My advice remains to be extremely defensive (page 3 of 3)

Put into the proper perspective, in real terms (inflation-adjusted) commodity prices were, in the 1998-2001 period, at the lowest level in the history of capitalism. And, although I expect some industrial commodity prices will suffer from a significant phase of profit taking in 2006, given the fact that commodity bull markets tend to last anywhere from 20 to 30 years, we may just be at the beginning of an extended rise in the price of natural resources.

There is another point I should like to add to Russell Napier's excellent study, which I strongly recommend investors to read. In a world of rapid monetary and credit expansion, an undervaluation of the Dow Jones might occur, with a Dow Jones at 36,000, 40,000, or 100,000 or more — a stock price level that was predicted by several analysts in 1999. How so?

Hyperinflation

At present, the Dow is at around 11,000 and the price of gold is at $590. Let us assume that, as a result of Mr. Bernanke's more efficient paper money printing machine (incidentally, a machine that has been in operation since the formation of the Federal Reserve Board in 1913 and which accounts for the dollar's 92% loss in purchasing power since then), the Dow Jones rises to 36,000 in the next few years. (It won't take another 100 years for the US dollar to lose another 92% of its purchasing power; more likely is 10 to 20 years.)

If this were the case, the price of gold could rise from $550 to $3,600, which would bring down the Dow/gold ratio from currently about 19 to 10; or, in an extreme case, gold could rise to $36,000, which would bring down the Dow/gold ratio to only 1 (as was the case in 1932 and in 1980).

Thus, in nominal terms, the Dow would have trebled from the present level, but lost significantly in real terms — a possibility that I regard as very likely. In this respect, we shouldn't forget that during the German hyperinflation period between 1919 and 1923, share prices rose sharply in paper mark terms but tumbled in dollar terms (then a strong currency), because the rate of the paper mark depreciation against the US dollar exceeded the local share appreciation.

Thus, by October 1922, an index of shares in local paper mark terms had increased from 100 in 1918 to 171 billion, while in dollar terms the same index had dropped from 100 to 2.72! Needless to say, the 1918-1923 German hyperinflation was devastating for paper mark cash and bond holders.

Now, I am not necessarily predicting that we shall soon experience hyperinflation rates in the US, but when the Dow Jones and the US housing market will decline by 10%, it is very probable that Mr. Bernanke will put the money printing presses into high gear in order to fight asset deflation. So, US asset prices including homes, stocks and bonds could depreciate in real terms and against precious metals.

Correction likely

Still, as I indicated last month, aside from bonds, all stock and commodity markets seem to be now overbought and vulnerable to a sharp correction. In fact, whereas I am extremely negative about bonds in the long term, I believe that for the next three months or so, bonds could actually outperform equities and also commodities.

From the charts we can see that equities have formed a rising wedge against bonds since 2005. More often than not, a rising wedge leads to a sharp downside reversals. This would not necessarily imply that bond prices will rally much, but the wedge might be broken on the downside by a sharp downturn in equities.

For this reason, my advice remains to be extremely defensive. Most asset markets including stocks and commodities are extremely overbought, and there is far too much speculation in all investment markets. Therefore, severe downside volatility, also in precious metals, should not be surprising in the period directly ahead.