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Inside this week's update...

 

***** New century, new rules.

***** Beating the S&P five-fold.

***** We may have underestimated gold and inflation.

***** Another stimulus package?

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If you need any convincing that making money in the 21^st century requires a wholly different approach than it did in the 20^th century, just look at what's happened to commodities.

 

Last century, it was a safe rule of thumb that commodity prices would rise in times of inflation and growth, and fall in times of recession and deflation. Until recently, if you told anyone that the world would enter a worldwide recession, while at the same time gasoline prices would climb above $2.50 a gallon, they would have thought you were crazy – or at least ignorant of economics.

 

In fact, in 1998, when we had a crisis far less severe than the current one, oil cost $10-$20 a barrel. Today's global recession should have rendered oil equally cheap.

 

Yet here we are, in 2009, with the world growing more slowly than any time since the 1930s, and commodities have been total stars. Oil is up 100% since its lows. Copper has risen 76%. Gold costs $200 an ounce more than in December. And other commodities have posted similar gains.

 

The world has changed – we're not in Kansas anymore. And we can only imagine what heights commodity prices will reach when the recession ends.

 

If you've read Game Over, you know the crisis that could result when worldwide growth turns positive again. Commodities are interrelated, like a Gordian knot, such that limited production of one commodity limits the production of others and vice versa. As growth pushes the demand for certain commodities beyond the level where production is economically feasible, the result will be a permanent ceiling on commodity production, which in turn implies an ultimate limit on growth.

 

But that may be still a few years away, depending on how quickly the recovery comes. In the meantime, we haven't ruled out the possibility that global economic growth could take another turn for the worse.

 

Regardless which comes next – growth or downturn – there's still one asset you should have in your portfolio...

 

 

THE GOLDEN DECADE

 

Over the past 10 years, the one asset that has been a stellar performer is gold. In the most recent issue of TCI, I've included a chart tracking the performance of gold vs. stocks. You can clearly see that gold has outperformed stocks by a ratio of 5:1. Since 1999, gold prices have climbed 300% or more, while the stock market (ex-dividends) remains down 30-35% from its high.

 

Gold thrives on turbulence, and we have certainly had some turbulent years recently. More importantly, gold is the one asset that can benefit from both inflation and deflation. In 2008, we had bouts of both “flations,” and gold was just about the only asset to end the year in the black.

 

Going forward, we cannot be certain whether the economy will take another hit or not. If another shock occurs, most commodities could come down in price, temporarily. However, gold will still likely be a stalwart. And if the economy does pick up, you'll have an even better reason to own gold.

 

OUR ONE MISTAKE

 

A few years ago, we expected that the current decade would resemble a replay of the 1970s – a period when gold also outperformed stocks. And that has been true, but for one key difference. In the early late 1970s/early 1980s, inflation ran into double digits. Today we have inflation close to zero.

 

It seems that we may have been premature. In the 1970s, the wild divergence between gold and financial assets predicted the end of inflation. By the early 1980s, the Federal Reserve had started to withdraw money from the system. Chairman Volker's mandate was to reduce liquidity in order to bring inflation under control.

 

Today, the Fed's mandate is to increase the money supply to make sure there's no chance of a serious economic slide. Considering the massive amount of liquidity we have poured into the financial system, gold's performance this time suggests we are near the beginning of a high inflation period. So inflation, and the gains from gold, could eventually be much higher.

 

In fact, the inflationary pressure keeps getting stronger...

 

 

 

ANOTHER STIMULUS BILL?

 

Adding to the case for inflation are the recent hints about another possible government stimulus package. (Stimulus spending is generally inflationary.) Warren Buffett recently suggested that a second package may be needed (if you assume the one in February was the first). Moreover, he too has also been warning that fixing the economy will lead to higher inflation.

 

Meanwhile, the Obama administration seems to be realizing that the few weak green shoots in our economy will not be enough to reduce unemployment in time for next year's election. So he's been testing the waters by dropping hints about a second stimulus bill. However, in today's political climate, Obama would have a hard time getting such a bill through Congress.

 

Realistically, Obama's approval rating has already fallen to 57%, and Congress seems reluctant to continue spending like there's no tomorrow. Even with a Democratic majority, there's no guarantee another stimulus bill would get enough votes.

 

That means the difficult task of keeping the economy going will not be done by Congress but by the Federal Reserve. It will happen not through spending but by creating more money out of thin air. This could eventually incite an inflationary explosion – one in which commodity prices will probably go through the roof.

 

Of course, the Fed argues that its stimulus efforts will be manageable, since there is a lot of excess capacity in the economy. That is, our factories have the capacity to produce much more than they are doing now. However, capacity may be a false measure. To produce more products, you need a lot more raw materials at an affordable price. And if the world is reaching a ceiling on commodity production, where will these cheap raw materials come from?

 

So from our perspective, the capacity numbers the Fed uses make no sense. The world has been turned on its head and we haven't realized it.

 

Meanwhile, instead of ramping up spending, consumers are making efforts to deleverage – pay down debts. Not only will this make it harder for the Fed to back off on stimulus, it is the worst thing a person can do if inflation is about to rise. In a high inflation environment, debts effectively shrink over time, since you can pay them off in the future with dollars that are worth less than they are today. So why pay down debts now?

 

Nonetheless, in the context of massive deleveraging by the consumer, massive increases in the money supply, massive government spending, and incipient resource shortages, inflation on a grand scale is inevitable, unless we're willing to risk a depression by cutting back on stimulus.

 

In fact, the Bank of International Settlements has suggested that some countries should consider moving to a less stimulating posture by reducing interest rates. That won't happen in the U.S., however. Not with unemployment near 10% and an election next year.

 

As we've said before, inflation is a much better choice than risking depression. So inflation is the most likely outcome.