Inflationary Surprises

We love surprises! But only when we see them coming.

We’re always wondering: how will we be surprised? What will happen that we don’t expect?

It’s easy to make money…if there are no surprises. You just put your money in something that is going up and let it go.

But surprises sink ships, marriages, military campaigns and investment portfolios. Things happen that you’re not prepared for…

A friend told of what happened to a mutual friend:

“I guess it was the embarrassment that bothered him most. I don’t know. He was happily married…or he thought he was. They had three children. They must have been married 10 years. And then, she announced she was a lesbian…and moved in with a woman.

“I imagine he was devastated. He didn’t seem to have any idea. But just think how you’d feel. You’d think that you were so awful you’d turned her off on the whole male sex. She wanted nothing more to do with any of them…”

Yes, dear reader, you have to watch out for the surprises…

Stocks have been rising since March 9th. Yesterday, the Dow went up another 15 points… The Dow now looks toppy…like it will go down again soon. But the rally may have further to go – maybe all the way to 10,000, as we originally guessed.

And yesterday’s rain of news brought forth another green shoot. New houses are selling again – with sales up 11% in June. Maybe it’s time to buy a house. Better yet…buy a huge house with a huge, fixed-rate mortgage! Sometime between now and the next 30 years a fixed-rate mortgage is bound to lose its bite. What are the odds that inflation won’t rise in the next three decades?

Last week, in Vancouver, we left listeners confused.

“Should I buy gold or not?” was the question one posed.

It’s a good question… we’ll turn to it in a moment.

First, the background…

Everyone knows that stimulus leads to inflation. And everyone knows that this is the most daring use of stimulus ever attempted. Ergo, it seems likely that we will soon see the most inflation we’ve ever seen.

But it’s not that simple. The story is too easy to tell. It’s too obvious. Too logical. Too easy to explain and too easy to understand. Under these circumstances, inflation would be no surprise!

At least…that’s been our worry. That too many people understand the inflation threat and are positioning themselves to avoid it. Everybody can’t be right. As they say on Wall Street, when everyone is thinking the same thing no one is thinking.

But is it true? Is it true that people fear inflation and that they are taking investment positions to counteract it? Alas, we don’t know…but perhaps not. Neither the yield on Treasuries nor the price of gold signals a panic about inflation. Just the contrary; they seem to be telling us that investors are complacent…that they’re aware of the inflation threat. They may be even sure that inflation is coming. But they seem to think that they can take action later – after inflation actually shows up. Seems reasonable, doesn’t it?

The inflation rate is currently MINUS 1.4%. That is, we’re experiencing deflation, not inflation. Why try to protect yourself against something that is such a distant threat?

Our guess is that this is what most investors are thinking: that inflation is coming, but that it isn’t here yet. They’re watching…they’re holding their fire…but they won’t be surprised by it.

But what if they’re facing the wrong way? While they’re keeping an eye on inflation, what could be sneaking up behind them?

Ah…keep reading…

Practically everyone anticipates rising rates of inflation. The adjusted monetary base of the United States has more than doubled in the past year. Deficits are staggering. The price of oil – at $68 – is telling us that inflationary pressures haven’t gone away. Gold, too, at $953, seems to be whispering – not shouting – a warning: watch out…

So, what’s the prudent thing to do? Shouldn’t you keep an eye on inflation, like everyone else…and participate in the stock market rally at least until it shows up? If you failed to join the rally, you missed an opportunity for a gain of 20% to 40%. Though a correction in the rally is probably at hand, wouldn’t it make sense to buy stocks…hold them until the rally ends or until inflation appears…and then jump into gold?

Yes…that seems sensible.

But where’s the surprise? Here’s one possibility: a much deeper and more persistent depression/deflation than people expect. Ben Bernanke told Congress that he had sought to avoid “a second Great Depression.” Well…what if he failed?

Roger Lowenstein in The New York Times:

“The US economy is not only shedding jobs at a record rate; it is shedding more jobs than it is supposed to. It’s bad enough that the unemployment rate has doubled in only a year and a half and one out of six construction workers is out of work…

“The Federal Reserve now expects unemployment to surpass 10 percent (the postwar high was 10.8 percent in 1982). By almost every other measure, ours is already the worst job environment since the Great Depression…

“In terms of its impact on society, a dearth of hiring is far more troubling than an excess of layoffs. Job losses have to end sooner or later. Even if they persist (as, say, in the auto industry), the government can intervene. But the government cannot force firms to hire.”

Job losses result in fewer purchases…which result in fewer sales and earnings…and that leads to more job losses and falling prices. That’s what a depression is all about.

Currently, we look at that -1.4% inflation rate as a fluke…an aberration. And most people are sure the feds will stir up the inflation rate soon. But what if the feds are more incompetent than we realize? What if they can’t cause inflation? The Japanese couldn’t. And they never had deleveraging consumers to contend with. In other words, their households were never so deep in debt that they had to cut back spending in order to pay down debt. But they cut back anyway…and Japanese prices fell.

Nor did the Japanese have an entire world economy that was deleveraging. Instead, they were able to continue supplying goods to eager consumers in the United States…and making profits.

America’s economic situation is much more dangerous…and potentially much more deflationary. We could be entering a period of falling prices that will last for many years.

So, should you buy gold or not?

Ten years ago, we suggested a simple Trade of the Decade. Buy gold on dips; sell stocks on rallies.

This was not the best trade you could have done. There were huge run-ups in stocks and in oil, for example. Many investments would have paid off more. Google was probably the biggest hit of the period.

But the Trade of the Decade looked to us like the safest, surest thing you could do with your money at the turn of the century. Gold was at a record low; stocks were at a record high. What could have been easier?

And it turned out to be a decent trade.

The decade is not finished. So, we’ll stick with our trade a bit longer. Our guess is that we’ll see some additional profit when the stock market turns down again. But gold’s big day still may be a long way in the future.

So, if you are looking for quick profits, gold is probably not a good buy. It’s a monetary metal. It is fundamentally a protection against paper money and financial distress, not a real investment…or even a speculation.

Since we rate the risk of financial distress very high, we buy gold – as insurance. But we do not expect a major bull market in gold soon. Later, after deflation and depression have surprised investors and squeezed inflationary expectations out of them, we will buy gold as a speculation. Then, investors will be surprised by how fast inflation comes back.

Until tomorrow,

Bill Bonner
The Daily Reckoning