Inflation, Deflation And The Big Gold Call

There are two camps of investors which have diametrically opposed views on why one should own gold. One camp believes that gold is an excellent hedge against inflation, while the other camp believes that gold is a hedge against "down markets," and deflation.

My perspective is that both camps are wrong. We have seen gold go up during periods of inflation, we have also seen times where gold goes up during periods of deflation ... and vice versa. Therefore, to me, it is not a question of inflation or deflation, but, rather, a question of market sentiment. That is the only constant that can explain why gold has gone up during periods of inflation and deflation, as well as down during periods of inflation and deflation.

Along these lines, I would like to analyze a period of time when gold did not act as a "safe haven" during a deflationary event, while at other times it did act as a supposed "safe haven" during such deflationary event. If we were able to find such a period of time, then the deflationary camp will be wrong if metals go down during a period of deflation, and the inflationary camp will be wrong if metals go up within the same period of deflation.

For, if one cannot rely on metals to act in a certain way during a specific economic event, then it is clear that one should not be investing in metals based upon these economic perspectives. Think about it. If gold goes down during a period in which one would need to rely upon it as a "safe haven," and if it also goes up during a period of deflation, how can anyone in either the inflation or deflation camp be able to rely upon their respective perspectives?

So, let's take a look at the 2007-2009 time frame, which evidenced the most recent period of deflation in our markets, and see if we can glean anything from the metals action in relation to the strongest period of deflationary market pressures since the Great Depression.

We all know that the S&P500 topped in October of 2007 and began an estimated 300-point decline into March of 2008, and then we saw a corrective bounce in the equities for a couple of months, before it continued to head down. During that same period of time, even while the markets were heading lower, the metals continued to rally strongly. Here we have "evidence" of precious metals supposedly rising during a period of deflation. So, we have a strike against the inflationary camp, and a support for the deflationary camp.

But when we then look toward the May 2008-March 2009 decline in the equity market, we witnessed the metals also experienced significant declines within that time period. In fact, gold lost a little more than 30%. But gold also found a bottom and began to rally four months before the equity markets. So, when one is presented with these facts, does it make sense that the metals are surely going to rise during periods of deflation? Are metals really the "safe haven" everyone believes they are during down markets?

I seriously hope you can all put aside your personal biases toward precious metals, and recognize that metals are not necessarily going to rise during periods of deflation. Oddly enough, metals can rally during periods of deflation, and they can fall during periods of deflation. The same applies to periods of inflation as well.

I know you are likely thinking to yourselves, "Avi has really lost it this time." In all honesty, how can you come to terms with the reality of how they reacted during the 2008 broad equity-market carnage, which was clearly a deflationary event? Did they act as the supposed "safe haven" during the strongest period of deflationary pressures experienced since the Great Depression? Yet, they still rallied during certain periods of time within this deflationary event.

Ultimately, one has to recognize that the metals are not driven by inflation nor are they driven by deflation. We have clear periods of time in our history where they have acted in the exact opposite manner in which each of the prominent camps would have believed. So, maybe there is another driver of metals which can be relied upon at all times?

My answer to that question is that market sentiment is what can be relied upon at all times to point you in the correct direction for the precious metals. Tracking market sentiment is how we were able to call the top in gold in 2011, and also predict that its price would be cut in half. Furthermore, market sentiment also explains the seemingly contrary action in the metals during 2007-2009.

One other related comment I would like to address is that some have pointed out that we need to explain why a downtrend in US Treasuries would not result in a rise in gold, since a downtrend in Treasuries portends inflationary pressure which "should" cause gold to rise. My answer is to explain to me why you think this premise is correct.

In fact, when you just go back a few years, we see the Treasuries declining from mid-2012 until 2014, yet gold did not rally then. Rather, it followed the Treasuries down. Even as the Treasuries then began to rally during all of 2015, what did gold do? Well, it rallied for the first month, then it declined, and then it simply consolidated.

Ultimately, one has to recognize that the old paradigms upon which you make your assumptions may be incorrect. In fact, much of inter-market analysis has lost its way over the last three years, which has confounded many analysts, and caused losses for many investors.

Rather, I would strongly suggest to anyone reading my columns to maintain an open mind so you can see what has worked and what has not worked in the markets. There has been no consistent inter-market relationship upon which one can rely when it comes to metals.

Therefore, as I have said many times, one must analyze the market before them irrespective of what other markets may or may not be doing. The main reason is because sentiment is what drives each market, and it varies by market. So, unless you have a reliable way to track market sentiment in the metals, you may be caught on the wrong side of the market while "waiting" for the old paradigms to re-align. Have you ever considered that they may not?