Big news: oil closed over $100 for the first time ever yesterday.

Gold rose too - $27, to $929. Platinum shot up $89 to $2153. And the commodity index, the CRB, hit a new record of 535.17.

Stocks, meanwhile, held steady. The Dow fell 4 points.

What is happening?

Let's begin at the end. "Buy gold on dips…sell stocks on rallies." This has been our Trade of the Decade…and our advice since 2000.

Yesterday, we proposed a modest hypothesis. Caught in the crossfire between the forces of inflation and the armies of deflation, stocks have been immobilized. They "should" go down…but they are getting mixed signals. Deflation forces them to keep their heads down. But inflation prevents them from retreating. They are stuck.

Many analysts look at the inaction in the stock market and think they see growth and prosperity ahead. "If a recession were really on the way, surely the stock market would see it," they say. But stocks DO see it. It's just that they see something else coming from the other direction - inflation. They're caught in the middle - with nowhere to go.

Gold and oil see the same thing. On the one hand, deflation "should" drag them down too. On the other, inflation will surely boost them up. But they react differently than stocks. First, they are more global than the U.S. stock market. While the U.S. economy is slowing down, China, India and Latin America are still growing rapidly. Yes, they are bound to let up a bit as U.S. consumers stop buying so much, but they have their own buyers to take up…gradually…some of the slack.

And second, while the United States is the center of the deflationary economic slowdown, inflation is more of a worldwide phenomenon. Inflation rates in China, for example, are higher than they are in the United States. Prices of apartments in Buenos Aires…subway tickets in Paris…hamburgers in Singapore - everything is going up.

In the past, inflation has always had a national identity card. The inflation of the '20s was concentrated in Germany, where hyperinflation wiped out the middle class and set the country on the road to ruin. Investors…like Jewish refugees 10 years later…had to move their savings to France or England to escape it. Likewise, in Argentina, the inflation of the '80s was easily avoided - just put your money in a Miami bank.

Traditionally, the dollar was a haven for people wishing to protect themselves from inflation - even though the dollar itself was losing value rapidly. In 1935, a U.S. dollar had about the same purchasing power as a U.S. dollar from 1800. Then, it began a steep decline…erasing 95% of its value over the next 70 years. Still, people with money usually preferred to keep their money in dollars, rather than in…say…australs or zlotys. The dollar may have been losing value, but at least it was doing so in a gentle, "controlled" manner.

But times have changed. Now, there's a new kind of inflation - it is practically everywhere…in every country…and it risks spinning out of control. That is why gold is hitting new highs - against almost every currency…and every other market…in the world.

News came yesterday, that the Fed has quietly lent some $50 billion to member banks using a new method - an "auction facility" that allows banks to put up unconventional collateral. The government no longer reports a figure for M3, the broadest measure of the money supply, but shadow analysts say it is going up at 15% per year - about six times faster than GDP growth.

Most of this money ends up outside the United States. That's where most U.S. Treasury debt ends up too. The dollar is America's leading (and highest margin) export. This has forced foreign central banks to create more of their own currencies to buy up the dollars; otherwise they would face a competitive disadvantage, in that the dollar would fall against their local currencies, making their exports more expensive on the world market.

And so, the whole world is being smothered in paper. Paper dollars…paper euros…paper rand…paper cordobas…paper money of all sorts. Where can the investor go to get away from this paper? What can he buy to protect himself from inflation? How can he get some air?

That's right. Gold. And it's why this bull market in gold could be even bigger than the last one. Then, in the late '70s, it was primarily the U.S. dollar that suffered from inflation…and primarily Americans, and perhaps Arab oil exporters, who were buying gold. The Russians were still building cars that didn't run. The Chinese were still recovering from their Great Leap Forward of the '60s and dismantling their backyard steel mills. And the Indians weren't even awake yet.

Now, the whole world is different. It is full of more paper money than ever before…and full of billions of alert people who will want to protect themselves from it. They might try stocks…or property…or Rembrandts…but traditionally, the surest, simplest solution is gold.

For those of you out there thinking that the yellow metal is too expensive to buy now, you are halfway right. The current cost of gold is above the level that we would generally advise you to buy…but our friends at Outstanding Investments have told us of a way you can get gold out of the ground and into your portfolio - for a penny per ounce. No joke - and no shovel required. Find out more here:

You Can Buy Gold With Your Pocket Change

*** While inflation is making most of the headlines, there's news from the deflation side too.

A headline tells us that homeowners are no longer remodeling as much as they used to. As expected, the people who hustle granite countertops are finally getting a rest.

Poor General Motors (NYSE:GM)…GMAC says it's closing offices in the United States and Canada following a $2.3 billion loss. First, the company takes it on the chin from mortgage losses. Now, it's getting jabbed by losses from auto finance. Repossessions, like housing foreclosures, are rising. The repo lots are said to be bulging at the seams.

Jeremy Grantham says he thinks housing prices in the United States will go down 20% to 30% from their peak. That's a potential loss to Americans' implied wealth of as much as $6 trillion. This is part of what leads Financial Times columnist Martin Wolf to describe the coming slump in the United States as the "mother of all meltdowns."

Wolf refers to the work of New York University economist Nouriel Roubini, who argues that the housing decline will put 10 million homeowners upside down, with more mortgage than house. It will lead to collapsing credit…defaults…and huge losses to lenders. It will also bring about a big cutback in consumer spending and unavoidably push the United States into a deep recession.

One of the wild cards of the doomsday scenario is the performance of the derivatives market. No one knows exactly what is in some of these instruments…and no one knows how they will hold up in a crisis.

One thing we do know here at The Daily Reckoning is that they will not hold up as expected. We know that because the assumptions behind them were, fundamentally, nonsense. The most sophisticated mathematical model in the world is not worth a campaign promise if the theory behind it is wrong. And the idea that you can model future prices on the basis of past prices with any predictive reliability is simply wrong. Speaking loosely, it is the problem noticed by Heisenberg when was trying to observe and measure atomic particles at the same time…or ethnologists when they are watching savages gootchy goo. The act of observation causes distortions. As soon as you notice "stocks outperform bonds over the long-term," for example…you cause a distortion in the stock market. People buy stocks, expecting better performance. Buying drives up prices. Then, higher initial prices bring lower rates of return over the long run.

Using Black-Scholes pricing model…and other sophisticated tricks…the salesmen proved that they could produce higher yields with lower risk. The models, of course, depended on the future being like the past. But never before had investors been offered such opportunities to distort the price curve!

The derivative market exploded in the 2001-2006 period, with annual rates of growth (from memory) of nearly 100%. But then, subprime debt blew up…and buyers started asking questions. In 2007, the derivatives market fell apart. And so far this year, new derivative sales are off 93% from the year before. CDOs, SIVs, Monolines…they've all had big trouble.

"Many CDOs could be worth less than 5 cents on the dollar," Strategic Short Report's Dan Amoss tells us. "Final values won't be clear until the loans supporting these securities go through the default and recovery process.

"Many Wall Street firms cannot simply confess their final losses, because delinquencies have just started picking up from generational lows. Also, these firms may soon discover that the insurance covering defaults of their CDO holdings is worthless."

And now comes the Financial Times with more trouble. "CPDOs are at risk," say the FT. What are CPDOs, we had to ask? They are Constant Proportion Debt Obligations…a kind of derivative on a derivative…a bet on the derivative index.

Not knowing anything about them ourselves, we turn to someone who does for an opinion:

"If these [structured products] do get unwound en masse, the effect on the market will be horrible," said credit strategist Barnaby Martin at Merrill Lynch. "Between $1,000bn and $2,000bn of synthetic CDOs have been issued over the last four years. Any unwinding will likely be crammed into a much shorter time period."

Until tomorrow,

Bill Bonner
The Daily Reckoning

P.S. Most newsletters tell you how to make money when stocks are rising. Dan's Strategic Short Report is dedicated to helping you profit when stocks fall. Mr. Amoss does this by harnessing a technique that has been used to bet against the bust - and win - during every stock market crash in the last 5 centuries.

You can give this 500-year-old secret a completely FREE three-month trial…but you only have until midnight, February 27, to take advantage of this offer. Click here for all the details…

The Daily Reckoning PRESENTS: Hundreds of years ago, pirates sought out India for centuries searching for treasures: spices…gemstones…gold. Today, India holds a different kind of treasure: It is home to one of the fastest growing economies in the world. Chris Mayer explores…

INDIA'S TREASURES: WHAT TO BUY
by Chris Mayer

It was perhaps the greatest treasure ever to fall into the hands of pirates…

In the spring of 1721, a French corsair named Olivier Levasseur beat a retreat from the Malabar Coast of India and sailed west to Madagascar. Levasseur was known as "La Buse" or "the Buzzard." He actually wore a patch to hide a mutilated eye.

In any event, he was wreaking havoc on the Malabar Coast when, finally, the British East India Co. decided it had had enough of La Buse and sent the entire Bombay fleet to hunt him down.

The Malabar Coast is one of my favorite places in India. The Western Ghats run the length of Malabar's eastern edge. The monsoons run in from the sea and slam up against the mountain range, depositing heavy rains on the coastal lowlands. This produces the lush green tropical environment so different from the interior of India.

During my trip to India, we visited some of the coastal towns. We also took a houseboat and lazily made our way inland on one of the sleepy rivers. The food here was also very good -- fresh fish, sweet bananas and coconuts.

Since medieval times, the maritime towns that grew up along the Malabar Coast have been known for trading rice, coconuts, gemstones, indigo and other dyes. Malabar is also rich in pepper, which became its cash crop in overseas trade. The dense forests on the slopes of the Ghats provide the only woodland around the rim of the Arabian Sea. So Malabar also exported teakwood, and its boats were also made of twine and teakwood.

As you can imagine, Malabar provided lots of good targets for a pirate. But things got too hot for La Buse with the Brits on his tail. He took off for Madagascar. Along the way, he decided to stop off in Reunion (then known as Ile de Bourbon) because his ship was low on water. Reunion is a little mountainous island east of Madagascar.

There he sailed into the harbor at St. Paul only to discover the Portuguese man-of-war Nostra Senhora de Cabo mooring there. Of course, La Buse could not resist. His ship fired a full broadside on the surprised Portuguese ship. His pirates then boarded it virtually without resistance.

And then, La Buse captured his greatest prize.

The ship was laden with gold and gemstones belonging to the viceroy of Goa, on India's Malabar Coast. The ship had been on its way home to Lisbon when La Buse caught it unawares. The total haul was worth over $1.5 million, maybe the biggest prize a pirate ever snatched.

But all did not end well for La Buse. In 1730, nine years after his big haul, a slave-trading bounty hunter captured him. Fittingly, La Buse would hang in Reunion. But he did not leave this world without putting on a little drama at the end.

At the gallows, the old pirate threw out a set of maps on parchment that supposedly revealed the location of where he buried the treasures of Nostra Senhora de Cabo . They were in code, and he told the crowd that whoever cracked the code would find the treasure.

To this day, no one has found La Buse's treasures. Many adventurers have tried.

William Dalrymple tells this tale in his book The Age of Kali, a collection of essays on India and Pakistan. It's a great tale and somehow appropriate for investors in India today. India still is home to great treasures of a different sort: It is home to one of the fastest growing economies in the world. It's also an extremely volatile market full of pitfalls. While I was there, the market was going crazy in a steep run-up to all-time highs.

I had some ideas I liked. There were a few stocks I wanted to own. I even wrote up a special report. But I withheld it, because the market just ran too far, too fast. Recently, the Indian market reached a point where it had dropped more than 20% from top to bottom.

I think now is the time to start looking again at building a position in India.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. The market may go even lower. No one can say for sure. But in the past, buying India after dips of 20-30% have paid off big in later years. So I released my India special report this week, after the market took another pounding and dropped 4% in a day.

For those who can stomach it, I think the ultimate rewards from these positions will be large over the long haul. Though there are plenty of risks, I think we'll make out better than old La Buse ultimately did from his India adventures…

Find out how you can get my special report here.

Editor's Note: Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.

Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider. Get your copy now…

-- Posted Wednesday, 20 February 2008 | Digg This Article