The following is an excerpt from commentary that originally appeared at Treasure Chests for the benefit of subscribers on Wednesday, December 10th, 2008.

Most financial commentators, even the well-known and respected ones, just don't get it. They don't understand what's happening in macro-conditions because they fail to accept the understanding that sentiment, as measured by speculator betting practices in the various options markets populating the landscape, is the single most important driver of prices in our mature fiat currency based financial markets. What this means is no matter how much money and bailouts our bureaucracy sponsors, until the collect mind changes, as measured by rising open interest put / call ratios on the major US indexes, meaning the speculators are becoming more pessimistic, in general, prices will keep falling. Of course this can change, and corrections (higher at present) will occur, however if you are waiting for unbridled monetary and fiscal largesse to result in hyperinflation with declining numbers of bearish equity market speculators to squeeze, you are likely in for a disappointment.

Does this mean that deflationists like Mike Shedlock are right, and that we are in a formal state of deflation at the moment? No, as a matter of fact, it does not. As outlined in our opening statement it simply means that en mass equity speculators don't see a percentage in getting short the various markets at current levels because they see prices moving higher, no matter how much they fall. It in no way means money supply is contracting, which is the formal definition of deflation, and the only one that would matter if equity bulls were to turn bearish. (i.e. falling prices do not constitute deflation.) Easily the best example of this at the moment is found in crude oil (and commodities), considering the stock market appears to have turned higher in earnest now. Are we in a state of deflation because crude oil prices are falling?

Here, it's important to note stocks have turned higher due to selling exhaustion and seasonal influences, not because speculators have turned predominantly bearish, as measured in still low open interest put / call ratios (see attached above) on the major US indexes. What this means is if speculative betting practices in these markets do not fundamentally change as the bounce in stocks matures into next year, any strength witnessed between now and then will be exactly that, a bounce, destined to fail once negative cyclical / seasonal influences are in a position to exert themselves once again. You will remember from our previous studies on this subject matter, history suggests this likely bounce could last into April of next year at which time the secular bear market will reassert itself.

In getting back to our crude example now, where prices have not turned higher due to selling exhaustion just yet, making a discussion on this subject matter here more pertinent, again, as mentioned above, it's important to realize why oil prices remain subdued so that correspondingly, we will know what to look for on the way up as well. This is very important moving forward because even though commodity prices have crashed with the larger equity complex in 2008, this does not mean the prices of these commodities can't run all the way back up to the highs (and beyond) under the right conditions. Is such an outcome possible if the stock market is to turn lower on a secular basis again next year, implying the credit cycle is still contracting long-term?

You bet it's possible under the right conditions, which is a lesson in history. First and foremost, and the reason I spent so much time explaining it above, one must realize we are not in a state of deflation, which I admit is challenging with all the confusing talk out there. Naturally then, if this true, we must necessarily be in a state of inflation to some degree, with currency hyperinflation the most excited condition therein. We are of course not there right now, however it's possible we are could be at some point if the Fed decides to devalue the dollar ($). And here's the kicker in terms of why commodity prices could run right back to the highs, with crude oil the exemplar due to it's importance to us, pictured below. If a $ devaluation were to occur concurrent to speculators becoming convinced such an outcome is not possible, which is not a stretch considering the drubbing commodity prices have just undergone, then the fuel for a short squeeze would be in place (put / call ratios on the energies would rise), and the 'wall of worry' would do the rest. (See Figure 1)

Figure 1

This is of course the condition set all bull / bubble markets have been built on within our fiat currency based system / economy / markets. And the traditional 'second leg' of a secular (long-term) commodity bull market has historically been quite daunting for investors in this regard for reasons explained above. So you see in fact it's not really appropriate to talk about bull and bear markets in terms of inflation and deflation like the majority of commentators on the such subject matter like to do because it's far more complicated than whether the Fed is 'printing money' or not. In the first place the Fed doesn't print money, they print currency, fiat currency, which has no value other than what the market perceives. (i.e. it's a confidence game.) This is important to understand in terms of just how fluid the situation is, and that price wise anything is possible.

And secondly, the right sentiment conditions need to be in place no matter how much currency is printed, or no bull market will ever materialize. Again, and as can be seen below in open interest put / call ratios on the United States Oil Fund (USO:NYSE), which is undoubtedly the best representation of sentiment for crude today, as market participants have moved into the Exchange Traded Fund (ETF) market(s) predominantly, it's because speculators see 'no percentage' in shorting oil as it continues to fall, much to the astonishment of just about all observers. Obviously all the speculators know about peak oil, and they are not about to get caught on the wrong side of that trade is the sentiment right now, so the price continues to fall. Of course a turn in the $ and selling exhaustion could be the catalyst for a bounce here, which could morph into something more down the road as is the case with precious metals shares. (See Figure 2)

Figure 2

Source: Schaeffer Research

That is to say once precious metals shares came off the lows back in November, speculators, who are now mistakenly convinced 'deflation' has gripped macro-conditions (we know this with T-Bill rates hitting zero), began shorting precious metals shares (buying puts), as measured by rising absolute put / call ratios on the Philadelphia Gold And Silver Index (XAU), seen below. And although they have pulled back slightly in recent days, as you can see below readings are still at elevated levels, which accounts for precious metal share relative strength evidenced in a rebounding XAU / Gold Ratio, a rebound that as you can see from the monthly chart in the Chart Room, could be quite dramatic. A more detailed explanation of what is happening to precious metals shares within the context of the above discussion can be found within the opening remarks of our last commentary. (See Figure 3)

Figure 3

Source: Schaeffer Research

So, the big question now is, will open interest put / call ratios on precious metals shares continue to rise and remain buoyant, or fall back, killing the rally not only in the golds, but also any chance of getting something sustainable going in energy shares? That's the question you see, and it's not an easy one to answer. Just off the top of my head (meaning this is an educated guess), my inclination is that with technical conditions across the precious metals sector so oversold, a tight physical market, and momentum / seasonals (January Effect) in our favor, I'm betting on the rally in precious metals continuing, minimally at least to the point more of the technical breaks across the sector are tested. For reference, in the case of the Amex Gold Bugs Index (HUI), such a juncture would come with a test of the channel break seen here on the monthly plot from the Chart Room, in and around the 325 area.

As can be seen on the following chart of Energy Select Sector Spiders (XLE:NYSE) ETF, if something does not happen to entice speculators back into this market on the short side, any strength witnessed in the trade will most likely end up being corrective, meaning lower lows for both crude oil and it's related equities are in the cards. So, let's hope that the coming expiry(s) in the various options markets produces some favorable results in put / call ratios, results the market participants do not seem to be able to manufacture on their own. This is partially what happened in the precious metals shares in November, where a great many calls simply expired, lifting the put / call ratio on the XAU in effect. (See Figure 4)

Figure 4

Source: Schaeffer Research

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Best of the season all.