Dukes of Hazard

We can dance if we want to
We can leave your friends behind
'Cause your friends don't dance and if they don't dance
Well they're no friends of mine
--Men Without Hats

In previous missives we made the case for a period of optimism, where bureaucrats, pundits, and investors would perceive that massive market interventions are working and that the worst is over. We appear to be in this period now, as bureaucrats chat things up and investors are jumping back into the pool--many with both hands and feet.

Echoing Mr P, my view is that any appearance of stability is merely an illusion, one that has been facilitated by throwing tens of trillion$ at a system that is effectively broken. More debt and spending can't solve a debt and spending problem. Current interventions merely serve to make the system more unstable down the road.

Instability favors extreme outcomes when potential energy turns kinetic. Two extreme scenarios seem plausible. One is a high inflation situation, where attitudes reverse towards greater risk seeking. Borrowing and debt expand--perhaps at even greater rates than those witnessed during the past few decades. Prices, particularly those linked to materials, scream higher. As commodity prices have just completed their biggest monthly jump in more than 30 years, market participants are casting a strong vote for this scenario.

The other plausible scenario is that after a stint of 'reflation,' a secular deflationary trend re-establishes itself. Credit markets, already up to their eyeballs in US debt, shut down for domestic borrowers. Borrowers, moreover, lose their appetite for risk, given the already extended state of their balance sheets. Prices of risky assets resume their decline.

I've waffled in my probability assignments toward these scenarios. For many years, I was entrenched in the deflation camp, which served my in pretty good stead. But after last year's collapse and the massive interventions brought on by past and current administrations, chances of the high inflation situation ratcheted higher in my eyes.

Now, however, I'm once again leaning towards the deflationary scene. There's still too much debt out there (not enough has been destroyed yet), and my sense is that borrowers and lenders are losing their appetite for risk. Most 'cash' out there is not free cash, but rather borrowed and linked to a liability. Rather than plowing this cash back into risky assets, there's a good argument to be made that people will use this cash to pay down debt. And because of the massive quantity of debt out there, this situation could last a long time.

As such, I've tilted my portfolio back towards the deflationary possibility. After shedding most of my commodity exposure after this recent run, I'm holding more cash than I have in a long time. Although I recently borrowed to buy a house, my plan is to chunk my mortgage down at an accelerated pace.

Should the inflation scenario win out, I'm holding a few dividend paying stocks as well as some gold as a hedge.

While financial markets can certainly run a while, my growing sense is that risk is high and getting higher.

position in gold