While most investors remain fixated on the spectacular damage done to financial shares this year, another sector of the market is suffering from major heartburn – gold mining stocks.

Amid a violent transition from inflation to outright deflation since July, investors have trashed natural resource stocks, including gold mining stocks. Many of these shares now sit about 50-75% off their all-time highs as the destruction of credit chokes off the biggest bull market for raw materials in history. China, the world’s largest consumer of commodities, saw its economy slow to 2002 levels in Q3, expanding at 9%. That compares to a 10% expansion in Q2.

Gold stocks as measured by the Philadelphia Gold & Silver Index or XAU Index, has collapsed since hitting an all-time high of 206.37 in April.

From its best levels, the XAU Index of major mining stocks has plunged 58%. Since July 1, the XAU Index has tanked 56%.

Compared to gold, the gold stocks have been a poor proxy over the last 12 months.

Gold prices have gained a cumulative 1% since October 2007 versus a crushing 51% loss for the XAU Index. Over the last 12 months, the Reuters-CRB Index of commodities has declined 17%.

This marks one of the rare occasions in history where a market anomaly has occurred between the physical metal and the underlying shares. It has happened before. The most violent disconnect occurred in 1979 as gold stocks broke down while gold bullion blasted off to hit a peak of $850 an ounce by January 1980.

The accelerated threat of deflation since July has resulted in a wholesale liquidation of assets as investors raise cold hard cash. The dollar, reining supreme since hitting the basement in July, is a consequence of a flight to liquidity, not a flight to safety. Global risk-based assets are coming home to meet redemptions, margin calls and bearish portfolio manager asset allocation changes. This includes even gold – a highly liquid asset.

It is incorrect to assume that the dollar is strong because the euro is weak; the dollar and the euro are declining vis-à-vis the Japanese yen. All three major currencies are a bunch of drunks with no real value and subjected to the same poor economic fundamentals that point to an ultimate victory for gold.

I suspect this short-term rally for the dollar will end rather violently once the world finally settles down and credit markets normalize. This process has already begun with LIBOR rates down sharply since last Friday.

The dollar will resume its long-term decline because the United States is on course to expand its balance-sheet by ultimately monetizing the debt or buying back Treasury securities. The funding obligations required for this bailout are staggering and will likely run into the trillions before it’s over. The U.S. will suffocate the financial system with T-bonds. Inflation will make a comeback and the Fed will make it happen.

At some point foreign lenders will demand higher interest rate premiums, especially at the long end of the yield curve, to compensate for massive Treasury issuance or booming supply. It won’t happen overnight but long term rates will rise substantially over the next 24-36 months as an overwhelming supply of Treasury bonds saturates demand. Do you honestly believe 30-year U.S. money should be trading at 4.14% this morning?

Jim Bianco, a very astute market seer, claims the United States is flushing the financial system with too many dollars, possibly creating the seeds of hyper-inflation. I’m not sure we’ll get to that extreme but it’s certainly unbelievable that gold prices are sitting at $750 an ounce this morning when global markets are torn at the seams. Gold has been a disappointment this year – down 27% from its all-time high in March.

If a banking crisis coupled with the worst credit crisis since the 1930s won’t lift gold prices, then what will?

Inflation and a renewed monetary crisis, probably starting in Europe, will put gold back on course to $2,000 an ounce or more before this bull market is over. The United States, Europe and other countries will spend their way into oblivion in order to arrest debilitating deflation.

This is exactly the time to dive into gold and the huge values now widespread in the gold mining sector. The declines have been enormous. Judging by previous market declines of this nature over the last 20 years, gold stocks should be accumulated at these prices along with physical gold.