Stocks and oil both held steady on Friday.

Gold, however, took a big hit – minus $26.

There are three kinds of money in the marketplace. There’s the smart money that goes with the trend. There’s the dumb money that bets against the trend. And there’s the money that doesn’t know whether it is coming or going.

The trouble is always figuring out which is which.

The markets are clearly in a deflationary downturn. No doubt about it. After a long period of credit expansion credit is finally contracting. The smart money is probably betting on lower asset prices.

“Consumer credit falls the second most on record,” reported Bloomberg last Thursday.

Houses, as everyone knows, are deflating. There are signs that the fall in housing prices is becoming less violent, but the trend is still down.

This from Robert Shiller, in the New York Times:

“Long declines do happen with some regularity. And despite the uptick last week in pending home sales and recent improvement in consumer confidence, we still appear to be in a continuing price decline.

“There are many historical examples. After the bursting of the Japanese housing bubble in 1991, land prices in Japan’s major cities fell every single year for 15 consecutive years.

“Why does this happen?”

Shiller goes on to explain that housing markets don’t adjust quickly. People make their housing decisions years in advance…based on changes in their lives. They may have found a job somewhere…or gotten a divorce…or their children may have left home…or they might just want to live in a different area. These plans take years to come together…and years to execute. They can be reversed by changes in market conditions…but not quickly.

And then, when people are planning to sell a house, they may not be in a hurry. If prices slip, they may decide to hold off – maybe for years.

Then too, decisions about buying or selling a house are often decisions taken by two people together. The husband may be desperate to get out of a sinking housing market, for example, but the wife may not want to leave her home. Even when they must sell for financial reasons, that decision can take months…even years…to reach. Often, they hesitate. The wife expects to get a better job…or the husband expects a raise…or they anticipate some other economic change in their lives that would forestall the need to sell their house.

Then, after the decision is made, there’s the actual process of selling a house — setting a price…and finding a willing buyer. In a downward market, buyers’ expectations tend to adjust most quickly. Reading in the paper about a correction in the housing market, the prospective buyer expects a great deal. The prospective seller, on the other hand, tends to deny the severity of the downturn. He reluctantly and belatedly acknowledges that he’ll need to lower his price. But as he gives in the market gives way further. The prospective buyer hears about more great deals that other buyers are getting…and he lowers his price targets even faster than the sellers lower their asking price.

Shiller gives another example…

“An elderly couple who during the boom were holding out against selling their home and moving to a continuing-care retirement community have decided that it’s finally the time to do so. It may take them a year or two to sort through a lifetime of belongings and prepare for the move, but they may never revisit their decision again.

“As a result, we will have a seller and no buyer, and there will be that much less demand relative to supply – and one more reason that prices may continue to fall, or stagnate, in 2010 or 2011.

“All of these people could be made to change their plans if a sharp improvement in the economy got their attention. The young couple could change their minds and decide to buy next year, and the elderly couple could decide to further postpone their selling. That would leave us with a buyer and no seller, providing an upward kick to the market price….

“Even if there is a quick end to the recession, the housing market’s poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.”

We’re also looking at $2.4 trillion worth of Alt-A mortgages that will need to be refinanced or reset. The peak in those resets won’t happen until January 2013.

So stay tuned…this housing bear market isn’t going away any time soon.

Housing is wealth for America’s middle class. As long as housing is going down – or even NOT going up – the middle class is going to feel poor. It has the huge debts that it built up during the credit expansion…and it has to pay them, even though it has 1) falling incomes…and 2) falling assets.

The smart money is probably betting that this deflationary correction has further to go…probably much further to go.

But against this natural, normal — and probably inevitable — market trend are the hopes and fantasies of an entire generation. The baby boomers have staked their futures on continuing EZ credit. So have their leaders. And so now, the feds and the voters are of one mind. Both want to stop the market correction AT ALL COST – especially if they can lay the bill onto the next generation.

Now, here’s where it gets interesting. Because the dumb money is probably betting that the feds can make this work. That’s what all this talk of “green shoots” is about. A huge part of the public believes that the ‘worst is over’…and that the feds’ policies are working. They’re buying stocks in the belief that this is a recession just like any recession of the post-war period. Ben Bernanke says it will be over by Christmas; they believe him.

Meanwhile, there are some very smart people who think the feds’ efforts not only won’t work…but will create an even bigger disaster. Those people are buying gold…and commodities.

David Einhorn, the hedge fund manager who foresaw Lehman Bros. going broke, is now buying gold. John Paulson, who made billions by being right about the credit crisis, is also buying gold. The Chinese are buying gold. So many smart people are buying gold coins that they have become hard to get.

What’s our view? Who’s right? The dumb money; the smart money; or the very smart money?

They may be all right…but at different times. This rally could last a while longer. Then, prices will probably resume their downward path…and then, eventually, inflation fears will send gold soaring.

We continue to answer the question – “will we have inflation or deflation” – in the positive. ‘Yes,’ we say, ‘both of them.’

The markets must fully express themselves – which means they need to bounce…and then take the stuffing out of asset prices. Today’s asset prices represent yesterday’s economic calculations. The value of a house, for example, depends the economic conditions of the bubble period, 2002-2007…and on the whole swell of the great post-war credit expansion. That house price is now adjusting to the post-bubble era…when people have lower living standards and less expectation of a rising housing market. That adjustment will take many years and eventually leave house prices probably 20% to 30% below where they are today.

But the feds must fully express themselves too. They’re bound and determined to cause inflation. They believe the country’s financial future depends on it. It may take them a long time to get the upper hand in their war against capitalism…but eventually, they will do it. And eventually, the very smart money will be proven right – when the dollar collapses…and gold goes up.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.