What is a bull market?

May 22, 2017

[This post is a slightly-modified excerpt from a recent TSI commentary]

A reasonable definition of a bull market must be practical. This means that it must take into account the fact that what people really want from an investment is an increase in purchasing power, not just an increase in price. Figuring out whether or not an investment is in a bull market is therefore not as straightforward as observing its long-term trend in nominal currency terms.

Here’s a great example of why looking only at nominal price change doesn’t necessarily indicate whether or not something is in a bull market: Ten years ago, the price of everything in the world was in a powerful upward trend when price was expressed in terms of the Zimbabwe dollar. Obviously, it was far more reasonable in this case to say that the Zimbabwe dollar was in a bear market than to say that everything else was in a bull market.

The Zimbabwe example is extreme, but the fact is that all of today’s official currencies are losing purchasing power (PP). They are losing PP at different rates and some are losing PP quite slowly at the present time, but not one of them is likely to be a good measuring stick over a long period.

Unfortunately, determining whether or not an investment is gaining value in real terms is problematic due to the impossibility of coming up with a single number that reflects the economy-wide PP of money. We have a method of adjusting for the effects of monetary inflation that should be ‘in the right ballpark’ over periods of more than 5 years, but our method could be wildly inaccurate over periods of less than 2 years. Inflation-adjusting using the official CPI, on the other hand, is likely to be inaccurate over all periods and wildly inaccurate over the long-term.

In a world where the official currencies make poor measuring sticks due to their relentless and variable depreciation, looking at the relative performances of different investments is probably the best way to determine which ones are in bull markets. Furthermore, because they are effectively at opposite ends of an investment seesaw, with one doing best when confidence in money, central banking and government is rising and the other doing best when confidence in money, central banking and government is falling, this is a concept that works especially well for gold bullion and the S&P500 Index (SPX).

There will be times when both gold and the SPX are rising in US$ terms, but it should be possible to tell the one that is in a genuine bull market because it will be the one that is the stronger. More specifically, if the SPX/gold ratio is in a multi-year upward trend then the SPX is in a bull market and gold is not, whereas if the SPX/gold ratio is in a multi-year downward trend then gold is in a bull market and the SPX is not. There will naturally be periods of a year or longer when it will be impossible to determine whether a multi-year trend has reversed or is consolidating (we are now in the midst of such a period), but there is a moving-average crossover* that can be used to confirm a reversal in timely fashion.

In conclusion, it is reasonable to say that an investment is in a bull market if it is in a multi-year upward trend in nominal currency terms AND relative to its main competition.

*Crosses of the 200-week moving average by either the SPX/gold ratio or the gold/SPX ratio have confirmed bull-bear transitions with only two false signals since the early-1970s.

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Inflation/deflation and the desire to avoid short-term pain

May 16, 2017

The desire to avoid short-term pain is a powerful motivator. Even in cases where it is known that the steps taken to avoid pain in the short-term will lead to greater pain in the distant future, people will often choose the path that entails lesser short-term pain. Also, there’s often the hope that if pain is postponed for long enough then something will spring up to circumvent the need to experience the pain. The relevance to the inflation-deflation issue is that the long-term cure for an economy suffering from the bad effects of high monetary inflation involves stopping the inflation, but stopping the inflation always results in short-term pain.

Nowadays, people look back at the devastating inflation that occurred in Germany in the early 1920s and think: “How could the central bankers of that era have been so stupid? There’s no way that the stewards of today’s major currencies would make the same mistakes!” In real time, however, the gross stupidity of the German central bank’s actions was only apparent to a small number of economists. At each step along the way to total monetary collapse, the pain involved in stopping the money-printing was weighed against the cost of continuing the inflation and it always appeared to make sense to continue the inflation for just a little longer.

It’s very unlikely that a hyperinflationary collapse will happen in any of the major industrialised economies within the next two years, but having watched the Bernanke-Yellen Fed, the Draghi ECB and the Kuroda BOJ in action it is not hard for me to imagine such a collapse eventually happening. I cite, for instance, the fact that ECB chief Mario Draghi is arguing the need to sustain an aggressive monetary “stimulus” program even though it should be clear to anyone with eyes and a modicum of economics knowledge that the “stimulus” implemented to date has been an abject failure. I also cite the very popular and yet completely wrongheaded tendency to measure the success of a policy by the stock market’s response to the policy. By this measuring stick, pumping new money into the economy will usually look smart. Lastly, I cite the widely-held conviction that it is up to the central bank and the government to do something ‘stimulative’ whenever signs of economic weakness emerge, despite the mountain of evidence that earlier attempts to ‘do something’ resulted in bad unintended consequences. The sad truth is that the framers of monetary and fiscal policies are strongly influenced by faulty economic theory and short-term thinking, and that’s not going to change anytime soon.

The day might come when the costs of continuing the inflation are so widely understood that there exists the political will to bring the money-depreciating policies to an end, but don’t hold your breath waiting for that day. If the day does come it will likely be years from now. In the mean time, the desire to avoid short-term pain will reign supreme.

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Gold, Commodities and Economic Confidence

May 10, 2017

To believe that the gold market is influenced by the manipulation of a banking cartel to the extent that the gold price doesn’t reflect the true fundamental drivers it is necessary to have almost no understanding of what those price drivers are and how they should affect the market. There are many fundamental relationships between gold and other markets that I could show in chart form to support this statement, but in this post I’ll focus on a chart that illustrates the relationship between gold, commodities and economic confidence.

The change in the average credit spread, that is, the change in the average difference between yields on relatively high-risk and relatively low-risk bonds, is a good indicator of changes in economic confidence. Specifically, when credit spreads are widening it means that confidence is on the decline and when credit spreads are narrowing it means that confidence is on the rise.

Fortunately, there are a number of easy and accurate ways of determining whether credit spreads are widening or narrowing. One that I like to use is the IEF/HYG ratio. This ratio is the price of an ETF that holds 7-10 year Treasury securities divided by the price of an ETF that holds junk bonds of similar duration. A rising IEF/HYG ratio indicates widening credit spreads (falling economic confidence) and a falling IEF/HYG ratio indicates narrowing credit spreads (rising economic confidence).

Those who understand gold’s role in the financial world would know that the gold price should generally trend upward relative to the prices of most other commodities (as represented by a broad-based commodity index such as GNX) when economic confidence is on the decline and trend downward relative to the prices of most other commodities when economic confidence is on the rise. Absent manipulative forces that prevent gold from behaving in the proper way, what we should therefore see is a positive correlation between the gold/commodity ratio and the IEF/HYG ratio. This is exactly what we do see in the following chart.

goldGNX_IEFHYG_090517

All markets are, always have been and always will be manipulated, but this generally doesn’t prevent them from responding in a reasonable way to the genuine fundamentals over multi-month periods.

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The insidious effects of monetary inflation

May 9, 2017

Most people with a basic grounding in economics know that increasing the supply of money leads to a fall in the purchasing power of money. However, this is usually as far as their understanding goes and explains why monetary inflation is generally not unpopular unless the cost of living happens to be rising rapidly. Monetary inflation would be far more unpopular if its other effects were widely understood.

Here are some of these other effects:

1. A greater wealth gap between rich and poor. For example, monetary inflation is probably a large part of the reason that the percentage of US household wealth owned by the richest 0.1% of Americans has risen from 7% to 23% since the mid-1970s and is now, for the first time since the late-1930s, greater than the percentage US household wealth owned by the bottom 90%. Inflation works this way because asset prices usually respond more quickly than the price of labour to increases in the money supply, and because the richer you are the better-positioned you will generally be to protect yourself from, or profit from, rising prices.

2. Large multi-year swings in the economy (a boom/bust cycle), with the net result over the entire cycle being sub-par economic progress due to the wealth that ends up being consumed during the boom phase.

3. Reduced competitiveness of industry within economies with relatively high monetary inflation rates, due to the combination of rising material costs and distorted price signals. The distortion of price signals caused by monetary inflation is very important because these signals tell the market what/how-much to produce and what to invest in, meaning that there will be a lot of misdirected investment and inefficient use of resources if the signals are misleading.

4. Higher unemployment (an eventual knock-on effect of the misdirection of investment mentioned above).

5. A decline or stagnation in real wages over the course of the inflation-generated boom/bust cycle. I point out, for example, that real median household income in the US was about the same in 2015 as it was in 1998 and that the median weekly real earnings level in the US was about the same in Q3-2016 as it was in Q1-2002.

Real earnings decline or stagnate because during the boom phase of the cycle wages will usually be near the end of the line when it comes to responding to the additional money, whereas during the bust phase the higher unemployment rate (the excess supply of labour) will put downward pressure on wages.

Note that while a lower average real wage will partially offset the decline in industrial competitiveness resulting from distorted price signals, it won’t result in a net competitive advantage. It should be intuitively obvious — although to the Keynesians it apparently isn’t — that an economy could never achieve a net competitive advantage from what amounts to counterfeiting on a grand scale. In any case, what sort of economist would advocate a course of action that firstly made the economy less efficient and secondly tried to make up for the loss of efficiency by reducing living standards (a reduction in real wages equals a reduction in living standards).

6. More speculating and less saving. The greater the monetary inflation, the less sense it will make to save in the traditional way and the more sense it will make to speculate. This is problematic for two main reasons. First, saving is the foundation of long-term economic progress. Second, most people aren’t adept at financial speculation.

7. Weaker balance sheets, because during the initial stages of monetary inflation — the stages that occur before the cost of living and interest rates begin to surge — people will usually be rewarded for using debt-based leverage.

8. Financial crises. Rampant mal-investment, speculation and debt accumulation are the ingredients of a financial crisis such as the one that occurred during 2007-2009.

The above is a sampling of what happens when central bankers try to ‘help’ the economy by creating money out of nothing.

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