Defend Against Deflation With Gold Short ETFs

By Chris Gallant | June 28, 2009 AAA

While some of the worst credit market conditions in modern history occurred as recently as 8 months ago, it seems that enough time has passed for the market to substantially get over its fears of deflation and drastic economic contraction. At least, that is the sense I get from reading the news ...

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Inflation Worries Dominate Recent Headlines
A June 24, 2009 MarketWatch article reports that "a vocal group of economists is more worried about inflation. They believe the central bank has created so much money that it will soon be used by consumers to chase fewer goods."

Also, a Reuters article from June 21, 2009 sports the headline, "Inflation sparks glowing on the horizon" and goes on to state that "with mounting evidence that the recession is loosening its grip on the economy ... investor focus is shifting to inflation."

And a June 19, 2009 Wall Street Journal article seems to capture the tone of the market's collective worry with a headline reading: "Let Federal Reserve Beat Inflation"

Contrarian Investing Decodes Misinformation
The prevalence of these types of articles in financial media today tells me that the overall market perception is primarily a concern for inflation. This sentiment exists while we are still less than one year into a much-needed correction of a credit-based inflationary bubble that took several decades to build up to its recently completed peak.

This reality has me wondering if it is really possible that the credit crunch has in fact been solved so early on in the game that deflationary risk is all but a passing memory. In other words, are the headlines really correct that inflation is the enemy to fear right now?

To answer that question, let's first look at the raw data to determine if it's possible (or dare I say, likely) that the market's collective inflation fears are mistaken.

Using the consumer price index (CPI) as a measure of inflation, look at what is happening to the CPI's rate of change, as reported by John Williams' ShadowStats.com. Regardless of whether you prefer the government's official CPI number, or the "alternate CPI" espoused by ShadowStats.com, the trend is obvious - the rate of inflation continues to decline more rapidly than at any other time in the last 30 years.

So, what is causing individual investors and financial pundits to worry about inflation? If the CPI data continues to fly in the face of this inflationary sentiment, eventually that sentiment will be forced to correct itself. Should that happen, countless investors will flee inflationary trades and jump back into deflationary positions.

Gold Short ETFs Are the Place To Be, For Now
If that scenario unfolds as I expect, I think we will see a repeat of what we saw last October - when deflation and depression worries overwhelmed the market in the short-term, causing gold prices to plummet while the U.S. dollar saw considerable strength. If that sounds far-fetched, consider that the SPDR Gold Shares ETF (NYSE:GLD) closed at $89.90 on October 9, 2008, and just two weeks later it had fallen 21% to close at $70.65 on October 23. If you were in GLD as an inflationary hedge at that time, those losses would be pretty difficult to swallow. Even more so if you happened to be aggressive and holding the PowerShares DB Gold Double Long ETN (NYSE:DGP), which seeks to return twice the daily percentage change in gold prices. (For more, see Does It Still Pay To Invest In Gold?)

For the time being, I see a pretty big divergence between economic and monetary reality and investor expectations. I am expecting that gap will likely be closed by a reversal in investor sentiment towards deflation, not by improving economic fundamentals or inflationary conditions. In the long-term, I do accept that increased rates of inflation are likely to manifest, but in the short run, I don't think it is unreasonable to conclude that gold prices could fall 25% from current levels, trading down to below the $700 mark.

Buying gold short ETFs such as the PowerShares DB Gold Short ETN (NYSE:DGZ), which essentially seeks to provide returns that are the inverse of the daily percentage change in the price of gold, are an easy way for the individual investor to protect themselves from this scenario. An ETF like this can be especially useful for trading in registered or otherwise restricted trading accounts that may not allow for direct short-sale trades. (For further reading, see Inverse ETFs Can Lift A Falling Portfolio.)

The PowerShares DB Gold Double Short ETN (NYSE:DZZ) seeks to provide twice the percentage return of DGZ, so it can be useful for aggressive investors looking to speculate on this scenario, or for those looking to hedge long positions with the leverage utilized by DZZ.

The Final Word
When it comes to investing, following the crowd can often get you into serious trouble. After all, it was irrational optimism and a general willingness of market participants to dramatically increase credit levels and asset prices that led to this financial bubble in the first place. Many investors must surely remember being told during the consumer credit bubble's peak, "buy a house now or you risk being priced out of the market forever!"

Well, that line of thinking could just as easily be applied to the present day situation as, "buy gold now or be inflated out of the market forever!" It's the same wolf, just in a different sheep's clothing. (For further reading, see Coping With Inflation Risk.)

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