until next week, thanks for reading.

Did you ever wonder why they call it hamburger? There’s no “ham” in it?

Did you ever wonder why they call a building where everyone lives really close together an “a-part-ment”?

Did you ever wonder how an economy can lose a million jobs eight months into a recovery? Did you?

To quote Edward Crotty, Chief Investment Officer at Davidson Investment Advisors, speaking about the better than expected U.S. jobs report on Friday:

“The next data points will let us know if it’s truly a peak or a peaking process, but any month we could see a creation of jobs,”

The Dow was up over 2% on the week, and all is well because the economy, only lost 36,000 jobs. Happy days are here again, and any month we could see a creation of jobs.

Am I the only one who is stunned by the fact that we are talking about almost being at the job creation phase? Here’s the way it usually works: a recession ends, and then jobs start to be created. I’m not an economist, but if you look at where the bottoming of output was, it was around eight months ago (which makes sense, since the stock market bottomed exactly one year ago today, on March 6, 2009 where the S&P 500 was at 683; it’s up 67% since then). Normally eight months into a “recovery” the U.S. economy has created about a million new jobs. In the last eight or so months we have lost around a million jobs.

In a normal recovery we should be creating between 100,000 and 150,000 new jobs per month.

This is clearly not a normal recovery.

The latest GDP data showed the U.S. economy growing at an annual rate of 5.9 per cent in the last quarter of 2009. So, normally in the two months after a quarter where the GDP grows by almost 6% you would see at least 200,000 new jobs created. Instead, we’ve lost over 30,000 jobs. Two months of declines have never happened after a quarter of strong GDP growth.

It’s obvious to see why. If the economy is growing, that means more products are being produced, and more services are being consumed, so more workers are needed to produce those products and provide those services, so more workers are hired, so employment increases. Makes sense. But that’s the opposite of what we have just seen.

This is clearly not a normal recovery.

Again, I’m no economist (and I’m thankful for that), but it appears obvious that companies have cut staff, and are making whomever is working work harder. The economy is more productive (higher GDP output, done by fewer people), but higher productivity does not create jobs. It creates profits, which presumably is why the stock market is up, but doesn’t create jobs, which is why unemployment remains high.

(If we were all replaced by machines, GDP would go up, but theoretically we would have 100% unemployment. Would that be bad? Presumably if we could produce everything we want without working for it, that would be great. But I digress).

Here’s another viewpoint: The average business owner realizes that the growth in GDP was not accomplished with real demand, but instead is a result of government “stimulus”. Obviously printing money is not sustainable forever, so businesses are not hiring, or if they are, they only hire temporary or contract workers. At the first sign of weakness, those temporary workers are gone, and there goes the recovery. In these uncertain times the average business also won’t invest in new capital equipment; it’s too risky. If you want to grow you may use your cash to buy a competitor to gain market share, but again, that’s not creating jobs, that’s just eliminating redundancies. Or, as the Wall Street Journal puts it, a lack of capital spending will end the productivity surge.

Cut staff. Be more productive. Merge. Acquire. Profit goes up. Don’t bother hiring or investing. Cut more staff. Be even more productive. Lather. Rinse. Repeat.

And did I mention wage deflation? High unemployment drives down wages. Which leaves less money to spend, which doesn’t stimulate demand and jobs. The good news is that wage deflation leads to general deflation, or at least very moderate inflation. Unit labor costs — a key inflationary gauge — fell sharply in the third and fourth quarters, according to the Bureau of Labor Statistics. For all of 2009, unit labor costs fell 1.7%, the most since the records were first kept in 1948.

Message: for the next few months, worry about deflation, not inflation. (Don’t worry, hyper inflation will get here eventually; it’s inevitable given the massive government spending, but it’s not imminent).

The conventional wisdom is that inflation is good for the price of gold (since it’s a store of value), but deflation is bad for gold (since if prices are dropping, you don’t need protection against inflation). That would not appear to be true, based on past history. For example, during the deflationary period from 1920 to 1933 operational wealth would have increased 2½ times if you held gold. Here’s a good summary of gold and deflation theories.

So what’s my theory?

This is clearly not a normal recovery.

However, gold does well in deflationary periods, so if you want a guess, I’d be betting on gold (click for a larger image).

It would appear that the short term correction that started at the beginning of December has ended, and $1,000 gold may be not be seen again, perhaps forever.

Longer term, golds uptrend since the start of 2009 remains intact, which is also good for medium term price support.

There still remains a very real risk of a general market correction. In fact, it’s almost a certainty at some point. When? I have no idea. So, this week, I gradually added to my gold holdings on dips, and I continue to leave my stink bids in place to buy more on any weakness. If the price is going up, it makes sense to be invested. However, I am still maintaining a large cash position, as protection against market weakness.

Time will tell. And I will continue to post quick updates on Twitter, including links to any interesting articles that cross my desk.

Thanks, and have a good week.

The optimist will point to the fact that we are now up against the short term down trend line, and therefore a break to the upside could indicate a short term rally.

Of course, the pessimist will show you a longer term chart:

Longer term, it’s quite obvious we are in a bear market. We are well below the 50 and 200 day moving averages, and there are lots of down trend lines to break before the market can be said to be going up.

As you know, I am a pessimist, and I have yet to see any indication that things will change in the near term.

We live in a credit based economy. Since the bottom of the last depression in 1932, we have lived in a society based on credit. It all started with FDR’s New Deal, where government deficit spending was used to create jobs in periods of high unemployment. A Keynesian approach would perhaps work if governments would run deficits during recessions, but then pay off those debts completely during boom periods. Unfortunately, human nature being what it is, the surpluses in boom times are never enough to repay the recession era deficits, and we are left with permanent government debts in most, if not all, industrialized countries.

Individual consumers are no different. It is not at all unusual to meet someone heading into retirement with a mortgage on their house, or with credit card debt. We follow the government model of deficit financing for our entire lives. Now we are paying the price. The “price” is the interest we are paying on past consumption, and it is a significant drain on all of us.

Sadly, as the credit bubble implodes, we may well be facing a deflationary period. We most certainly are now in a period where prices are falling. The price of oil is down two thirds from it’s peak of a few months ago. Gold and most other commodities are also down, as the recession shrinks demand. Real estate prices are collapsing in many parts of the world.

Falling prices lead to more falling prices. If I want to sell my house I have to drop the price because there are limited buyers, which causes a further drop in prices. It’s a vicious cycle. If consumers expect prices to continue falling, they stop buying in anticipation of future price decreases. It becomes a self fulfilling prophecy.

Even worse, we are in a credit bubble, where most of us, including the government, are carrying too much debt. I can’t refinance my mortgage at the bank, because the security for my mortgage, my house, is now worth less than it was when I got the loan. The sub-prime crisis in the United States has been well documented. Less well known is the mortgage crunch happening in Canada right now. In most cities house prices are at their lowest level in over two years, so anyone who bought a house within the last two years has lost money. Even worse, some mortgage lenders are pulling out of the market. A big American mortgage lender moved into the Canadian market two years ago, and last month begin notifying customers that they will not be renewing their mortgages. These “sub prime” borrowers can’t find a mortgage lender to replace their existing mortgages, and many of them will end up losing their houses.

As prices fall and debts become more expensive to repay, the risk of default increases, and bankruptcies increase. In Canada, personal bankruptcies increased by 30% in September, 2008, as compared to September, 2007. They are only up 7% year to date, which means the number of bankruptcies filed has accelerated significantly in the last few months. That’s bad news for the economy.

And bad news for the economy is bad news for the markets.

Now, many of you may agree with everything I have just said, but you may counter with the thought that “it’s all baked in”, meaning the collapse has happened, and the worst is over.” Perhaps, but what indication do you have that the worst is over?

Do you believe that the real estate market has bottomed?

Do you think there will be no more government bailouts?

Do you believe that the automotive industry is back on track, and won’t need to restructure?

Do you believe we have avoided the credit card crunch, where banks experience massive bad debts on their credit card portfolios?

I don’t. I believe it is more likely that the real estate market is not anywhere near the bottom, that there will be more government bailouts, that at least one of the “Detroit Three” will fail, and that over the coming months banks will report massive losses on their credit card portfolios (requiring more government bailouts, of course).

Then, as the massive government spending works its way into the system, we will get to experience inflation, which will mess everything up once again.

For 2009, I am, therefore, a pessimist.

Of course, I could be wrong. I may be wrong. I hope I’m wrong. But if I am wrong, what am I missing? Where is the flaw in my logic? What is the piece of information I am not considering that will turn everything around?

Let me know on the Forum, since I would prefer not to be a pessimist.