Recently, I had written about how a deflationary impulse in the capital markets would be a catalyst for the gold stocks. This turned out to be accurate as stocks and commodities weakened while treasuries and the US Dollar advanced. Gold and gold stocks also moved higher. Nevermind the comments I received about how we are in an inflationary period and Gold will go down in a deflationary period.

The typical mainstream view is that for Gold to do well reflation needs to take hold. Banks need to lend and velocity of money needs to pickup. Gold can't do well if assets are declining. This is what many were saying back at the end of 2008.

Fast forward 18 months and Gold has soared to a new all time high with Silver and the gold stocks close behind. Stocks and commodities have gained but only marginally. The US Dollar is about flat. Bank lending and consumer credit continues to decline. Why are the precious metal outperforming?

Deflationary forces can weaken an economy severely and in turn, exacerbate government finances. This is how a sovereign debt crisis becomes a currency crisis. We have deflationary forces in the US, Europe, the UK and Japan. Yet, unlike ten or twenty years ago, governments are in a terrible fiscal situation. Hence, the market sees this and sees that currency depreciation is inevitable no matter if a government defaults or hyperinflates. In smaller and weaker countries, this scenario can play out in weeks or months. For the western world, it will play out gradually over a span of years.

Interestingly, the decline in credit and the money supply serves to exacerbate the problem. Here is why. Initially (and as we are seeing now), the market begins to recognize monetization and currency depreciation. Eventually this will lead to higher inflation. Yet, tight credit then restricts new production and supply. As a result, supply shortages emerge. This is the hyperinflationary spiral that results from deflationary forces and an over-indebted and essentially bankrupt state.

When the economy bounces or recovers, Gold underperforms commodities and sometimes stocks. Remember 2003 to 2007? Remember what happened from March 2009 until recently? Hence, reflation is not good for Gold.

In the months ahead, as the global recovery struggles to sustain and deflationary forces persist; don't get caught on the wrong side of the trade. Ill-informed or biased observers will take any weakness in Gold as a sign that a major deflationary downturn is on the horizon. Such folks may include Gold in with the rest of the commodity spectrum, unaware of the major fundamental differences. The smart money will use any weakness to increase their positions and load up, knowing that the point of recognition is close at hand.

In closing, there is one point I'd like to make about the gold stocks. The chart below shows that when Gold outperforms both Industrial Metals and Oil (as its doing now), it is a very good sign for the HUI/Gold ratio.

While the outlook for Gold is very positive, the outlook for the gold stocks and various juniors is even brighter. Learn more about that in our premium service, which offers a free 14-day trial.