If you haven't done so already, we recommend you first read Gold Revisited, Part I: The Fundamental Case for Gold.

Gold stocks have undergone a fairly serious downturn over the past 8 months, with the main gold stock index (the HUI) down 35% over that time.  This is actually a very typical correction in this sector: in the past 10 years, there have been 6 other HUI declines of 30% or more, and each time, the index has eventually gone on to make new highs.

Gold Stocks Extremely Undervalued

What's atypical about this particular correction is that it has resulted in the stocks of gold miners becoming unusually undervalued compared to the price of product they produce.

Gold-related investments comprise just one area of the markets that we invest in, but the topic of gold prompts a lot of questions (especially since our  exposure to the gold mining sector has been a major contributor to our recent market-lagging investment performance).  So we recently sent our clients an in-depth review of the fundamental case for gold and gold mining stocks. 

Part I, below, reviews what drives the gold price (it's not what most people think) and advances the case for higher gold prices in the years to come.  Part II examines valuations of gold mining equities, which we find to be extremely undervalued and poised for potentially dramatic gains ahead.

The following is excerpted from a letter to investment clients sent on 4/11/2012.

As we've seen time and time again, markets do strange and often nonsensical things over shorter time periods.

We've observed multiple bubbles, crashes, panics, and rebounds in the past decade or so.  During this time, markets have frequently moved in exactly the opposite direction than the fundamentals would have suggested, making fundamental/value investors appear wrong as a result, at least for a while.  But we've also seen, over and over, that markets do eventually return to their fundamental value.

One can't discuss the issue of excessive debt without being treated to this platitude:

"Sure, it may be bad in the US, but it's worse everywhere else."

This statement simply isn't borne out by the facts.  There are many nations out there with far healthier levels of indebtedness than the US.  In fact, out of the 172 countries whose federal government debt is measured by the IMF, the United States has higher debt as a proportion of GDP than all but 12 of them!  And most of those countries aren't piling on further debt at a rate of 8% of GDP per year like the US.

The following is excerpted, with minor edits, from a letter sent to investment clients on October 11, 2011.

"Fear is the foe of the faddist, but the friend of the fundamentalist." -- Warren Buffett

Our Investing Approach

When times are tough and we are all worried about the markets and the world we have to be sure that those emotions don't dictate the course of our investments.  Without the benefit of an explicit and disciplined investment approach, the emotions of fear and greed often take over and lead to irrational, random, and contradictory decisions.  The stereotypical emotional investor "chases returns" by simply reacting to recent price changes, resulting in far lower returns over the long run.

In this article we will explore the ability of stock market valuations to predict both eventual investment returns and the risk of subsequent losses.  This is a topic about which we've written before: bearishly prior to the 2008 crash, bullishly in late 2008 after the bulk of the crash had taken place, and then bearishly again -- prematurely, it would seem -- in late 2009.  (These past articles are included for historical context; all necessary background will be provided below). 

“If something cannot go on forever, it will stop.” -- Herb Stein, chairman of the Council of Economic Advisers under Presidents Richard Nixon and Gerald Ford 

Budgets, Deficits, Debt Ceilings and The Debt

In terms of our fiscal situation, the government reminds us of a character in the old Looney Tunes cartoons who is being chased and is running at full speed as he goes off a cliff.  You might recall that those guys kept running for a while after they had already gone off the cliff.  Then the character finally realizes that there's no foundation supporting him and that he can't go any further... he looks down... his expression says "oops," and soon he begins falling to an ungraceful landing.  Our government and our people seem to be at the point where we're off the cliff, we're still moving, but we're at the "oops" moment and we're starting to look down to see how far we have to fall.  Fortunately, the animated characters always survive and keep going and we're confident that our country will survive and move on as well.  For an amusing clip of the classic cartoon example, click here. :-) 

The following is excerpted from a letter sent to investment clients on January 29, 2011.

Valuations

If the stock market were cheap enough, we might be willing to accept some of the risks outlined in our prior article, The Recovery Will Continue Until Something Blows Up. The problem is that, from our historical perspective, the general stock market is very expensive at this point. People are sometimes surprised when we tell them that, but just because it's less expensive than it was at a credit-bubble-induced top doesn't mean that it's cheap!

The following is excerpted from a letter sent to investment clients on January 29, 2011.

The recovery will continue until something blows up.

That, in a nutshell, is our economic forecast covering the next year or so.

Let's look at each part of that sentence in turn. First, the recovery. Yes, there is an economic recovery underway, though it is an extremely weak one in light of the preceding downturn's severity. But there are some indications that the economic rebound may begin to pick up the pace in 2011.

One such clue comes from the recent upward revisions in employment data coming from the Bureau of Labor Statistics. The way these stats work is that the BLS makes an initial estimate of how many people have jobs, and then revises that estimate the next month based on more refined data. Their estimates tend to lag what's really going on in the economy. If the BLS is habitually revising job data downward, meaning that they have been overestimating employment, that is probably a sign that employment is on the decline. But right now, the opposite is happening -- the BLS has revised its employment estimates upward for the past four months in a row. This is a sign that job growth may be picking up the pace.

Summary

• While continued low inflation or another bout of price deflation are both possible, there are several factors -- none of which require an economic recovery -- that could prevent deflation or even cause inflation to surprise to the upside. 
  
• In the event that deflation does take place, we believe it will be met with a powerfully inflationary policy response.  As a result, any foray into deflation will likely be relatively brief.
  
• Any deflation-fighting policies enacted will further strengthen the already robust, fundamentally-driven case for a significant eventual loss of dollar purchasing power against things that people need to buy.
• Rather than speculating on inherently unpredictable short-term events, we prefer to own a diversified basket of investments that stand to benefit from our high-confidence, fundamentally supportable long-term forecasts.
  

Definitions

In this article we employ the standard usage of the terms "inflation" and "deflation" as protracted changes in the aggregate price level of consumer goods and services. Some analysts describe changes to the money supply, system credit, or asset prices as inflation or deflation.  These are all important factors that exert an impact on general consumer price levels, as we described in a previous article on the mechanisms of deflation, but we think it only confuses matters to use the same term to describe multiple phenomena.  For this reason, and because this article concerns itself primarily with the purchasing power of US dollars, we will stick with the most commonly accepted definition of inflation and deflation as changes to consumer prices.

Neither Deflation nor Continued Low Inflation Are Certainties

Our monetary and political system is so biased towards inflation that it took an unprecedented private sector credit collapse -- along with the attendant financial market panic, severe economic downturn, and energy price crash -- in order to cause just six months of CPI deflation back in 2008.

The implosion phase of  private sector deleveraging is already behind us.  We do believe that a credit bubble still exists, but that it has moved to the government debt sector.  As we will discuss below, a crisis in government debt would not be deflationary in the way that the private sector credit collapse was.  So it is far from assured that there will be another wave of deflationary force sufficiently massive enough to overcome our systematic inflation bias and push us into outright deflation.

Meanwhile, there are several potential circumstances that could overcome the current economic weakness and continued (though much slower than late 2008) debt deleveraging that are both currently keeping inflation low:

-- More quantitative easing.  At the last Federal Reserve policy meeting, it was ordained that the proceeds from maturing mortgage-backed securities and bonds (purchased during the prior round of quantitative easing) would be rolled over into purchases of US Treasuries.  This policy move put to bed any talk of an "exit plan" for the Fed's wildly stimulative monetary policy.  It also sent a signal that the Fed is willing to use quantitative easing ("QE" -- a fancy term for the direct creation of new money in order to buy assets) not just as a crisis measure but as an ongoing policy tool.

This latest move takes place at a time when inflation is still positive and the stimulus-driven recovery, while feeble and getting weaker, is still somewhat intact.  More quantitative easing could well take place if the current lull continues, but in our opinion, QE2 would be almost a sure thing if the economy were to take another leg down or the CPI were to start dropping. 

The first round of QE appeared to help put a fairly quick end to CPI deflation, but there are too many factors involved to be certain of causality.  Still, logic dictates that if QE causes new money to be created and circulated, prices of at least some items will go up more than they would have.  In addition to increasing the amount of money being circulated, quantitative easing could also cause a loss of confidence in the dollar -- also a potentially inflationary outcome.

The money created by QE1 tended to just sit in reserves, so it did not get into general circulation in sufficient amounts to create much overall CPI inflation (although one could argue that it was sufficient to forestall further deflation).  But that need not be the case with QE2.   If the Fed monetizes US Treasuries, then the newly created money being supplied to the government can be disbursed to consumers via fiscal stimulus measures (see next section).  If that doesn't work, the Fed could monetize other assets or make purchases from non-banks in order to get the new money into wider circulation.  While not specifically quantitative easing, the Fed could further widen monetary circulation by directly granting loans to private parties.  The options available to the Fed are many, and the Fed has both stated and demonstrated that it is willing to use non-standard policies to boost inflation.

Another round of QE seems likely if the current stagnation continues, almost assured if we actually dip into deflation again, and could very well head off deflation or even cause a surge in inflation.  Just based on the possibility of further QE alone, we'd be very hesitant to declare future low inflation or deflation a sure thing.

-- More fiscal stimulus.  Unemployment is stubbornly high, voters are unhappy with the weak economy, and high-profile economists are screaming that another Great Depression is guaranteed without huge further stimulative efforts.  Under these circumstances, it's not unrealistic to expect more fiscal stimulus.  If we were to dip into actual deflation again, the case for increased stimulus would become stronger still.

Scattered mentions of austerity pop up here and there, but in most cases we believe that this is just empty electioneering.  The reality is that few politicians are willing to be the ones to force meaningful belt-tightening, especially should they find themselves in the midst of a deflation scare or serious economic downturn.

More stimulus is likely at some point, but given the widespread public bitterness towards Wall Street, future spending will probably not be aimed at propping up the financial industry.  Instead, the next round of stimulus is likely to target jobs, wages, and general spending within the economy.  Such spending programs would be more likely to stoke inflation than the prior bank-bailout stimulus.

-- A falling dollar.  There is a widespread belief that inflation can't take place in the absence of rising wages, but this is not the case.  A decline in the foreign exchange value of the dollar could drive up import and commodity prices for Americans, causing a loss of dollar purchasing power even in an environment of stagnant wages.

Currency-driven inflations against a backdrop of (often extreme) economic weakness have been quite common historically, so we are puzzled as to why this possibility is completely ignored by most analysts.

A currency-driven inflation would likely not consist of an across-the-board increase in prices.  Prices of items affected by exchange rates, such as food, energy, and imported goods, would rise even as items that weren't affected as much by exchange rates -- notably, housing -- stagnated or declined.  The price indices, averaging out all items as they do, might not even look like they were rising much, but this would feel very much like inflation as people would find that their money was losing purchasing power against the things that they needed most.

A sufficiently large dollar decline could additionally undermine confidence in the currency, leading people to exchange their dollars for more reliable stores of value and driving prices up further.

-- A US government debt crisis.  We believe that a crisis of confidence in US government debt at some point is a high-probability event.  The reason, in very brief, is that the US has amassed enough foreign debt that there is no politically feasible way to pay it off in real terms. Eventually, we believe, our creditors will come to understand this reality and will begin to price it into our debt.

A crisis in Treasury debt would look very different from the deflationary private-sector credit bust of 2008.  Back then, Treasuries and the dollar were the so-called "safe havens" to which panicky investors fled.  If the US government's solvency came into question, that safe haven status would be lost and investors would likely be clamoring to get out of the very same assets that they piled into in 2008.  A resulting flight out of US dollars could have the inflationary effects described in the "falling dollar" section above.

The inflationary potential would likely be exacerbated by the belief -- probably correct -- that the Fed would monetize Treasuries in order to keep a lid on rates, thus substantially increasing the money supply.

The timing of a crisis in US sovereign debt will be driven more by crowd psychology than by anything else, so we don't think it's possible to predict ahead of time when it will take place.  But we believe that something like this will occur, that it is likely the next big crisis that our nation will have to face -- and that it has the potential to be highly inflationary.

-- Rising commodity prices.  A steep drop in the dollar's value would not be required to drive up prices of energy, food, or industrial materials.  Increased economic activity in foreign countries (even if US did not participate) could lead to rising commodity prices -- as could the gyrations of the markets, which we've clearly seen can often be completely unpredictable in the short term.   In spite of the lack of a robust recovery in the US, prices of many commodities have been surging lately.

None of the potentially inflationary outcomes listed above requires robust economic growth to take place.  In fact, some of them -- quantitative easing, fiscal stimulus, and a government debt crisis -- are more likely in the absence of an economic recovery.  A stronger recovery would likely cause more inflation as a result of increased bank lending and consumer spending, but a recovery is by no means a prerequisite for inflation.

Any of these outcomes could do more than just offset the deflationary pressures in the economy and keep us from dipping into deflation.  Depending on their magnitude, they could also cause a fairly serious increase in inflation, at least in the goods that Americans most need.  Continued low inflation -- which many analysts consider to be guaranteed -- is almost as far from being a sure thing as outright deflation.

Any Deflation Will Sow the Seeds of Its Own Demise

The US government is able and willing to do whatever it takes to prevent a serious deflation.  This conclusion is so self-evident that we don't even understand why it's a matter of debate.

We very thoroughly dealt with this topic in an article we wrote at the depths of the deflation panic in January 2009, so we aren't going to rehash it here.  We will just note that right around the time the article was written, the government intervened with even more massively inflationary policies and the price deflation soon came to an end.  Both ensuing policy and the results of that policy have overwhelmingly supported our thesis that the government can and will head off long-term price deflation.

If we were to experience another round of deflation at this point, the government would surely intervene with a similar if not even more dramatic policy response.  And to the extent that didn't have the desired effects, the government would step up the inflationary policy until something succeeded. 

Such policies work with a lag, so it's possible that prices could deflate for a while.  But we would expect that lag to be on the scale of months, not years as suggested by so many analysts -- including those who are predicting a similar experience to Japan's, which we have shown to be a completely inappropriate comparison.

Whatever the exact nature of the deflation fighting policy, at its core would be an effort to create more money and to get that money to be spent in the general economy.  Over time, an increase in the amount of money being spent in excess to economic production eventually leads to a reduced value for each unit of money -- inflation, in other words.  So the policy response to more deflation would sow the seeds of even more purchasing power loss in the future.  The worse the short-term brush with deflation was, the more money would be created, and the more inflation eventually to come.

Focus on High-Confidence Outcomes

Several of the factors that could cause an increase in inflation -- the dollar's exchange rate, the risk premium on US Treasuries, and commodity prices -- are determined by financial markets.  And it's abundantly clear that while markets almost always eventually move toward their fundamental values, they tend to react more to crowd psychology in the near term.  So while fundamentals are an excellent predictor of long-term market outcomes, it's really impossible to use them to reliably determine short-term outcomes.

The looming possibility of more quantitative easing or fiscal stimulus makes it even tougher to predict near term deflation or continued low inflation with any certainty.  And yet all over the analytical community, people are doing just that.  In a time of great monetary and market instability, we believe that trying to predict how high or low inflation will be several months out is an inherently low-confidence forecast.

We can forecast with high confidence, however, that if we do experience deflation or sufficiently protracted economic weakness, that more stimulus and QE will be employed until inflation is created.

We can also forecast with high confidence (based on the US' foreign indebtedness; the structure of its economy and political system; and prevailing policymaker attitudes towards inflation, stimulus, and debt) that the US dollar will at some point experience a substantial reduction in purchasing power against the things that Americans need to buy.

But while we consider these high-level outcomes to be nearly inevitable, it's much more difficult to pinpoint either their timing or the manner in which they will take place -- to say nothing of how soon the market will start pricing them in.  Our approach, then, is to own a diversified basket of investments that we believe will benefit should our high-confidence forecasts come to pass. 

We believe that this strategy will increase our chances of eventual success, but it has another positive aspect as well.  Because our varied investments often move in different directions from one another in the short term, and because some are far less volatile than others, we can take advantage of the market's inevitable ups and downs by tactically rebalancing into those areas with the best values at any given time. 

Another bout of deflation probably wouldn't be fun for us, but it would allow us an opportunity to increase our exposure to any good inflation-hedge investments that had been beaten down due to deflation fears.  This is what we did in late 2008 and early 2009, and we will continue to use this approach in an effort to turn short-term market moves -- even if they are "against" our long-term theses -- to our advantage.

Modifying our investment stance as valuations change isn't the same as speculating on short-term market outcomes, however.  The latter entails trying to guess where the herd will turn next, and we think that's just too risky.  We prefer to stay in alignment with the fundamentals and to try to take advantage of the ups and downs while we wait for the market to price those fundamentals in, as it always eventually does.

That means looking past the widespread inflation complacency and deflationary hand-wringing, and staying focused on the loss of dollar purchasing power that we strongly feel still lies ahead.

The following is excerpted, with very minor edits, from a letter to investment clients sent out on January 20, 2010.

Inflation Risk

We've explained many times our strongly-held conviction that in the years ahead, the dollar is going to lose a significant amount of purchasing power against things that people need to buy. 

A longer explanation for our reasoning can be found on the site -- just adjust for the fact that this was written in late 2008 and the dollar's fundamentals have deteriorated enormously since then. 

Here is a shorter version.  We believe that the dollar's purchasing power is at risk due to the following:

The following is excerpted from a letter to investment clients sent out on January 20, 2010.

The Recovery(?)

In a client letter written in April 2009, we made the bold (at the time) suggestion that regardless of the long-term structural issues facing the US economy, it was entirely possible that the jaw-dropping levels of economic stimulus underway at the time could create some sort of cyclical economic rebound.  This claim seems less crazy now, as there has clearly been a rebound in various sectors of the economy. 

People focus on unemployment, which remains quite high, but employment is a lagging indicator of economic activity.  This graph that I put up at voiceofsandiego.org shows that going as far back as the data allows, unemployment has never begun to decline until after the recession was over.  (I even checked this for the Great Depression and got the same result).

In contrast, many of those data points that tend to be leading indicators of economic activity have rebounded strongly.  There's little question that an economic rebound of some sort is underway.  The question is how strong and enduring that rebound will be.

Back in June of 2008, we wrote that the US stock market -- then at 1,377 on the S&P 500 -- was priced for poor returns. We were talking about prospective long-term returns, but as everyone knows, the market experienced an epic crash beginning just a few months later.

In late October, after the S&P 500 had plummeted more than 38% to under 849, we posted an update arguing that the US market was now priced for good (though not great) returns.

Well, we're here to tell you that the market is priced for poor returns once again.

The following thoughts on the economic stimulus and its potential outcomes are excerpted from a letter to clients sent out on April 20, 2009.

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The Stock Rebound

You may have noticed that stocks in general have made quite a rebound over the past couple of months. As I write this, the S&P 500 has moved up nearly 35% from its early-March lows. Also beneficial to our portfolios, the dollar has dropped pretty sharply over that same period and many of the inflation-hedge themes we favor have done quite well.

Which is all very nice. But will it be sustained? Our emphasis on fundamental analysis and long-term returns mitigates the need for us to make short-term predictions. We try anyway.

As a first step in answering that question, let's have a look at: The Stimulus.

In our prior article on the government's willingess and ability to create inflation, we noted that Japan is often held up as an example of a country that was unable to inflate despite having a fully paper-based monetary system. But while the crash of Japan's credit-fueled stock and real estate bubbles resembles our own situation, the monetary policy responses in each case have been markedly different.

It's true that the Japanese authorities did not create any enduring price inflation after their credit crash. But a quick look at the data shows that this is because they opted not to do the one thing that can reliably create eventual inflation: rapidly grow the supply of money in circulation.

The modern-day monetary system employed in the United States is based on currency that can be created at the bureaucratic touch of a button. In charge of that button is a group of people with a firmly entrenched belief that deflation is the worst of all possible monetary outcomes.

We believe that this state of affairs is simply incompatible with the existence of the type of protracted "deflationary spiral" about which it has become all the rage to worry. Deflation is a choice in the current monetary regime, and it is a choice that our government simply cannot make.

Back in June we wrote an article entitled "US Stock Market Priced for Poor Returns" in which we argued that stock market valuations are predictive of long-term returns when measured in such a way as to smooth out earnings volatility. As evidence, we presented the following chart comparing quintiles of market valuation against average 10-year forward performance (please see the original article for an explanation of our methodology):

While we invest in many sectors and asset classes, the recent steep selloff in precious metal mining stocks inspired us to write an article focusing in on that particular sector's long-term fundamentals. The resulting piece was emailed to clients on September 16, 2008 and is excerpted below.

Back in March, we pointed out some important similarities between the current financial environment and that of the 1970s.

Aside from gratuitous decades-old pop culture references, the main focus of the article was on real short-term interest rates, which we approximated by subtracting the year-over-year CPI inflation rate from the Fed funds rate. At the time, real rates by this measure had just turned negative, meaning that the Fed funds rate was actually lower than the rate of CPI inflation. We thought this an important development because the real Fed funds rate provides an indication of the tightness (or lack thereof) of monetary policy.

Checking back in on those real interest rates, we see that they have proceeded further into negative territory and now rest at -3.6%.

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The following is taken from a letter to investing clients written on the evening of Tuesday, July 8. 
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The Bear Market Continues

You may recall from our last investment update that we were unconvinced by the stock rally that was then taking place. This is what we said at the time:

By early March, the stock market (as measured by the S&P 500) had declined nearly 20% from its peak. Since then, however, it has made a big comeback and is now down less than 10%. Is the downturn over?

We are skeptical.