"Inflate or die"

"Inflate or die." That's been the story for years. But today if you continue to inflate you're dealing with a global market and powerful creditors. Our number one creditor is China. China holds a staggering $2.3 trillion in reserves, 70% of which are US securities. China is looking at US money creation (inflation), and wondering what to do about it. Here's an idea - why doesn't China buy up the US with China's ever-growing hoard of US dollars? Wait, maybe they're doing it - this year, for the first time in history, China spent more buying US assets than the US spent buying Chinese assets. Ah well, as one jokester put it, it's going to be tough when Chinese families have American house-boys.

Below is the dire picture from the viewpoint of Austrian economics.

The Austrian Monetary Theory of the Trade Cycle offers a political-economic explanation of why an economy's debt-to-GDP ratio may rise over time. Output gains fall short of the government-sponsored circulation credit growth rate. With this in mind, it might be insightful to briefly recall the so-called "debt dynamics."

If an economy's debt-to-Gross Domestic Product (GDP) ratio is allowed to rise further and further, interest rates must keep declining so that borrowers do not default on their debt. In the short-run, lower rates might prevent widespread bankruptcy. However, a policy of pushing interest rates down would by no means offer a solution to the underlying problem.

In fact, an artificial lowering of interest rates through the central bank would represent the very process that Austrians consider a perpetuation of the fateful expansion of circulation credit that must end in a collapse of the monetary system.

Russell's Comment - For the sake of argument, let's say the Austrians are correct, and in the future we face a collapse of the monetary system. What then? If the current monetary system collapses, nobody will know what any currency is worth. In that event, I'd want to be 100% in gold. The reason is - as the monetary system moves ever-closer to collapse (distrust), people will turn to the one currency that has been trusted and hoarded since Biblical times, and, of course, I'm referring to gold.

If your nation's currency is losing purchasing power and is being devalued, how much is gold worth in terms of your currency? The answer is, in that case, the price of gold is open-ended in your currency, since you will pay any amount in your fading currency to obtain money of unchallenged value. What's a life-saver worth to a drowning man? Answer - It's worth everything he owns.

Comments - There's no question about it, the stock averages are pushing higher. In view of that, there are two questions that might be asked. (1) Take the move at face value. Is the market correctly discounting better times ahead? I believe this is the widely-held view. The market's function is to discount. Therefore, the market is now discounting better times ahead.

But what if we are experiencing a bear market advance? Following the 1929 market crash, which ended in November 1929, a huge rally occurred. By April 27, 1930, the rally had recovered over 50% of the ground lost during the 1929 crash. Many investors bought the '29-'30 rally on the thesis that "the worst is over" and that better times lie ahead. Many thought it a resumption of the bull market.

(2) The great counter-trend rally ended in April 1930 at 294 in the Dow. Following the rally, the market turned down and the Great Depression began. The lesson - rallies in bear markets don't necessarily reflect good times ahead. And that's about where we are now.

When life is a puzzle, I like to go back to fundamentals. The most basic of fundamentals (Dow Theory) is that the market runs from extremes of overvaluation (where I believe it is now) to extremes of undervaluation, a place where it has not been since the early 1980s.

And the question is - are we now on the long winding path to extreme undervaluation? I really think that's what's happening now. And I ask myself, how does this help us with positioning ourselves for the coming years?

First, if equities are headed (over time) toward undervaluation, I don't want to be loaded with common stocks. I'm not a trader so holding stocks, even top-grade blue chips, is not the way I want to go.

As for money instruments (bonds, notes, bills), I think as the dollar sinks over time, interest rates (now abnormally low) will head higher. That leaves out bonds as an investment as far as I'm concerned. Besides, if I hold a bond yielding 4%, and over the next year the dollar drops 5%, I'm out money, and I'm out purchasing power.

So where does that leave me? It leaves me holding as much in the way of precious metals (particularly gold) as I'm comfortable with. So half of all my liquid assets are in gold. But I don't want to put all my liquid assets in gold, because in investing nothing is guaranteed. The other half of my liquid assets I'm going to leave in dollars, because that will give me time to think, and hopefully, over the next six months to a year the situation will clarify.

This may be the time to repeat an old Russell aphorism. "In a primary bear market, everyone loses, and the winner is the one who loses the least."

A final thought. As I read my voluminous daily and weekly material, it occurs to me that most investors and most analysts are viewing the current situation as a "bothersome, temporary patch" that should, within a few years, give way to normalcy, and I'm talking about the "old normal." In other words, after a year or so "this too shall pass" and stocks should be heading higher again as they usually do once we return to the good old normal days.

I think almost everybody's on that side of the boat. But it's not going to happen. That's the Warren Buffett optimistic view, "Don't sell America short. Stocks go up over the long haul."

I believe too many people are on the optimistic side of the boat. The boat is about to list the other way. The unexpected trend would be a long journey towards deleveraging, devaluation and deflation, all leading to an even more recession or depression.

You say "it can't happen here." Maybe so, but I'm not playing it that way. In the investment business anything can happen, and it's been almost three decades since we've experienced a great bear market bottom, during which stocks sell at extreme undervaluation. As far as I know, there's never been a period this long without the appearance of a great bear market bottom.

(from ww2.dowtheoryletters.com, January 23, 2010)