Article originally submitted to subscribers on 17th September 2006.

This may very well be the last shake out before the next multi-year Bull run begins...

Are the stars aligning for Deflation?

Monday September 11th 2006 was not a good day for Gold, Gold Stocks, Oil or Industrial Commodities.

Chart 1 - Gold Stocks (top) ; Gold; Industrial Metals ($gyx); Oil ($wtic)

Last week the stock market moved up with much fanfare and noise, but just like housing stocks, the stock market has taken weeks and only managed to challenge its Summer highs.

Chart 2 - Housing Stock Centex has taken weeks to challenge its Summer high; so has the S&P (black)

Bonds have continued strong and the Dollar has surprised everyone by rallying.

Chart 3 - US Dollar broken above right-angle triangle; Bonds (below) continue trending higher

What gives?

The market is pricing a global slowdown and people are running to the Dollar to pay down debts. Oil and Industrial Metals fall on lower expected demand especially from manufacturing Giants such as China and India. Gold falls because of lower price inflation expectations.

Commodities led the market higher. I'm wondering if they'll ultimately lead the market lower?

To service debt the economy needs to generate income and profits. In a slowdown, profits are hit hard and so is the ability to service debts. With a housing debt burden in excess of $2 Trillion, the economy will not survive a slowdown for long before debt IMPLODES.

The Fed obviously knows this and will attempt to stimulate the economy by repeating what they did to halt the 2000 - 2002 Bear Market. Slash interest rates.

Will cutting interest rates arrest a Bear market this time?

In my opinion - No.

Here's why:

By 2000 the public had been whipped into an Internet speculative frenzy. They then got caught in the headlights of a Nasdaq crash. Individual balance sheets were hit but the speculative mood wasn't dampened, it was transferred to Real Estate through the Fed slashing interest rates.

In other words, from 2003 to 2006 the public was still in a playful mood. "Yeah sure, my portfolio is down, but housing prices are strong and getting stronger. I'll hop on board that train and make up for my Stock Market loses."

The Real Estate market became the only game in town.

Fast forward to 2006:

The public is even more weighed down in debt now than they were in 2000. The speculative frenzy may also be softening as Real Estate cools (and Nasdaq stock market losses were never recovered).

Rydex cash flow ratios suggest the public continues to remain Bearish even whilst the stock market moves higher [Rydex Ratio Implies Prices Will Go Higher].

People are now worried about the price of Gas and the War on Terror (which was non-existent in 2000). The psychological pendulum has swung from over-exuberance to cautiousness and is on its way to despair.

What would the object of speculation be if the Fed slashed interest rates? What asset class could even remotely be big enough to substitute for Housing?

The answer, for a battle-wearied public, is possibly none. No asset class is big enough to absorb the necessary funds to make up for the Real Estate bubble.

Hold on! There is one exception.

Defence.

But defence is the domain of governments. In order for defence spending to provide income to the public (to pay their debts) a HUGE mobilisation effort would have to take place. We would have to face a really SERIOUS enemy for that to happen - War on Terror???

Chart 4 - Weekly Defence Index continues to look very strong

Psychology

Assuming Housing is now Kaput, does the public have the stomach to continue speculating? And if they do, where would they speculate? Is there a chance they may get serious and begin SAVING (gulp)?

These are the million $ questions and ofcourse nobody knows for certain. I am however a believer in cycles. I believe in the Kondratieff Cycle and I believe we are now approaching the Coldest Part of the K-Winter.

The FED must start reducing interest rates (soon) in an effort to stimulate the economy. There is a delay between the time the Fed begins reducing interest rates and lower interest rates impact the economy. When confidence gets hit, I doubt whether deflation will be offset quick enough by falling rates.

The asset class that would benefit most from slashing interest rates would be Gold. Gold will turn around swiftly as it senses a large monetary reflation is underway. We are not there yet, but this important fact ensures that the current drop in Gold and Gold Stocks will not take out the June lows and will probably be the last major correction before a multi-year Gold Bull market gets underway.

Hold tight until psychology swings back in favor of Gold.

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