Deflationary Collapse Crushing Gold and Silver

Source: Jason Hamlin, Gold Stock Bull††(9/28/11)

"The monetary metals are likely to bounce back quickly and the downside risk at this point seems rather limited."


Precious metals are getting absolutely crushed, as investors are rushing for liquidity and selling anything in the green to cover losses in other assets. The market has good reason for concern. It is all but inevitable that Greece is going to default, a few major European banks will fail and this will throw the entire world economy into a tailspin. The FED hasn't helped the situation, announcing a very deflationary "Operation Twist," rather than a new round of quantitative easing as the market was so desperately craving.

The move was reportedly intended to help the housing market by lowering mortgage rates and encourage businesses to start spending the cash they are hoarding, but investors reacted by selling off equities. The FED appears to be running out of bullets and the only true way that they could help the economy is to announce their dissolution.

Inflation vs. Deflation

It has been a while since I've commented on the inflation versus deflation debate. It is a confusing thought to ponder, especially if your goal is to walk away on one side or the other. After all, intelligent minds argue forcefully on both sides. But I believe that we can have both inflation and deflation at the same time.

The massive amounts of stimulus and money printing over the past few years have been undeniably inflationary. There is significantly more fiat paper in existence today than there was in 2008. But the velocity of money has decreased significantly, meaning that cash is not flowing through the economy and exchanging hands at a very fast pace.

In addition, the larger portion of the overall money supply is credit, which has contracted sharply. Banks are not lending to individuals or businesses, while most of the new money created has benefited only a small segment of the population. This creates a scenario where there is some degree of monetary inflation, especially in cash-based markets, (food, energy, stocks, etc.) but very little inflation overall, particularly in credit-based markets such as housing.

With this massive credit contraction, lending has slowed, manufacturing has slowed, unemployment remains high and GDP growth is anemic at best. Economies cannot grow when credit markets are frozen and this is the current state of economies across the globe. GDP growth has failed to keep up with debt growth and all of the toxic derivative creation has brought the world economic system to the breaking point.

I believe we will eventually have inflation or even hyperinflation in America, but we are currently in a deflationary dip that has yet to run its course. The final outcome is likely to be stagflation, a period with high inflation and low economic growth. Keynesians may be confused to see both occurring simultaneously, but the real issue is the how difficult stagflation is to overcome.

Why Gold and Silver Are Collapsing

Gold is down more than $300 or roughly 16% in the past few weeks. Silver has lost nearly 40% in the same time period and the mining companies have also been hit hard. This decline in precious metals has been driven by funds scrambling for liquidity, the CME hiking margin rates and a stronger U.S. dollar. Many also suspect that the banks helped to manipulate the price lower in order to cover as many of their underwater short positions as possible. JPMorgan and their cohorts control the paper markets and can use their leverage to manipulate the spot price to whatever level they want in the short term. This is done via "stuffing" trades and using a variety of other methods to make the markets believe that there is considerably more selling pressure than actually exists. This is particularly profitable, as options expiration is this week and the current smack down will leave most options expiring worthless, in addition to providing an opportunity to exit short positions.

But despite the apparent manipulation, JPMorgan has been woefully unsuccessful at suppressing the price in the long term. After all, gold is still up 25% and silver 40% in the past 12 months!

Parting Shot

Investors have to determine whether we are entering a new deflationary chapter that will result in a prolonged period of depressed prices for gold and silver, or whether this is another short-term correction and buying opportunity. While I am usually quick to view these dips as excellent buying opportunities, any number of events could push the global economic system over the edge. In such a scenario, investors will likely continue to dump precious metals and mining shares, throwing out the baby with the bathwater in a panic. But the monetary metals are likely to bounce back quickly and the downside risk at this point seems rather limited.

If the market does not fall apart quite yet and the Bernank decides to announce another massive stimulus, gold and silver are going to spike to new highs in no time. This is the scenario that most investors have been waiting for, although the electorate has lost their appetite for such bailouts and the political will has all but dried up. Still, more QE and bank bailouts will be necessary to avoid financial collapse in the short term, so my bet is that we will continue to see quantitative easing, even if it isn't announced officially by such a name.

No matter how our central economic planners decide to deal with this ticking time bomb, I'd rather be holding gold and silver than any other asset class. They have been money for thousands of years, have held their purchasing power under a variety of adverse conditions and have proven to be an effective safe haven asset. Safety should be a growing priority for your investments these days. First Mayor Bloomberg predicted riots would hit the streets of America and now Geithner has hinted at the possibility of bank runs:

"The threat of cascading default, bank runs, and catastrophic risk must be taken off the table, as otherwise it will undermine all other efforts, both within Europe and globally," the Treasury chief said. "Decisions as to how to conclusively address the region's problems cannot wait until the crisis gets more severe."

I suppose you could follow Buffett's advice and be greedy now while others are fearful, but Iím not sure that old adage will prove profitable this time around. I am going to avoid most equities, opting only to hold quality miners at this point. And while cash might be king during uncertain times, the only form of money that I am holding is the precious type. If you have been waiting for an opportunity to buy precious metals and mining stocks on a dip, I think this will prove to be an excellent entry point. With the world aflame and protests finally spreading to America, this is a good time to get positioned and prepared for uncertain times ahead.

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