Again yesterday, we saw our formula at work.

Inflation boosts up commodities, gold and oil…deflation takes its toll on stocks. The price of oil hit a new record high…while the Dow lost 214 points.

What is surprising is that stocks have not lost more.

As Richard Russell puts it:

"Everybody knows that this bloody market is supposed to go down. The dollar is sick, US deficits continue and they're huge, consumers are pulling back on their spending, the housing picture is a disaster, the war in Iraq is God-awful expensive, the banks are wobbly and inflation is heating up.

"So why hasn't the market already crashed?"

"Consumers are being squeezed from several directions," Fed Governor Frederick Mishkin said in a speech this week. Reduced household wealth, combined with a weakening job market and near-record fuel prices "are likely to restrain spending growth in the period ahead."

The report on Bloomberg continues: "Owners' equity as a share of their total real-estate holdings fell to 47.9 percent, the lowest since quarterly records began in 1951, from 48.9 percent in the prior period."

Foreclosures just hit a new record level, as owners "give up" trying to make mortgage payments on houses that aren't worth what they owe on them. And now comes news that U.S. household net worth declined in the fourth quarter. With the loss of equity in their homes, Americans were down $532.4 billion.

While the little guy takes his lumps, so do the big fellows. Merrill (NYSE:MER) had to shut down its subprime lending unit, reports TheStreet. Carlyle's mortgage fund defaulted. Peloton investors won't get a penny back of their investments, say the latest reports. And UBS (NYSE:UBS), HSBC (NYSE:HBC), Credit Suisse (NYSE:CS), Societe Generale (OTC:SCGLY) - they're all still toting up their losses.

"Deleveraging's vicious spiral picks up speed," says the Wall Street Journal.

Until now, investors have been mostly positive on the situation. They saw trouble coming…but assumed it would be easy to deal with. They applauded the Fed's quick response and believed it would soon put the economy back in the pink of health. Practically every prediction included a "recovery in the second half," provision. Now, the commentators aren't so sure.

Martin Barnes of the Bank Credit Analyst says, "The recovery is likely to be unusually shallow given the headwind of an extended deleveraging cycle." Even the Kiplinger Letter sees a downturn that "may be short, just a quarter or two of negative growth. But recovery will take much longer with ill effects lingering till at least 2010. There'll be no quick snapback in job growth, no strong surge in income, spending or profits."

Standing against this grim prospect…we have a thin blue line of feds. Cutting rates, providing tax refunds, urging the banks to forgive mortgages, and preparing a multi-billion dollar bailout - the feds are going to 'do something.' But what can they really do? Ah…there's the rub. These cops have no shields…no truncheons…no hoses…and no shotguns. How can they stop the mob from deleveraging itself?

We recall Paul Volcker's words from last autumn. "The Fed has lost control of the situation," he said. Like a line of policemen, trying to control a crowd, the Fed is pushed out of the way by events. Despite its rate cuts, the deleveraging continues.

But inflation continues too. And the more the feds fight the deleveraging process - with the only thing they have at hand…more paper money - the higher inflation rates go.

It is just a matter of time, says our old friend, Marc Faber, before the Fed will "destroy the U.S. dollar." The United States is now in a "'de-leveraging' phase where banks make fewer loans, stunting economic growth," he said, adding that he thought a U.S. recession began two or three months ago.

"In the U.S., they pursue essentially economic policies that target consumption, which in my opinion is misguided," Faber said in an interview with Bloomberg Television from Chicago. "They should pursue economic policies that stimulate capital investment and capital formation."

The Bloomberg report continues: "The Standard & Poor's 500 Index is down 9.7 percent since Sept. 18, when the Fed began cutting the fed funds target to 3 percent from 5.25 percent. The dollar has lost 9.2 percent of its value versus the euro, crude oil futures gained more than 29 percent and gold added 34 percent during that time.

"Further interest-rate cuts may spur inflation and reduce the value of 10- and 30-year Treasuries, Faber said, calling the bonds "a disaster waiting to happen." Ten-year notes fell to a four-year low of 3.44 on Jan. 22.

Marc went on to say some other interesting things, according to the report:

"Faber said sugar is inexpensive relative to other commodities and said stocks in emerging markets are more vulnerable than U.S. equities because speculation has created larger asset bubbles. He predicted shares in India and China could lose 30 to 40 percent of their value as markets decline worldwide."

*** What happens to a paper currency when its custodians decide to destroy it? We have the answer to that question illustrated for us in the headlines from Zimbabwe. Last we heard, inflation was running at 100,000% per year. The average employee made millions per day…but could barely buy a can of beans with the money. Worse still, the beans - and everything else - had disappeared from the shops…hyperinflation has destroyed the economy.

Yes, that's what happens. First the money. Then, the economy. Finally, the society itself.

Today's news tells us that the inflation rate has driven the Zimbabwe down to a new record. It takes 25 million of them to buy one U.S. dollar. At least there is one place on earth where the dollar is going up!

*** What a marvelous ride down from Paris to Geneva. It is a part of France we rarely see - with hilltop towns, abandoned castles, valleys and hills, old farmhouses…hedges… The ride takes about 3 hours. You almost wish it were longer.                                               

More below…

The Daily Reckoning PRESENTS: With the price of gold hovering near the $1,000 mark, investors are beginning to call for the end of the road for this precious metal bull market. However, Bill Bonner thinks otherwise - and has good reason. Read on…

THERE'S STILL MORE BULL IN BULLION
by Bill Bonner

At the end of the last century, nothing seemed more obvious: the price of gold would go up. We pass over the previous 20 years, in which the same blindingly obvious truth practically bankrupted us. But there's nothing quite like two decades, back-to-back, in which the price of his favorite commodity falls continuously, to grind down a man's youth, wear away his pride and polish off his fortune. On the other hand, there's nothing like a bull market to perk him up again.

In 1980, the gold price peaked out at $850. Year after year, it went down. And year after year, we gold bugs became less sure of ourselves. The dollar 'should' fall, we kept saying to one another. Gold 'should' go up. Instead, gold went down until it hit a bottom at $253 almost twenty years later. And this was in a period in which the dollar was losing purchasing power every year, too. Adjusting for inflation, gold lost about 92% of its value. By then, our confidence and our money were almost all gone, but at least we had a full tank of humility. Of course, we'd rather have the money. But that is just the way the financial markets work; if you live long enough they will make a fool of you twice…coming and going.

Then, in July of 1999, the long bear market in the yellow metal was over. We bought at $300, hesitantly, not sure prices wouldn't keep going down. At $400, we were still buying…cautiously. Then at $500, we called for more, practically sans soucis. At $600….$700…and even $800, we happily added to our stash. And then, last year, gold passed the $850 mark - finally, we broke even on the Kruggerands we had bought in 1979! We guessed it would go up more - at least to $1,000. And now that it has almost hit the $1,000 mark, maybe it is time to think twice. What if gold were to take another 20-year dive? Anything is possible, isn't it?

Yes, we live in a world of remarkable wonders. Who would have imagined 30 years ago that that communist China would soon have the world's fastest-growing economy and Americans would have to borrow from the thrifty Chinese to maintain their standards of living? Back then, they were still waving their Little Red books of Mao's silly quotations…and trying to make steel on their backyard barbecues. And who could have known that Gordon Brown was the world's biggest chump when he sold Britain's gold in 1999…at the very bottom of the 20-year bear market?

But even at today's price around $975, gold is still less than half the inflation-adjusted high it set the year Ronald Reagan moved into the White House. And think of all that has happened since then! For one thing, more gold has come onto the market. Gold is never destroyed or used up. Still, an additional ounce of it is much harder to make than a crisp, new $100 bill. You have to find it and then dig it up out of the ground. That's why the world's gold supply increases only about 2% to 3% per year. But the supply of the paper money - in which gold is calibrated - goes up much, much faster, at least 4 or 5 times as fast over the past 30 years. And the world's assets - also measured in paper money - have skyrocketed too. Our houses are worth 3, 5, 10 times as much as they were in the early Reagan years. So are our stocks. What's more, now there is trillions of dollars worth of tradable financial assets in places where none existed at all in '79 - such as in India, China, and the former Soviet Union.

Gold began floating on this flood of liquidity nine years ago. It has doubled…and doubled again. Since 2001, it has gone up 240%. Since Ben Bernanke began cutting rates on Sept. 18, 2007, it has gone up 37%. And if you believe in the volume theory of money - and we do - you can reasonably expect its price to keep going up. Gold is, ultimately, money and it is also the world's ultimate money. Adjusted for inflation, it will have to go up to $2,500 or so, just to match the peak set in 1980. Most likely, it will go far further; we're no longer young and foolish enough to think we know where.

What could go wrong with this forecast? When we were callow and clever, we didn't worry about such things. But now, we put a 'probably' before every verb, and take it for granted that Plan A won't work and the car won't start in the morning when we have an important meeting.

Investing in gold at $253 per ounce was one thing. Like robbing a liquor store; you could scarcely miss. But buying gold at $1,000 is another matter, more like robbing a bank. Theoretically, a big security guard like "Tall Paul" Volcker could appear at any minute. Unlike Greenspan or Bernanke, he might take his duty to protect the dollar seriously. He could raise rates and tighten lending standards; the price of gold could fall.

But it is extremely unlikely that the Fed will raise rates any time soon. Mike Huckabee will be elected as the new Pope first. Bernanke is no Volcker…and the America of '08 is not the same as it was during Reagan's 'Morning in America' years; thirty years ago the U.S. economy was strong enough to take Paul Volcker's bitter medicine. Now it is evening; the U.S. economy is weak and tired. With today's debt levels, Volcker's dose of 15% prime rates would probably kill it.

A more likely threat to gold is that the world economy will enter a long, slow Japan-like slump - despite Bernanke and company. Prices for just about everything would fall -- including gold. While that is a possibility, it does not seem imminent, and its first stages are likely to bring a boost for gold anyway. Initially, investors would turn to gold as a safe haven against bankruptcy and default. Later, they may wish they held more cash…but for the moment, investors' money is safer in Kruggerands than in sterling or dollars.

The classic investment advice is to divide your investment portfolio into thirds, with one third in property, another third in stocks and bonds, and the final third in precious metals - notably gold. That's still good advice, even with gold at $1,000. And this is much easier to do than it was in the '70s; now there is an ETF, with the symbol GLD, which follows the gold price.

For what it is worth, we are at least as sure that the gold bull market will continue now as we were in January '80.

Enjoy your weekend,

Bill Bonner
The Daily Reckoning

P.S. For a limited time, we are offering you, dear reader, an unique opportunity to take advantage of this epic rise in not only gold - but all commodities. Until the stroke of midnight, next Thursday, March 13, you can get a lifetime membership to every research service Agora Financial publishes that's devoted to commodities and natural resources. That includes Resource Trader Alert, Outstanding Investments, and Energy & Scarcity Investor.

And there is a very special reason you have to sign up for the Resource Reserve by next Thursday… We're launching Gold & Options Trader on Friday, March 14. Non-Resource Reserve members will have to pay $1,495 for this service. But as a Resource Reserve member, you'll receive Ed's service for FREE for life.

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-- Posted Friday, 7 March 2008 | Digg This Article