Why gold, the only currency not subject to a printing press, will rise again.

Earlier this week we talked about why gold got crushed.

In response to that piece, some of you felt the Russia-Georgia conflict was more of a “post-mortem” than a true explanation. Taipan Daily reader Luis from Mexico writes, “I would appreciate a more technical view of gold's valuation, since it has some predictive power.”

Luis, your wish is my command... but with a slight twist. Take a look at this recent chart of GDX, the Market Vectors Gold Miners ETF.

Notice the volume bars at the bottom of the chart. See that huge spike on Monday the 11th? The one that nearly touches the 10-million-share mark? You don’t have to squint to spot it -- it’s easily the biggest spike of the year.

What you’re seeing there is major capitulation... traders throwing in the towel big time on gold mining stocks. I focused on the Russia-Georgia conflict earlier this week because it was such a key emotional factor.

The fundamental backdrop for commodities and precious metals was already tough, with the dollar going up and raw materials going down. On this GDX chart, we can see how short-term pessimism led to an avalanche of selling.

As a technical rule of thumb, major volume spikes tend to mark the beginning and ending of moves. The reason why is pretty straightforward: A big down day on big volume clears the “weak hands” from the marketplace. After a mass rush to the exits, most everyone who wants to sell has already sold.

The reverse logic applies on the upside. After a huge up day with volume to match, most traders looking to buy have already bought. The combination of volume and volatility can reveal a lot -- not because of some special magic in the chart pattern, but because these factors sit at the intersection of sentiment, supply and demand.

The sentiment in gold and gold stocks is bad right now, but I have to admit... I like that washout pattern in GDX. With most of the nervous Nelly sellers now done, having panicked to the sidelines on Monday, the decks are cleared for a strong move higher when GDX starts acting right again.

The von Mises Prophecy

But what I really want to talk about today is the “bedrock” case for gold... the reason why I have every confidence the yellow metal will rise again.

I have to confess, though, for longtime readers, the argument I’m about to present isn’t new. I’ve been saying it for years now. It’s been true since time immemorial, and nothing has changed.

Rather than repeat myself yet again, I’ll indulge in the luxury of quoting myself (if you don’t mind). Below is an excerpt from a piece I co-wrote with Sally Limantour earlier this year.

Ludwig von Mises, the father of Austrian economics, recognized early on that government attempts to massage the credit cycle always end in tears. The problem is that no politician wants an economic downturn to take place on his or her watch; so why let it happen when a little stimulus can keep the party going? A little stimulus becomes a little more, and then a little more, and next thing you know, addiction sets in.

Business downturns are natural things for a healthy economy. They are the economic equivalent of breathing in and out. In a normal downturn, debt levels are cut back, weak businesses close, resources are gathered up and redistributed, and the economy overall takes time to heal and restrengthen.

When this process isn’t allowed to happen, however, the shaky parts of the economy get built up too much. Expansion ceases to be healthy. Ongoing stimulus leads to excessive debt creation, the debt builds up to unsustainable levels, and eventually the whole shebang implodes on someone else’s watch. Von Mises memorably described the phenomenon as follows:

There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

The “final and total catastrophe of the currency system” -- in this case the U.S. dollar -- is what we are headed for. It isn’t all Bernanke’s fault, though. Bernanke simply inherited this mess from Alan Greenspan. We are not just heading into the endgame for a short-term boom-and-bust cycle, but rather a much longer borrow-and-spend cycle that took root early in Greenspan’s tenure.

Who Ya Gonna Believe?

In a nutshell, gold is not done because the great unwinding is far from done. We have not yet seen “the final collapse of a boom expansion brought about by credit expansion” that von Mises called for.

With all the idiocy Wall Street has thrown at us these past two years, hopefully the last efficient market theorist has closed up shop and turned out the lights. Stock markets are decidedly not efficient. (One could say they are mostly efficient, but that’s a whole other kettle of fish.)

And so, when investors and traders get emotional, they tend to get really emotional... and when a big hope jag or a really dumb idea gets in the crowd’s collective head, that statement goes double.

Take a look at this dollar chart to see what I mean…

What I’m arguing here is that the dollar’s giant spike over the past two weeks -- and gold’s corresponding fall -- are a sort of faulty “all clear” signal. With oil and gold falling and the dollar spiking, Wall Street is indulging itself in the hope that the worst has passed. Good times are here again.

It’s a massive hope jag... a bold assertion that von Mises was wrong, that the dollar won’t be destroyed, that all will be well and the Fed has won the war.

But here’s why I have trouble with that hope jag:

• The folks who predicted the credit crunch would happen -- the analysts and forecasters and traders who got it right -- are still expecting more pain to come.
• The Pollyanna types who think the worst is over, in contrast, have already said “the worst is over” multiple times... and they’ve been wrong all along! (So what gives them odds on being right now?)

On the one hand, you have the views of forecasters like Meredith Whitney and Nouriel Roubini. Both were very early, very bearish and very right. Both are expecting a lot more pain to come, with the likelihood that consumers will be further crunched and hundreds of banks could fail.

On the other hand, you have guys like Bill Miller, the mutual fund demigod who fell hard from grace. Not only was Miller aggressively long and wrong the whole way down, losing billions for his investors on bad bets in financials and homebuilders, he is still doubling down on his blown-out financial positions. (Legg Mason is now Freddie Mac’s top shareholder.)

To believe that gold is done here is to believe that the worst is over... that the excesses have all been unwound, that the central banks have triumphed, that paper currencies have won the day. That proposition just seems like utter goofiness to me.

The dangers surround us. We are only two years out from a time when America’s savings rate went negative (for the first time since the Great Depression). We have only just begun to feel the effects of consumer belt tightening. There is clear evidence that “subprime” woes are spreading to “prime.” GM, Ford and Chrysler are still on a path to a disaster. More bailouts loom.

A Central Banker’s Worst Nightmare

There are some who agree that the U.S. is in for more economic pain but stay bearish on gold anyway because of deflation fears.

That argument goes something like this: “Because we are headed for global slowdown -- with Europe maybe worse off than the US -- we’re going to see inflation slow down, too. All the consumer belt tightening and economic malaise and so on will translate to falling prices... which means no inflation fears and no need for gold.”

I can respect this line of thought. It make sense to assume that prices will fall in the event of global slowdown. And we’re seeing evidence of this, too. According to Bloomberg, the Baltic Dry Index, a benchmark for shipping costs, has fallen for 23 consecutive sessions.

“What we have is a classic cyclical downturn,” says Andreas Vergottis of Tufton Oceanic Ltd. “People are not buying cars and people are not buying houses, and when that stops, it travels backwards all the way back to the mine.”

But those who expect falling prices to rule the day are forgetting something very important: In a paper currency world, the central banks build their reputation as inflation fighters. But when it comes to economic devastation, deflation is the real bogeyman.

When prices start to fall in earnest, consumers get scared and start cutting back on all their purchases. This in turn causes prices to fall further as sales dry up and business profits fall. A fall in profits causes more people to lose their jobs, which in turn causes more fear to set in, and the cycle deepens.

This is known as a “liquidity trap,” leading to conditions where the central bank finds itself “pushing on a string.” When the deflationary spiral gets bad enough, extra stimulus fails to have any effect. The Fed becomes like a credit card lender trying to help a debt addict who just can’t borrow anymore.

Deflation Begets Inflation

Fed Chairman Ben Bernanke will never let the above scenario happen. He is, literally, a student of the Great Depression. Studying the Great Depression, and coming up with ways to prevent its reoccurrence, is in large part Bernanke’s lifework.

This is why deflation will ultimately beget inflation... it will come by way of the printing press.

The greater the leverage in the system, the greater the risk a deflationary downward spiral poses. No central banker worth his salt will ignore that risk.

A healthy economy -- that is to say, one that isn’t loaded to the gills with debt -- has no problem handling a mild downturn. Like a healthy human body, a healthy economy has reserves of strength to handle sickness and facilitate the healing process.

But a badly weakened economy -- one that labors under a crushing burden of debt -- will have trouble handling even a mild illness. The reserves of strength are already used up. By way of this analogy, the Fed is like a doctor who has no choice but to intervene with massive doses of drugs. If the patient is going to die of fever, then even the most radical course of action is preferable to doing nothing.

A Window That Will Close

As far as gold goes, I believe we’re in the midst of a short-term “sigh of relief” window right now... and it’s a window that will close. The dollar may be rallying hard now, but the von Mises prophecy still applies. The situation on the ground hasn’t changed.

On the currency side of things, gold’s fortunes will change when traders realize that all paper currencies are headed for oblivion.

For a while there the euro was king of the hill while the dollar was being beaten down. Now that the world is waking up to Europe’s slowdown, the euro is getting trashed while the greenback gets a boost. But guess what... All over the world, the bankers’ reaction to the threat of slowdown is the same: Print more money. Slash interest rates. Find ways to stimulate. Pump more money into the system.

As others before me have so eloquently put it, gold is the only currency not subject to a printing press. When the complacency window shuts, traders and investors will realize anew just how important that is. If inflation continues to march higher, so will gold. If deflation catches the world in a vice grip, gold will skyrocket relative to fiat alternatives as all paper currencies get debased.

Have a great weekend,

JL