BIG PICTURE - The financial crisis is now spreading into the real economy - corporate profits are falling, bankruptcies are soaring, unemployment is rising and various nations are now officially in recession. The economic data is worsening and sentiment is horrendous. To make matters worse, several prominent economists are forecasting another depression. These conditions certainly do not provide any comfort for investors. So, if the economic news remains poor for the foreseeable future, should investors rule out the potential for a significant recovery in asset prices?

The bearish camp is pointing towards Japan and claiming that asset prices will not rebound for many years. According to these folks, corporate earnings will continue to decline and unemployment will rise to much higher levels. So, the bears have concluded that global financial markets will stay depressed for the foreseeable future. It is my observation however that in post-war history (with the exception of the previous recession when stocks were grossly overvalued) stock markets have always commenced a new bull-market prior to the end of each recession.

The current US recession commenced late last year, so it has already lasted for more than a year. The average post-war US recession lasted 10 months making this downturn more severe. With the exception of the Great Depression, the worst post-war recessions occurred in 1974 and 1982. Both of these lasted for 16 months, making them the worst recessions since World War II. Now, if we were to assume that the current recession continues well into 2009, this would imply that stock markets will probably bottom out over the coming months.

We must remember that the financial markets are a discounting mechanism and with prices down significantly from their highs, most of the negative news seems to be already factored in today's prices. In the past few months, some nations have been brought to their knees, the entire investment banking industry has been decimated, homebuilders have taken huge losses and now auto-makers are facing bankruptcy! For sure, such circumstances are not signs of a major top; rather they are usually associated with the bottom of the business cycle. So, liquidating positions and taking losses during such a pessimistic environment would be a big mistake. On the contrary, the ongoing liquidation of all assets is providing long-term investors with a fantastic buying opportunity. Accordingly, over the past couple of months, I have deployed all of my personal surplus cash reserves into the markets. Now, I concede that it is possible that prices may continue to drift lower in the short-term, but the recent market action suggests that we may have reached an important low. Unfortunately, I cannot state with certainty as to whether or not last quarter's low will turn out to be the ultimate low for this bear-market. However, I do know that investors who deploy capital in commodity stocks and bullion today, will probably be sitting on huge profits in 5 years from now.

At present, the markets are extremely oversold relative to their moving averages and investor sentiment is awful. In this environment, I anticipate a multi-month rally in commodities, related stocks and precious metals. Conversely, at the same time, I expect a decline in the US Dollar, Japanese Yen and US Treasuries. All of these assets appreciated considerably during the liquidation phase and they will come under pressure when the tide changes.

The main reason why I do not foresee deflation (decrease in the supply of money) is due to the fact that the contraction in credit arising from deleveraging is being more than compensated by the money-pumping actions of the various governments. In the past year alone, the Federal Reserve has expanded its balance-sheet by a whopping US$1.2 trillion! Moreover, thanks to Mr. Bernanke's cash injections (quantitative easing), reserve balances have sky-rocketed from roughly US$5 billion to almost US$600 billion in roughly 3 months (Figure 1)!

Figure 1: Lift off in bank reserves - helicopters being primed?

Source: Federal Reserve Bank of St. Louis

Furthermore, it is interesting to note that the Federal Reserve (money-printer extraordinaire) has now started to inflate the supply of money. Over the past few weeks, the Federal Reserve has injected roughly US$300 billion into the banking system without a proportionate increase in its non-banking liabilities via deposits by the US Treasury. In simple terms, what this means is that the Federal Reserve is now increasing bank reserves without the US Treasury removing an equivalent amount of money from the system. Usually, when the Federal Reserves provides surplus reserves to its member banks, the US Treasury borrows this money from the market by issuing bonds; thereby offsetting the inflationary impact of the Federal Reserve's monetary injections. However, this is not what is happening now and this has inflationary implications. Essentially, the Federal Reserve is now creating money 'out of thin air', debasing its currency and sowing the seeds for sky-high inflation.

At present, commercial banks are hoarding this cash, but I expect this newly created money to seep through the economy over the following months. When that occurs and credit starts flowing again, business activity will pick up and prices will start appreciating.

In the past few weeks, we have received numerous queries from anxious investors who want to know if we are heading into deflation. Obviously, we don't know what will happen in the future, but for now, data shows that all the deflation hype is absurd. If you have any doubt whatsoever as to whether we are facing inflation (expansion in the supply of money) or deflation (contraction in the supply of money), you need to look no further than Figure 2 which highlights the rate at which various nations are inflating the money supply. There is no doubt in this writer's mind that deflation is out of the question when the money supply is expanding at such a frantic pace. For the sake of clarification, I must state that what we have witnessed over the past year is not deflation but a contraction in asset prices due to forced liquidation (non-availability of credit).

Figure 2: Inflation is the problem

Source: The Economist

Now, you may be wondering why there is so much talk about deflation these days when inflation (expansion in the money-supply) is the real issue at hand. There are two reasons for this:

First and foremost, you must remember that banks are in the business of lending and the central banks' prime objective is to manage inflationary expectations. So, Mr. Bernanke and his comrades are paid to keep a lid on the public's inflationary fears. Accordingly, a 'deflation scare' is engineered ever so often, so that they can continue with their long-term stealth inflation agenda without raising too many eyebrows. Secondly, the establishment needs to advertise a 'deflation scare' so that the central banks can slash interest rates. If inflation rather than deflation was perceived as the legitimate threat, then the Federal Reserve would not get away with near zero interest-rates.

In summary, I am of the view that the set-backs in our preferred areas (energy, miners, agriculture and bullion) will prove to be temporary and these assets should outperform the broad market once the recovery commences. Finally, it is worth noting that silver and platinum are now unbelievably oversold and they should rally hard and outperform gold over the following months. Accordingly, I would recommend buying some silver and platinum bullion at these levels.