2012 Outlook: Gold And Silver

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

An important part of the discussion when looking at the future direction of precious metals are the shorter term fundamentals such as the physical supply available vs. the paper money and credit in the financial system, the new physical supply coming to market vs. current and expected investment and industrial demand, and overall sentiment toward the metals.

These are all very important factors when discussing precious metals and they are key concepts that I will return to on a regular basis throughout this year.  For recent discussions on these topics just click on the links provided in the previous paragraph.

Today, however, as we start this new year I would like to take a bigger picture look at the precious metals providing a broader scope of discussion.

In the financial world today there are essentially three categories of financial analysts/economics that become visible after a considerable amount of time studying market data and history.

Category 1: The 99%

The first category are the 99%.  This is the large army of people you see being interviewed all day long on television that work for financial firms.  They are your average money manager.  They tell you that a portfolio should be composed of a percentage of stocks and bonds based on your age.  They tell you that stocks go up about 10% per year and that bonds provide less growth opportunity but provide the safest location for your money.  They get a paid on a commission basis based on the amount of money you have invested with their company.  Their goal is not to veer to far away from their peers so if they are wrong they will be with the crowd and not singled out: meaning they will not lose their jobs. 

The consensus among the major financial firms entering 2012 is that stocks will rise 9% this year.  Entering 2011 it was that stocks would rise 10%.  The year before, the same.  The year before, the same.  When asked about precious metals they discuss the high risks, lack of dividends, and how they did not protect you from inflation from 1980 to 2000.  They never mention that they receive no commission for funds invested precious metals.

Category 2: The Inflationists

This is a group of financial analysts and economists that have a taken some personal time to study both market history and the current market conditions that exist in the world today.  They have to courage to move away from the group think and can feel that something is different now.

 They look at the balance sheet of the United States and understand that it is not possible to pay off our liabilities and there is a fork in the road that is right in front of us.  They believe this moment will be met with money printing to ease the debt burden.

Category 3: The Deflationists

The inflationist argument is easier to understand and it is why investors who first venture off the path are drawn to it.  I was first introduced to this world years ago through the eyes of money manager Peter Schiff, which then led me to the study of Austrian Economics.

After spending a considerable amount of time studying the argument laid out by the inflationist camp, my natural reaction was to look for those out there that both understood the inflationist argument and then had an opposing view that they could back up with a strong counter-argument.  I found that these people existed, but their numbers are extremely small due to the fact that 99% of the financial community does not understand the thought process of category 2 thus creating an even smaller group that has taken further steps to try and disprove them.

That is why I think the deflationists are very special and are composed of some of the brightest minds in finance today.  Some of the names in this elite group are Robert Prechter, David Rosenburg, and Gary Shilling.

The general argument for the deflationists is that there is a coming fork in the road ahead of us that is composed of an enormous debt burden the size of which the world has never seen.  Coming debt defaults will overwhelm any ability central banks have to print new money, causing the total money supply plus credit to shrink in size; the definition of deflation.

Where I Stand

Albert Einstein once said that the level of a man's intelligence should be judged based on his ability to hold competing ideas in his head simultaneously.

I spend time on Friday nights reading the work of Elliott Wave and Robert Prechter when they release their subscription newsletters.  Then on Saturday mornings I listen to a radio program hosted by Jim Puplava called Financial Sense where he discusses market events, interviews guests, and talks about his outlook for the future.

Prechter is strongly in the deflationist camp and Puplava is strongly in the inflationist camp.  By the time I finish listening to both arguments Saturday afternoon my head is hurting.  My mind is trying to simultaneously process both sides and come up with some sort of conclusion.  It is tough to describe, but I understand what Einstein meant with his quote.

I think this is why many members of the inflation camp do not spend time really studying the deflation side.  For example, those that have not taken the time to research the deflationary argument will usually say that the Fed is printing money and their balance sheet is expanding which means we have inflation.  What they do not understand is that the Fed is only one side of the balance sheet.  They must also look at the debt and credit contraction taking place and being removed from the system.  This process is far more difficult to process simultaneously.

You can take a few years to study the long arguments of both side (and I recommend you do so because it is extremely fun to research), but I will provide you with an opportunity now to skip to the end of the story and arrive at where both sides come to a head.  It can be summed up in two simple words:

Political Will

That is the key phrase.  Both sides understand and admit there is a debt crisis and the current economic outlook is terrible thus not allowing for a normal restructuring of the debt.  Both sides understand that central banks have the ability to print an unlimited amount of debt to ease this burden, and that the scorecard for both sides is based exclusively on the total supply of money and credit in the system, not the short term direction of any specific asset price.

The deflationists believe that the mountain of debt is now so enormous that when we reach that ultimate point, central banks are going to be overwhelmed and will not be able to stop the cascading debt defaults.  They will not have the political will to provide the amount of bailout money needed.  This is what occurred in 2008 when Lehman failed, there was no political will to save them.  It is what is occurring today as the European Central Bank has not yet entered the market with the force needed to stem the sovereign debt crisis.

Inflationists believe that when we reach the ultimate point, when the financial system has its back against the wall, that the central banks will step in with everything they have to keep their current system moving forward.

I believe that in order to have the political backing or will to do this we have to first have one more major "Lehman" type moment.  This will once again rock the markets and the financial system.  It could come from the failure of Greece, a French bank failure, a geo-political black swan event, a terrorist attack, or a natural disaster.  It is impossible to know what the catalyst will be. 

Up until now, just as we moved along during the subprime crisis in 2007-2008, governments and central banks have kept everything together with duct tape and glue.  They have bailed out Greece just as they bailed out Bear Stearns.  They have created bailout funds in the form of EFSF just as they created SIVs back in 2007-2008.  They have opened up borrowing lines in the form of global swap facilities just like they cut the Federal Funds rate back in 2007-2008.

The question is, will they let a Lehman even occur again this time, and if they do, will the cascade of debt defaults be too much for the central banks to backstop even if they enter the market after with a bailout?

Because the direction of the markets are now backed by the political will to bailout, it is far more difficult to navigate the future.  In a normal business cycle you can make investment decisions based on the analysis of a company's balance sheet and their prospects for future growth.  Now, in our globally central planned world, you must make investment decisions based on how much money you believe will be printed in Europe during 2012.

I believe that we have one more deflationary shock in front of us.  This shock will provide both governments and central banks with the political will to print the level of money needed to create an inflationary environment. 

So which camp am I in?  I am in both.  Deflation first, inflation second.  However, as an investor you must be prepared for both.  You must have safe cash ready if we enter a period of deflationary deleveraging so you have the ability to purchase assets before the next inflationary cycle. If they do not let a Lehman moment occur and central banks have the political will to inflate directly out of this current debt crisis, then you must be have some protection or insurance for that scenario as well.

Next: 2012 Outlook: How To Invest


  1. Thank you for that really informative and comprehensively descriptive and analytical piece.
    I was or better still am also caught in the inflation/deflation struggle in my head. The one aspect I would add from my perspective is, political will in this context is a matter of representation and has depending on the underlying sovereign responsibility structure an exponential cost curve in terms of moral hazard to it. You may subsume all this under the term political will, but that does not capture contextual differences sufficiently.
    The FED is entirely different from the ECB (regarding responsibility, objectives, governing framework, and currency status). Further, the problem roots in different hierarchies of the respective sovereign's structure. Toxic assets in 2008 originated in subprime mortgage loans and left a toxic trail up to the bank level, meaning any bailout would serve subordinate levels, ie entities controlled and regulated by the FED. In the case of the 2011/2012 European sovereign crisis, the toxic assets root in particular nations and have partly grown before the creation of the EUR and the ECB governing framework are subject to discretionary manipulation and most importantly, bailouts would serve nations, which are neither subordinate nor fiscally controlled or regulated by the ECB.
    So, in essence, the FED could at least theoretically control future moral hazard, whereas the ECB would be exposed to moral hazard risks of nations fiscally consolidating beyond emergency through ECB bailouts. The eurozone just lacks the regulatory and fiscal framework (for now) to allow such political will. Further, the political will of the FED is less directly bound to political representation as is in the case of the ECB. The FED shifts financial burden vertically from banks to the population )or respectively any USD asset holder) with no repurcussions through the democratic representation system. The ECB in contrast would shift the financial burden horizontally from the periphery to the core, which would rather directly translate into political consequences through democratic representation at the core.
    So, overall, I would distinguish between the inflationary effects in USD-denominated assets and deflationary effects in EUR-denominated assets, as long as the eurozone (if it survives that long) is not equipped with a strict supra-national regulatory and fiscal framework.


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