We are living in interesting times.  While the professional economists are trying to figure out what happened we have all become economists of sorts just to try and understand the events that greet us every day.

With huge deficits many would expect inflation as another weak willed government resorts to the printing press to solve its problems.  In response we are saturated with ads to buy gold, the default inflation hedge.  Yet I well remember the inevitability of inflation in the 1970’s as gold passed $800 an ounce; only to hit the Reagan/ Volcker wall.  Inflation fell as did the price of gold.  In inflation adjusted dollars gold has yet to recover over 25 years later.

Retired economist Scott Grannis, in his excellent blog, Calafia Beach Pundit, explains how we can be looking at record low bond yields and interest rates while the deficit hits and record levels and  inflation remains tame.  It is a subject that has puzzled me. Read A bond bubble?

Excerpts:

So perhaps there is, in addition to weak growth expectations, an inordinate fear of the future: a fear of big tax hikes, and of a prolonged economic malaise caused by an overbearing state that absorbs the fruits of and smothers the private sector. Japan comes to mind, with its massive deficits, a debt/GDP ratio that has been well into triple digits for years, and sluggish growth. Perhaps it’s the case that as debt approaches and exceeds 90% of GDP the economy simply loses much of its forward momentum, a thesis supported by the findings of a recent research paper by Rogoff and Reinhart. There’s even some support for this thesis in our own history—muddled of course, by WWII—when federal debt surged to 120% in the early 1940s, even as 10-yr yields traded at 2% or so.

If the market is scrambling to buy bonds yielding 2.5% or less, it only makes sense if market participants hold little or no hope for a better alternative in the foreseeable future on a risk-adjusted basis.

It also makes sense that today’s almost-zero yields on cash, extremely low yields on risk-free bonds, and massive debt sales become in a sense a self-fulfilling prophecy. Low yields represent very low hopes and aspirations on the part of the private sector, while the bonds being sold and the money absorbed from the private sector by our federal deficit are being used to fund a level of spending and wealth redistribution such as we have never seen before.

We’re not witnessing a bond bubble in the making, we’re living in a statist nightmare.

IBM, Johnson and Johnson,  and McDonalds are issuing debt with rates comparable to US government debt and at lower rates than that offered by many foreign governments. What does this mean?  That bond buyers consider blue chip corporations as safe as the government which has the power to print money.  That is profound: we have greater faith in the power to create and produce than we have in the power in government.  The secret to surviving and prospering in a country with the government gone wild is to somehow insulate your life from the ill effects of a looter mentality; to make government as irrelevant as you can.

While our current regime is as anti-business as any seen in some time, stocks may be the preferred investment choice. Real estate is still rocky.  With interest rates so low, they only have one way to go, and that makes bonds a risky investment.  Gold is so popular that the contrarian in me hesitates, and few remember how gold collapsed from $800 an ounce to nearly $200 from the 1970’s to the 1980’s.

While many near retirement fear the low interest rates will strongly impact their retirement income, this low interest rate may not be so bad if we do incur any deflation.  A 1% yield against a 3% decline in prices (deflation) is a real 4% gain in purchasing power.

The impact of the huge national debt may be offset by the eradication of wealth in the real estate collapse. This may explain how we have so much debt, yet prices are stagnant.

The federal stimulus is negated by the cuts in state spending and the unwinding of the credit bubble.  The stimulus is unable to counteract the lack of confidence and trust. People are saving instead of spending because of the combination of fear and the collapse of credit. The government and the fed  is trying to stimulate a demand that may not exist. They are fighting the last recession. This one is different.

While I share the great concern about her destructive economic policies of this administration, I am getting a contrarian tick about the dollar and gold.

Every right wing talk show and business TV show is flooded with adds selling gold to consumers.  “The dollar decline is inevitable” the pitchmen warn, “Gold is the only safe money.”

When there is this much noise and whenever anything is inevitable it is time to be cautious.

I remember during the seventies when inflation seemed inevitable. The doomsday newsletters like Harry Brown and Howard Ruff had middle class investors buying gold coins, opening us accounts in Swiss banks and investing in Swiss Franc CDs.  Gold reached over 800 dollars an ounce.

And then the inevitable did not happen.

Volcker and Reagan wrestled inflation out of the system, the dollar soared and gold plummeted. Silver which ran as high as $50 an ounce came crashing down to under $5. The real reason for its rise and spectacular bubble was not the desire for sound money but the manipulations of the notorious Hunt brothers.

Middle class investors who bought into the fear and invested heavily in foreign currencies and gold were badly damaged.

It is challenging enough to get accurate information about domestic stocks. Understanding the factors affecting currency values and foreign markets are far beyond the scope of middle class investors (and most professional investors as well.)

Interest rates are near zero. They cannot go down any further, and given the deficit will likely go up.  When interest rates go up the costs of holding a non interest bearing asset like gold goes up, and this puts down ward pressure on the price of the metal.

While the dollar may seem vulnerable its value on world markets are relative to other currencies. As we see the Dubai fantasy teetering on the brink of bankruptcy and countries like Greece nearing default, the dollar may start looking better if for no other reason than other countries are looking worse.

The amount of uncertainty multiplies greatly when you leave our borders. If you are concerned and want some gold limit your exposure to 10% of  your assets and even dollar average that to avoid buying at a top. Consider gold stocks like Newmont or Goldcorp that you can sell easily and quickly if the market turns against you.

Do not put gold in your 401k or retirement account. The tax protection is better suited to income investments, even low yielding but secure Treasuries. If you think interest rates are going up (I do) avoid long term bonds of any nature. Bond face values drop as interest rate rise.

Successful investing requires controlling your emotions.  Anger and fear over this administration’s policies can easily influence your investment decisions.  Rarely does such emotional influence lead to better decisions.

Beverly Gunn writes writes in American Thinker “Fighting the Beltway Mentality.”

Excerpt:

“This was demonstrated as each person we met immediately gave us their job title, followed by the title of whatever their (significant other) did for a living. It was clear this was done to highlight personal importance.  In part this amused me, but I soon came to understand this was only the beginning of what we learned was called Beltway Mentality.  We discovered that this was an area where each person we met was competing to out-do everyone else, while also cultivating self-importance.”

“It was a singularly insular place where a certain framework of assumption included the concept that ideas formed here should be the gold standard for the nation and the rest of the world.  Or worse, the assumption’s further corollary was that if others did not think your way, then they must have a significant defect!”

There are a few indisputable changes in our economy.

Credit is tightening. Generally this is good because  lending standards, whether to individuals to buy homes, or to real estate developers or other businesses, were way too lax.  Marginal businesses will have much tougher standards to meet to renew credit lines.

Income statements have deteriorated.  Especially if you are in a commodity business like steel, lumber or fuel, you have experienced the opposite of gouging as you sell your goods for less than you paid while your unit sales have dropped and desperate competitors sell at any price they can get to keep the doors open another week. You have probably experienced several consecutive months of losses.

Banks have a further problem lending to businesses with consecutive months of losses. But here is where a real potential problem awaits. We have a record deficit in a peacetime that will likely lead to inflation.  The only reason it has not yet is because unemployment, uncertainty, and credit tightening has reduced the velocity or the speed of money circulating.  Said differently, everyone is sitting on their cash, even with low returns. Therefore this cash is not chasing and inflating the prices of the goods in the economy.

If the flood waters don’t recede the levee will eventually break.  This vast horde of cash will eventually enter the economy and a likely recipient will be industrial commodities.  Housing and real estate wounds are still too fresh and the banks will not quickly pour their funds into that hole, although banks are noted for very short memories.

Stocks have a very clear value mechanism. If earning are poor and money pours into the stock market then the price earnings multiple elevates to a level when it is clearly overvalued.  After the dot.com bust and the housing bust, pedestrian investors are still gun shy of the stock market.

But commodities have no clear valuation ceiling.  Is gold overvalued at $1000 even if that is double its value of a few years ago?  Is scrap fairly valued at $300 a ton or $600 a ton?  Who knows?  Is the proper price of gas $2.19 a gallon or $6.00 a gallon?  There is no PE ratio to quickly determine if commodity prices are overvalued.

Inflation gets us used to higher prices. And we must compete with global economies for these commodities.

When inflation reignites industrial commodity prices, as I think it will, those who inventory and sell those commodities will be caught in a cash squeeze.  They will need cash to cover the higher cost of replenishing inventory at a time when credit is sharply reduced.  Many of these companies have been able to survive the recession with crappy income statements because of the cash they generated from their balance sheets as inventory and receivable costs dropped.

When this reverses they will experience a liquidity squeeze that will threaten all but the strong. If you sell these people on credit start watching them like a hawk. When inflation rebounds it will focus in industrial commodities and many in that field will be in trouble.