By Dan Amoss

02/18/11 Jacobus, Pennsylvania – At this week’s hearing on Capitol Hill, Fed Chairman Ben Bernanke demonstrated a lack of understanding about what causes inflation. His comments reflected a belief that GDP growth causes inflation.

But true economic growth is production-driven, and adds to the supply of goods and services in the economy. True economic growth is not inflationary. Rather, inflation is driven by runaway government deficits and bloated central bank balance sheets. And right now, we have plenty of both. So we have every reason to expect the CPI, even with all of its window-dressing shenanigans, to soar past 2% in short order.

I’m surprised at how complacent the stock market remains in the face of obvious pressure building on the CPI. If the Fed doesn’t react to a rising CPI by tightening policy, Treasury yields will keep soaring, and inflationary psychology will take root among most producers. If the Fed does react by ending Quantitative Easing and raising short-term rates, it doesn’t require much imagination to guess what would happen to a stock market that’s running entirely on fuel from the Fed. Either of these potential scenarios is bad for stocks. The only scenario that argues for further rallies in stocks is if – miraculously – even with unprecedented money printing and deficits worldwide, the CPI doesn’t continue rising.

A rising CPI will give more ammunition to the growing chorus of Fed critics in Congress. At this week’s hearing, when questioned about the building pressure on consumer prices, Bernanke answered that it would be easy to stop this trend by reversing his policies. But you know he’s terrified at the prospect of tightening. He’s an academic with his head in the sand.

When asked about the impact of QE2 on global food prices, Bernanke responded that the destabilizing spikes are due to weather and rapid growth in demand for grains in emerging markets. What a lame excuse! As an admirer of Milton Friedman, he must know that “inflation is always and everywhere a monetary phenomenon.” Inflation isn’t a “weather phenomenon.”

Without forever-growing money supplies, price spikes in one set of goods, like food, would be offset by price declines in more discretionary goods. But in today’s world, demand isn’t limited to what one can produce and save; it’s boosted further by what one can get from government handouts and what one can borrow at the Fed window at 0%.

Yet after all the experiences of recent years (including the early 2008 experience in oil and grains), Bernanke is still oblivious to the consequences of debasing the world’s reserve currency. In his view, if the world doesn’t conform to his personal Phillips Curve and output gap models, there must be something wrong with the world, not his models.

Bernanke has the intellect to understand the negative consequences of the Fed’s radical policies, but he simply chooses to ignore them or rationalize them away. By pushing on the monetary accelerator last fall (rather than wait for another “deflation scare”), Bernanke is going to undermine public support for the Fed. As a result, Bernanke gambled that he could spark a stock market rally. He indeed sparked a rally, starting last August – one that looks very long in the tooth.

But the fact remains that there is no direct “transmission mechanism” from the Fed’s balance sheet to the stock market. Speculators have to have a very specific, benign perspective on Fed policy in order for Fed policy to impact stocks. Today’s misplaced faith in the omniscience of the Fed will soon fade, and when it does, the market will return to intrinsic value very rapidly. The day trading robots and speculators counting on a “Bernanke put” will all look to sell at the same time, and patient investors won’t look to buy until prices fall much closer to intrinsic value. Using the most robust, back-tested historical valuation models, the best estimates of fair value for the S&P 500 that I’ve seen is somewhere in the range of 800-1,000 – 25% to 40% below current levels.

At times like these, it is often constructive to contemplate probable outcomes – to thoughtfully consider the likely winners and losers that soaring food prices will create. The shares of Ag equipment guys and fertilizer companies have been soaring. For example, the shares of Deere and Caterpillar have both more than tripled since Chairmen Ben announced his very first QE program on March 18, 2009. Fertilizer company stocks like Potash and Mosaic have also been on a tear. All these companies are on the receiving side of rising food prices – more or less.

But what about those companies who are on the paying side? Food producers and processors of all types are struggling to accommodate soaring food costs into their business models…and their share prices are showing the strain. Pilgrim’s Pride, Tyson Foods, Sanderson Farms, Kellogg, General Mills and Safeway have all turned in conspicuously poor stock market performances during the last several months.

I recently issued a bearish call on another likely victim of rising food prices. This company is subject to many of the same food price stresses that have been buffeting the companies cited above. Yet, for reasons that are not completely intuitive, the shares of this particular company continue to trend higher. Nevertheless, I suspect rising food costs will put the breaks on this uptrend and cause the stock to reverse course.

This company is facing serious fundamental stresses that will cause similar problems for individuals as well. Inflation is here, folks…whether we like it or not. No use in complaining. Better to prepare.

Regards,

Dan Amoss
for The Daily Reckoning

Read more: The Food Crisis is a Dollar Crisis http://dailyreckoning.com/the-food-crisis-is-a-dollar-crisis/#ixzz1ETXDooDA

As most sophisticated investors and traders are aware, the U.S. Federal government has run up significant deficits and the long term debt burden is becoming a drain on Gross Domestic Product. That being said, most economists are discussing the possibility of a major decline in the value of the U.S. Dollar going forward as inflationary monetary policy begins to strangle growth. While that view point may prove right over the long haul, in the short run most traders are not likely expecting the U.S. Dollar to rally.

The U.S. Dollar is expected to reach a multi-year cycle low in the near future. From the cyclical low, I expect the U.S. Dollar to regain a strong footing and work higher against the crowd. This is not to say that the U.S. Dollar will not eventually decline, but financial markets do not work that easily. Shorting the U.S. Dollar is a crowded trade and Mr. Market punishes crowded trades quite often by pushing prices the opposite of what the heard is expecting. Should the U.S. Dollar find a strong underlying bid, precious metals and domestic equities would feel the brunt force of such a move. While it remains to be seen if the U.S. Dollar rallies, if it does it will catch many traders and economists by surprise and the unwinding of the short dollar trade could unleash a wave of buying that we have not seen for quite some time.

Let’s take a look inside the market…

Major Index Price Action Over The Past 12 Trading Sessions – Bearish
Below is a table showing the main indexes used for tracking the market. The interesting thing about this data is that the indexes which typically lead the market have been deteriorating for the past 12 days and no one has noticed.

In short, the Nasdaq, Russell and Dow Transport indexes typically lead the market

Every radio station and business channel covers the Dow and SP500 indexes therefor the general public hears the market performance based on the those indexes. The problem here is that the Dow only consists of 30 stocks and the SP500 only holds the top 500 companies which is not a full view of the overall market because there are thousands of stocks listed on the exchanges.

The analysis below can be taken two ways depending which boat you are in… which I will explain in just a minute. The way I see things is a bit of both, I’m not really in or boat or the other… rather I have one foot in each because I have seen the market do things which support both sides (manipulation and measured technical moves) during my 14 years trading.

Ok here are my thoughts/opinions/forecasts…

Idea #1: Dow and SP500 indexes which 99% of the public use to gauge the market are moving higher on light volume. I feel because these indexes hold the stocks which everyone knows and is comfortable buying that this is the reason why they keep going up while the rest of the market silently erodes. It’s the simple thought that big money is moving out of leveraged positions (small cap stocks, transports, technology) in anticipation of a market correction, and the Average Joe continue to buy into brand name stocks boosting the Dow and SP500 thinking things are peachy..

Idea #2: We all know there is market manipulation, the question is how much of the price action is manipulation and how much is real supply and demand? No one will ever really know and that’s just part of the market and trading we have to deal with as traders. But I know there are traders out there blaming the Feds, POMO, and PPT for pushing the market up month after month. So the question is if these invisible forces manipulating the top 30-500 stock prices by buying them up which naturally boosts the Dow and SP500 indexes to keep everyone bullish on the market?

My thinking is that it’s a bit of both and that a correction is just around the corner.

Gold Miner Stocks Underperform Gold – Not a good sign
Gold stocks today (Wednesday) underperformed the price of gold and are also forming a bearish chart pattern. If this plays out then we can expect another sizable pullback in both gold stocks and the price of gold because this index typically leads the gold.

US Dollar Multi Year Support Trendline
The US Dollar is trading down at a key support level and if we get a bounce and possibly even a rally then we could see a sizable correction in stocks and commodities across the board. As we all know everyone is shorting the dollar, buying gold and buying food commodities…. So it makes sense that all these crowded plays are about to see a major shift. Now this is just my contrarian point of view and those of you who follow my work know I’m not bias in my trading. I just take the market one day or week at a time and play the setups. But you must step back and look at the larger picture and at least give it some thought…

Concluding Thoughts:
In short, the major indexes are moving higher on light volume which is not a strong sign, and other key indexes are pointing to lower prices. The question everyone wants to know is how low will this correction be? The answer to that is that you must play the trend as you never know if a trend will last 2 days or a year. I take the market one day at a time continually analyzing price action.

If you would like to get my detailed reports and daily videos covering my analysis please join my newsletter at: www.TheGoldAndOilGuy.com

Chris Vermeulen

By Chuck Butler

01/07/11 St. Louis, Missouri – The dollar is rallying again today, and quite frankly, right now, the institutional momentum is so strong, that there’s nothing that would stop this rally…today that is. It’s a Jobs Jamboree Friday, the first of 12 for 2011, and as I said yesterday, I believe that the US will post the best monthly number for job creation in a couple of years today. I truly don’t believe that it’s something that can be maintained, given the fact that we’re talking about December, when shops bump up their employment to deal with the Christmas shopping season. But, it will be the Big Kahuna today, job creation that is, and for that, we need to analyze what this will do to the currencies, right?

First of all, the Bureau of Labor Statistics (BLS) will print job creation for November this morning. Right now, the “experts” believe that 150,000 new jobs will show to have been created in November. The unemployment rate, however, will only tick down 1/10th to 9.7%… Again, that’s the forecast by the “experts”. I think that if the actual, no wait there’s no such thing as “actual number” with the BLS, well, then what should I call it? OK… I think that if the trumped up number is anywhere close to the forecast, then the dollar will rally further… And even currencies like the Japanese yen (JPY), Swiss franc (CHF), and Chinese renminbi (CNY), who have found solace in any past dollar rallies, will be sold… Because, it’s going to be all about the dollar today…

The beleaguered and beaten down euro (EUR), is really feeling as though it’s getting sand kicked in its face again. Yesterday, the euro fell through the 1.3050 line of resistance, which according to the technical people, means the next stop for the euro is 1.2970… After that, we’ve got a quick fall to 1.28 and change, where the euro fell last winter, when Greece was a major contributor to the euro’s weakness. Remember, I’ve told you for years now, that the euro is the offset currency to the dollar… So, it makes sense that dollar strength will show up in euro weakness. Hey! You can’t say that I didn’t warn you that we could see euro weakness early in 2011… (Sorry, I have to put that in there, because there will be quite a few emails in my box telling me that I should have warned people about a weaker euro to start 2011, and this way, I cut that off at the pass!)

Did you hear what European Central Bank (ECB) President, Trichet said about the euro? He said that the euro was “a stable currency, as stable as its predecessors, including the Deutsche Mark.” WOW! I’m sure the Germans weren’t too happy to hear those words coming from a Frenchman… Besides that comment from Trichet, the only other thing going on in the Eurozone was the printing of third quarter GDP, which was bang on expectations of +0.3%… This is the GPD for all 16 countries… So, Germany’s third quarter GDP was quite strong…

The Canadian dollar/loonie (CAD) seems to be the only currency with any intestinal fortitude to stand up to the dollar’s rally this morning… The Swiss franc is holding on, but if you go back to last Thursday, the headline on the Pfennig was “Swiss francs and Copper reach all-time record highs”… And gold? OMG! The shiny metal has lost another $13 this morning! And silver is $3 lower than it was a week ago!

After the Jobs Jamboree this morning, I expect the dollar to be entrenched in rally mode, and then Fed Chairman, Big Ben Bernanke will give his testimony on the economy to lawmakers… I truly believe that Big Ben will toe the line and explain why the Fed needs to continue its QE2 program… For those of you who missed class yesterday, I said that the Fed had only bought $170 billion of the $600 billion total scheduled for this round of QE. For those of you keeping score at home… The total in the first round of QE was $1.75 trillion… Holy Money Printing, Batman! What will be the end result of these QE implementations? Well, Robin… It’s not going to be pretty… But at least the Fed has applied lipstick to the pig for now, and that’s all the media and markets care about, which is shameful… Shouldn’t the Big Picture be explained for fair and balanced reporting? You are so smart, Batman…

So… At the top I told you that even the Japanese yen was losing ground to the dollar. Well, there seems to be a rumor going that one of the major credit rating agencies may be about to downgrade Japan’s credit rating, because of their debt picture. Hmmm… I can tell you right here, right now, that the credit ratings agencies don’t have the intestinal fortitude to cut the US’s rating because of its debt picture… No way, no how… It ain’t gonna happen! Why? Because if there was news about a possible cut, the US would simply close down the rating agency… That’s my scenario; I have nothing to back that thought up… It’s just how I see it happening, and as always, I could be as wrong as two left shoes…

I would caution the markets from making too much of a credit rating cut for Japan… A currency dealer told me yesterday that 95% of Japanese Government Bonds (JGB’s) were in the hands of domestic investors… So the Japanese hold 95% of their country’s debt, and those domestic investors aren’t going to give two hoots about a credit rating cut.

Don’t you just love tidbits of info like that? Here you are, standing around at a cocktail party, and some guy says, “Hey! My inside information tells me that Japan is going to get a credit rating cut. That will sure knock the stuffing out of Japanese Government bonds.” And you can say… “Ahhh… Not so fast there, cowboy… My guy tells me that 95% of Japanese Government Bonds are held by domestic investors, which will mean the credit rating cut won’t mean a hill of beans to them”… And to think you get this cocktail information for free!

But… The rot on the Japanese yen’s vine could very well, finally be exposed…

The Norwegian krone (NOK) is beginning to rally against the dollar as I write this morning… A quick look at their data cupboard, and I see where Norwegian Retail Sales for November showed a nice rise of 1.8%, and Industrial Production printed with a rise of 0.9%… Both of these results were far greater than the expectations, so, that’s why the krone is feeling better about itself this morning, and mounting a mini-rally against the dollar.

A former colleague of mine, sent me a note last night, telling me that he had read a research report that called for investors to buy Singapore dollars (SGD) instead of Chinese renminbi… He asked me what I thought. I said… “That’s exactly what we’ve told investors for over a year now… That Sing dollars are a great proxy for renminbi.” I went further to say that I wish all our investors would opt for Sing dollars over renminbi, as long as renminbi remains a non-deliverable forward, which means it’s non-deliverable, and its liquidity is tight! You can wire Sing dollars anywhere you want… So, for those of you who missed this discussion that we had about a dozen times in 2010, there you go!

So… I told you yesterday of Brazil’s latest attempt to stem the real’s (BRL) rise… Well, now Chile has decided to do the same. Now, the Chilean peso (CLP) is an ill-liquid currency, and you would have to be an institution, or Monty Millionaire to find an institution to make a market in it for you. I find it interesting to talk about, given the Chilean pesos’ rise in 2010…and the fact that these developing markets have central banks that believe they can manipulate their currency, with limited resources.

The Aussie dollar (AUD), is really feeling the problems that the floods have caused, as exports are now threatened, and we, (Pfennig readers) all know that a major portion of Australia’s economy is derived from exporting those raw materials…

Well… That brings me to the Indian rupee (INR)… This marks two comments on rupees in the same week for me! WOW! Well, to follow up the discussion we had a couple of days ago regarding the rising inflation in India… I saw this… India’s annual food-price inflation jumped to 18.32% in the week ending Dec. 25, a development that experts said might lead the central bank to raise interest rates. This should underpin the rupee…

And then to follow up my discussion about worldwide food prices rising… Food and commodity prices are expected to rise worldwide because of flooding in Australia, an extremely cold winter in Russia and drought in Argentina… So get ready… stock up the pantry shelves…

Then there was this… The good folks over at the NIA (National Inflation Association) put out their forecasts for 2011, and it looks like they will be bang on with this one, considering the report yesterday, that showed the Holiday sales were not as robust as first thought… Here’s the NIA’s thought…

Although most analysts on Wall Street believe retailers will report a major increase in holiday season sales over a year ago, NIA believes any top line growth retailers report will come at the expense of dismal bottom line profits. NIA expects many retailers to report large declines in their profit margins for the 4Q of 2010 and first half of 2011. Retailers have been selling goods at bargain basement prices in order to generate demand. Americans, being flush with newly printed dollars from the Federal Reserve, have been eager to buy up supplies of goods at artificially low prices. However, shareholders will likely sell off their retail stocks on this news. As share prices of retail stocks decline, retailers will begin to rapidly increase their prices by mid-2011.

To recap… The dollar continues to swing the hammer, even against the Chinese renminbi, and Japanese yen, two former stalwarts versus the dollar, rain or shine… It’s a Jobs Jamboree Friday, which will show that job creation in December will have been the best in a couple of years… But is it December holiday employment only? We’ll have to wait for the January numbers to know… There are rumors this morning that a credit ratings agency is going to downgrade Japan’s credit rating because of their debt picture… Would this same credit ratings agency do the same in the US? And Chile is following Brazil into the currency manipulation ring.

Chuck Butler
for The Daily Reckoning

Read more: US Dollar Entrenched in Rally Mode http://dailyreckoning.com/us-dollar-entrenched-in-rally-mode/#ixzz1AOxufiVp

Over the past few months it seems as though everything has been tied to the dollar. Simple inter-market analysis makes it obvious that almost everything in the financial market eventually has an affect on stocks and commodities in some way. But recently trading has really been all about the dollar. If you watch the SP500 and gold prices you will notice at times virtually every tick the dollar makes directly affects the price and direction of gold and the SP500 index.

Let’s take a look at some charts to see the underlying trends and what they are telling us…

Dollar Index – Daily Chart

As you can see the trend is clearly down. Currently the dollar is trying to find a bottom as it bounces and pierces the previous high. The question everyone wants to know is if the dollar is about to rally and reverse trends or was Friday’s pierce of the October high just a shake out before the next leg down?

Back in late August the dollar pierced the July high on an intraday basis (shake out) just before prices dropped sharply. I think this could very easily happen again but when you see what gold volume is doing, it’s a different story.

Those who follow me closely know I focus on trading with the underlying trend, but manage my risk by trading smaller position sizes when the market has more uncertainty than normal with is what we are currently experiencing.

GLD – Gold Fund – Daily Chart

Gold and the dollar are almost inverse charts when comparing the two. Gold happens to be testing a key support level and its going to be interesting to see how the price holds up going forward. The one thing that has me concerned is the amount of selling taking place. The chart shows heavy volume selling and could be warning us of a possible trend change in the dollar, gold, oil and equities in the coming weeks.

Again the trend for gold is still up, so I would not be trying to short it at this time, rather look to buy into dips until the market trend proves us wrong. That being said, with the selling volume giving off a negative vibe and the fact that gold has rallied for such a long time, any new positions should be very small…

Crude Oil – Daily Chart

Oil looks to be forming a possible cup and handle pattern. If the Dollar continues to consolidate for another 1-3 weeks and breaks down, then we should see the price of oil trade in the range shown on the chart and eventually breakout to the upside. I have a $95-100 price target on oil if the dollar continues to trend down. Until we see some type of handle form here I am not trading oil.

SPY – SP500 Fund – Daily Chart

The equities market looks to have had one of those days which spooked the herd. Friday the price dropped triggering protective stops with rising volume. I was watching the intraday chart as the SP500 broke below the weeks low, and this triggered protective stops which can be seen on the 1 minute charts. In an uptrend I prefer watching stops get triggered because it means traders are getting taking out of long positions and most likely looking to play the short side. When the masses become bearish on the market, that’s when I start looking to play the upside in a bull market (buy the dip).

The chart below clearly shows the days when the shake outs/running of the stops took place. Most traders were exiting their positions and/or going short because the chart looked bearish. One thing I find that helps my trading is that if the chart looks rally scary (bearish) then I start looking at a shorter term time frame for a possible entry point to go long using price and volume analysis.

Weekend Market Trend Trading Conclusion:

In short, I feel the market is at a critical point which will trigger a very strong movement in the coming days or weeks. Because the dollar, gold, oil and the equities market have had such big moves I think trading VERY DEFENSIVE is the only way to play right now. That means trading small position sizes. Right now I am trading 1/8 – 1/4 the amount of capital I generally use on a trade. Meaning if I typically put $40,000 to work, right now I am only taking positions valued at $10,000.

Remember not to anticipate trend reversals by taking a position early. Continue to trade with the underlying trend with small positions or skip a couple setups if you feel strongly of a possible reversal. Once the trend reverses and the volume confirms, only then should you be playing the new trend. Picking tops can be expensive and stressful.

Get My Daily Pre-Market Trading Analysis Videos, Intraday Updates & Trade Alerts Here: www.GoldAndOilGuy.com

Chris Vermeulen

Numerous factors and markets are telling us the odds of short-to-intermediate-term reversals are elevated for numerous markets including silver (SLV), gold (GLD), the U.S. dollar (UUP), the euro (FXE), stocks (SPY), and the VIX (VXX). The objective of both fundamental and technical analysis of the financial markets is to help us better understand the risk-reward ratio and relative attractiveness of a wide variety of investments. Since no chart or annual report can help us predict the future, our study of markets deals in probable outcomes.

The possible drivers for market reversals in dollar, euro, gold, silver, and VIX include:

• Concerns about Irish debt
• Uncertainty related to the G20 summit
• High levels of optimism (bullish sentiment/contrarian indicator)
• Near vertical, and correction-less ascents in numerous markets
• Mania-like moves in gold and silver
• Stretched valuations

We at CCM, along with many others, believe the sharp gains in many asset classes off the summer lows were primarily driven by the expectation of money printing and a weaker dollar. As the dollar weakened, many risk assets or inflation-protection assets rose. One example is gold; note the negative correlation between the yellow metal and the U.S. dollar.

These charts can help us from both a bullish and bearish perspective. If the markets reverse near the areas highlighted below, we would be more apt to become risk averse in the short-term, especially in terms of decisions related to cash. If these markets break through areas of potential resistance, then another leg up in risk assets becomes more likely, and we would be more amenable to increasing risk exposure in the short-term.

Just as a declining dollar increased the appetite for risk over the past five months, a countertrend rally in the dollar may open the door to corrective action in stocks and commodities. The Dollar Bear ETF (UDN) was down Tuesday on a 56% increase over average daily volume. As you review the charts below, ask yourself, “Is this market at a logical point for a possible reversal based on the recent action of buyers and sellers?”

The euro may have reached a point where buyers have become less interested. Recent concerns about Irish debt may also give currency traders a reason to cut back their exposure to the euro. Since the euro makes up roughly 60% of the U.S. Dollar Index, a drop in the euro would help propel the dollar higher. The desire to sell the euro ETF (FXE) was not atypical from a volume perspective on Tuesday, which tells us not to assume anything in terms of a reversal. A decline in FXE over the next few days on strong volume would add credence to the trendline. Average daily volume for FXE over the past three months was 1,556,260 shares. A decline over the coming days on more than 1,867,512 would add to our bearish concerns. A break to the upside on more than 1,867,512 would lean toward favorable outcomes for risk (stocks, commodity-dependent currencies, and commodities).

Technical analysis can look complex, but many of the most useful tools are very easy to understand. Trendlines are used to identify areas of past importance in the minds of buyers and sellers. Buyers tend to see value at areas of “support” and sellers tend to see “overvaluation” at areas of resistance.

The VIX, or the “fear index”, has reached what many would term as a level of “complacency”. A rise in the VIX, especially a sharp one, often occurs during periods of risk aversion. The VIX ETF (VXX) was up Tuesday on strong volume.

Silver tends to outperform gold during periods of risk-taking and when the economic outlook skews toward the more favorable end of the spectrum. Silver may have experienced a blow-off rally yesterday (SLV). Markets cannot logically rise in a vertical fashion forever; silver will correct at some point. Another day of high-volume selling would increase the odds that Tuesday’s intraday selloff on extremely high volume was indeed significant from a bearish perspective. As we head into trading on Wednesday, silver gets the benefit of the doubt since the bulls have been firmly in control, but Tuesday was a big yellow flag for the silver bulls.

Gold’s appeal has increased as fiat currencies are being debased around the globe. Gold has not had the high degree of mini-mania seen recently in silver, but the yellow metal has also reached a point where the desire to sell may now exceed the desire to buy. The gold ETF (GLD) was down Tuesday on strong volume.

The S&P 500’s intraday high on November 5th was 1,227.08. A 61.8% Fibonacci retracement of the October 2007 to March 2009 bear market falls near 1,228 on the S&P 500. These levels can be important to traders, so it is helpful to keep them on your radar, especially when you have trouble understanding why a market is stalling with no apparent resistance nearby.

The chart of the S&P 500 seems to be a little better positioned relative to overhead resistance. If stocks can push higher, a move to 1,234ish to 1,256ish on the S&P 500 seems within reason. The S&P 500 ETF (SPY) was down Tuesday on below average volume, which again highlights the need to pay attention rather than assume reversals are going to take place – no one knows what is going to happen, especially over the short-term. Over the summer, many were convinced the Hindenburg Omen spelled doom for the markets; the S&P 500 is now 16.7% above the Hindenburg Omen lows made in late August 2010, which is just one example of the importance of remaining flexible in terms of market outcomes (bullish and bearish).

Trendlines are broken all the time, which reinforces the probabilistic nature of this analysis. We cannot predict the future, but we can say it makes sense to pay attention over the next week or so. With the information we have in hand now, we believe many market reversals will represent corrections within ongoing trends. We believe gold, silver, and stocks will eventually make higher highs after the next correction, which will come at some point. We recently outlined other concerns about the dollar, and concerns about gold, which still apply to the current market.

If you are a little perplexed by the recent gains in inflation-friendly assets, it may be helpful to scan some of the charts on the lower portion of this Quantitative Easing page. The Fed’s objective of re-inflating asset prices and debasing the dollar will probably lend support to gold, silver, and stocks after the next round of corrective activity. Since there will probably be a QE3, QE4, and QE5 over the next few years, it is worth the time to understand how QE works, what the Fed is trying to accomplish, and the possible impact on your purchasing power and investments.

Source: http://dailyreckoning.com/why-the-value-of-paper-money-declines-as-the-quantity-rises/

By Bill Bonner

10/29/10 Baltimore, Maryland – Not much action yesterday. The Dow fell 12 points. Gold rose $19.

What else do you need to know? Nothing much has changed.

US stocks are up about 6% so far this year. Gold has gone up three times as much.

The Wall Street Journal: “Gold vs. the Fed: the Record is Clear.”

Yeah, the record is clear. The Fed’s money has been losing ground against nature’s money for the last 10 years. Roughly, if you’d stuck with gold you’d have 5 times the purchasing power you got from the US dollar.

That’s pretty clear, isn’t it?

But you could go back and look at the history of every pure paper money. Look at how it did against the yellow stuff. Same story every time. No exceptions. Once you let human beings print “money” at will, they will print a lot of it. And unless they repeal the laws of diminishing returns, marginal utility and supply and demand, the paper money will lose out.

The law of diminishing returns says the more you do something the less good it does you. We’re not sure that’s true of everything… Mae West had a slight twist on the concept. “Too much of a good thing is wonderful,” or something like that. But for almost everything but THAT thing, the more you do it, the less you get out of it. It applies to printing up $100 bills too.

The law of marginal utility is just another way of looking at the same concept. It tells you that when you get more and more of something, each additional unit has less value than the one that came before it. You can see how that works in the case of dessert, for example. The first chocolate pudding tastes great. The 10th one makes you sick. At that point, you’re getting not only diminished marginal utility, you’re getting negative marginal utility – which is what you get from bank credit too, but that’s another story.

We once knew a very rich man. He ran for governor of New York. We asked him why he bothered. He didn’t need to steal from the taxpayers; he already had enough money.

“Yes,” he replied. “But that’s just it. I’ve reached the point where the marginal utility of more money is extremely low. I need to do something else.”

He didn’t win the race.

But the point is, the fed’s gazillionth dollar is going to be worth a whole lot less than its first dollar. The more they print, the more you wish you had gold.

And you know the law of supply and demand already. There is a certain amount of goods and services available. This amount can be increased. But not overnight. It takes time, investment, expertise…and so forth.

By contrast, the feds can increase the supply of dollars almost instantly. It can just add zeros and multiply the supply by 10. These new dollars compete with the old ones for the available goods and services. Pretty soon, prices are rising – fast.

Oh…if it were only that simple. Trouble is, there’s the velocity of money too. When the economy takes a cold shower, the velocity of money slows to a crawl. Then, the feds can add as much new money as they want. It doesn’t necessarily get around the way the old money used to. Everybody holds onto it. The banks just keep it in their vaults. Householders keep it in their wallets and mattresses. Everyone figures he might need it.

When trouble hit in 2007, the banking sector had just $2.3 billion in excess reserves (money they held beyond the legal requirement) – barely enough to buy a drink in a good bar. Now they’re swimming in it. They’re got $976 billion in excess reserves. So how come consumer prices aren’t going wild?

By the way, where’d that money come from? The Fed already gave the economy a BIG dose of paper money. The feds were afraid that the banks were failing. They were right to be afraid. They were wrong to try to do something about it. It would have been much better to let the chips fall where they may…maintain the integrity of the government’s own finances and protect the dollar. There were plenty of sensible, well-funded bankers to pick up the pieces of the broken ones and make something good of them.

And by the way, again. This is not just our opinion. Mexico and Chile went through a similar crisis in the early ’80s. Mexico did what the US would do a quarter century later. It “allowed [its] archaic bankruptcy system to perpetuate the lives of money-losing businesses and allocated credit by government direction,” says Grant’s Interest Rate Observer.

And Chile? It let companies fail and allowed its markets to clear.

And what was the difference in outcome? Chile was back on track a decade later, soon surpassing its pre-crisis growth trendline. Mexico, on the other hand, never fully recovered. It’s still 30% below trend.

Just what you’d expect, in other words.

Bill Bonner
for The Daily Reckoning

Why the Value of Paper Money Declines as the Quantity Rises originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today’s markets. Its been called “the most entertaining read of the day.”

Never mind sky-high deficits and a crushing debt overhang, at its most recent FOMC meeting, the Federal Reserve all but guaranteed another round of quantitative easing.

While the American central bank did not officially expand its quantitative easing program last month, it did reiterate its willingness to institute more aggressive monetary policy measures in order to combat the risks of deflation.  Furthermore, Mr. Bernanke did officially downgrade the Federal Reserve’s outlook for inflation.

The truth is that the US is insolvent and its policymakers will stop at nothing in order to avoid sovereign default.  So, it should come as no surprise that at its latest meeting, the Federal Reserve downplayed the risk of inflation, thereby setting the stage for another round of money creation.

Make no mistake; Mr. Bernanke has already created copious amounts of money. Granted, the Federal Reserve’s previous monetisation was highly secretive, but you can be sure that it did occur.  Allow us to explain:

You will recall that during the depths of the financial crisis, the Federal Reserve expanded its own balance-sheet and bought all sorts of toxic assets from the financial institutions.  By doing so, Mr. Bernanke created money out of thin air and bailed out the major banks.

Thus, the banks were able to dump their garbage assets on to the Federal Reserve and once they received the newly created cash in exchange for these securities, they loaned this money to the US government by purchasing US Treasuries.  In summary, in the previous round of quantitative easing, the Federal Reserve created new money and instead of lending it directly to the US government, it used the banking cartel as its conduit.  Back then, not only did the Federal Reserve create more than a trillion dollars, it also dropped its discount rate to almost zero; thereby allowing banks to borrow money cheaply!  It should be noted that since the banks were able to obtain such inexpensive funding from the Federal Reserve, they had absolutely no qualms about re-investing this capital in US Treasuries.

At first glance, the Federal Reserve’s stealth monetisation plan seemed flawless.  The banks offloaded their toxic assets on to the Federal Reserve, they made fortunes by investing in US Treasuries and the American government got access to a cheap source of funding.  Magic!

Despite the fact that this financial wizardry was a lifeline for American policymakers and their banking cronies, let there be no doubt that it was an unmitigated disaster for the American public.  Not only did the Federal Reserve nationalise the banks’ losses but more importantly, Mr. Bernanke’s money creation efforts have seriously undermined the viability of the US Dollar.

It is noteworthy that since bailing out the major banks and orchestrating the stealth monetisation, the Federal Reserve has been busy purchasing US Treasuries.  Furthermore, it is now almost certain that in next month’s FOMC meeting, Mr. Bernanke will unleash yet another round of quantitative easing.  In other words, in order to fund Mr. Obama’s out of control spending, Mr. Bernanke will create even more dollars out of thin air!  Allegedly, this new round of money creation will drive interest-rates lower, thereby helping the US economic recovery.  Or so the story goes.

Unfortunately, as any serious student of economic history knows, there is no such thing as a free lunch.  By adding trillions of additional dollars to the monetary stock, Mr. Bernanke may succeed in bailing out his friends in high places but he is seriously jeopardising the US Dollar.  In fact, bearing in mind the recent developments, it has become clear to us that the Federal Reserve wants to debase its currency.  In our humble opinion, the US Dollar is a doomed currency and there is a real risk of an abrupt plunge in its value.

If our assessment turns out to be correct and Mr. Bernanke unleashes the second phase of quantitative easing, you can be sure that the US Dollar will slide against most un-manipulated currencies (which are few and far between) and hard assets.  In fact, monetary inflation is the prime reason why we believe that the ongoing bull-market in stocks and commodities will continue for several more months.

Look.  The US economy is swimming in debt and the total obligations (including social security, Medicare and Medicaid) now come in at around 800% of GDP!  Furthermore, this year alone, Mr. Obama’s administration plans to spend another US$3.5 trillion, meanwhile the US Treasury will raise roughly US$2.2 trillion from issuing new government debt!  Clearly, these numbers are unsustainable and you can bet your bottom dollar that the Federal Reserve will end up buying a large proportion of the newly issued US Treasury securities.  As the American central bank funds more and more of Mr. Obama’s spending by creating new money, it will trash the value of its currency.  In fact, given the growing imbalance between the government’s spending and tax receipts, very high inflation is inevitable and even hyperinflation cannot be ruled out.

For the sake of their financial well being, it is crucial that investors understand that inflation or even hyperinflation is a monetary phenomenon and a strong economy is not a pre-requisite for the debasement of a national currency.  Whatever the reason, if a central bank decides to significantly increase the quantity of money in the system, that currency’s purchasing power will always diminish.  This is how fiat-money regimes have operated since the beginning of time and this era is no different.

It is interesting to note that throughout recorded history, the worst excesses of inflation occurred only in the 20th century.  Undoubtedly, this was a direct consequence of the adoption of fiat-money.

Figure 1 highlights all the hyperinflationary episodes in recorded history and as you can see, with the exception of the French Revolution (1789-1796), all of the other disasters occurred in the last century.  In fact, it is an ominous sign that 29 out of the 30 recorded hyperinflations in human history occurred during the 20th century!

Figure 1: Hyperinflations in history

Source: Monetary regimes and inflation, Peter Bernholz

Let there be no doubt, a paper money system usually ends in the reckless destruction of money and it is no coincidence that all hyperinflations in history have occurred in the presence of discretionary paper money regimes.  Furthermore, it is important to understand that a political system based on democracy is inherently inflationary and political leaders have been responsible for all major inflations in the past.  Conversely, history has shown that monetary systems binding the hands of political leaders are essential for keeping inflation in check.  If history is any guide, metallic monetary systems have shown the largest resistance to inflation and this is due to the fact that currencies anchored by a tangible asset cannot be inflated ad infinitum.

It is our conjecture that the current monetary system is absolutely pathetic; a system designed to enslave society.  Unfortunately, the vast majority of humans do not understand the endless inflation agenda and this is why the perpetrators get away with this crime.  Furthermore, let it be known that the Federal Reserve is largely responsible for the incredible inflation we have experienced over the past century.

Figure 2 plots the cost of living in Britain, France, Switzerland and the US.  As you will note, the cost of living in these nations was relatively stable for over 160 years (1750-1913) but once the Federal Reserve came to power in 1913, everything changed.  Suddenly, the cost of living exploded in these nations, so it should be clear that the Federal Reserve’s covert policy of currency inflation and debasement is solely responsible for this mind numbing inflation.

Figure 2: Cost of living in various nations (1750-1998)

Source: Monetary regimes and inflation, Peter Bernholz

Unfortunately, the Federal Reserve and its allies have not finished inflating and over the following years, they will create even more confetti money.  Under this scenario, cash will continue to lose purchasing power and the asset poor middle-class will get even more impoverished.  If our assessment is correct, cash will prove to be a disastrous ‘asset’ over the next decade and once the Federal Reserve’s manipulation ends, fixed income securities will also depreciate in value.

Bearing in mind our grave concern about high inflation and the very real possibility of hyperinflation, we continue to favour hard assets such as precious metals and energy.  At present, we have allocated roughly half of our clients’ capital to these sectors and it is our belief that this should be an adequate inflation hedge.

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets.  In addition to the monthly report, subscribers also receive “Weekly Updates” covering the recent market action. Money Matters is available by subscription from www.purusaxena.com.

Puru Saxena

Website – www.purusaxena.com

Puru Saxena is the founder of Puru Saxena Wealth Management, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients.  He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

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