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Inflation or Deflation - Invest in Gold

Inflation or Deflation? Invest in Gold

by: Dr. Stephen Leeb September 10, 2009

The big question remains: will we experience inflation or deflation in the months ahead? The good news for investors in gold is that it doesn't really matter. Precious metals will do well in either scenario.

True, we have seen gold move more or less in step with the market of late. But the yellow metal has taken bigger strides. Despite the recent rally, the 12-month return for the overall stock market is negative 17%. Whereas, shares in gold miners - as measured by the Philadelphia Gold & Silver Index (XAU) - have gained 35%. That's a 52% outperformance for gold stocks.

Tuesday, gold broke through the psychologically significant $1,000 mark for the first time since February. We're not surprised by this move. And while gold may pull back a little in the near term, we have little doubt the metal of kings will seek much higher heights before too long. In fact, we have far more faith in gold today than we do in the stock market or the economy.

That's why we're recommending everyone own a stake in gold, including this gold fund which we expect will easily outperform the XAU in coming months...

SIDESTEP THE ECONOMY, BEAT THE MARKET

Within the gold arena, both bullion and the large miners offer potential gains and protection from both the 'flations. However, the strongest growth potential can be found among the small to mid-sized miners that are rapidly expanding their reserves. The easiest way to get diversified exposure to this group is through the closed-end fund, ASA.

We like ASA because its top holdings are not the usual suspects - the handful of large blue chip miners such as Barrick (ABX), Goldcorp (GG), and Newmont (NEM), whose growth potential is limited. ASA does invest in these three, but underweights them in favor of faster growing companies like Randgold Resources (GOLD) and Newcrest Mining (NCMGY.PK). ASA even includes one of our favorite junior miners, Nova Gold (NG), which is developing one of the largest gold deposits in the world (located in North America). Nova has partnered with Barrick on the project, which pretty much guarantees completion.

Nova shares once traded at around $20, before being trammeled last fall, and the stock carries some risk. But we believe it will eventually surpass its former high, and that the safest way to get a piece of the action is to buy ASA.

Returning to the question of inflation vs. deflation...

DEFLATION - BUT ONLY IF THE GOVERNMENT NEGLECTS ITS DUTY

The Friday's employment numbers made a palpable argument for deflation. Despite today's massive stimulus efforts, U.S. unemployment reached 9.7%. If you count partially employed persons, the rate jumps to over 16%.

That's hardly the sign of a rapidly growing economy. In recent past recessions, unemployment did not get anywhere near double-digits by any measure. Obviously, we are seeing deflationary pressure at work.

Moreover, those who argue that unemployment has acted as a lagging indicator of growth in past recessions have missed the point. Unemployment under 7% can be a lagging indicator. But we cannot see one in six people unable to find work in this country in the same positive light.

We're concerned about the recent slowdown in M2 growth. M2 is the broadest measure of the money supply which the government dares publish today. Recently, the 3-month rate of M2 growth hit generation lows, while the 6-month rate is near zero. This is a clear sign that banks are afraid to lend and instead are hoarding their cash. Coinciding with consumers who are spending less and saving more, the lack of lending argues against economic growth.

We also feel dismay when we look at the bond market. In any kind of recovery, whether "V" or "U" shaped, bond yields should be rising. Yet they remain very low, contradicting the theory of "green shoots" and suggesting deflation could arise.

However, the case for deflation has one weakness. If the government wants to prevent deflation, it can. And it has every reason to do so.

Consider the recent "cash for clunkers" program. Rumor had it that many people in the administration expected this program to fail. Some of the President's advisers expected very few Americans would trade in their car to take advantage of it. Instead, it was a success, proving that no matter how badly a stock market crash affects the American consumer, he still can't resist the lure of free money.

As we near the election of 2010 and push comes to shove, the government will find it hard to resist launching similar programs that will boost consumer spending high enough to counteract the forces of deflation.

Given the choice, the government will always choose inflation over deflation as the lesser of two evils. We can see this bias reflected in the neglect of the U.S. dollar value. As the government stimulates the economy through deficit spending, nations around the world, including China, Brazil, Russia, and even agencies of the UN are losing faith in the dollar and calling for the creation of a new reserve currency. So far, the Fed has done little to counter this push.

Should the dollar actually be replaced, its value will drop substantially, resulting in higher prices for everything we import - an extremely inflationary event. Even if manufacturing started shifting back to the U.S. from China, we would have no way to protect ourselves from the rising global prices for oil, copper, and every other commodity. Higher commodity prices will act as a tax on the economy, requiring even higher stimulus spending to counteract. The dollar would continue to lose ground.

Of course, the Fed could elect to let the economy fall apart. The 1930s proved that might be good for the financial markets - which is the case for deflation - but it would be political suicide at the very least. Nonetheless, short bouts of deflation are quite possible, so you need to be prepared.

If you look at a chart comparing the performance of the S&P to gold and zero coupon bonds since the beginning of this decade, you'll find the 2000s were a great decade to own zero coupon bonds. Zeros doubled in value, while stock prices fell in both nominal and real terms.

Clearly, during this period the average investor feared deflation more than inflation. Zero coupon bonds did well because they offer protection against deflation.

However, you would have made even more money by investing in gold. No matter if inflation or deflation is the biggest threat, investors will turn to gold for safety. Gold thrives during uncertainty and financial turmoil. We've had plenty of that this decade, and we may get plenty more.

So even though gold may look pricey today at around $1,000, that price may seem dirt-cheap a few years from now. Of course, you should continue to own other investments, including our recommendations. But even if you only hold 10-15% of your savings in gold, you may be very well rewarded. It's the only investment that protects you from both the 'flations.

Slowly, the world will realize the days of American hegemony have passed. So have the days of growth without inflation. Now we have the days of turmoil in which the golden rule is "He who has the gold rules."

Once again, almost any sound gold miner or bullion itself should do well, but we think ASA is the best bet for most investors.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.

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Categories : Finance    Themes : Inflation Gold Deflation
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