Making Stagflation Your Friend
By Frank Barbera CMT. November 20, 2007
The US Stock Market most likely logged an important short term low in today's session, a bad news bottom if there ever was one with the likes of Fannie Mae and Freddie Mac experiencing a Richter scale 10.00 type quake. Clearly, all of the evidence that has continued to pour from the Financial Sector suggests that the hemorrhaging of Structured Finance is only in the first inning. For most Americans, the upcoming economic contraction will pose enormous risks as the odds are high that over the course of time, a collapse in confidence and widespread defaults within the credit markets will bring the American financial system to a full-blown crisis. We hate to sound negative, but the numbers being bandied about by those few analysts that probably have a grip are in the trillions, implying that this downturn will probably rival or exceed that scene during the Great Depression. It is a sad day indeed, and no doubt when the full extent of this developing economic-financial crisis is revealed, there will be much weeping and gnashing of teeth, and a draconian clamp down on derivatives and non-traditional lending practices -- all after the fact.
Yet, what to do in the meantime? As I see it, there are two goals that need to be achieved during this upcoming period: (1) preserve accumulated wealth, and (2) if possible, enhance wealth and purchasing power. Understanding precisely what we are up against is key to achieving both goals. In my view, and without getting into an expose with unending supporting evidence, the US is confronting an Inflationary Recession/Depression. In the end, whether the problem becomes a full scale depression, or simply a very bad recession will likely hinge on a combination of �goodwill� from foreigners and government policy. However, in either outcome, a few key elements are sure to follow.
First, the US Dollar is likely to continue much lower, and may or may not survive the forthcoming contraction in its present form. Oh, to be sure, there will probably be something called a Dollar, but if hyperinflation really takes hold, we may be exchanging one of the �NEW� Dollars for five or six, maybe 10 of the �OLD.� Who Knows? It probably won't be pretty.
Impossible, you say? Unfortunately, the long history of fiat �paper money� argues persuasively to the contrary, which means that all individuals need to look to protect the purchasing power of their accumulated savings. It is in this area that the Precious Metals are involved. Think of Gold and Silver as Insurance. The same way you would go out and purchase Healthcare insurance to see a Doctor, or Life Insurance for your family, or even Auto Insurance for your Car, Gold and Silver act like an insurance policy on the Purchasing Power of Your Accumulated Savings. The good thing about the Precious Metals, they are extremely leveraged and become progressively more leveraged as one of these Inflationary Depressions runs its course. The more inflation heats up, the more the metals become the penultimate store of value, and the more capital will take refuge in the metals in order to maintain purchasing power. As a typical rule of thumb, it is often stated that a mere 5% of wealth in Precious Metals will protect the purchasing power of 100% of your hard earned money during a runaway inflation. In my view, that number is probably a bit low, with something on the order of 10% probably more accurate as per the experience of the last few centuries.
Years ago, Professor Roy Jastram traced out the �Golden Constant� � the retrieval phenomenon which has been evident in the purchasing power of precious metals over the course of Centuries. What is the �value� of One Ounce of Gold? The cost of a high quality Man�s Suit? Perhaps, especially if it is made these days by Brioni or Canali, around $4,500 to $6,000 dollars per. That to me seems like a minimum upside target for the Yellow Metal, with Silver, the �Poor Mans Gold,� likely to vault forward in even greater percentage magnitudes.
In the final analysis, a hyper-inflation, or any inflation for that matter, will come to an end once the government reduces the supply of new money and has successfully inflated away most or all of its accumulated debt. In the US, off-balance sheet items for Uncle Sam are already past $56 Trillion Dollars; that's a lot of potential inflation ahead. In fact, in the case of Uncle Sam, even the Comptroller General of the United States, David Walker is openly telling anyone who listen, �Houston, we have a problem.� See �60 Minutes� video courtesy YouTube.
In his talks, Walker points to the imminent retirement of the Baby Boom generation and a host of long term funding liabilities directly ahead. Inflation will become Uncle Sam�s best friend, as it will help pay off the bills with cheaper dollars. Thus, for the average American, it is time to think about accumulating Precious Metals so that over time, the impact of this inflationary tidal wave will be muted. As a footnote, when inflations do come to an end, either by a �Volckeresque� jamming of Short Term Interest Rates through the roof, or by a serious collapse in the currency, in either event, the real damage of the contraction is revealed, as the price level usually collapses. This happened in Argentina not long ago, where the currency collapsed, unleashing hyperinflation upon the people where very quickly accumulated savings were utterly destroyed, leaving the economy in a state of collapse. The result, by the end of the process, Argentina was one of the lowest cost places to live, with wages, rents and costs having been reset to a fraction of there former costs. At first, the collapse produced high anxiety and desperation among the people, and the crime rate soared out of control. Later on, as foreign capital came back to Argentina, and the economy stabilized at a very low operating level, the crime rate gradually eased, and jobs gradually began to appear.
Flash forward a few years later to today, and the place is booming, crime is way down, and foreign capital has flooded in, attracted by the real discounts available and the low cost lifestyle. This is a play that has been done over and over again. In such an outcome, someone who was able to place money in precious metals avoided the collapse of the local currency, would now have that previous purchasing power intact, and could have used it in the last few years to buy back many fold depreciated assets in Argentina. The chart below shows the Collapse of the Argentine Peso and what happened (in a positive way to your purchasing power) if you had your money in Gold when the Peso collapsed.
Above: top clip, collapse of Argentine Peso, Lower Clip, Purchasing Power of Gold as measured in Argentine Peso�s. Got Gold?
Of course, currency collapses are usually not a good thing for the stock market, at least at the time of the financial panic. Typically, when the currency crashes, interest rates of all types shoot through the roof, the stock market crashes, and the economy contracts. Later on, as inflation really kicks in, money will tend to move back into the stock market for a time to own assets of real value during a hyperinflation. Very often, there is a period of time where stocks can outpace inflation, but usually, a secondary reaction will see the stock market give back much of those gains. Once inflation really subsides, the currency stabilizes (the two go hat in hand), interest rates begin to fall, the stock market will tend to move up at a rapid and very sustained rate, as corporate profitability can generate a windfall in a post�inflation, wage depressed economy.
Thus, one element to be aware of is that with the US teetering within the framework of a serious Housing and now, Banking crisis, the stock market in the year or two ahead could be a massive wipe out. In our view, the one exception could be the natural resource stocks that are closely linked to commodity prices. Our �gut level� suspicion is that these stocks could continue to fare well in the months ahead, and decouple from the broad market. There is past precedence for this type of outcome, as Gold and Oil Stocks decoupled from the S&P for extended periods of time during the two prior 1970's Arab Oil Embargos. The one element where Natural Resource stocks will probably not fare well is within the context of an accelerating market crash. In a real crash, everything is usually thrown out the window for some period of time, but quality will usually quickly find its values, and can often bounce back fairly soon. As we see things shaping up in the year or two ahead, the stock market is headed for a momentous crash. For the time being, the resource sector will probably decouple and continue moving higher. Then, at some point later on, resource stocks will likely top out and then reverse sharply lower and crash with the market. After the crash, we expect resource stocks to be one of the first groups leading the market back to the upside, and for many investors, at crash depressed prices could offer another super long term investment opportunity. Thus, we think the path ahead for resource stocks could be �Up Big� then �Down Big,� then �Back Up Again� the second time even bigger. It will be a wild ride, and within that outcome, �Market Timing� will be a very key element in not losing valuable capital. To track the broad resource sector, we have constructed an Index, (150 stocks) which we call the Stagflation Index, which is composed of Energy, Metal, Alternative Energy, Transportation and Infrastructure stocks. Over the last few months, as the index has moved steadily higher, the daily A/D Line has confirmed each higher high -- a good sign.
Above: the Stagflation Index (150 stocks) with Daily A/D Line
In addition we note that, as can be seen in the chart above, the long term trend of Relative Strength for the Resource Sector versus the S&P is still holding above a rising 50 and 200 day moving average. Perhaps even more importantly, the recent correction to the 50 day moving average saw the 9 day RSI move from readings in the +80 zone, to a corrective low value in the +40 zone, a sure fire indication that a bull market is in force. While a long term �buy and hold� ownership of Precious Metals can help investors achieve the primary goal of protecting purchasing power against inflation, Tactical Timing and astute movements �in and out� of leading sectors such as the Natural Resource sector, will help investors grow their asset base helping them to achieve the all important second goal of enhancing wealth.
Above: Stagflation Index with the 9 day RSI
While there are no perfect indicators, it is amazing what can be achieved by using some of the basic tools available, with special thanks to the power of modern computers. In the chart below, we show the final output �rebased� for the Dow Jones Industrial Average going back over the last 100 years. The lower line is the accumulated DJIA gain (not including dividends) while the top line is the output of a Timing Model. Notice that during the Great Depression, (lower left), when the DJIA collapsed 90%, the Timing Model was in cash, so the account did not move lower, and instead would have been earning interest in the bank. The Point: by avoiding these very Bearish episodes, total return is greatly enhanced, as accounts that are exposed to these bearish episodes often take years, or decades to recover. In the climate that lies ahead, there be no room for even the slightest degree of indecision. Rule #1 of Investing � protect capital, will apply as perhaps never before.
We end today's WrapUp with a chart listing of the Sub-Indices comprising our Stagflation Index, and a heartfelt Best Wishes to our loyal readers for a Happy Thanksgiving. The DJIA ended higher with a close of 13011.45, up 53.01, the S&P higher by 6.43 at 1439.70, with the NASDAQ higher by 3.04 at 2596.42. That's all for now,
Sector Components of GST Stagflation Index
Above: Stagflation Index � Large Cap Energy Index
Above: Stagflation Index � Oilfield Services Index
Above: Stagflation Index Gold and Silver Precious Metals Index
Above: Stagflation Index � Natural Gas Producer Index
Above: Stagflation Index � Oil Refining Index
Above: Stagflation Index � Alternative Energy and Coal Index
Above: Stagflation Index � Smallcap E&P Index
Above: Stagflation Index � Energy Transportation Index- Shipping.
Above: Stagflation Index � Infrastructure and Engineering Stocks
Above: Stagflation Index � Base Metals Mining Stocks
© 2007 Frank Barbera