I'VE BEEN USING THE 1930S AS MY DEFLATION MODEL FOR THE LAST DECADE -- KONDRATIEFF WINTER HAS BEEN ON TARGET -- GOLD STOCKS AND DEFLATION

GOLD AND DEFLATION... I'm going to be writing about deflation in this message, since that's the only model that seems to have worked over the last decade. But first, I'd like to respond to one of our reader's question about the performance of gold in a deflation. The question includes the following observation: "Since we have not had deflation in the U.S. since the 1930s, and gold was not freely tradable then, there's no precedent to look to ... for how gold might perform in a deflation". Actually, that statement is only partially true. My 2004 book entitled "Intermarket Analysis" described the new deflationary threat that started in 1998 (during the Asian currency crisis) and wrote about the major upturn in gold prices as a result. Page 123 includes the following quote: "Some skeptics questioned the staying power of the rise in gold shares on the grounds that gold was an inflation hedge and there was more deflation than inflation. However, gold shares have done historically well during both inflations and deflations...Although gold bullion was set at a fixed price during the deflationary years from 1929 to 1932, the price of Homestake Mining (a gold stock) gained 300 percent while the stock market lost close to 90 percent of its value". [The price of gold was revalued upward in 1933 and the dollar devalued in an effort to combat deflation]. In fact, the two top performing assets during from 1929 to 1932 were bonds and gold stocks. The two worst were stocks and commodities. That's the deflationary model that I warned about in my 2004 book and which I believe is still in play.

DEFLATION SCENARIO... The Introduction to my 2004 intermarket book reviewed relationships that prevailed up to 1998 (which I had explained in my 1991 book on the same topic). One of the paragraphs containing the headline -- "Then Came 1998 and Things Changed" -- which explained that "deflation" played a key role from then on. A later paragraph (p. 52) entitled "The Deflation Scenario" explained that deflationary trends not seen since the 1930s were starting to take hold which would result in falling stocks and commodities with rising bond and gold prices. The biggest intermarket change was the major decoupling of bond and stock prices which has lasted until the present day. One sentence reads: "Market events of 1998 were a dramatic example of ... how bonds and stocks can decouple in a deflationary world". [Last Thursday's article on why falling bond yields were bad for stocks was based on that earlier deflationary theme]. Another explanation for deflationary trends over the last decade comes from Kondratieff Winter which was also described in the 2004 book.

KONDRATIEFF WINTER ... The Kondratieff Wave (discovered in the 1920s by Nikolai Kondratieff, a Russian economist) is well known to most technical analysts and describes a "long cycle" of economic activity which lasts approximately 55 to 60 years. I bring it up here because it may explain why the last decade has gone so badly for stocks and so good for bonds and gold. I take no credit for the accuracy of its prediction made in my 2004 book since it was based on the work of Ian Gordon, editor of the newsletter "The Long Wave Analyst" (although I included it in the book because it coincided with my own views). Gordon divides the long wave into four seasons with each "season" lasting approximately 15 years. Autumn (which he says started in 1980) sees the greatest speculation in bonds, stocks, and real estate. Gordon put the start of "Kondratieff Winter" in 2000. The 2004 book summarized Gordon's view as follows: "The main characteristic of the economic winter is deflation. Stock prices plunge (as do real estate values)...The two best defenses are cash and gold". Gordon refers to the long wave as a "lifetime cycle" because it happens only once in a lifetime (the last time being in the 1930s) and each generation is unprepared for its onset and unfamiliar with its solutions. What's worse, nearly a decade later, Wall Street and the economic community still doesn't seem to recognize that we've been in the first truly deflationary environment since the 1930s. Once you understand that, most intermarket trends will make a lot more sense to you.