Posted by: taureanglobal | October 22, 2009

Inflation is coming, but not before a long process of value erosion

Deflation – the Wealth Killer
While most commentators are warning about the dangers of inflation, we are far more aware that the environment we are in is deflationary. While the governments around the world have poured money into the system, they have not been able to come close to keeping up with the amount of purchasing power that was actually taken out. The thing that most people don’t realize is that we are de-leveraging, and that always means removing credit, reducing the amount of money available for investing and discretionary purchasing. And with less available credit, most assets, especially financial ones, decline in value. We’ve already seen huge deflation in stocks and residential real estate. It becomes a perpetual cycle, feeding on itself, because as the assets decline in value financial institutions are reluctant to extend credit for their purchase or, more importantly, to re-finance them at the same value, forcing foreclosures, a new round of forced selling and even lower prices. With the stock market the effect is even more dramatic and self perpetuating, leading to historic volatility and losses.
But you can profit from a deflationary environment – in fact, this is the most fertile environment for developing wealth since, well, the Great Depression. It was during the Depression that the savviest of investors made huge fortunes, mostly because they recognized that they could purchase fantastic cash-flowing assets for a mere fraction of their true value. The secret was that instead of counting on making money in asset appreciation, they concentrated on maximizing the cash flow.
But shouldn’t I be buying Gold?
The economist John Maynard Keynes, who is credited with many of the economic policies that lead the U.S. out of the Great Depression, called gold a “barbarous relic”. Gold “bugs” consider it a true store of value. Indeed, in times of inflation it seems to hold up much better than paper currency. But it doesn’t really “create” any wealth. Aside from gold miners and jewelers, gold has no real practical application. A lump of gold yields no dividends or income of any kind. And in a deflationary environment, gold goes down in value because money goes up in value.
Inflation – Wait for it…
It’ll come, eventually it must. But you’ll need to be prepared, and the current economic environment is perfect for that preparation, especially if you know where to look. Here’s what we do know – inflation requires a vibrant economy, one that’s kicking on all cylinders and approaching full employment, because it’s demand for higher wages that fuels inflation. Courtesy of Gluskin, Sheff, here is a chart showing the latest PPI and CPI figures

Gluskin Sheff Inflation chart

You see those big spikes up during the 70’s? Now that was inflation, but it also happened to be a time of incredible economic expansion – businesses were booming and real wealth was expanding, so of course prices were going up. But with North Americans increasing their level of savings and unemployment approaching 10% (and promising to get much worse before it gets better) this is not your Dad’s garden variety recession, where we just bounce back after a year or two of belt tightening thanks to a hodge podge of government spending, rekindled consumer demand and the need to finally rebuild inventories.
But the stock market has come roaring back!
It sure has – but if you look really closely you’ll see that it has done it on ever decreasing volume. In fact, most of the buying is the result of investors who had massive short positions while the market was falling and are now covering those positions (at still massive profits). Adjusted for various programs like the “Cash for Clunkers”, retail sales are still falling; house prices are moribund (the market rallies when it gets a statistic that is “less bad”). By no means is the stock market reacting to increased economic activity. It’s what we call a head fake.



  1. That’s a pretty interesting article. What are the key indicators you watch for then?

    • Well, I look at employment and productivity. You can’t have goods and services inflation without pressure from increasing employment. We have the opposite right now – productivity is rising which means that less people are needed to produce necessary goods and services – so there’s less money in the hands of the majority of consumers. Since the financial wizards effectively gutted the middle class and strung them out with mortgages on assets that are underwater, it’s a complete mystery to me where the jobs are going to come from, or the resources for spending.
      As well, M3 is falling – that’s right, despite all of the government attempts to juice the economy, the total amount of cash and credit is still falling. Just wait and see what happens when stock market investors finally realize that the U.S. isn’t going to experience 4 or 5% growth in 2010. More wealth destruction. Geithner says they won’t allow it to happen. It’ll be interesting to see – at some point water always finds its level. You can’t fool mother nature.

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