Friday File: Lewitt’s Zenith Trading Circle, and Thoughts on Deflation, Hedging and Gold

Some Put Option Teasers Revealed, Blatheration and Ramblings on the short side, plus a personal buy

By Travis Johnson, Stock Gumshoe, October 14, 2016

A question from a reader today echoes the sentiment that I’m hearing from a lot of other folks, so I’m going to run with it… and that will lead me into looking at a teaser pitch for a bearish options trading service. Here’s the question:

“I’m a believer in an impending crash. What do we do with our investments? If it’s big enough for deflation, then gold and other things will go down too, correct?”

You can scroll about halfway down if you just want to skip to the teaser solution bit, but I’ve got some ranting and bloviating to do first.

The first thing we have to say in answering that is that question is that no one is sure, and that crashes, deflation, and recessions don’t always come all together in one package, or for the same reasons as the last crash.

We have not had any meaningful level of deflation in the United States since the Great Depression (though some would argue that point), and it’s hard to judge the impact of deflation on gold because the US Dollar was still backed by gold then (gold prices were reset by FDR through gold confiscation, partly in order to create inflation and generate “stimulus,” which are otherwise hard things to do under a gold standard… but the gold price didn’t fluctuate in the market like it does now).

The best-known gold mining stocks of the time, Homestake and Dome, posted massive returns coming out of the 1929 market crash, doing far better than the broad market, so we know there was some fervor for gold stocks even during the deflationary period of the early 1930s… but I don’t know if that means deflation caused the enthusiasm for gold stocks (the gold business was also fundamentally far different at the time — their costs were crashing because of deflation and high unemployment, but they had a set selling price for their produced gold because of the gold standard).

You’ll see these examples, particularly Homestake, trotted out by pundits when they want to argue that gold will soar during deflation… and it might, but that’s really a guess (and it probably depends, at least in part, on the cause of the deflation). Many of those pundits seem to be using their base assumption, that deflation will mean a loss of confidence in the currency (a currency that most ardent gold fans think should have lost global confidence 40 years ago), and extrapolating that belief to predict that people will hate dollars in deflation, and will rush to gold to protect their assets. This is certainly a possible outcome, but I don’t think you can assume it’s the only likely outcome — we really don’t know. It’s also quite possible that gold will follow the logical path of other commodities during deflation: Dollar becomes more valuable, people hold dollars and demand for most things erodes, commodity prices fall. “Commodity prices falling” is, after all, the root cause of several periods of deflation we’ve had in the past, and gold is special… but it’s also a commodity.

It might just be that the reason for deflation matters a lot — the depression of the late 1920s and early 1930s was caused, at least in part, by banking failures and bank runs, but the deflation started before the depression, particularly because of falling prices for agricultural commodities that crushed the rural economy. Rural America was in a depression for a decade before the “Great Depression” hit, and that was part of what drove people to the cities to participate in (or at least go to look for) the “roaring 20s.” So that was oversupply causing deflation, too much corn and wheat and cotton was produced as farms expanded, partly to meet the demands of WWI, and then farmers kept producing more as demand dropped. The deflation we saw during much of the 19th century was caused more by productivity growth (industrialization and improved agricultural yields). Prior deflations were caused by lots of things — the forced discipline of the gold standard when that was adopted in the 19th century by a few countries, etc. etc.

What will the next deflation be caused by? Just “not enough money?” Money supply can be shrunk, of course, if interest rate rises or continued regulatory pressure on banks make lending shrink… but that seems an unlikely cause to me, because central bankers are so worried about deflation that they’ll continue to print more money or take interest rates lower (or negative) to try to boost the money supply.

So I think there has to be another reason. Maybe just global stagnation or recession that causes everyone to sit on their hands, maybe we finally go through a big period of deleveraging when everyone has to pay their debts for the past 30 years of global largesse… but those are things we only really understand in retrospect. They’re really, really hard to forecast with any precision — hard even if you’re an economist trying to get a handle on 10, 20, or 50 year cycles, probably all but impossible if you’re an investor trying to figure out what will happen in 6-18 months.

Deflation just means “falling prices” — the same way that inflation means “rising prices.” It means that each dollar you’re holding in cash gets more valuable, that the purchasing power of that dollar increases each day — so the tendency is to hold on to the cash, because you think prices will fall tomorrow. That destroys economic activity, because consumers and investors hold back and wait — and capitalism requires a steady stream of people who want to buy products and invest in productive assets, without that you have no chance for growth. The risk is that falling prices create desperation for the asset owners and the companies who are trying to sell to consumers, so prices fall further, wages fall, and deflation gets worse in a spiral into long-lived economic depression.

That, really, is what keeps the central bankers up at night — they know how to stop inflation, all you do is slow down the economy and create more friction by raising interest rates. It hurts, but the mechanism works and is fairly simple. But stopping deflation is much, much more difficult… and the best tool they have, cutting the cost of debt to inflate the value of assets, may not work as well to inflate prices and inspire economic activity as it does to inflate asset values (as we’ve seen over the past seven years) — and even that option is really no longer available now that debt has been made ridiculously cheap after seven years of near-zero interest rates.

That’s why central bankers are willing to push negative interest rates in Europe and Japan right now, despite the fact that we don’t really know what negative interest rates will do to a big economy: They do know what deflation does to a big economy, and they’re terrified of it and willing to try crazy things to try to stop it. Including, effectively, threatening people that if they don’t spend their money it will be confiscated (which, really, is what a negative interest rate means — negative interest rates are just another way, like FDR’s gold confiscation, to try to force more activity in the “real” economy by punishing savers).

I try not to fool myself that I have a great ability to predict the future — so far, there has been little evidence that my sentiments about the broad economy or markets have any sway on the path of events, or any predictive power. It is humbling, of course, to admit this — but I just don’t know (it’s OK, I get humbled every day — I’m used to it). Which means I try really, really hard not to bet too heavily on any one outcome even if I’m sure that it must be inevitable. In my relatively brief 20 years as an investor, lots of things th