As expected, right when everyone is leaning bearish, the
markets rally. After all, when the New York Times runs a feature story on Robert Prechter and his
1,000 Dow doomsday scenario, you know that overall sentiment has turned overly bearish, at least in the short term.
The interesting thing about Prechter is that he predicts a collapse in confidence, debt defaults, and an eventual flight to quality. About these points we are in agreement. However, Prechter concludes that these trends will be deflationary. About this, I believe he is dead wrong.
The crux of Prechter's argument centers around fractals and the tendency for markets to oscillate in predictable wave structures. To put it very simply, Prechter envisions a replay of the deflationary Great Depression of the 1930's. I am the first to admit many of the variables between then and now are the same: the expansion of credit preceding the crisis; the stock market crash; high unemployment; and the collapse in real estate. However, there are 2 key differences between then and now: 1) we were a creditor nation, and 2) we were on a gold standard.
Let's think Prechter's doomsday scenario through logically. A deflationary collapse would be attended by a rise in the dollar and U.S. bonds. If the collapse in confidence unfolds as Prechter predicts, it's hard for me to imagine people flooding to the "safety" of U.S. dollars and U.S. Treasuries. Prechterites will respond by saying that people flooded to the "quality of dollars" during the Great Depression. This is true. But why?
Again, back then we were on a gold standard. Buying dollars was the equivalent of buying gold. So in fact you were seeing a flight to the quality of gold, not the dollar. Also, since we were a net creditor nation, we did not have to resort to monetizing debt; our accounts were balanced by an influx of gold. This brings a brand new inflationary variable to the table to counteract deflationary forces. You can now start to see how foolish it is to extrapolate past price action to the present when the conditions are different.
So the arguments for 1,000 Dow, $50 gold, and $1 silver are fundamentally flawed. Most people think that if we enter into a Depression, all asset classes will go down. This is patently false. All you need to do is follow the money. A flight out of the dollar will naturally lift assets prices across the board. Only the most leveraged assets (i.e. real estate) will remain depressed, since the unlevering will take a bit longer to play out. This is especially true since the government has stepped in to support prices, which in fact, need to fall.
The deflation thesis is a contrarian stance that has gone mainstream. Respected pundits, including the highly-regarded "bond kings" over at PIMCO, are all saying that current bond yields are justified. They relate low yields with a slowing economy, which is exactly what I've been expecting since last year. Unfortunately, they are conflating a slowing economy with deflation. Obviously, everyone received the same education and read the same textbooks. As a contrarian, this is wonderful news. Inflation is the only real threat facing us. And the inflation facing us has nothing to do with economic conditions; it is tied to confidence in the U.S. dollar, period.
Gold is going to rocket launch to the stratosphere and beyond. I am building my position right now while the deflationists are taking center stage. I will then watch from afar as the inevitable trends that everyone should have seen coming assert themselves. Prepare to be amazed.
