Gold’s True Fundamentals

June 23, 2017

[This post is a modified excerpt from a TSI commentary published a few weeks ago]

To paraphrase Jim Grant, gold’s perceived value in US$ terms is the reciprocal of confidence in the Fed and/or the US economy. Consequently, what I refer to as gold’s true fundamentals are measures of confidence in the Fed and/or the US economy. I’ve been covering these fundamental drivers of the gold price in TSI commentaries for almost 17 years. It doesn’t seem that long, but time flies when you’re having fun.

Note that I use the word “true” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the volume of gold being transferred out of the Shanghai Futures Exchange inventory, the amount of “registered” gold at the COMEX, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These aren’t true fundamental price drivers. At best, they are distractions.

In no particular order, the gold market’s six most important fundamental price drivers are the trends in 1) the real interest rate, 2) the yield curve, 3) credit spreads, 4) the relative strength of the banking sector, 5) the US dollar’s exchange rate and 6) commodity prices in general. Even though it creates some duplication, the bond/dollar ratio should also be included.

Until recently I took the above-mentioned price drivers into account to arrive at a qualitative assessment of whether the fundamental backdrop was bullish, bearish or neutral for gold. However, to remove all subjectivity and also to enable changes in the overall fundamental backdrop to be charted over time, I have developed a model that combines the above-mentioned seven influences to arrive at a number that indicates the extent to which the fundamental backdrop is gold-bullish.

Specifically, for each of the seven fundamental drivers/influences I determined the weekly moving average (MA) for which a MA crossover catches the most trend changes in timely fashion with the least number of ‘whipsaws’. It’s a trade-off, because the shorter the MA the sooner it will be crossed following a genuine trend change but the more false trend-change signals it will cause to be generated. I then assign a value of 100 or 0 to the driver depending on whether its position relative to the MA is gold-bullish or gold-bearish. For example, if the yield-curve indicator is ABOVE its pre-determined weekly MA then it will be assigned a value of 100 by the model, because being above the MA points to a steepening yield-curve trend (bullish for gold). Otherwise, it will be zero. For another example, if the real interest rate indicator is BELOW its pre-determined weekly MA then it will be assigned a value of 100 by the model, because being below the MA points to a falling real-interest-rate trend (bullish for gold). Otherwise, it will be zero.

The seven numbers, each of which is either 0 or 100, are then averaged to arrive at a single number that indicates the extent to which the fundamental backdrop is gold-bullish, with 100 indicating maximum bullishness and 0 indicating minimum bullishness (maximum bearishness). The neutral level is 50, but the model’s output will always be either above 50 (bullish) or below 50 (bearish). That’s simply a function of having an odd number of inputs.

Before showing a chart of the Gold True Fundamentals Model (GTFM) it’s worth noting that:

1) The fundamental situation should be viewed as pressure, with a bullish situation putting upward pressure on the price and a bearish situation putting downward pressure on the price. It is certainly possible for the price to move counter to the fundamental pressure for a while, although it’s extremely likely that a large price advance will coincide with the GTFM being in bullish territory most of the time and that a large price decline will coincide with the GTFM being in bearish territory most of the time.

2) The effectiveness of fundamental pressure will be strongly influenced by sentiment (as primarily indicated by the COT data) and relative valuation (as primarily indicated by the gold/commodity ratio). For example, if the fundamental backdrop is bullish and at the same time the gold/commodity ratio is high and the COT data indicate that speculators are aggressively betting on a higher gold price then it is likely that the bullish fundamental backdrop has been factored into the current price and that the remaining upside potential is minimal. The best buying opportunities therefore occur when a bullish fundamental backdrop coincides with pessimistic sentiment and a low gold/commodity ratio.

Getting down to brass tacks, here is a weekly chart comparing the GTFM with the US$ gold price since the beginning of 2011.


A positive correlation between the GTFM and the gold price is apparent on the above chart, which, of course, should be the case if the GTFM is a valid model. If you look closely it should also be apparent that the fundamentals (as represented by the GTFM) tend to lead the gold price at important turning points. For example, the GTFM turned down in advance of the gold price during 2011-2012 and turned up in advance of the gold price in 2015 (the GTFM bottomed in mid-2015 whereas the gold price didn’t bottom until December-2015).

The tendency for gold to react to, rather than anticipate, changes in the fundamentals is not a new development, as evidenced by gold’s delayed reaction to a major fundamental change in the late-1970s. I’m referring to the fact that by the second half of 1978 the monetary environment had turned decisively gold-bearish, but the gold price subsequently experienced a massive rally that didn’t culminate until January-1980.

The GTFM was slightly bearish over the past two weeks, but three of the model’s seven components are close to tipping points so it wouldn’t take much from here to bring about a shift into bullish territory or a further shift into bearish territory. The former is the more likely and could occur as soon as today (23rd June).

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The Central-Bank Moment

June 19, 2017

Hyman Minsky was an economist who popularised the idea that “stability leads to instability”. According to Minsky and his followers, credit expands rapidly during the good times to the point where a lot of borrowing is being done by financially fragile/vulnerable entities, thus sowing the seeds of a financial crisis. That’s why the start of a financial crisis is now often referred to as a “Minsky moment”. Unfortunately, Minsky’s analysis was far too superficial.

Minsky described a process during which financing becomes increasingly speculative. At the start, most of the debt that is taken on can be serviced and repaid using the cash flows generated by the debt-financed investment. At this stage the economy is robust. However, financial success and rising asset prices prompt both borrowers and lenders to take on greater risk, until eventually the economy reaches the point where the servicing of most new debt depends on further increases in asset prices. At this stage the economy is fragile, because anything that interrupts the upward trend in asset prices will potentially set in motion a large-scale liquidation of investments and an economic bust.

This description of the process is largely correct, but rather than drilling down in an effort to find the underlying causes Minsky takes the route of most Keynesians and assumes that the process occurs naturally. That is, underpinning Minsky’s analysis is the assumption that an irresistible tendency to careen from boom to bust and back again is inherent in the capitalist/market economy.

In the view of the world put forward by Keynesians in general and Minsky in particular, people throughout the economy gradually become increasingly optimistic for no real reason and eventually this increasing optimism causes them to take far too many risks. The proverbial chickens then come home to roost (the “Minsky moment” happens). It never occurs to these economists that while any individual could misread the situation and make an investing error for his own idiosyncratic reasons, the only way that there could be an economy-wide cluster of similar errors at the same time is if the one price that affects all investments is providing a misleading signal. The one price that affects all investments is, of course, the price of credit.

Prior to the advent of central banks the price of credit was routinely distorted by fractional reserve banking, which is not a natural part of a market economy. These days, however, the price of credit is distorted primarily by central banks, and the central bank is most definitely not a natural part of a market economy. Therefore, what is now often called a “Minsky moment” could more aptly be called a “central-bank moment”.

I expect the next “central-bank moment” to arrive within the coming 12 months. I also expect that when it does arrive it will generally be called a “Minsky moment” or some other name that deftly misdirects the finger of blame, and that central banks will generally be seen as part of the solution rather than what they are: the biggest part of the problem.

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The limitations of sentiment, revisited

June 12, 2017

In a blog post in March of this year I discussed the limitations of sentiment as a market timing tool. I wrote that while it can be helpful to track the public’s sentiment and use it as a contrary indicator, there are three potential pitfalls associated with using sentiment to guide buying/selling decisions. Here are the pitfalls again:

The first is linked to the reality that sentiment generally follows price, which makes it a near certainty that the overall mood will be at an optimistic extreme near an important price top and a pessimistic extreme near an important price bottom. The problem is that while an important price extreme will always be associated with a sentiment extreme, a sentiment extreme doesn’t necessarily imply an important price extreme.

The second potential pitfall is that what constitutes a sentiment extreme will vary over time, meaning that there are no absolute benchmarks. Of particular relevance, what constitutes dangerous optimism in a bear market will often not be a problem in a bull market and what constitutes extreme fear/pessimism in a bull market will often not signal a good buying opportunity in a bear market.

The third relates to the fact that regardless of what sentiment surveys say, there will always be a lot of bears and a lot of bulls in any financial market. It must be this way otherwise there would be no trading and the market would cease to function. As a consequence, if a survey shows that almost all traders are bullish or that almost all traders are bearish then the survey must be dealing with only a small — and possibly not representative — segment of the overall market.

I went on to write that there was no better example of sentiment’s limitations as a market timing indicator than the US stock market’s performance over the past few years. To illustrate I included a chart from showing the performance of the S&P500 Index (SPX) over the past 30 years with vertical red lines to indicate the weeks when the Investors Intelligence (II) Bull/Bear ratio was at least 3.0 (a bull/bear ratio of 3 or more suggests extreme optimism within the surveyed group). An updated version of the same chart is displayed below.

The chart shows that while vertical red lines (indicating extreme optimism) coincided with most of the important price tops (the 2000 top being a big exception), there were plenty of times when a vertical red line did not coincide with an important price top. It also shows that optimism was extreme almost continuously from Q4-2013 to mid-2015 and that following a correction the optimistic extreme had returned by late-2016.

Sentiment was at an optimistic extreme late last year, at an optimistic extreme when I presented the earlier version of the following chart in March and is still at an optimistic extreme. In effect, sentiment has been consistent with a bull market top for the bulk of the past four years, but there is still no evidence in the price action that the bull market has ended.

Regardless of what happens from here, four years is a long time for a contrarian to be wrong.


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The “debt jubilee” nonsense

June 6, 2017

This post is a rehash of something I wrote at TSI last September in response to the article titled “The Gold Standard and Debt Jubilee“. The article is a confused jumble of Marxist, biblical and capitalist ideas/assertions, but its gist is that we need both a debt jubilee and a gold standard. My views are that a gold standard is not a worthwhile objective and that a debt jubilee would be both an economic and an ethical disaster.

If the market for money were free then gold would probably be money. However, there would NOT be a gold standard. A gold standard is, by definition, a monetary system imposed by government, whereas in a truly free market the government would have no role in determining what is/isn’t money.

Under a gold standard the government sets the rate at which money-substitutes such as dollar notes are convertible into gold. A gold standard is therefore a type of government price-fixing scheme.

It can certainly be argued that a gold standard would be a better monetary system than the one we have today, but there’s no reason to expect that it wouldn’t eventually transmogrify into what we have today. After all, the current system evolved from a gold standard.

That’s why I say that a gold standard is not a worthwhile objective. A worthwhile objective is to get the government out of the money business and allow people to use whatever money they want.

I’ll now turn to the “debt jubilee”, which entails wiping the slate clean of ALL existing debts. Here’s how it is described in the article linked above:

A “jubilee” is the complete renunciation of all debts. Any/all debt instruments become null-and-void. Debt Slavery is abolished. The Workers are allowed to retain the fruits of their labours, and use their productive efforts to build and improve their societies — rather than simply fattening financial Criminals.“*

And who would provide “the Workers” with all the capital equipment and education they need to be productive? And who would lend the money needed to fund new businesses, invent new products and conduct life-improving medical research? The financial criminals, perhaps?

Details, details.

There are all sorts of economic and ethical problems with the “debt jubilee” concept, but the biggest problem is that it amounts to the government stealing wealth from all lenders and giving it to all borrowers. The more profligate you were prior to the “jubilee” the more that you would ‘make out like a bandit’ as a result of the “jubilee”.

It would result in economic devastation, because many of the most productive members of society would be financially crushed and the ones who weren’t financially crushed would never lend their money again.

The dire economic consequences of a “debt jubilee” and the terrible injustice of it is why it has probably never happened in world history and probably never will happen.

As an aside, if a “jubilee” event ever occurred in the past it was during “biblical times”, but that’s hardly a selling point. These were times when there was no economic progress (there was no general improvement in living standards from one generation to the next), most people died before the age of one, the best the average person could reasonably hope for was basic subsistence, and slavery was both widespread and generally accepted.

The only type of debt for which a good-faith repayment effort is not justified is government debt. This is because government debt is repaid via theft. As the great Murray Rothbard eloquently put it: “The purchase of a government bond is simply making an investment in the future loot from the robbery of taxation.” The appropriate punishment for lending money to the government is a 100% loss on investment, so wiping the government’s debt-slate clean would be a good thing.

Fortunately, discussions about a “debt jubilee” are purely academic as it is not something that has a chance of happening. Moreover, nobody with respect for property rights and a reasonable understanding of economics would advocate it.

*Note that the “jubilee” definition used by the author of “The Gold Standard and Debt Jubilee” and that has become popular is not consistent with the way “jubilee” is described in the Old Testament. In particular, the original biblical description does NOT imply that debts are forgiven. Refer to “Five Myths about Jubilee” for more information.

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Random thoughts on Global Warming

June 2, 2017

1. Intellectual honesty requires that the issue be referred to as “Global Warming” and not “Climate Change”. The theory is that human-generated CO2 is causing the world to warm up, not that humans are causing the climate to change. The climate is always changing. It was changing long before humans existed and will be changing long after humans become extinct.

2. Anthropogenic Global Warming (AGW) is a hot/emotional topic because it is perceived as a potential excuse for more government intervention in the economy, that is, for a more powerful government.

3. Due to the above point, the more libertarian-minded a person the more likely that he will disbelieve the AGW theory and be on the lookout for evidence that refutes or is inconsistent with the theory, whereas the stronger a person’s belief in a big role for government the more likely that he will be a proponent of the AGW theory and on the lookout for evidence that supports the theory.

4. It should be a question for science, not politics, and the science is definitely not settled. There are very knowledgeable people on both sides of the debate, the models that link global temperature to prior changes in the amount atmospheric CO2 have generally not worked, and in any case the science is never settled (it is constantly evolving).

5. The real issue is pollution, not global warming or climate change. Pollution is a serious problem in many parts of the world.

6. Pollution is a property rights issue, or at least it should be. In countries where there is no or minimal respect for private property rights and particularly in countries with very powerful or all-powerful governments, pollution tends to be a bigger problem and the frequency of ecological disasters tends to be greater.

7. In a free country, the amount of pollution that was deemed acceptable would be determined by the law courts, not government regulation. It’s likely that the amount deemed acceptable when dealt with as a property rights issue by the law courts would generally be less than the amount allowed by current government regulations.

8. It is often the case that one side in the debate labels the other side in ways that are designed to make the other side look bad. For example, referring to AGW skeptics as “deniers” or “denialists” and AGW advocates as “alarmists” or “hysterics”. This is a form of ad hominem attack. A person who uses the aforementioned words to describe the other side may as well hold up a sign that reads “I’m not looking at the issue objectively”.

9. Characterising the issue as believers versus non-believers in climate change is a deliberate attempt to mislead (it’s a type of “straw man” argument) because there is no debate as to whether or not the climate is changing. Everyone with a modicum of general knowledge knows that the climate has always been changing and will always change. The issue under debate is the effect of man on the climate.

10. A scientist making an honest and rigorous attempt to determine the effect of man on climate must necessarily analyse the other influences on climate, chief among them being the sun. Furthermore, he must deal with questions like: Given that the Earth’s climate has always been cycling, with long periods of cooling followed by long periods of warming, and that the Earth was warmer during pre-industrialisation periods when human activity could not have had any effect whatsoever on climate, why should the latest warming cycle be attributed primarily to human activity?

11. Even if we assume that Global Warming is still happening, that it is a problem to be reckoned with and that it is caused by Man, the claim that the best solution is for the government to become more involved in policing economic activity is, at best, the triumph of hope and naïveté over experience, logic and good economic theory. If history has taught us anything it is that when the government tries to fix a problem by getting more involved in the economy it either causes the original problem to become worse or creates an even bigger problem elsewhere.

12. It is error alone that needs the support of government. Truth can stand by itself. (Thomas Jefferson)

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The World Gold Council’s gold market analysis is useless

May 30, 2017

A few weeks ago the World Gold Council (WGC) published its “Gold Demand Trends” report for the first quarter of 2017. These reports actually provide no information about gold demand and in my opinion are useless. In fact, they are worse than useless because they are misleading.

It is axiomatic that at any given time the total demand for gold equals the total supply of gold, which, in turn, equals the total aboveground gold inventory. The total aboveground gold inventory is somewhere between 150K and 200K tonnes, so at any given time the total demand for gold lies somewhere between 150K and 200K tonnes.

When new buyers enter the market they draw from the existing aboveground supply. These new buyers cannot possibly increase the total demand, because the increased demand on the part of people who add to their gold ownership will always be exactly offset by the decreased demand on the part of people who reduce their gold ownership.

A balance is maintained by the changing price. For example, if there are more buyers than sellers at a particular price or the buyers are more motivated than the sellers then the price will rise to establish a new balance. Therefore, a price rise is irrefutable evidence of a momentary rise in demand relative to supply and a price decline is irrefutable evidence of a momentary fall in demand relative to supply.

Importantly, the change in price is the ONLY reliable indication of an attempt by demand to rise or fall relative to supply. Any statement to the effect that a price rise was accompanied by reduced demand or that a price decline was accompanied by increased demand is therefore ludicrous.

The effect of the gold-mining industry is to increase the total aboveground gold supply by about 1.5% every year. Actually, as the result of gold mining both the total supply and the total demand increase by about 1.5% every year, since demand and supply must always be equal with price changing to maintain the balance.

Although gold miners are adding new gold to the total supply, the newly-mined gold is no more capable of satisfying current demand than gold that was mined in the distant past. Consequently, gold miners are similar to any other sellers. The one significant difference is that a gold miner will generally take whatever price is on offer, whereas most other owners of gold will have a price in mind at which they will sell (and below which they will not sell). In some cases this price will be a great distance above the current price and in other cases the owner of gold will intend to hold indefinitely regardless of how high the price rises. All of these intentions by the existing holders of gold contribute to the performance of the gold price.

Getting back to the WGC reports, what is being referred to as gold demand is actually just the sum of some easy-to-identify gold flows. In effect, these reports confuse trading volume with demand. Furthermore, they don’t even come close to accounting for all trading volume. What they essentially do is begin with the wrongheaded assumption that the total supply of gold equals the amount of annual mine production plus recycled gold plus producer hedging, or an amount of around 4,000 tonnes. They therefore begin with the assumption that the total supply of gold is about 1/50th of its actual amount. They then come up with a bunch of so-called (but not actual) demand figures, including the amount of gold moving into bullion ETFs and the amount of gold sold in jewellery form, that add up to about 4,000 tonnes.

As an aside, there will usually be a positive correlation between the gold price and the amount of gold moving into gold ETFs, but that’s only because the ETF inventory often FOLLOWS the price. I’ve discussed this in previous blog posts.

Summing up, the gold supply/demand reports put out by the WGC are based on numerous logical errors and misconceptions, such as ignoring the dominant role played by the aboveground gold stock, treating transfers from some sellers to some buyers as indicative of changing overall demand, and assuming that shifts in demand can be determined independently of price. Due to these deficiencies they are worse than useless.

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Why bad economic theories remain popular

May 26, 2017

Ludwig von Mises and Friedrich Hayek, the most prominent “Austrian” economists of the time, anticipated the 1929 stock market crash and correctly predicted the dire consequences of government attempts to artificially stimulate economic growth in the aftermath of the crash. John Maynard Keynes, on the other hand, was totally blindsided by the stock market crash and the economic disaster of the early 1930s. And yet, Keynes’s theories gained enormous popularity during the 1930s whereas the work of Mises and Hayek was largely ignored. Why was it so?

Keynes became popular because he told the politically powerful what they wanted to hear. In particular, he provided power-hungry politicians with intellectual support for the schemes they not only already had in mind, but in many cases were already putting into practice. Despite being riddled with errors, Keynes’ theories also appealed to many economists because the implementation of these theories would confer a lot more influence upon the economics fraternity. The fact is that in a free economy there wouldn’t be much for an economist to do other than teach economics. He/she would certainly never have the opportunity to be involved in the ‘management’ of the economy.

The points outlined in the above paragraph, along with Keynes’ charisma and salesmanship, explain why “Keynesian” economic theories became dominant, but it doesn’t explain how they managed to stay dominant in the face of an ever-growing mountain of evidence indicating that they result in long-term economic decline.

As far as I can tell, the theories have stayed popular for three  main reasons. First, not only do they mesh with the personal goals of almost all current politicians, but also there is now a huge government apparatus in place that depends upon the continued application of these theories. In other words, a large chunk of the population now has a vested interest in perpetuating the myth that the government should ‘manage’ the economy. Second, it usually isn’t possible to disprove an economic theory using data, because the same data can usually be interpreted in different ways and used to justify opposing theories. The hard reality is that in the science of economics you must start with the correct theory in order to correctly interpret the data. Third, Keynesianism is more like a stream of anecdotes than a coherent theory, in that under this so-called theory most things are ‘explained’ by unforeseeable events and unpredictable shifts in “animal spirits”. It is impossible to invalidate an intellectual position that is constantly changing.

A good example of how the same data can be interpreted in different ways in order to support conflicting theories is provided by the 1937-1939 collapse of the US economy. According to the “Austrians”, the fact that the US federal government propped up prices, drastically increased its spending, inflated the money supply, began interfering with many industries and generally did whatever it could to prevent the corrective process from running its course following the 1929 stock market crash guaranteed that all signs of economic recovery would quickly disappear as soon as the artificial support was scaled back. The mistake, according to the “Austrians”, was to provide the artificial support. According to the “Keynesians”, however, the mistake was to remove the artificial support prematurely. They argue that the government and the Fed should have continued to do whatever was needed to postpone a collapse, the idea being that with enough government assistance in the form of new money, new regulations, handouts, price controls and job-creating public works projects the economy would eventually gain enough strength to become self-supporting.

Unfortunately, when throwing ‘Keynesian stimulus’ in the form of more government spending, more credit and more monetary inflation at an economic downturn doesn’t lead to a self-sustaining recovery, the followers of Keynes will always have two comebacks. They can always assert that the stimulus would have worked if only it had been done more aggressively and/or that as bad as the economy has performed it would have performed even worse if not for the stimulus.

You can’t argue with that. At least, it’s an assertion that can never be unequivocally invalidated because it is never possible to go back in time and show what would have happened with different policies.

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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.


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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