Money Coming Out of Treasuries And Into Gold

To understand how the macroeconomic picture is changing, we can take a look at how various asset classes are changing relative to one another. With that in mind, see the chart below, which shows the ETFs for four asset classes -- Treasuries, gold, commodities, and the S&P 500 -- to see where money is moving.

The chart illustrates the following:

• 20+ year Treasury bonds were rising, but now appear to be consolidating and possibly turning bearish
• S&P is rangebound between 850 and 950
• Gold is rallying
• Commodities are still in a bear trend

Interpretation

The rise in gold coupled with weakening Treasury bonds, commodities, and S&P suggests the market is still rooting out false forms of wealth -- and that the market is shifting to gold as its preferred method of safety. Inflationists will posit that the rise in gold results from greater inflation concerns, and this may play a part into it as well; money supply indicators and money velocity indicators are both pointing to inflation.

Trade Setups

Two potential trade opportunities come to mind:

1. Betting on a continued exodus from Treasuries into gold, in that the market will continue to favor gold over Treasuries as a safe haven
2. Long commodities relative to S&P; commodities seem grossly underpriced relative to the S&P, doubly so for those expecting a deflation spiral.

Disclosure: Long gold.

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An Inside Look at the Beef Between Mike Shedlock and Peter Schiff

The Austrian economics blogosphere was rocked to its very core yesterday, when Mike Shedlock, one of the most popular economics bloggers on the web, dropped a serious smackdown on Peter Schiff in a post entitled, "Peter Schiff Was Wrong." In this post we'll analyze the beef between two of the most prolific economists of our time.

Meet the Contestants: Peter Schiff vs. Mike Shedlock

Peter Schiff: Adheres to the Austrian school of economics. President of his own brokerage firm, Euro Pacific Capital. Here's his web site.

Mike Shedlock: Austrian economist. Investment advisor. Prolific blogger -- check it.

Like any great rivalry -- Ali vs. Frazier, Google vs. Microsoft, Batman vs. Joker, etc. -- Schiff vs. Shedlock is not without history; see their previous debate.

Now that we've met the contestants and know the history of this longstanding rivalry, let's take a look at what it's really about.

Schiff vs. Shedlock = Dead Dollar vs. Rangebound Dollar

It's crucial to note that Schiff and Shedlock agree on quite a bit. Such as:

• Gold will rally
• US stocks will decline
• Japanese yen will appreciate

Their primary point of contention is their debate on what will happen to the US dollar. Schiff thinks the dollar is doomed and will lose more than half its value over time; how long is unclear, though Schiff has been anti-dollar for some time (since at least 2002), and is sticking to that as the long-term trend. Shedlock, on the other hand, thinks the dollar will be rangebound and is not expecting to see the dramatic decline Schiff is expecting.

Schiff is referred as an inflationist, while Shedlock is a deflationist. It is crucial to note the terms inflation and deflation refer to money supply, not prices. Thus, a key difference in the analysis of Schiff and Shedlock is that most inflationists will use MZM as a money supply indicator, while Shedlock and other deflationists are more inclined to use something else. As a result, the issue of how best to calculate money supply also plays into the heated rivalry between Schiff and Shedlock.

Secondary Conflicts Over Treasuries and Commodities

Their conflicting views on the US dollar lead to conflicting views on other asset classes -- namely government bonds (i.e. Treasury bonds) and commodities. Commodities are traditionally anti-dollar investments; if you think the US dollar will fall, buying commodities is a way to hedge against this. This was proven to commodities investors who enjoyed the rally from 2002 to mid-2008, which coincided with ongoing dollar devaluation. Likewise, bonds are typically favored when investors "go cold" and look for safety -- but are dreaded by those who view currency devaluation as a great concern.

Sizing Up Schiff

Peter Schiff is an icon of sorts amongst bears, as he has been the most successful in breaking the "bear barrier" and expressing bear ideology to millions via regular appearances on national television. Personally, I agree with Schiff's long-term fundamental analysis, which is bullish for commodities, metals, and Asia, while bearish on the US economy. I think dollar devaluation is baked in, that there is a bubble in Treasuries, and that once this bubble pops, a run on the dollar will ensue (the Argentina and Iceland scenario).

With that said, as Schiff himself admits, it is unclear when the bubble will pop. Bubbles can go on for a few years, and during that time, clinging to your investment thesis can hurt -- and Schiff's overall thesis did not fare well in 2008, as his archnemesis Shedlock is fond of reminding us. For that reason, I think it would be advantageous to couple Schiff's fundamental analysis with momentum following technical analysis. This is essentially my trading strategy, and 2008 was a healthy and profitable year for me -- as it was for anyone who coupled Schiff's views with technical analysis.

Sizing Up Shedlock

There is no denying Shedlock is an excellent economist, and he deserves much credit for being one of the few people who called for a strong rally in the dollar, US Treasury bonds, and a decline in commodities. While most perma-bears and Austrian economists saw the collapse of XLF (financials) and XHB (homebuilders) coming, a more common view was that the bubble would go to commodities, where it would stay and grow. Thus the calls of oil going to $200 (which is something I must confess to having said, but not traded). And we did proceed on this path -- oil got above $140 -- but then came sharply back down, and the bubble was passed to Treasuries.

Ultimately, Shedlock thinks the Treasury market is safe, and is not one of those concerned about a potential collapse in Treasury prices. Shedlock maintains this concern when wealth contraction occurs around the world, thus leaving less investment dollars available for foreigners to buy US Treasury bonds, and also while gold and silver become increasingly popular alternatively stores of wealth, something which Shedlock correctly forecasted. And he maintains the stability of the Treasury bond market when supply is set to increase significantly given Obama's aggressive stimulus mandates and philosophy of "deficit's don't matter."

The Key Factor: To What Extent Is Monetary Policy Fiat?

So who's the winner? Schiff or Shedlock?

Well, as noted previously, I consider both to be outstanding economists, and thus they have already won in the eyes of this judge. In terms of whose investment thesis will prove to be more victorious, however, much of it will boil down to one key question: is monetary policy fiat? Meaning can the Federal Reserve inflate if it wants, and deflate if it wants?

Deflationists will argue that because the Federal Reserve cannot force banks to lend, it cannot affect the portion of the money supply that is created by commercial banks when they lend money into existence, and that credit destruction (declining availability of credit and falling asset prices) will result in a declining money supply. Inflationists will argue deficit spending, interest rate cuts, induction of sell offs by foreign central banks, and coordinated activity with other central banks can always result in inflation, provided there is no restriction on money supply, like a commodity standard that guarantees the value of each note of circulation with respect to a commodity.

In my opinion, the Federal Reserve can inflate if it wants, and that monetary policy in an economy with a central bank a fiat currency is a fiat matter -- if inflation is decided, than that is what shall happen. As Bernanke and friends still view inflation as the solution and view deflation as intolerable, I'm inclined to think inflation/currency devaluation is the greater concern, and that Schiff's long-term thesis is still correct.

Alternatives to Schiff and Shedlock

There are those who may find Schiff and Shedlock to both be unsatisfying in ways, and thus may find the rivalry to be less than compelling. For those folks, I'd recommend Eric Janszen and Stefan Karlsson.

For another take on Schiff vs. Shedlock, see this commentary from David Waring.

Discuss on InformedTrades

If Inflation is Institutionalized, We Need to Learn Short-Term Trading

Inflation is and has been the monetary policy of choice since the gold standard was fully abolished in 1971. See the long-term money supply chart below.

Consequences of Institutionalized Inflation

The key question for investors and traders: what are the consequences of inflation being institutionalized as monetary policy?

1. It leads to a "pass the bubble" economy. When the Federal Reserve inflates to counter deflation, the excess money supply will be directed into an asset class besides the ones being deflated, thus leading to a new bubble. The bubble in US Treasury bonds is the current example of this.

2. It leads to more of a fiscal-based economy, not a production-based economy. The creation of money and the financial markets, rather than market demands, guide investment and production.

3. As the fiscal economy -- the financial institutions that profit from the creation of bubbles -- becomes the dominant part of an economy, the largest incentives are in speculation and enabling speculation.

4. It's a trader's not an investor's, paradise. A "pass the bubble" economy is, in many ways, a short-term trader's dream come true. When an economy becomes more driven by monetary policy than by market demand, speculation becomes more profitable than production.

5. Consistent with the notion that institutionalized inflation favors traders, analytical tools like technical analysis and short-term money management practices become an increasingly important tool in forecasting price movement.

6. Because legislation and brokerage firms can steer the Federal Reserve's inflation into certain asset classes, sector trading -- trading based on the correlation between sectors -- may become more lucrative. The proliferation of ETFs facilitates this.

Other Key Considerations

It's worth noting that bubbles can last for quite a while. In fact, there are those who argue there is a bubble in Treasury bonds, and that it will last a while -- thus creating a prolonged deflation in the economy. As always we can look for momentum in price charts and potential outlier, "black swan" events to understand when the bubble is being deflated and how monetary policy will try to reflate.

Discuss on InformedTrades

The Aggregator Bank Intervention Trade

In its simplest form, the financial mess could simply be explained as a bunch of bad loans being made -- loans to home buyers who couldn't really repay the loans, banks taking on too much debt due to the securitization of loans, and government issuing more debt than its tax base can handle.

The government response has been to try to bailout the bad debts through the usage of taxpayer funds and obligations. To this end, the Obama administration is now considering the creation of an "aggregator bank" -- one that will buy up bad loans, under the rationale that this will relieve the banks and cause them to lend.

As market speculators, there are a few things we should consider:

1. Whoever holds the bad loans is holding an asset that needs to fall in value. If the US government creates an aggregator bank specifically to acquire bad loans, the US government will bear the loss. As the US government borrows money, it would mean Treasury holders would bear the loss. Should appetite for Treasuries dry up, the dollar will be devalued, and US dollar holders will bear the loss.

2. As such, bailouts are a way of transferring market losses from financial institutions to taxpayers. An opportunity to trade this would be in going long XLF, an ETF that tracks the financial sector, while going short TLT, an ETF on 20+ year Treasury bonds.

The XLF chart is pictured below; currently, the market is at 9.66, almost 100 points above its 52 week low at 8.67. Government actions may hold up XLF and lead to a rally back up to resistance near 13.20, another key price point to watch.

Discuss on InformedTrades.com

An Introduction to China-US Decoupling and the Potential Trade of the Century

Some argue that this financial crisis will lead to China "decoupling" from the US economy; meaning it will need to find other buyers of its exports, and will not be able to continue buying US Treasury bonds, which have the affect of propping up the US dollar's value. Instead, the decouplers argue, China will need to invest in increasing its own consumption capabilities. This will have the effect of decreased buying in the Treasury bond market while the supply of Treasuries expands as US government deficit increases -- thus making short selling long-term Treasuries one a very lucrative opportunity, if this is in fact the case.

Can this happen? If so, when?

Skeptics of decoupling argue that the decline of US demand will weaken the Chinese economy along with the US economy, and that the current structure of US consumption driving the global economy will maintain. Decouplers note that the Chinese economy will weaken, but this will force the Chinese government to invest in more infrastructure programs instead of buying Treasury bonds -- at a time when the US is planning to take on more debt and thus increase the supply of Treasury bonds. The result of this will be currency decoupling in that China will become an increasingly powerful buyer relative to the US. And from a geopolitical perspective, China is more economically aligned with Pakistan, Iran, Russia, and Hamas rather than the US/Israel/Britain economy. Thus far, we have seen China direct its buying towards domestic stimulus packages.

With that said, though, Treasury buying could go on for a while; Naked Capitalism notes that China is still buying Treasury bonds. For those who think decoupling is bound to happen, the opportunity to short Treasuries may be the best trade out there when the bubble starts deflating, whenever that may be. TBT is the double inverse ETF for the long-term Treasury bond market.

Three Little Pins and Their Quest for a Treasury Bond Bubble

As we've discussed previously, there is a bubble in the US Treasury bond market. And as we discussed in Ka-Poom Theory, bubbles always find black swan events -- "pins" to pop them and cause a market panic. As John Mills, a historian of market panics, said, "Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works."

What will be the pin that pops the Treasury bubble, causing a panic that reveals its true value? While it would be futile to try to predict an outlier event, understanding areas where it may be more likely can help us identify potential triggers for what will cause a market panic, so that we can more easily recognize it when it occurs.

There are three pins I think are most likely:

1. Mass monetization announcement. We are seeing appetite for Treasury bonds decline. If the Fed either significantly begins to monetize the debt (i.e. print money to pay it off) or announces it will do so, this could trigger an exit from Treasuries.

2. Military threat. 9/11 was a black swan event that punctured the dot com bubble significantly. As there is still a significant amount of conflict and political tension in the world, a military event triggering a mass exodus out of Treasuries seems possible -- particularly when one considers that some of the largest holders of Treasury bonds are foreign central banks with economic interests that run contrary to those of the United States.

3. "Legislation". The Federal Reserve can modify its charter, Congress can assign more authority to it, and central banks can come into new agreements amongst themselves. For instance, a regional currency which national currencies would be re-valued against is becoming a more commonly voiced idea in many parts of the world. If there is a monetary agreement of sorts, it will likely have the impact of devaluing the US dollar, as a way of compensating foreign US Treasury bond holders.

As a dollar trader, I'll be keeping an eye on potential pins for the Treasury bubble, as well as price charts that can show when momentum has turned. Though when the bubble will pop, as well as how bit it will get before doing so, remain unclear.

Discuss on InformedTrades

Ka-Poom Theory: Understanding and Predicting Black Swan Events

In this post, we'll take a look at the Ka-Poom Theory, a framework for investing in "bubble" economies -- economies driven by the creation of asset bubbles.

Ka-Poom Theory: What It Is

Ka-Poom Theory is a theory that postulates how the asset bubble cycle works -- meaning how bubbles are created, destroyed, and reborn. It was developed by Eric Janszen, former venture capitalist who now writes commentary at iTulip.com.

Ka-Poom Theory offers the following framework for understanding bubble cycles:

1. The Bubble is created. Ka-Poom Theory posits that the creation of the bubble is a result of interest rates being kept too low by the central bank. This is the same conclusion reached by the Austrian Business Cycle Theory.

2. Also like Austrian Business Cycle Theory, Ka-Poom Theory expects the bubble to begin deflating at some point. In addition, though, Ka-Poom Theory expects a "black swan event" -- an unpredictable, external, outlier event that has a monumental impact and, in the context of Ka-Poom Theory, a deflationary effect. It does not, however, cause a deflationary spiral. Thus, Ka-Poom Theory refers to this state as disinflation.

3. The central bank will respond to disinflation with inflationary policies that will take approximately 12 months to impact the markets. The period of disinflation will be erratic.

4. The black swan event is the "ka" of the Ka-Poom Theory. The "Poom" is the subsequent re-inflation of the money supply. Deficit spending and inflationary policies initiated by the Fed dictate to what sector the re-inflation of the central bank will go.

Ka-Poom Theory posits this is what has been happening in the US economy since the dot com bubble, and thus is the current framework for understanding thus US economy.

Assumptions of Ka-Poom Theory

The most critical assumption the Ka-Poom Theory makes is that the central bank has the power to inflate the market at will, invariably. In other words, Ka-Poom Theory is based on the premise that if the Federal Reserve wants to inflate and create higher prices, it can -- by printing money, buying up assets, working through the credit market, or inducing foreigners to sell Treasury bonds and dollar holdings. It also assumes that the results of the central bank's actions are not instantaneous; the gap between their policy enactment and the corresponding re-inflation of asset prices is a period referred to as disinflation.

Because of this assumption, Ka-Poom Theory is essentially a framework for understanding how a planned economy works.

Implications of Ka-Poom Theory for Traders and Investors

To the extent that Ka-Poom Theory is valid, a few deductions can be made for traders and investors:

1. The period of disinflation -- what Ka-Poom Theory argues we are in now, which is characterized as the period between the Federal Reserve's policy enactment and the corresponding effects -- is deemed to be erratic. Janszen prefers to stay out of the market during these times.

2. In a debt-based bubble, the long-term bond market will likely be where the arbitrage opportunity is, in the sense that bond prices will fall as the market begins to re-inflate.

3. In order to understand what sectors will be set to inflate -- where the next bubble will be found -- Ka-Poom Theory looks at government spending to lead the way.

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Bears Reported to Have Begun Munching on Bulls Who Have Fallen Into Bear Trap

I'm sorry it has to be this way, folks, I really am. But it looks like the bears have set the trap. The bulls have wandered in. And now, there's only one thing left: for the bears to have their lunch, and for the bulls to meet their fate.

Fundamentally we know the story: unemployment and low retail sales in the US economy are all the talk. And while the January effect coupled with inflationary stimulus packages may have helped the market engineer a bit of a rally, the economic woes are still clearly in place, and it looks as though the primary trends are preparing to resume themselves. For instance, at the time of this writing, S&P 500 futures are pointing to a fifth loss in a row.

Technically we see a nice potential trade lining up on SPY, particularly if SPY can break support at 85.43. The market is now trading below the 5, 10, 20, and 50 simple moving averages, all of which are converging -- another indication the bear market rally may be concluding. A break below 85.43 could pave the way for a retest of previous lows at 75.

Check the chart below.

A lower S&P 500 is also generally correlated to a stronger yen. We have seen the yen begin to rally again, as the USDJPY exchange rate has broken below 90. The chart below plots the USJPY (blue and gray candles) against the SPY (red and green candles). In sum, a resumption of the bear trend in the S&P would be a bearish sign for USDJPY, which stock market traders can take advantage of via the FXY ETF.

Disclosure: Short USDJPY.

Discuss this article with me and others on InformedTrades.

Analyzing The Arbitrage Opportunities in Commodities

Regardless of what side of the inflation/deflation debate you're on, one thing is certain: false forms of value are being destroyed, and there is a "flight to safety" -- safe ways of preserving purchasing power. In our current environment, this has caused the US dollar to strengthen in the second half of 2008, and US government treasury bonds to rally as well.

So what's this mean for other asset classes, like commodities? To answer this question, we will need to understand the origins of money.

The Origins of Money

Long, long ago, before the advent of paper money, people bartered goods. In other words, if you made shoes and I made pants, we might be able to work out a trade in which you would make a pair of shoes for me and I would make a pair of pants for you. In this way we would both be able to increase our wealth.

Of course, what if I wanted shoes but you did not need pants? We might then be able to have difficulty in making a trade. Unless, of course, you were able to accept my pants and trade them with someone else who wanted pants. And that is precisely what began to happen as economies developed. In such an environment, what became money was simply the most easily traded commodity. Such commodities typically had a few attributes:

1. durability -- did not deterioriate over time, thus allowing wealth to be accumulated and an economy to be built on savings
2. divisibility -- easily divided, thus enabling transactions of all sizes
3. recognizability -- so that people could accept it as money with confidence
4. portability -- so that people could take their money with them
5. scarcity -- because too much of it would encourage speculation and making savings difficult

Many commodities were tried as money, though in the end, two stood out as clear winners: gold and silver. Thus you will sometimes find passionate gold and silver investors who say "gold is money."

What This Means If You Believe Deflation is a Concern

If you view the crisis as deflationary in nature, the asset classes most appealing to you will be as follows (listed in order):

1. real cash -- i.e. US dollars, euros, etc
2. government issued bonds
3. precious metals
4. commodities
5. consumer goods
6. real estate
7. financial goods (stocks, bonds, derivatives)

Deflationists argue the supply of paper, government-issued money in the economy is contracting, and thus it is not in danger of being devalued by excessive supply -- and so its purchasing value will increase as the market moves to find real stores of value.

What This Means If You Believe Inflation is a Concern

If you believe inflation is a concern -- meaning that the government has excessively expanded the supply of paper money in the economy -- then the asset classes of choice will be as follows:

1. precious metals
2. commodities
3. consumer goods
4. real estate
5. financial goods
6. real cash
7. government bonds

Of course, this would depend on how much inflation there is -- cash would higher on the list in the event if there is not much inflation. And with respect to financial goods, those correlated to healthy companies will be higher on the list.

How to Trade This

The easiest way of trading this is to trade asset classes against each other; for instance, if you're a deflationist, going long cash while shorting financials (which simply amounts to selling stocks and holding your money in a bank account). Conversely, you can look for potential arbitrage opportunities in which the market is not behaving as macroeconomics would posit that it does. In our current times, for instance, commodities have fallen more than financial assets; the chart below shows the SPY against DBC (an ETF tracking an index of commodities). Commodities, represented by the blue and gray candles beneath the red and green candles, have fallen 16% more than the S&P over the past 200 trading days. For this reason, many investment advisors are quite bullish on commodities, citing it as some of the best buying opportunities.

Of course, as the old saying goes, the market can stay irrational longer than you can stay solvent, so such strategies looking to take advantage of economic inconsistencies may benefit most if coupled with trend-following technical analysis.

Disclosure: Long gold and silver.

Click here for a review of products and services I use to profitably trade.

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Analyzing What the Conflict in Israel and Gaza Means for the Financial Markets

The combat currently going on in Gaza involving Israel and Hamas could have profound effects on the financial markets. Let's take a look at the situation.

Where We Currently Stand

Egypt and France are leading the way to broker a truce between Israel and Hamas. Egypt's ambassador to the UN, Mr. Maged Abdelaziz said peace talks could begin in Cairo today (January 8, 2009). French President Nicolas Sarkozy has said Israel has accepted the ceasefire plan. And in what could be a step towards a peace agreement of sorts, Israel halted its military operations for three hours yesterday to allow for civilian aid; Hamas is reported to hold fire during those hours as well. The Scotsman has a more detailed report.

Still, though, the conflict has widened, as rockets from Lebanon have struck northern Israel today. Bloomberg has the full story.

Ultimately, the geopolitical scenario remains tense. If the conflict continues and widens, it sets the stage for a larger war to emerge, with US, India, and Israel on one side, and Pakistan, China, and Iran on the other. Economic interdependencies can help expand the war as well, and may have the impact of pulling in seemingly uninvolved countries, like Russia and Venezuela.

Impact on the Financial Markets

Four key observations:

1. As bad news and uncertainty in general tends to be bullish for gold, this could stimulate demand for gold. We have already seen a bit of this.

2. Given the economic aid US provides to Israel, the threat of economic warfare against the United States becomes more likely as a way of weakening Israel. Economic warfare would come in the form of selling US dollars and US Treasury bonds. A key turning point to watch for is if China is pulled into this conflict, as China is a large holder of US Treasury bonds and thus more capable of waging economic warfare by dumping Treasury bonds. Thus far, China has urged for a ceasefire, though China has been reported to have provided arms to Hamas, and has cooperative relationships with Pakistan as well. Economic warfare would be bearish for US dollars and US Treasury bonds.

3. While neither Hamas nor Israel is directly in the business of oil, conflict in the Middle East tends to increase the likelihood of supply lines being attacked, intentionally or not. Moreover, whether or not actual supply is affected, the psychology of traders is, as evidenced by a spike in oil prices at the onset of the conflict. 24/7 Wall St notes that Iran benefits from higher oil prices, and as a source of funding for Hamas, and thus there are economic incentives that play into prolonging/exacerbating the conflict as well.

4. US Defense ETFs naturally benefit from the greater likelihood of war, particularly if it becomes seems more likely that the United States will get involved. In particular, PoweShares Aerospace & Defense ETF (PPA) may be an interesting play from a technical perspective; the market is making a double top formation and is testing its November 4 high of 14.69. This could be a nice "break or bounce" play, in that a break above 14.69 coupled with momentum indicators and expansion of war could be a buying opportunity, while a bounce off this level coupled with successful peace talks could represent a short selling opportunity. The chart below illustrates.

Disclosure: Long gold.

What Does a Trillion Dollar Deficit Mean for the Financial Markets?

The New York Times has an article this week reporting on US President-elect Barack Obama's warning that there will be trillion-dollar deficits for years to come." What's that mean for the markets?

The first line of recourse will be the issuance of Treasury bonds; in other words, the US government will look to borrow money, offering to pay it back with interest. The key question, though, is to what extent buyers of Treasuries will be easily found. As we have discussed previously, the very low yield on bonds coupled with the fact that the economic pains are being felt all around the world suggest one of two possibilities: bond rates will have to go up or the Federal Reserve will have to "monetize the debt" -- meaning it will simply have to print more money.

I have stated and continue to believe that the result of increased deficit spending, due largely to government bailouts, in this environment will be debt monetization (even if there is a rate hike, that will only increase the future debt, and thus will only delay and exacerbate debt monetization). I believe this will prove to be inflationary, that it will devalue the US dollar, and that this is the real way the bailouts will be paid for; not via a direct tax, but rather a tax through inflation. Economist Mike Shedlock, however, offers a counter viewpoint:

The Fed at some point will resort to out and out monetization, and that will have the inflationists screaming at the top of their lungs. However, banks will still be reluctant to lend, and consumers and businesses will be reluctant to borrow. In addition, I expect the velocity of money printed to be close to zero and for the savings rate to rise. In aggregate, these are not hyperinflationary things. Heck, they are not even inflationary things.

Admittedly, I am one of those inflationists who will be screaming at the top of my lungs.

There are two reasons I believe debt monetization will be inflationary:

1. I disagree with the notion that banks won't lend and consumers won't borrow. As I recently noted, we are seeing a declining TED spread as well as an increase in many money supply metrics (M1, M2, MZM). And even in this environment, we have seen companies like Verizon be able to secure a massive $17 billion loan.

2. Even if lending is reduced due to the economic climate, debt monetization increases the likelihood that foreigners will not only stop buying Treasuries, but that they will sell the ones they have, and will dump US dollar holdings out of a concern of dollar devaluation by the part of the Federal Reserve. This suggests there will be a "run on the currency," similar to what was seen in Argentina. See our previous article on the similiarities between the US economic crisis and the Argentinian crisis of 2001 for more on this subject.

How to Trade This Scenario

Timing is the key issue for trading this; we are currently seeing a rally in the market, though I expect that at some point in the second half of 2009 we will see the concerns about the Treasury market begin to manifest. As a trend-following trader I look for momentum that corresponds to my fundamental viewpoint, with the exception of precious metals, which I treat as buy and hold type investments.

With that in mind, here are the conclusions I am making based on the trillion dollar deficit scenario:

1. US dollar will fall in value. For stock market traders, UDN is an ETF to watch.
2. Dollar hedges like gold and silver will rise. GLD and SLV are corresponding ETFs.
3. Both monetization of debt as well as a hike in interest rates will send bond prices falling, as a rate hike devalues all bonds previously issued at a lower rate while monetization of debt introduces inflation concerns and the possiblity of the bond being paid back with a currency that is worth less.
4. A rate hike, which I think is increasingly unlikely given the Fed's behavior though still possible, will be bearish for US stocks. DOG and SH are inverse ETFs worth considering in such a scenario.

Disclosure: Long gold and silver; currently short US dollar against Australian dollar.

Analysis of GEX and Alternative Energy Investment Opportunities

The alternative energy sector has been heralded by many as an investment opportunity in the US over the next four years. The rationale:

1. Fossil fuels are declining in supply and are environmentally destructive. While there are those who dispute this, there seems to be enough of a "green movement" that demands alternative energy.
2. Because fossil fuels are declining in supply, they will rise in costs,thus fueling an economic need for alternative energy solutions. This seems to be questionable of late, as gas prices have fallen sharply in the US.
3. US President-elect has made government investment in alternative energies a priority.

While there are scientific arguments for and against alternative energies, the "green movement" seems to be quite strong, suggesting strong consumer demand, and Barack Obama's stimulus plan suggest this the US government will look to feed this demand.

How can investors profit from this?

GEX: The Alternative Energy ETF of Choice

While there are a number of alternative energy ETFs, Market Vectors-Global Alternative Energy (GEX) seems to be the best one over the long-term. The primary reason I hold this view is that GEX is internationally diversified; European companies constitute 47.1% of the fund, China/Japan 11.1% and U.S. 41.8%. In light of the uncertainty in global economy, I view international diversification as something that is of paramount importance from a long-term risk management perspective. GEX meets this requirement better than many of the other alternative energy ETFs.

From a long-term perspective I remain bearish on all aspects of the US economy -- stocks, bonds, and the US dollar. While an internationally diversified ETF can help significantly in hedging against this risk, investors may wish to take a market-neutral stance by coupling any long position in GEX with a short position in a market index. Inverse ETFs like DOG and SH can help in this regard.

The Short-Term Outlook for GEX

For those looking at the market from a short-term perspective, the daily chart of GEX may be of interest.

Momentum traders could find a short-term buying opportunity on a break above 25.56, with a target of 28.17, the recent high reached on November 4, 2008 (the day of the US Presidential elections). Traders who enter on a break of 25.56 may want to see RSI break its recent high as well to ensure that the momentum is real and that the breakout is not false.

January Effect: What It Is And How to Trade It

As US equities market have rallied since the beginning of 2009 -- the S&P is up 3.03% at the time of this writing since the start of the year -- many traders and investors have begun to ask a key question: is this rally a sign of the January Effect?

What is the January Effect?

The January effect is a term given to the tendency of for the US stock market to rise in the month of January. In particular, small cap stocks -- generally those with a market capitalization of less than 2 billion USD -- will rise more than mid cap and larger cap stocks. The rationale for the January effect is that investors often sell positions in December with the intent of creating tax losses that can be written off, and then buy them back in January. There is some evidence for that, as the January effect does not seem to be in place prior to 1913, the year the income tax was introduced.

Is the January Effect Real?

There is much debate as to whether or not the January Effect is real. Meaning do stocks actually rise in January? The chart below, courtesy of World Beta, suggests they do. The chart shows the results of trading the January effect over the past 80 years. The red line represents buying and holding the bottom 20% of the US stock market during January of each year; the blue line represents investing in the S&P 500 during January of each year. Both strategies prove to be consistently profitable.

Chart by World Beta

However, as the chart above illustrates, though, returns over the past three years have not been as great as the January effect's heyday back in the '80s. This has caused some to suspect that the market has begun pricing in the January effect, and that it is thus no longer a viable investment strategy. 2008 in particular was a negative year for the January effect. Conversely, those who remain advocates of the January effect will note that it works particularly well in years where the stock market declined in the previous year. This is consistent with the notion that positions will be closed and losses will be recorded for tax reasons, but then re-opened in January to resume the trade.

How Can You Utilize the January Effect In Your Trading Strategy?

Personally, I wouldn't use the January effect; it doesn't fit into my style of trading, and I'm not particularly comfortable with it, especially when I already have my own analysis of the market based on economics and technicals. However, if you're looking to trade the January effect, here are some ideas:

• Go long the whole market, small caps and large caps, skewing your position to small caps as they tend to do better than large caps during January.
• Go long small caps and short large caps; this allows individuals to be market neutral while still profiting from the January effect. If I were to trade the January effect now, I would favor this strategy, as I would not want to be long US stocks.
• ETFs are a great tool for trading the January effect; in particular, PZI, FDM, and IWC are great for playing small caps, while SPY and VTI are great for the larger caps. Inverse ETFs like SH and DOG are also worthwhile if you're looking to short large caps as part of your January effect strategy.

Links to Help You Learn More About the January Effect

World Beta - Engineering Targeted Returns and Risk: The January Effect After Really Bad Years In Stocks
CBOE - The January Effect and Portfolio Management Tools
The January Effect | Investment U