As most of you already know, I have for years been in the vanguard warning about the inflationary policies pursued by global governments and central banks. However, we now face a hiatus of monetary intervention and that has once again brought about the fear of deflation-which is the natural countervailing force to inflation.

The value of any currency is what the market perceives its value to be. Even though there may not be an actual reduction in the supply or that currency, the market will price in the effects of a decrease in the second derivative of money supply growth and the possible eventuality of deflation; if market forces are allowed to operate.

 In the U.S. for example, during the late summer and early fall of 2008, M3 was growing at a 10-15% annual rate. It wasn't until the beginning of 2009 that money supply growth rates began to decline rapidly. And they didn't actually turn negative until the fall of 2009. Money supply growth rates bottomed out in May of 2010 at a -9%

However, markets first began to price in the decline in money supply growth during the summer of 2008. Oil prices began to fall from $147 in July of 2008, down to $33 per barrel by early 2009. The S&P 500 went into free-fall starting in September of 2008 and bottomed out in March of 2009-falling almost 50% in six months.

The point here is that you don't need deflation-a reduction in the outstanding supply of money-to have markets react to a decrease in the rate of money supply growth and to then anticipate the eventual deflation. This is what has already happened to the gold mining sector.

Today we find that M3 is still rising at a 3% annual rate, but that is down from the 6% annual rate of growth at the start of 2012. Therefore, commodities prices have reacted to the slowdown in money supply growth and the direction towards deflation.

Investors need to understand that gold mining stocks have already discounted a severe dose of deflation, which in my view has a very low likelihood of actually coming to fruition. Remember, central banks may be on a counterfeiting holiday but they have a history of taking very short vacations.

Just as oil and equity values declined in 2008, in the anticipation of a much stronger dollar, the gold mining shares have now retreated to a level that forebodes massive sovereign defaults in Europe, Japan and quite possibly even in the U.S.. Since a deflationary depression and a tremendous reduction in gold prices have already been priced into gold stocks, the odds strongly favor a rally at this juncture. But, it should be made clear that mining shares will still need the support of central banks to embark on a new and sustainable secular bull market.

Michael Pento
President: Pento Portfolio Strategies
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